The Significance of Track Records

The following article is based on the recently published book The Mutual Fund Bible, 1996 by Mark Edward Newsome and Thomas Holyoake Box

Whose record is it, and why is it important?

Past performance dominates the evaluation of a mutual fund's potential. Typically, consideration of past performance has focused on the question: "How good is the track record?" The length and quality of the record typically receive far less attention.

Unfortunately, this preoccupation with purely numerical comparisons overlooks the fundamental reason for evaluating past performance. The important objective is to differentiate investment skill from luck, and to identify those funds with the greatest likelihood of future success. However, by focusing attention primarily on the highest returns, most analysis largely ignores the qualitative considerations behind the record.

It is essential to remember that the track record of the fund is far less important than the track record of the manager. Regardless of its excellence, the track record of a fund now run by manager "B" cannot provide helpful information about its potential performance if the past performance was achieved by manager "A".

What to look for in evaluating a manager's track record.

In evaluating the track record of a manager, we think the following considerations are important.

1. A long track record. In our view, long track records are a much more useful guide than short-term performance to the probability of future success. We base our view on a number of factors.

• Statistically, the relationship between past and future performance of mutual funds is strongest for longer periods. Some studies suggest, in fact, that the relationship between future performance and performance for the preceding single year is negative. In other words, funds with the best one-year records are more likely to perform poorly over the next year than funds with poor one-year records.
• Investment risk almost always decreases with the length of time the investment is held. Since mutual fund are for the most part long-term investments, longer track records give a more accurate indication of a fund's true risk profile.
• Longer track records permit investors to evaluate the performance of a fund through a complete market cycle. It is particularly important to understand how well (or poorly) the manager performs during bear markets. Since the 1987 market 'crash' occurred prior to the current surge of interest in mutual funds, few investors have experienced the actual effects of a true bear market, and fewer fund managers have demonstrated that they are capable of coping with the consequences of a significant downturn in the markets. Bull markets often mask the true risk of aggressive investment approaches. While aggressive strategies can produce very high returns during bull markets, they are also prone to much more substantial losses in bear markets. To put it crudely, it is a lot easier to make money when the markets are rising than when markets are falling and investors are redeeming their investments in droves. Given the durability of the current bull market, our view is that a track record of ten years is necessary to evaluate a manager's potential.
• Longer track records moderate the effects which unusually good or bad short-term performance can have on a fund's track record. Even over ten year periods, unusual short-term results can skew a fund's overall performance. Their effect on performance measured over two-, three-, and five-years is much more pronounced.
• Longer track records compensate for the effects of a manager's particular investment "style". Every manager's style produces better results in some market conditions than others. Over the short-term, these differences in "style" can create a distorted impression of overall performance, but over the long-term differences in performance attributable to the manager's style are far less significant.

2. Experience with similar investment mandates. It is absolutely essential that a manager's record relate to funds with comparable investment mandates. Success in managing a small, resources-based fund, for example, cannot be relied upon as evidence of anticipated performance in managing a large, broad-based fund. A manager's previous experience is only relevant if it relates to a fund with similar objectives and portfolio characteristics. In evaluating the merit of Mackenzie Financial's relatively new Ivy Canadian Fund, for example, the track record of Jerry Javasky and Gerry Coleman at the old United Canadian Growth Fund can be useful because the investment mandate of the Ivy fund is similar to that of the United fund.

3. Stability in management personnel. If the personnel in the management team are constantly changing, it is impossible to say with any certainty who is responsible for the fund's track record. There will inevitably be personnel changes in any management team, but excessive turnover is not a good sign.

It is also important to look at the seniority of any new or departing staff. At Trimark, for example, there have been a number of personnel changes over the past few years, but Bob Krembil, who founded the funds in 1981, continues to be intimately involved in investment decisions. In contrast, management changes at the Cambridge group of funds are more troubling. Tony Massie had been the central investment advisor, and his replacement by Raoul Tsakok in 1992 brought a substantially different (and more aggressive) approach.

The depth of the organization is sometimes relevant. Funds which can develop the talent of new portfolio managers within the organization often have a more disciplined investment approach. For example, although Sir John Templeton no longer plays a role in the investment management of the Templeton funds, the current senior managers (Holowesko, Mobius and Reed) are all Templeton disciples.

4. Discipline in the investment approach. Discipline means that the portfolio manager's investment approach is applied consistently through varying economic and market conditions. Although most fund managers claim to pursue a disciplined approach, it is in fact very hard to do. The pressure on portfolio managers to perform is very intense. They are subject to constant comparison with the managers of other funds. As a result, managers are always susceptible to the urge to "second guess" their own investment approach, and the choices they make for their portfolios. A recent US study based on data supplied by Morningstar Inc. found that more than one-third of US equity funds had changed their investment approach in the preceding year.

Discipline does not mean that the investment approach should never change. The markets are constantly evolving, and a doctrinaire refusal to adapt can be dangerous. Nevertheless, change should be infrequent and evolutionary. Just as the past performance of one manager is meaningless in evaluating the potential performance of a different manager, past performance based on approach "X" cannot be relied upon to evaluate the future performance of approach "Y". Frequent and abrupt changes in investment approach are really a signal that there is no true discipline, and past performance based on a hodge-podge of approaches is thoroughly unreliable as a guide to the future.

This article is excerpted from the new book on mutual funds by Tom Box and Mark Newsome.

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