Persistence in investment manager performance – can he/she keep it up?

We’re now in year 7 of an equity bull-market; those patient and/or lucky enough to have bought the S&P 500 early-March 2009 are now up about 200% on their capital invested.  Each year, since 2009, seems to be the same story of ‘death of hedge funds…long live cheap equity ETFs’.  Linked to this idea is the underlying concept of performance persistence – how likely is good performance observed in past indicative of future performance?  Before shrugging off the previous question with the ubiquitous ‘Past performance is not indicative of future returns’, let me make a few observations on persistence, some of which are likely different from what you’ve come to expect:

  1. Persistence as link to risk premia: suppose we have an underlying risk which is investable – e.g. economic growth, inflation, credit worth.  If the underlying risk remains (e.g. the economy continues to grow), while folks remain uncertain about the extent and timing of the risk (e.g. some believe the economy is about to crash, versus others who believe it will continue growing), we should reasonably expect persistence in the risk premium over the very long run.  Solution: invest in risk exposures (‘betas’) for the very long run, e.g. long equity ETFs.
  2. Persistence among long-only asset managers: suppose we’re considering buying equities; now we wonder whether to put all long-equity investment into basic ETFs, or give some to long-only managers.  After all, several guys seem to have done very well, relative to the broad market, so can’t we pick well?  The answer is generally no, you are very unlikely to pick a long-only manager well.  In several studies – including this one – long-only manager skill is shown to have near zero persistence.  That means, while it’s possible to choose the rockstar manager for a short period of time, over the long-run you’ll likely end up with mediocre or worse returns versus the benchmark.  Solution: stick with pure index ETFs for long-only exposure.
  3. Persistence among alternative asset managers: now suppose you’re looking at alternative strategies, such as hedge funds, managed futures or private equity.  In contrast with #2, there is persistence in alternative manager alpha (e.g. see here).  With many hedge fund sectors, the best relative performers in the past remain so in future.  Solution: assuming everyone is accepting new capital, feel free to use historical track record relative to peers, when choosing alternative asset managers.
  4. What am I not saying? I’m not characterising persistence here as something magic – e.g. a 10% gain last year implies a 10% gain this year, or something like that.  Persistence mainly revolves around the very long term, with the noisiness of markets wiping out observed persistence over short time spans.  So the ‘Past performance … ‘ statement is absolutely correct in that, for example, we shouldn’t expect performance from fixed income long-only funds to be anywhere near as strong as in the past; the market conditions just aren’t there right now.  However, the underlying risk premium which fixed income funds exploit isn’t likely going away in the long term; there will likely be more gains to come for these funds.

In sum: keep those long-only ETFs as a basic exposure to (persistent) risk premia.  Don’t bother with rockstar long-only asset managers… you’ll likely be disappointed in the end.  Past (relative) performance for alternative asset managers seems to have more persistence, so feel free to use historical track records as a data point when considering these guys.

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Investing time horizons: which risk premia go where

So I guess the world is going to be OK now.  The VIX futures strip is back to contango (see my old trade idea…I never put it on, but let me know if you did!); equity markets are back in the green; bonds are falling back.

Back above the Death Cross - the S&P500.  50/100 MA combo never went short.

Back above the Death Cross – the S&P500. 50/100 MA combo never went short.  Source: Google Finance.

The thought of us pulling back from correction time made me think about my portfolio as a whole; in particular, what bits of my portfolio were really exposed to this sell-off, and which bits were aloof?

  • Long-term risk premia: the majority of my book is occupied by long-term sources of return/risk premia.  These include:
    • Equity risk – about as standard as it gets.  I have been hit in Europe/Asia/US stocks from this long beta exposure.
    • Liquidity risk – I hold some closed-end funds and long-dated options (e.g. LEAPS) in the book.  These weren’t hurt in the sell-off, as (unlike 2008) the negative move wasn’t due to lack of liquidity.
    • Carry – right now this is mainly expressed through high dividend-paying stocks.  Dividend yields are a bit more attractive now, and the recent sell off doesn’t affect the ability of most of these companies to deliver dividends (oil producers aside).
    • Real estate – the real estate ETF in the book (IYR) has held value just fine.
    • Volatility drag – As mentioned in an earlier post, I like to monetise this when I can.  Equity vol hurt me on these trades, but they’re back to looking like a good long-term call.
  • Medium-term risk premia: I classify trades lasting around a month in this bucket.  Much less exposure than LT in my book, but some of the better recent performers.
    • Momentum – the managed futures mutual fund has profited nicely amid the sell off in USD and oil.  Gains in bonds helped as well.
    • Carry – mostly expressed through selling option volatility.  The beginning of the sell off was brutal for this (see the VIX chart – selling volatility into a rising vol market is not a fun experience).  Now vol has come back, I’m feeling more chipper.
    • ‘Rent’ – I proxy a rental income through selling option premium in IYR.  I’ve found the yield is about 2x average rental yields, without the hassle of unclogging toilets.  Given IYR didn’t really move, and vol stayed under control, this didn’t get hassled by the sell off.
  • Short-term risk premia:  I classify trades in the intraday – within a couple weeks in this bucket.  Basically the trades I wouldn’t be able to do if I had a job away from my trading terminal.
    • Swing trades – intraday trading of equity index futures.  Depending on conditions, these trades may be momentum- or mean reversion-based.  The sell off brought a lot of opportunities for these.

So that’s where I am.  What next?  Probably some more equity risk – maybe this time focused on the value risk premium.