In his latest piece, Francois Sicart, Founder and Chairman of Tocqueville Asset Management, examines investment performance measurement, viewing it as a “striking example of an originally good idea made bad by its success.”
He believes the problem with business of investment performance measurement is that it has become just that, a business. Therefore, “measuring and critiquing performance has become a quarterly practice – and at times, more often than that.”
Sicart believes a measure of investment success should encompass “several cycles, with bull and bear markets as well as many fads and fashions and their aftermaths.” He notes that “economic events really progress at a near-tectonic pace,” so “a quarter or even a year is almost always a totally irrelevant period.”
He discusses a “serious misinterpretation” made by investment consultants, whereby they “use volatility as a substitute for risk in their calculations.” Financial risk should refer “to the possibility of permanently losing some or all of your equity in an investment. Volatility merely refers to the amplitude of price fluctuations within given periods.”
He concludes: “Most performance consultants try to minimize or eliminate volatility. In doing so, they all but abandon the possibility of being durably better than the majority; but, in my view, they do not reduce true risk, which can only be avoided through extensive fundamental (not just statistical) analysis of specific investments.”
The Unintended Consequences of “Sophisticated” Performance Measurement
Investment performance measurement is a striking example of an originally good idea made bad by its success. It is true that a standardized way of measuring performance is necessary to weed out money managers’ claims that are outrageous, plain dishonest, or even merely “selective.” But unfortunately, too many imitators embraced the original concepts; and as the size of the performance-consulting industry grew exponentially, more gimmicks were incorporated in addition to the simple indicators used early on by measurement pioneers. Today, these augmented concepts are very widely used, often inadequately so, and in my opinion have frequently become counterproductive.
Outstanding investors vs. consultants
Most exceptionally successful long-term investors have proclaimed, at one time or another, their skepticism about investment consultants and the growing use of performance benchmarks aimed at splicing performances among investment styles, geographies, company sizes, sectors, etc. The skeptics have included the likes of Warren Buffett, Charlie Munger, Peter Lynch, Martin Whitman, Jim Rogers, Seth Klarman, Georges Soros, Howard Marks, et al. Recently a new Oxford University paper joined this critique. The Financial Times of September 22, 2014, cites a study by a team of from Oxford University’s Saïd Business School, which analyzed consultants for more than 90 per cent of the retirement market. It concludes, “On an equal-weighted basis, U.S. equity funds recommended by consultants underperformed other funds by 1.1 per cent a year between 1999 and 2011.”
Why should the record of consultants be so disappointing? Certainly not because they are stupid or ignorant. In fact, most are not only highly educated, but also are very proficient in math and statistics as well as highly articulate in their presentations.
Instead, I believe that their problem is rooted in the fact that what was once a practice has become a business. This business requires consultants to foster a growing appetite for their services among clients, by creating a need for more frequent measurement and decision-making. Thus, measuring and critiquing performance has become a quarterly practice – and at times, more often than that.
Unfortunately, in investing, a quarter or even a year is almost always a totally irrelevant period.
Measuring performance over relevant periods
When I referred above to successful long-term investors, I did not mean successful over three, five, or even ten years, which in investment history amount to little more than one fashion or style season. I mean a stretch of years encompassing several cycles, with bull and bear markets as well as many fads and fashions and their aftermaths.
If one overlooks the “noise” of superficial hiccups and false signals, economic events really progress at a near-tectonic pace that does not require constant monitoring. Except for occasional accidents, corporate fortunes do not change in three months either, and new business strategies often take several years to bear fruit – or not.
Over shorter periods, it is mostly crowd psychology that moves markets. Thus, trying to measure how well a portfolio has performed over three or six months really amounts to measuring how well a manager has participated in the mood-induced ups and downs of a bipolar group (the investing crowd). Once we realize this, the risks of quarterly performance-measurement become clearer.
The counterproductive avoidance of volatility
Over time, as the performance of a majority of hedge funds and the consultants who recommend them has proven disappointing, it appears that the selling argument of this relatively new industry has shifted from “superior returns” to “acceptable returns with lower risk.” This too, I am afraid, reflects a dangerous misunderstanding.
Consultants – and the academics who gave them their theoretical arguments (including Nobel laureates) – cannot quantify risk. This is because risk can only be measured for individual investments rather than groups or indexes; it necessitates exhaustive analysis; and it cannot be summed up easily in a single statistic. So, a consensus developed among consultants to use volatility as a substitute for risk in their calculations. And, eventually, they even began to call it “risk.” But this is a serious misinterpretation. Financial risk refers to the possibility of permanently losing some or all of your equity in an investment. Volatility merely refers to the amplitude of price fluctuations within given periods.
Since the principal determinant of short- and medium-term price fluctuations is the mood of the investing crowd (as opposed to changes in the fundamental value of companies, for example), most successful investors welcome volatility. Over their longer time horizon, they recognize short-term volatility as a periodic opportunity to find unrecognized value or growth.
By definition, for an investor to be better than the majority, he or she needs to be different. This implies that he or she can also, occasionally, be worse. Bernie Madoff’s notorious Ponzi scheme, where he sold billions of his funds to investors by producing made-up performance statistics (the investments did not actually exist), was particularly smart in one respect: The performances “produced” and implicitly promised were not outrageous. Good investors achieved similar results over the years. But one giveaway was (or should have been) that this performance showed no volatility: Almost the same results were achieved period after period. A good analysis should have told investors that this kind of performance could not be achieved without occasional shortfalls. Merely statistical methods did not.
Most performance consultants try to minimize or eliminate volatility. In doing so, they all but abandon the possibility of being durably better than the majority; but, in my view, they do not reduce true risk, which can only be avoided through extensive fundamental (not just statistical) analysis of specific investments.
The goal: not relative performance, but absolute return
Another criticism aimed at consultants by highly successful investors is their primary focus (also out of business necessity) on performance relative to various fabricated benchmarks, rather than on absolute results, which would answer the question, “Am I becoming richer after inflation and taxes or not?”
Seth Klarman, founder of the Baupost Group, is at