Track record: it’s one of the building blocks of all fund selection strategies. Managers who cannot at least submit a three-year performance record will not qualify for many investors. In the shady, uncertain, noisefilled world of investments, anyone can claim to be an alpha generator. But not everyone can answer the challenge: “Go on then, prove it.” That is the comfort track record gives.
And yet track record is also one of the most notoriously unreliable indicators of the future, to the extent that some research has shown that good past performance can actually be a contrarian indicator. So what is its appropriate place in the selection process and what behavioural biases does a track record incite in a fund selector? Can you actually do without it?
For Omar Gadsby, head of fixed income fund selection for the private banking arm of Credit Suisse, the track record is a cornerstone in his selection process. “When selecting a [alternative Ucits] fund, I assess the Sortino ratio, the performance and volatility,” he says. He looks at other factors too, such as the intrinsic strategy applied by the fund manager. “But in the end we want to see the track record as demonstrable evidence that the strategy works.”
Fund selector split
According to Javier Hoyos Oyarzabal (pictured left), an investment manager for Crédit Agricole Mercagestion SGIIC in the Basque region of Spain, there are two types of fund selectors. “For me, nothing but past performance counts, so the track record is definitely one of the main points,” he explains. “In principle, I want a manager to show me a track record all the way back to 2007, the last year financial markets behaved normally. “However, some fund selectors are more specialised and are focused on discovering specific new talents in managers. But that’s not how we work.”
Rasmus Soegaard, who is in charge of the selection of alternative Ucits funds for Old Mutual Global Investors in London, is someone who fits in the latter definition. Moreover, he prefers avoiding the track record altogether.
“I would get fired if I selected a fund on the basis of its track record,” he says. “I can’t make a decision based on how a fund performed in the past. A track record could be luck. Moreover, I haven’t yet seen a correlation between past and future performance.
“What I want to understand is whether a manager can generate return in the future. Besides that, past performance can be misleading because there are many examples of funds out there which have, for example, changed their volatility target or investment policy on the way,” he says. So you then basically buy them on the basis of what they have done in the strategiespast, not what they are doing [image_library_tag 9117b5c4-d53b-4efe-90b2-007bc0c01946 130×195 ” style=”width: 130px; height: 195px; float: right; margin: 10px;” title=”Soegaard,-Rasmus280.jpg” ]now.”
So Soegaard gives priority to rather less quantifiable selection criteria. He explains: “Absolute transparency of the investment process and unrestricted access to the managers is key for me, while the right management and performance fees are extremely important to me as well.”
But in the end, Soegaard’s basically looking for one thing: a manager who is able to exploit inefficiencies in the market. “For me, inefficiency is the main opportunity to generate return,” he says. “Most alternative fund managers focus on what they term alpha, but that is usually nothing more than some form of market risk premium. What I look for instead, is whether a manager has the right skill set to exploit particular market inefficiencies.”
Trapped by the bias
Fund selectors who adhere to using the track record accept that there is a range of biases which could fool them. Some of the most prominent of these biases are the recency bias and the confirmation bias. The former refers to overemphasis on the most recent performance data, while the latter means fund selectors tend to turn a blind eye to any negative qualities of a fund after having initially been impressed by its track record.
“Every fund selector should acknowledge that sooner or later he falls into every bias. It’s just very difficult to avoid them,” says Hoyos Oyarzabal. The most dangerous bias for him is the herd instinct, or going with the crowd. This is caused by investors’ irrational feeling that it is safer to take a risk which everyone takes, by buying a popular fund, than to invest in a relatively new strategy which is not commonly used.
“When I started fund selection, I only used large houses. I had a shortlist of 10 to 12 funds I could invest in, only to discover later that nine of these funds were among the most popular in Spain. I must admit I felt more relaxed when I noticed that some of my competitors had chosen the same fund on their buy lists as I had.”
Hoyos Oyarzabal notes that this herd instinct has become more common, especially with private banks.
“Clients demand funds from asset managers which have targeted their marketing directly at them. As a consequence funds from these houses have become very popular. However, this is not always justified by their performance.”
Snub or embrace?
So even the biggest track-record fans acknowledge the pitfalls associated with them. Some fund selectors therefore deliberately ignore the track record initially in an attempt to avoid being fooled by bias. Niclas Hiller, chief investment officer of Norwegian wealth management company Formuesforvaltning, is one of them.
“I never start by looking at the performance of a fund,” he insists. “Before that, I consider what drives the performance, but I always start by making up my mind about what kind of fund I actually want; what kind of manager do we look for and what sort of strategy are we aiming to buy?”
However, for Gadsby, the track record remains at the centre of the selection process. “When selecting an alternative fixed income fund, we want a manager who reaches our objectives, which is Libor plus 300 basis points, each calendar year,” he says. “Therefore I want to see evidence that government bonds, quality credit as well as high yield all contribute to return; in other words that the manager’s asset allocation ideas have delivered over the cycle. Only the track record can deliver that.”