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The Significance of a Financial Track Record: Fund Performance

In general, credentials are just one aspect of a manager’s track record that should be considered in an evaluation of past performance. Ultimately, the only true indication of a manager’s skill is their specific fund performance in specific markets at specific times. Generalizations are rarely conducive to accurate evaluations.

The Significance of a Financial Track Record

Credentials are one factor in determining the investment track record of a manager. Besides education and career history, they can also outline the manager’s style of investment management and their fund performance success rate with particular types of investment.

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

Unfortunately, this preoccupation with purely numerical comparisons overlooks the fundamental reason for determining past performance and credentials. The important objective is to differentiate investment skill from luck, and to identify which funds have 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 “Manager A” achieved its past performance.

Investment Credentials: Aspects of a Track Record

In determining the track record of a manager, we think the following considerations are important:

A long track record

In our view, long track records are a much more useful guide than short-term fund performance to judge 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. For the most part, since mutual funds are often 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 performed during bear 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. Our view is that a track record of ten years is necessary to evaluate a manager’s potential.

· 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 fund performance attributable to the manager’s style are far less significant.

Experience with similar investment mandates

It is absolutely essential that a manager’s record and credentials 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.

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.

The depth of the organization is sometimes relevant. Funds that can develop the talent of new portfolio managers within the organization often have a more disciplined investment approach.

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 so. The pressure on portfolio managers to perform is very intense. They are subjected 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.

Discipline does not mean that the investment approach should never change. The markets are constantly evolving, and a refusal to adapt can be dangerous. Nevertheless, change should be infrequent and evolutionary. Frequent and abrupt changes in investment approach are a signal there is no true discipline. Past fund performance based on a hodge-podge of approaches is thoroughly unreliable as a guide to the future.