Understanding Performance: The Right Questions to Ask Advisors – why it’s a tough question to answer and why it should be that way
Marcus Schafer (00:05)
Hello, welcome back to the latest episode of Greenstream I think this is going to be episode number 12. I’ll maybe add some comments about number of episodes towards the end. But once again, Greenstream is where we’re taking the research, trade-offs, and strategies that inform the advice we give to individuals and institutions. We unpack that, we share that with you so you can make the best decisions while cutting through the noise of markets, media,
and products that often enrich the product provider and not ⁓ the purchaser, the consumer. With me is the CEO of Greenspring, Pat Collins, and I am Marcus Schafer Director of Growth. Pat, I thought today we could talk about a question we hear often, and I’m going to frame the question as, how have you done? What has the actual performance been?
So when a prospect or a client is asking that or an investor asking it, think the merits behind the question are really, really relevant. How do you think about responding to that? Well, first off, I think the question is the wrong.
Patrick Collins (01:04)
Well, first off, I think the question is the wrong question
to ask. that may sound a little bit vague, but I want to unpack it because it really is an important question. And really the question is this idea of performance and how have you done. Now, first off, the reason why I think it’s the wrong question is that, at least from an advisory standpoint,
Patrick Collins (01:31)
We have all sorts of different types of clients. We have clients that have a high level of risk. We have clients that have a low level of risk. We have clients that come to us that we have to work around positions in a portfolio for tax reasons. So there is no one standard portfolio that any manager ⁓ or any advisor has. So when you ask, how have you done to an advisor, it’s really hard to answer that because there are so many different types of portfolios that we’re managing. But there’s a bigger part to that as well, which is
Let’s say somebody could answer that question. The question is, is then,
is that relevant to me? Is that, is that answer relevant? Because what they’re telling me is, if I can believe it, is what happened in the past. Does that mean that’s what’s going to happen in the future? think as humans, kind of will extrapolate what happens in the past should happen in the future. But in reality, it doesn’t work that way with investing. And so I think it’s important to understand
If you can even ask that question, which I think is, you know, for the reasons I mentioned is a challenging thing to ask,
you have to unpack it a little bit more. What I think we’ll get into eventually on the podcast here is the more important question is not as what has your performance been, but what is your process? How do you go about investing? And that may not seem very sexy, but it’s really important to understand that. So I think that’s what kind of framing this episode is going to be.
around why that question is really challenging. At the same time,
what is the right questions to be asking and what are the right things to be looking at?
Marcus Schafer (03:01)
Yeah, again, the merit behind the question, absolutely, you want to be trying to understand, hey, I’m paying a fee. What value are you bringing me? Absolutely fair. You just have to make sure you’re asking the more specific, the right questions to really get at the value. So let’s maybe talk about some of those questions and then we can come back around. And as always, I did a little too much.
research and a little too much reading. So we’ll share some of the reasons and the evidence behind why you actually can’t ask the questions. There’s this SEC disclosure that kind of says the end of every performance statement, it should be there. And it says past performance is not indicative of future success. So we’ll maybe unpack why everything has that statement because to your point, persistence does not really seem to show up in the…
in the evidence.
Patrick Collins (04:02)
Yeah, yeah,
totally agree. And again, we get this question a lot. And what I’m really excited about with this podcast is most of the time we don’t have 45 minutes to answer a question like that. We’re going to unpack it quite a bit, but it is a really good question. And as an advisor, it’s really difficult to answer. We’re going to hopefully help people understand why it’s a tough question to answer and why you should be careful if someone just gives you an answer to it.
Asset Allocation and Stock Selection – the two components of a proper performance attribution analysis
Patrick Collins (04:30)
that that’s maybe you really need to understand what goes behind that. So I think that’s what I want to talk about now is just this idea of if someone, if you ask that question, how have you done? And someone gives you an answer that you can now look at and take. They’re, you know, most likely the thing that would be most attractive to a ⁓ potential new client would be someone that has done very well, that’s outperformed some relevant benchmark. And there are typically,
two ways that an advisor is going to outperform a benchmark. So one way would be they are picking managers or picking stocks themselves that are outperforming the broad market. So I’m going to invest in, you know, I invest in the top 50 stocks in the country or in the world and I can outperform the broad market. I can understand when the market’s going to go down and I get out or I get back in at the right time. I have a trading philosophy.
