After a rough March for managed futures, and more of the same thus far in April, we’re likely to see some nervous investors pulling some or all of their managed futures exposure next month to alleviate some short term pain. This is usually a bad idea, especially for systematic strategies which tend to cycle in and out of performance based on market consolidation, volatility expansion/contraction, and so forth. Meaning, the conditions causing poor performance can create the environment needed for good performance. We were reminded of this today via this tweet from Jim O’Shaughnessy:
This points you to an excellent Reformed Broker post containing this nugget concerning pension fund’s hiring and firing of managers – where the fired managers (the ones underperforming) go on to out perform the managers they were replaced with.
Chart 5. clearly illustrates the impact of this phenomenon in the pension space. The grey bars represent the average annualized performance of terminated managers in the three years prior to, and three years subsequent to, their termination. The white bars represent the performance of replacement managers in the same years. Clearly institutions are hiring managers with exceptional historical track records over trailing 3 year periods, and firing managers with poor track records. The joke is on the institutions, however, since on average the fired managers go on to outperform the hired managers over the subsequent 1, 2, and 3 year periods!
This is a sort of negative compounding effect going on here, where in the name of improving performance, investors actually negatively impact their performance. Pension funds, with their consultants and employees whose job it is to monitor things and make changes in the name of better performance are particularly at risk of the change to improve fallacy, but they are by no means alone. Everyday investors do the same thing in all sorts of investments, usually getting out when they should be getting in on the investor emotional cycle.
We did the math on this a while back, calculating the performance of a basket of managed futures programs at each level along the emotional investing cycle, finding that indeed, the point of greatest return above the average is at the point of highest emotional distress – capitulation and despondency – mapping to 18 and 21 month lows.
Info Courtesy: Performance on the Market Cycles
We’ll sum it up with this awesome graphic from the behavior gap:
Chart Courtesy: Behavior Gap
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