Past Performance Does Not Guarantee Future Results
Ask a CIO #11
If you have kids in your life, your own children or nieces or nephews, then you’re likely aware that little kids are prolific question askers. They are unabashed, unfiltered, and occasionally, unhinged.
Their questions can elicit hilariously honest answers – it’s a kid superpower. But more often than not, kids are just satisfying a deep desire to learn more. And it works! They learn so much so quickly, it’s remarkable.
As responsible grownups, we encourage them over time to adopt our social norms around acceptable lines of questioning. They also usually develop enough self-awareness to start holding back.
At some point in our lives though, many of us overcorrect. We’re still curious, but we become far more self-conscious about the questions we ask.
Institutional investors are constantly exposed to new investment ideas and strategies, and we’re tasked with getting up to speed quickly. If we’re doing our jobs well, we don’t let the risk of embarrassment stop us from asking the necessary questions, no matter how basic. In any given manager meeting, some of my questions might be insightful, but I know others aren’t! It’s ok.1 The good questions and the “should have been obvious” ones equally give me the chance to learn faster and dig deeper. Which then helps me be a better investor.
I bring this up because some readers have shared that certain topics in prior weeks have been complex and harder to understand. And the last thing I want is for those readers who aren’t capital markets professionals to feel like this newsletter isn’t for you. I started this for readers like you.
I’ve gotten a lot of fantastic, technical questions, and I’m excited to keep digging into those topics. But if you have questions that are more fundamental, I would love to tackle those too! I truly hope you’ll consider sending them over.
What do investment managers (GPs) frequently not understand about how institutional investors (LPs) think about performance track records?
This is a super interesting question, because you’ve pointed to a disconnect that I think is both pervasive and underappreciated. I’ll answer the question from the LP perspective of evaluating established managers (as I noted previously, emerging managers with limited track records merit different considerations). I also think there is a very useful parallel here for individual investors, which I’ll summarize at the end.
As LPs, we hear the frustration from managers who can’t understand why institutional investors aren’t interested in a fund despite a year or multiple years of strong performance.
But as we know, and universal compliance disclaimers remind us, past performance doesn’t guarantee future results. In a vacuum, performance numbers don’t tell us much, but combined with other data, track records can be revealing.
There are certainly others, but I’ll point out three considerations that I think LPs care more about than GPs might realize:
LPs generally care about the why (and if applicable, the who) more than the what. In other words, from what I’ve seen, LPs put more weight into the attribution that leads to a track record than the absolute performance numbers.
Let’s use a global equity manager as a simple example. In this case, we would typically evaluate the manager’s performance against the MSCI All Country World Index (ACWI) as a benchmark.
LPs will naturally start by looking at the monthly or annual fund returns versus the benchmark. If the manager has a history of outperforming, LPs will then want to know how much of the manager’s performance comes from country allocation versus stock selection. We’ll want to know whether there are certain countries or sectors where the manager does a better job picking stocks. We’ll likely also pry into whether the manager is interpreting the attribution data the same way that we are (and if not, why not).
LPs care about attribution because some skills are arguably more replicable – superior stock analysis is arguably more repeatable than predicting which country in the MSCI ACWI will generate the best return in any given year.
LPs care about consistency. With some notable exceptions, such as venture capital, LPs generally prefer managers that can demonstrate more balanced returns across the portfolio.2
To use an extreme example, ignoring fees and waterfalls, let’s say two private equity buyout managers both generate 2x returns to LPs over the same time frame. Manager 1’s portfolio includes an even mix of 4x returning investments and zeros. Manager 2’s portfolio is entirely 2x returning investments. Unsurprisingly, most LPs would probably prefer Manager 2.3
Consistency doesn’t necessarily mean outperformance over a benchmark year in and year out, though that certainly would be attractive. Consistency is more about the proof that a manager knows its strengths, can reliably capitalize on those strengths, and is disciplined enough to stay focused.
Finally, LPs look at a lot of managers in any given strategy. We generally have the benefit of seeing more track records than any individual GP sees. A common disconnect between LPs and GPs can be distilled down to the difference in what LPs know about the relative peer set and how LPs view GPs within that set.
Key takeaway? LPs are mining track records and other data to validate what a GP is telling us about their team, investment process, and risk management. As hard as it can be, we’re trying to distinguish luck versus skill. Sometimes we see inconsistencies in the track record and accompanying data that make us question a manager’s ability to continue generating similar returns. Or we suspect they’re taking on more or different risks than those we want to underwrite.4
Of course, there are times where none of the above applies, and LP decisions just come down to total portfolio considerations. LPs are generally trying to build diversified streams of returns without overly concentrating into any set of risks. Sometimes a manager has a great, compelling track record, but it’s just not a fit at the moment.
So what can individuals take away from the institutional LP approach to track records?
In all seriousness, don’t assume past performance will equal future performance. I know you’ve probably heard the disclaimer so many times that it’s background noise at this point. Remember the wisdom in it. If you’re not sure how an investment or a fund generates its returns, take a pause to figure it out. Then keep following along even after you’ve invested. Keep learning, evaluating, and recalibrating.
Thanks for joining me for another week! As I said at the outset, if you have a question, I hope you’ll send it over: askacio@ivyinvest.co.
Until next week,
Wendy
Despite what GPs often generously tell LPs, we know they’re not all great questions (but we appreciate the ego boost).
Specific to VC, particularly early stage, LPs expect to see fatter tails in the return distribution. An absence of zeros would raise concerns that the VC investor isn’t taking enough risk to generate the outsized returns expected from the asset class.
This is obviously an unrealistically stark example, but you’d be surprised at how relevant it is and how often LPs see unexpectedly wide dispersions of returns within manager portfolios.
LPs do not like downside performance surprises, obviously. But one thing I’ve learned over my career is to be equally concerned about upside performance surprises – it can be an overlooked indicator that the manager is taking unexpected risks intentionally or unintentionally.