So it could be anything around kind of market timing, stock selection, active type investing to try to outperform. So that’s one way that they’ll maybe potentially outperform. And we’re going to talk about that as a one way to kind of evaluate whether or not that can be repeatable. And then the other way would be more asset class selection, how they allocate your assets. So for example,
How much do they put in US stocks versus international stocks versus bonds versus real estate? I mean, there’s all these different asset classes. So again, that would be another way that you could outperform is that you select asset classes that do better than let’s say a broad benchmark. So you invest in only the US for example, and your benchmark is the world stock market. Over the last few years, that’s been a pretty good investment.
So I do want to maybe start with a little bit of a story here because I think it’s relevant. And I’ve seen this throughout my career, but I think I was lucky enough to start my career in 2000. So 25 years ago, those that were investing at that time would remember what was kind of going on. were at the, we didn’t know it at the time, but we were at the very end of a massive bull market in the United States. The internet had basically had kind of exploded.
And that was the time of the dot com stocks and whatnot. So ⁓ when I got into the business and I worked at a big brokerage firm, the idea of diversification in a portfolio meant that you had a few mutual funds, you had a large cap growth mutual fund, you had a technology mutual fund, and maybe you had like an S&P type fund. And that felt like pretty good diversification because every one of those had just gone up year after year after year for probably 10 years, nearly 10 years. ⁓
So if you had gone to an advisor in 2000 and said, how have you done? Well, if they had been investing in technology and they have been investing in the US and large cap stocks, they would have had an amazing answer to that. It would have been, we have done amazing. And in particular, if I had been heavy in technology, I would have an even better answer for you because we would have outperformed every relevant benchmark. The problem is,
is that if that’s how you judged making your decision, the next 10 years saw some of the worst returns in the market. So technology imploded, large cap grid stocks imploded, the NASDAQ imploded, all these things happened. And so again, if I was using how have you done as a basis for making a decision and I’m using that, that how have you done as performance,
I would have been really, really disappointed.
And so I think it’s really important to think about not just how have you done, that should be a part of it, but there has to also be a round process. What is the process that you take for investing funds? Because if you just base it on performance, performance comes and goes, there’s going to be times where it really underperforms. have to understand it before you invest in it.
Marcus Schafer (8:13)
Yeah. It highlights a few things that I think are tangible questions.
that you can ask. Did you do what you said you would do? Right? And so that’s, hey, if you build a diversified portfolio, are you delivering a super diversified portfolio every single day? Do you even understand what diversification means? And diversification has changed a lot because the time period you’re talking about, diversification used to mean three funds, the naming convention, I would assume, I wasn’t in the business back then, but it was like growth and income.
Use Long Run Historical Returns as Expectations1 – to hedge against the emotional power of narratives that surround short-term performance (0-5 years)
And now we fast forward, it’s like, no, I don’t really care about three funds. I care about how many underlying stocks are you actually holding? I care about stocks and bonds and I want to that exposure. So do they say what they’re going to do? The second thing I really think about is are your expectations grounded in reality? And what I mean by this is the narrative power of the last one, three and five years.
really seems to take hold for all of us. And we think the world is going to be really different in the next one, three, and five years. That narrative power, you have to weigh it against the long run evidence of the past hundred years and say, Hey, it always feels like it’s going to be a different time. And most of the time it’s not. So we really have to counteract this tendency to try and overshoot. And if you kind of think about
Are those expectations grounded in reality? There’s a few ways I think you could do that. You can look at long run historical market performance and if somebody says, hey, I’m going to get you 15 % a year. And you say, hey, actually stocks have done 10%. That 5 % alpha, that’s Warren Buffett-esque alpha. That’s better than David Swinson at Yale, who’s closer to 2.5%. So you’re really going to be the best investor that ever lived.
I think that’s very unreasonable. You can look at the performance of institutions, which we did a podcast on this, the elite institutions, big investors, and you look at their long run track record, it’s somewhere between a 60-40 and a 70-30 simple index portfolio. And so if somebody is saying that they’re going to do dramatically better than that, to me, that’s a really cautionary aspect because you’re going to make decisions.
in your life or for your company’s financial future that are based on expectations that really are not grounded in reality. And so I just think like one of the key things is the more data you have, the better informed you’re going to be about whether or not those expectations are real or not.
