Credentials are one factor in determining the investment track record of a hedge fund firm. Besides education and career history, they can also outline the manager’s style of investment management and their fund performance success rate with particular types of investment.
Past fund performance dominates the evaluation of a mutual fund’s potential. Typically, consideration of past fund performance has focused on the question: “How good is the track record?” The length and quality of the record typically receive far less attention. Another important objective is to differentiate investment skill from luck and to identify which funds have the greatest likelihood of future success.
What to Look Out For in a Track Record
In determining the track record of a manager, we think the following considerations are important:
A Long Track Record
In our view, long track records are a much more useful guide than short-term fund performance to judge the probability of future success.
Investment risk almost always decreases with the length of time the investment is held. For the most part, since mutual funds are often long-term investments, longer track records give a more accurate indication of a fund’s true risk profile.
Longer track records permit investors to evaluate the performance of a fund through a complete market cycle. It is particularly important to understand how well (or poorly) the manager performed during bear markets. Bull markets often mask the true risk of aggressive investment approaches. While aggressive strategies can produce very high returns during bull markets, they are also prone to much more substantial losses in bear markets.
Discipline In The Investment Approach
Discipline means that the portfolio manager’s investment approach is applied consistently through varying economic and market conditions. Although most fund managers claim to pursue a disciplined approach, it is very hard to do so. The pressure on portfolio managers to perform is very intense. They are subjected to constant comparison with the managers of other funds. As a result, managers are always susceptible to the urge to “second guess” their investment approach and the choices they make for their portfolios.
Discipline does not mean that the investment approach should never change. The markets are constantly evolving, and a refusal to adapt can be dangerous. Nevertheless, change should be infrequent and evolutionary. Frequent and abrupt changes in the investment approach are a signal there is no true discipline. Past fund performance based on a hodge-podge of approaches is thoroughly unreliable as a guide to the future.
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