Sunday, January 11, 2009

The Perils of Cumulative Returns

In addition to having to confront miserable absolute returns in their investment programs, investment fiduciaries will have to contend with more than the usual number of relative performance issues where investment funds are not meeting their performance benchmarks. This is because of the higher than average fund performance dispersion in 2008 and the surprisingly significant impact that a single high deviation performance year can have on 3 and 5 year cumulative returns.

Short term investment performance is generally regarded as having a high noise to signal ratio. This means short term performance patterns usually do not persist into the future and therefore provides little useful information for investment decision making. Yet, 1 year performance variances, positive or negative, can substantially infect longer term 3 and 5 year cumulative performance measures, which are routinely used by investment fiduciaries in investment decision making. The larger a fund’s annual performance variance, the higher that years impact on 3 and 5 year cumulative performance. We have estimated that equity mutual fund performance return dispersion is 31% higher in 2008 than the average annual return dispersion since 2003. This suggests that the 3 & 5 year cumulative return rankings for investment funds will be subject to more fluctuation, influenced by a broader range of positive and negative 1year variances.

To counteract the effects of these short term performance biases, it is particularly important that investment fiduciaries look at a mosaic of other quantitative measures such as long term (5 +) and life of fund performance as well as rolling period data when evaluating fund returns. Fiduciaries might be considered imprudent not to consider other factors besides returns in their analysis. A number of risk measures are routinely used in conjunction with returns. Some studies, such as that by Martin Eling, Does the Measure Matter , point out that the Sharpe ratio is a reasonable and adequate measure to rank funds for additional due diligence work, though these measures are time period dependent as well.

In truth, even multiple statistical tools may not capture the critical attributes and dynamics of an investment fund. Subjective analysis and investment judgment will always be required to transform investment data into prudent investment decisions. Evaluating the fallout of 2008 will put a particular premium on those skills.

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