Persistence is the Difference Between Skill and Luck 2, 3 – investing is different than other disciplines because the evidence doesn’t support persistence
Patrick Collins (11:18)
Yeah, totally agree. I think there’s this concept that it would be really good to unpack around talking about this question of how have you done. And it’s this concept of skill versus luck. And it’s a really, really hard thing, I think, for us to grasp because as humans, we tend to kind of look at the past and say that it will happen in the future. And in most cases in our lives, like the things that we’ve probably
observed day to day, tends to be the case. You um, you know, we’re, we’re in baseball season here in Baltimore. And if, if I’ve seen a player that hits 30 home runs a year for the past five years, there’s a good chance it’s going to hit a lot of home runs this year. Um, if someone, you know, in relationships, if I, uh, I’m dealing with someone who’s lied to me multiple times in the past,
it’s a good chance they’re going to lie to me again. So the past has been predictive of the future in a lot of things. I have
kids that are going to college and are in high school and college. And you see good students, students that have gotten good grades in the past, they tend to get good grades in the future. So you kind of extrapolate that, that if someone has had good performance in the past, it should be the case that they have good performance in the future. But the real question is,
is the past based on skill? Is a manager being able to outperform in the past because they’re skillful
or maybe because they’re lucky? And that’s a really important distinction. If it’s skill, you should see persistence because someone who’s really good at it should continue to do really well at it. And if it’s luck, it should be somewhat random that it would be that, yeah, we understand that there’s going to be people that outperform just based on luck, but it shouldn’t be that the same managers continue to outperform if it’s luck. That would not be luck, that would be skill.
And it’s exactly what we see in the data is what it looks more like luck. It’s that if you look at say a five year stretch,
and you look at managers that have outperformed, it’s not the same that are going to outperform over the next five years. Or if it is, it’s a random sampling. Like I would look and say, of these hundred managers that have outperformed over the last five years, maybe only 20 or 25 will continue to outperform. It’s the exact same number I would expect if I just picked a random sampling of managers. So it looks a lot like luck. And so we see this in the mutual fund space.
And if you’re going to advisors expecting something different that
they will have some secret sauce that it’s been able to outperform. I would caution to say that the evidence really does not suggest that can happen. And so again, that’s why if you ask this question, how have you done and somebody has an answer that you like, is it based on skill or luck is a big question. And the last thing I’ll say on that is the timeframe matters. So,
I’ll use an extreme example. think I may have used this in the past with some people, but my son had to do this thing in high school, the stock market game where they picked a stock and where they picked some group of stocks and they try to outperform their classmates. Well, my son picked a Chinese electric car company. I don’t know how he picked it, but for whatever reason, it went crazy. It went up.
And he had amazing performance. was judging himself against the S&P come home every night. Like Dad, I’m outperforming them by this amount. I don’t think anybody ⁓ that has any sense of finance would say that my son is skillful. He was just plain lucky that he picked the stock that went up. And so that’s obviously an extreme example, but if he had done this for 20 years straight and outperformed, then we might say, wow, he he might know something. This guy might be skillful.
But he did
it for a few months and it went up and it was one stock. So I guess the reason I say that is, is that how long do you need to have when you ask that question to an advisor, how have you done? You know, if they have a 10 year track record, is that enough to be able to say that they’re lucky or skillful? The data and the evidence there, you need long, really long periods and kind of say with certainty that someone is skillful. And so I just bring that back to again,
Even if someone has a good answer that you’d like to hear, it may not be because they’re good or they’re skillful. It might just be because they’re lucky. And it’s really hard to distinguish between the two.
Marcus Schafer (15:28)
It’s hard to distinguish, and it’s really even difficult to understand what the historical performance has been. And you kind of talked about the two common forms of attribution analysis, where it’s…
Hey, stock picking, did you select better stocks or different stocks compared to the index? Or asset allocation, hey, did you just move your portfolio in a slightly different way? Not really looking at the individual stock, but more, are you more international? Are you more bonds? Are you more stocks? Kind of the bigger picture. And I think one of the challenges is sometimes people blend those two things without the track record.
that can show up in either one. I’ll kind of talk about stock picking. We have great data to evaluate whether managers that get paid to be really successful at stock picking can do it can do it consistently. And we’ll talk through some of that probably here in a little bit. Asset allocators, those are people that are combining the different stock pickers and saying, hey, can I select the best? We have some data on whether or not they can do that.
effectively. And then you have what I think is this really dangerous world of people that say, we don’t believe that the managers who get paid and this is their business can do this, but we’re going to do that while being an allocator. So we actually don’t have the track record that you can judge us on, but we’re going to be trying to blend these two worlds. And I think one of the really, really big problems of that
is it’s just convoluted and you don’t understand what’s happening. So the way you would tell is, hey, are there moves in the portfolio? Can you explain why you did that? Are they big moves? Are they small moves? Do you have a mixture of direct held securities, co-mingled solutions, which means mutual funds and ETFs? And if the evidence in either one of those camps doesn’t really pan out, then somebody without a strong track record that’s judged against a benchmark
How are you supposed to evaluate them? It’s really, really difficult. And also I think everybody has to look, including us, you have to look internally and think about, hey, am I overstating my own historical track record? And really think about what was the opportunity cost every time you did one of these decisions. And it’s really difficult to go through this analysis. When the big institutions go through these analysis, what they find oftentimes is,
the outperformance they thought they were getting through investments was more due to timing of cash flows than necessarily necessarily scale and kind of the logic behind that is a public market equivalent when they’re looking at alternative investors, ⁓ KS alphas, things like that. We don’t want to get into that, but what evidence do you think we should highlight next Pat?
