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The standard procedure of firing losing managers and hiring winning managers based on their past three-year performance leads to losses, according to Rob Arnott at factor specialist manager Research Affiliates. This is not a new insight. What follows, though, is.

“Even though it may sound counterintuitive, a comfort zone is a dangerous place to be.” -Mary Lou Retton, 1984 Olympic Champion in Gymnastics.

Arnott and his colleagues published a paper last week which said three main things:

• The standard procedure for firing losing managers and hiring winning managers based on their past three-year performance leads to losses.
• Investors need to look forward-not just back-when allocating to fund managers by using a measure of expected fund returns that considers factor exposures, fees, manager skill in security selection, and factor expected returns estimated based on relative valuation.
• As investors and their consultants gain a better understanding of the predictive efficacy of relative valuations in factor and strategy performance, they gain an objective reason to avoid the blunders of performance chasing.

Investors can make better choices with their active managers by studying factor analyses.

The paper says: “Institutional investors often sell funds (or fire managers) once they have underperformed the market over the last two to three years, typically replacing them with funds or managers that recently outperformed. This seemingly sensible strategy, intended to identify skilled managers, is often bad for future returns. No doubt some of the recently stellar managers have skill, but high alpha is often a result of luck, and the newly expensive holdings typically set the stage for poor future performance.

“Meanwhile recently disappointing managers often provide exposure to assets, factors, and strategies that have become inexpensive and are positioned for near-term success…

“Investors should urgently stop relying so heavily on past performance to choose investments. Performance chasing is a reliable path to poor investment results: too often it means that we sell newly cheap and buy newly expensive assets. When we supplement information about past performance with current relative valuation-compared with past norms-our decisions will be far more richly informed. We can determine whether the past performance was merely a consequence of portfolio revaluation, which may be more luck than skill, and we can determine whether the portfolio is now cheap or rich. And, we can predict mutual fund performance with better reliability than past methods.”

Last year, in a series of articles, Research Affiliates demonstrated that relative valuations can predict future performance of equity factors and smart beta strategies. The new research shows that factor valuations can not only forecast factor returns, but can also forecast mutual fund alpha, and can provide a tool to select the managers that have better chances of future outperformance.

The paper says: “Factors and strategies can get relatively expensive after periods of great performance, and can get relatively cheap after periods of poor performance. When a factor or a strategy is cheap relative to its own history, it tends to perform well, while valuations that are high relative to historical norms predict subsequent underperformance.

‘The counterintuitive policy of firing recent winners and hiring recent losers, relative to the market, is-demonstrably-a better way to invest than the conventional performance-chasing manager-selection rules that most investors rely on today…

“In institutional investing, standard procedure is to terminate managers and funds after about three years of underperformance. Retail investors and their broker/advisors are frequently even less patient. Often in evaluating past manager performance, investors do little to adjust for a manager’s style. Terminated managers are predictably dominated by representatives of recently underperforming (and often newly cheap) styles. Will these terminated managers be replaced with another underperforming manager, representing a newly cheap style? Hardly.³ They are most likely to be replaced with a recently impressive manager, one that is representing a newly expensive style and thus positioned for future underperformance.

“This standard procedure of seeking managers with stellar past performance is both intuitive and comfortable. Our ancestors on the African veldt did not survive by running toward a lion, so it should not be surprising that we, today, still instinctively avoid what has caused us pain and losses, while seeking more of what has given us joy and profits. This behaviour is innate. Yet, in investing, what seems intuitive and comfortable rarely pays off-all too often, it leads to bad choices. In the capital markets, whatever has recently mauled us in the past is (slightly) more likely to comfort us in the future, than to inflict further pain.

“Underperforming strategies are often newly cheap and might well be better candidates for new assets, not for termination. For example, the Russell Value Index underperformed the market in the last three years of the tech bubble by an enormous 2,400bps, laying the foundation for 39 per cent more wealth generated by value versus the market in the next three years and 49 per cent more wealth in the subsequent five years.

“If a manager has performed brilliantly and the manager’s assets are at record-high valuations relative to the market, investors should arguably redeem, not invest more. If a manager has performed badly and the manager’s assets are at an exceptionally cheap relative valuation, investors should seriously consider topping up, rather than firing the manager. We are not suggesting that past performance is irrelevant, only that it’s a terrible predictor of future prospects.

“Likewise, past success is not always a sell signal.  Just like ignorance of past performance is self-evidently naïve, so is ignorance of current valuation levels. When investors use a richer toolkit that combines past performance and current relative-valuation levels, the decision will not always be to fire the winners and hire the losers, or vice versa. If a fund has outperformed, but the assets are not at newly lofty valuation levels, that manager is amply deserving of consideration for a far larger allocation. Conversely, if a manager has had bad performance relative to the market, and the assets have not become massively cheaper, that’s really bad news. In most cases, this should be grounds for immediate dismissal…

“Can we distinguish such managers from the managers who have underperformed by dint of their strategies becoming newly cheap? Yes, we can, albeit without great precision. Relative valuation is the key.

“Relative valuation and performance go hand in hand. Equity factors, just like individual stocks or different asset classes, can get cheap at certain times and expensive at other times. If mean reversion occurs in valuations, the expensive valuation today is likely to disappoint in the future. Reciprocally, today’s cheaply valued factor or strategy is likely to offer strong future return prospects.”