Tuesday, October 16, 2012

Universes Part 3: A World Where Half the Managers Are in the Top Quartile

Universes Part 3: A World Where Half the Managers Are in the Top Quartile

Failing to beat a benchmark or index isn’t the end of the game for money managers seeking to demonstrate their acumen.  We might be able to entice you by comparing our performance against a set of competitors.  The immediate goal is to be better than the median (average) manager, which is probably good enough to keep you from firing us.  However, the long-term goal is to be in the top quartile (at or above the top 25%) among competitors, because that type of performance hooks you in and generates new business.  The peer group of competitors is known as a “universe.”

Valuing A Deal (2009)

In order to construct a universe we need a high-speed blender to chop up our performance into lots of different timeframes and very fine filter paper to carefully select a set of managers that we’re capable of beating.  With enough creativity there’s undoubtedly some universe and some time period where our historic investment performance looks appetizing.  These favorable comparisons will be prominently displayed in our marketing materials and advertising copy.  The following advertisement from T. Rowe Price is typical.  It boasts of its historic performance against the average manager in the Lipper universe of managers, but the lawyers make them warn that the future may not be as rosy as the past.

At T. Rowe Price, our collaborative global research process helps us better understand the connections of a complex, global economy, so we can make the best decisions about where to invest your money. It's just one of the reasons why over 70% of our funds beat their 10-year Lipper average as of 6/30/12. 
Results will vary for other periods. Past performance cannot guarantee future results. All funds are subject to market risk, including possible loss of principal.

There are plenty of services cranking out universes, such as Morningstar for Mutual Funds, so the odds are that our performance can be made to look good in some comparative universe.  However, if you dig into most universes, you’ll find a fruit salad of managers, rather than a collection of apples or oranges.  Usually the similarities among managers in a given universe is just about offset by the differences.  Nonetheless, investors and their consultants rely on universes, so they are here to stay.

We’ve learned that investors like you will give us your money if we can claim membership in the top quartile club of some universe, so we search high and low for a way to squeeze into a box where we’ll look good.  Unfortunately, if we’ve managed to beat our competition for a couple of years, and you’re now inclined to give us your money, we’re probably going to perform poorly in the future.  All too many managers attract large slugs of money based on a couple of years of beating the competition only to fall to the back of the pack.   So when we’re in a position to boast about our 4 or 5-star ratings, you should become more, rather than less skeptical.

We also give extremely silly advice when people ask us how they should select money managers.  I cannot count the number of times I’ve heard an investment professional intone, “you shouldn’t invest in [fill in the asset class] unless you invest with first quartile managers.”  Obviously, anyone would love to give their money to someone who will beat the competition in the future, but there’s not much evidence that anyone knows who is going to do well in the future.

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