In part one of my blog post, I discussed how important it is to read the fine print when selecting the right managers. “Things are not always what they seem, and by doing a little bit of digging, you can unearth some red flags that hopefully help you make a more educated decision, or at least ask the right questions.”
I left you with three warning signs of sorts that I’ve run into throughout my years of selecting investment managers:
- Backtested numbers
When you take a particular portfolio, or a process, and ask, “How would this have performed over a certain time period?”—that’s backtesting. There’s merit in doing this, but you really have to be careful on the value you place on the data. Anyone can build a portfolio that looks great using backtested data. If it’s a portfolio of mutual funds, just pick the ones that did the best. If it’s a quantitative model or a tactical model, just pick the algorithm that worked the best. You’ll never see a backtested quantitative or tactical model that doesn’t have a good outcome in recent markets.Not surprisingly, I have yet to come across a quantitative or tactical portfolio that has performed in actuality as well as it performed in backtesting. A backtest is good for telling you how the strategy would perform in various markets to help develop your expectation levels, but should not be used to decide if the strategy adds value.
- Seed Accounts
Firms will often start seed or model accounts to get a track record of performance started. These typically have little or no client assets and are often funded entirely by firm assets. While the firm can make the claim that they’ve been running money that way for a number of years, the reality was that their clients didn’t experience the front end of that.There are a few risks in play here. The firm could have run multiple seed accounts, discarding the ones that didn’t work and promoting the one that did. The objective itself or the universe of eligible securities may have changed before the strategy was offered to clients. As with backtested numbers, there is value in looking at seed performance, but if the backbone of a strategy’s pitch is great performance in 2008 and there were minimal assets that benefited, you have to ask, “Why?” Would the firm make the same decisions with billions of client assets that they did with $100,000 of seed capital?
- Merged Track Records
When firms combine, or merge products, often from multiple track records comes one track record. Ideally, the track record from the product that was most reflective of the surviving product would be used, but, more likely, the best track record will be the one that wins out. Knowing whether the track record is reflective of the current team, process and philosophy is vital.
Whenever you look at the performance of an investment strategy, you should always give careful consideration of exactly what you’re looking at. Reading through the disclosure is a necessity, as is asking questions about things that are unclear. The fine print can often help you make more educated decisions of where to invest.