Research Affiliates is warning advisors that past is not prologue and manager selection may not be worth the effort at this late stage of the economic cycle and bull market.
“We can’t find anything in the data in academic circles that indicates that manager selection is a high value add activity for financial advisors, especially because their clients more than institutional investors have a tendency to emphasize recent performance,” John West, the firm’s head of client strategies, told ThinkAdvisor.
Advisors who go along with such performance-chasing are catering to clients when there are many other things they can and should do to add more value, says West.
“Past long-term returns of US equities are negatively correlated with their future long-term returns, whether we use a horizon of 10, 20 or 30 years,” writes West in his piece, “The Most Dangerous (and Ubiquitous) Shortcut in Financial Planning,” part of a series of articles on the firm’s website directed at advisors.
“Your clients’ experience in the capital markets (i.e., relatively high past returns), irrespective of the client’s age, is unlikely to be duplicated in the future.”
A better and easier way to add value for asset selection, says West, is to choose a transparent strategy that emphasizes those factors that drive returns over the long term, such as portfolio turnover, transaction costs, liquidity and certain factors such as value investing.
Research Affiliates is a value-focused firm whose founder and current chairman, Rob Arnott, is considered the “godfather of smart beta.” It doesn’t manage most money directly but designs smart beta indexes and mutual products and ETFs for asset management clients such as Pimco and PowerShares.
“Stress low turnover and the largest, most liquid names,” West says. Then you’re not explaining to a client about the brilliant performance of a particular portfolio manager that’s not likely to repeat itself over the long term, according to West.
But if advisors must regularly assess performance, which most do, then they should “focus on performance relative to expectation distributions, such as a strategy’s expected tracking error of returns relative to its benchmark,” writes Jonathan Treussard, head of product management at Research Affiliates, in another of its advisor series of articles, “Performance Measurement: How to Do It If We Must.” They shouldn’t overdo it, however.
Treussard includes a performance chart of eight hypothetical long-only value strategies over the 50 years ended Dec. 31, 2017: book to price, earnings to price, cash-flow to price, dividends to price, sales to price, assets to price, operating profits to price, and dividends-plus-buybacks to price. All generated an annual return greater than that of the S&P 500, ranging between 11.4% and 12.8% versus 10.6%, and half of those strategies had less volatility than the large-cap benchmark.
Breaking down those annualized returns over 10 five-year periods shows that none of the eight strategies persistently outperformed or underperformed. For example, the sales-to-price strategy ranked high in the five-year window 1988–1992, then fell to the bottom ranking in the next five years and reverted to a top ranking over the next two five-year windows.
The assets-to-price strategy showed that pattern in reverse: the lowest ranking in the 1983-1987 period, the highest ranking in the 1993-1997 period but placed near the middle from 2013 to 2017.
“We see here quite clearly that the process of mean reversion turns return-chasing behavior into a drag on investment outcomes,” writes Treussar.
— Check out Here’s How Advisors Are Investing Now: FPA Survey on ThinkAdvisor.