Patrick Collins (18:41)
Well, I think it’s probably not a bad idea for us to get into some of these two kind of areas if we’re talking about, I’ve asked the question, which we’ve tried to already caution, be careful of asking this question, how have you done? But even before I get into this next section, I think it’s important to state that most advisors, because this podcast is really geared towards if you’re looking to hire an advisor, could you ask this question?
Um, but most advisors are going to have a hard time, even from a regulatory standpoint, answering that question because of all the reasons I said before, we don’t have as advisors, one portfolio for our clients, every client’s unique. And we are, you know, there is, there’s nuances across the board. So, you know, internally at Greenspring , for example, one of the things we do is we take all of our clients, for example, that have a.
60 % weighting in equities
And we will compare them against each other. We’ll look for outliers and we’ll make sure there’s nothing going on strange or poor. So there’s real internal processes, but we don’t publish that because one, they’re all different every return based on lots of different factors from the client. ⁓ But two, we also think that it’s not really that helpful to share somebody, there’s a hundred portfolios at all that different returns. It’s really hard for an investor.
to decipher all that. Why has this client done better than that? So I think, moving on to like, okay, you’ve asked this question, you’re kind of getting an answer from the advisor. Maybe it’s not a specific, hey, I’ve done 8 % per year, but it’s more of a general kind of discussion around this. Let’s maybe dig into this idea that they’ve been able to outperform. Maybe there’s a statement or some, at least to kind of an inference that.
I’ve been able to outperform because I can select managers that have outperformed their benchmark. I’ve been able to find talent, be able to find managers that have outperformed benchmarks. You come from this world where these are mutual funds that make these claims that they’re able to outperform. So whether you’re hiring an advisor or whether you’re thinking about doing this yourself to try to find managers that outperform,
Persistence is the Difference Between Skill and Luck 2, 3 – investing is different than other disciplines because the evidence doesn’t support persistence
Let’s start there. What are some of the things that managers are doing or mutual funds or whatnot
that make it really hard to ask that question? I know there’s a lot. you know, maybe we can dig into some of those to be mindful of.
Marcus Schafer (21:13)
Yeah, I think this is really getting into is the past performance, are you viewing the full picture of that past performance? And once you start to view the full picture of the past performance and see how over time, if you would have looked at past performance and made different decisions, would that
extrapolate into future performance. And that’s where we just see this massive disconnect. And it goes all the way back to theory that if everybody is holding the market and there’s fees being charged as a whole, everybody is going to underperform the market by the fees being charged. This is the arithmetic of management, of active management. This is before a lot of costs and other frictions are added in.
So right there, there’s a statement that says on average we expect to lose. Right there is an immediate hurdle. Now the incentives to win are massive. there’s this saying, one of my former professors, Neal Hall, whose research we’re going to talk about here in just a little bit, he always says, “Hope springs eternal.” And there’s just this belief that, I can do dramatically better and I can really, really change my…
my life, see there’s all these people chasing that. So let me just talk about some different things that when you start to unpack what’s happening, isn’t there. The first thing is seeding or incubating strategies. Then we have merging strategies and then closing strategies. So seeding or incubating strategies kind of takes this form of a few different ways. Number one, asset managers launch a bunch of different strategies.
Some work, so some don’t. Now, what that means is when you’re looking at performance, you’re only ever seeing good performance. You’re never seeing the bad performance because they closed it and you just can’t see that. The other thing you kind of have to be careful of that goes with this seeding or incubating is asset managers that have pre-existing strategies. Those strategies might invest in new strategies. Again, some of this
might be on the up and up, they might really believe in this idea. But when you’re invested in a strategy that’s investing in something else, you’re paying some of these startup costs. And there’s different ways some people try and get around some of the conflicts, fee waivers and things like that. But they’re using your money to see the different strategy. And the question is, is that what you wanted? And it may be or it may not be, but you’re losing control.
And the more you outsource things and the less you understand the process and the goals of a portfolio, the more likely it is for some of this stuff to get left out. The bigger thing, I think, when it comes to this is also strategies merging, right? So you’re invested in one strategy. Asset managers can take that. And if the strategy is not succeeding, they can merge it into a different strategy to keep the better strategies performing.
