This article outlines the phenomenon in which some investment professionals can manufacture a track record and the implications of this practice. The material in this article is excerpted from the book “The Mutual Fund Bible” (1997) by Tom Box and Mark Newsome.
What is a Track Record?
A track record outlines an investment professional’s past accomplishments and performance to indicate their success rate for investment management.
Track Record Uses
Establishing Performance Credibility
Due to the movement of investment professionals from one firm to another, and an increase in the number of portfolio management strategies which depend on computer modelling, many firms are ‘manufacturing’ the performance results of the portfolios under management. The ‘manufactured’ results may not reflect the true results of the management strategy being employed.
Unfortunately, many funds use inappropriate comparisons to bolster the credibility of the portfolio manager’s track record. One technique is to draw on a portfolio manager’s previous experience in managing other types of investment funds such as pension funds or closed-end mutual funds. The Beutel Goodman International Equity Fund, for example, bolsters its four-year track record by promoting the fact that it’s manager, Brian Brownlee, has nine years of experience with the CBC pension fund. In fact, the management of an open-ended mutual fund, like the Beutel Goodman International Equity Fund, is significantly different from the management of funds like pension funds and closed-end mutual funds. In these other types of funds, cash flows can be anticipated relatively accurately. In a pension fund, the fund’s cash flows are quite predictable. The benefits that the fund must pay can be identified quite closely on the basis of actuarial projections, and because the fund’s obligations can be identified, the income required to meet those obligations can also be determined with precision. In closed-end mutual funds, cash flows are typically quite predictable because they are entirely the result of portfolio investment.
In an open-end mutual fund, cash flows are much less predictable because the rates of both new investments and redemptions are uncertain. The process of portfolio management is therefore complicated by the need to accommodate these uncertainties without impairing the performance of the fund.
Additionally, investors typically have much higher short-term expectations of mutual funds. While the beneficiaries of pension funds are ‘locked in’ to a long-term perspective, mutual fund investors can easily redeem their investments if they are unsatisfied. This creates a pressure to perform which is not imposed on pension fund managers, and can have consequences for the way in which the fund is managed.
In short, it is misleading to conclude that a manager who has exhibited success in managing a pension fund, or closed-end fund, will have similar success with open-end mutual funds.
Fallacy of Backtesting
Another method of creating a management track record is the ‘technique’ of backtesting. Backtesting is a mechanism for establishing the merit of a particular investment strategy by assessing the strategy retroactively in order to determine what performance would have been if the strategy had actually been used. The technique is particularly popular in buttressing the credibility of asset allocation funds and services, which are often based on formal models of market behaviour. By demonstrating that in the past the allocations dictated by the model would have produced superior results, the model’s designers attempt to show that the assumptions on which the model is based are appropriate, and that a strategy based on the model will therefore also produce superior results in the future.
There are, however, at least two difficulties with this ‘technique.’ The model that is being tested is itself based on historical data; therefore, it should come as no surprise that such models perform very well in backtests – after all, they are merely confirming the data on which the model was based. In addition, the rationale for backtesting assumes a similarity in circumstances between the past and the present that is usually unjustified.
Creating a Track Record
The best way to create a manage a relevant track record is to ensure that the parameters used to define the professional’s history of investment management are relevant to whatever fund is currently being considered.