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2. Choosing Last Quarter’s Top Performer
Investors who chase performance often end up buying high and selling low. What’s past is prologue. While performance is important, it is also history. It is important to ask: “Why was this manager a top performer last quarter?” Without careful analysis it can be difficult to separate the manager who finally got lucky once — after ten years in business — from the one who is consistently good and just turned in his best quarter ever.
Why was this manager a top performer? One clue is to look at the other top performers and their strategies. If most of the top performers were Small Cap Value managers, who invest in small companies that they feel are undervalued for some reason, this tells us that the economic conditions favoring these stocks are driving their returns. The market is being good to many Small Cap Value managers, including this one.
So the next question is: How long will this trend continue? As you can see on this chart, illustrating how different Asset Class Returns have performed over time, the same asset class is rarely the top performer more than one year in a row. As the economy moves through cycles different asset classes are favored. Long term investors will pick good managers in several different asset classes so they don’t have to try and guess which one will be the next winner.
So how should you pick a manager? First, you should not pick just one (see Mistake Number 1). That said, there is no one right answer and there are many factors to consider, including the manager’s experience, the economic outlook, the current market attitude toward a given manager’s strategy, and your personal level of tolerance for risk. But, when evaluating performance, we compare managers of the same asset class and style on a number of factors including things like:
- Consistency — We look for managers with consistently good returns over a number of years, in all kinds of markets. The manager who is never number 1, but always a top contender is often a better choice that one that was number 1 last quarter, but an also-ran in five of the past eight quarters.
- Alpha — Sorry, we’re going to talk math for a moment. Alpha is a statistical measure of excess returns over the market. Generating Alpha consistently over time, say three to five years, is very hard. Look for an Alpha greater than 0. The higher the manager’s Alpha, the better.
- Sharpe Ratio — Again with the math! The Sharpe Ratio measures risk adjusted returns. Managers who take more risks than the market should get higher returns, at least when the market goes up. A Sharpe ratio greater than 1 means that the manager is getting excess returns over those expected for the amount of risk he is taking. The higher the manager’s Sharpe ratio, the better.
As a wealth manager, WrapManager works for you, not for any particular money manager. We can put together a portfolio of managers who employ a variety of strategies. Such a portfolio is designed to help you reach your financial goals without taking more risk than you are prepared to accept.