Choosing any partner, whether personal or business, can be fraught with complexity, and the process of hiring and firing managers does not escape these selection perils. While most sophisticated investors pay more attention to investment process than performance, the latter still acts at least as a filter for most shortlists. A recent paper by funds manager Enhanced Investment Technologies (INTECH), Chasing performance is a dangerous game, explores how insidious chasing performance can be.

The paper aims to provide a framework for mitigating the detrimental effects of chasing performance by putting historical performance in its ‘proper analytical perspective’, where the focus is on the investment process and historical performance plays a secondary role. David Schofield, president of the international division for the firm, which adopts a unique investment process based on the mathematical foundation of Stochastic Portfolio Theory, believes a rudimentary screen covering process should be preferred over the common default screening on numbers only.

“Investors have to have some sort of screen to narrow the field, but by basing it on performance you are probably excluding some good with the bad. The key thing is to attempt to identify the process that makes a priori sense, but most are based on financial theory and equity assumptions,” he says. “Most sophisticated investors pay more attention to investment process over performance, but it is still often a secondary attention – the short list still arises through a performance filter. And even those institutional investors hiring on process will fire on performance.” The authors of the paper, Robert Ferguson, Jason Greene and Carl Moss, use a mathematicallybased parable – or story – to demonstrate the shortfalls of using performance to measure managers.

In the working example it shows the probability that the good manager will beat 20 bad managers over a 10-year period is only about 9.6 per cent. “This implies that chasing performance leaves the investor with the good manager only about 9.6 per cent of the time and with a bad manager about 90.4 per cent of the time. The investor’s average relative return will be only 19.3 basis points annually, his tracking error will be 980.7 basis points and his information ratio will only be 0.024. This compared with 200 basis points, 800 basis points, and 0.25 for the good manager,” the paper states. “Sceptics might argue that the number of managers at a finals presentation typically is far less than 20. This misses the point. The adverse filtering on historical performance begins early in the manager selection process. The universe of investment managers that the finalists are drawn from far exceeds 20. The problem may actually be worse than depicted here.”

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