Sometimes this makes a ton of sense. You say, hey, I have a taxable mutual fund that’s managed in a tax-deferred way and there’s a new SEC rule that says, hey, I can actually manage this in an ETF now. You can do that. That’s a merger. Probably a better thing. You now have more tools to tax-efficiently manage it. That’s a good thing. Sometimes when you look at this, I mean, we’re talking…
growth to value strategies, there’s just a lot that’s going on behind the scenes. And actually about 22 % of the funds that close, they’re merged. So you might not see that. Two thirds underperform their category benchmark, which again underperforms the index that it’s tracking. So if you have bad performance, you kind of merge it away. And then you talk about, Hey, look at our great track record. I’m not sure that’s…
That’s the right way to do it.
Taking More Risk Than Benchmark – especially in lower volatility asset classes like bonds, picking a favorable benchmark is a common tactic to be aware of
Patrick Collins (25:22)
It reminds
me of the quote, you know, “there’s lies, damn lies and statistics.” It’s, it’s kind of like, you know, there’s such an incentive for mutual funds to show out performance. so whether it be merging the funds, closing the funds, changing the benchmarks, that’s another way that you could do it is you’d say, you know, we’re not performing this benchmark, but what if we were benching benchmarking against this asset class or this, this index, we’d actually look a little bit better. So why don’t we change that? So.
You know, there’s so many tricks and tools that people use to try to show out performance because it is so lucrative. When you show out performance, asset flows come in. When asset flows come in, your fees go up. so there’s just the, you want to follow the money to a degree and understand this. So I think it’s really important to understand that. The other one that I’ll just
say that, you know, I’ve seen a decent amount is that you just take more risk.
than the benchmark. okay, I have a benchmark that is in large cap US stocks. Well, maybe I start buying mid cap stocks and maybe I start going down into small company stocks a little bit too, because over time, those asset clients have better performance than or have higher expected returns at least than large cap, for example.
And that may work for me for a period of time. Now, as an investor, I kind of want to know that, that yeah, this is not.
because this person is skilled in picking stocks, it’s because they’ve just gone outside the benchmark and bought some different stuff. there are so many, again, so many ways that people and managers can try to show out performance. And if you’re not aware of it, you may not be buying what you think you’re buying, or you may be taking more risks than you think you are,
or it may not have really had as good of a performance as you thought it did.
So there’s just so many things you have to be mindful of. So again, if we go back to our original premise of an advisor who says, I can pick managers that outperform or the one I hear a lot that kind of the term is best in breed or best in class, we pick best in breed managers, best in breed asset class managers.
That to me means that they’re picking, they’re trying to pick some of these managers. They have to deal with the advisors have to deal with same thing as investors do, which is how do you select these managers
based on all these things that are going against you, trying to show you that they’ve outperformed. And so it’s tough. I think if you are selecting an advisor based on at least fact, know, based on that factor, or at least that partial factor, be mindful because that may not be, if it even hasn’t done at all.
based on all these things that are kind of going against you, trying to show you that they’ve outperformed. And so it’s tough. And I think if you are selecting an advisor based on at least factor, based on that factor, or at least that’s partial factor, be mindful because it may not be, if it even has been done at all, it’s probably
gonna be tough to be repeated.
Marcus Schafer (28:04)
Let me pick up on some of the stuff from benchmarks and then we’ll come back to kind of is there evidence that people can pick best to breed because there is some research around there that we have. But this concept of benchmarks is by far a net positive. Benchmarks give you a ton of information. The challenge now is you really have to have the ability
to unpack it and say, let me understand how this strategy is different from the benchmark, how those differences evolve over time. But if you just look at a number at a point in time, it’s not going to give you the full picture. So you mentioned S&P kind of buys some mid- caps. Let me give a starker example, which is bonds.
Let’s say you’re looking at two different bond funds. One has an average credit rating of A, the other one has an average credit rating of AA. That seems like a very intuitive thing. Okay, hey, I have two measures of risk. Now I can look at which one performed better and I can make a judgment. Well, there’s this crazy thing when you unpack it. Some of the differences, I’ll give the example.
The US government, depending on the provider you look at, they have two different measures of their credit rating risk. Some have them rated at a certain level, others have it different. And asset managers have the ability to say, I could pick the best rating or I can pick the middle rating. So they might actually hold the exact same thing, but they’re going to state two separate credit ratings.
So it’s just really difficult because you look at this, how is this possible? Well, they’re just using two different sources for essentially the same underlying holdings. see that, you see more active bond strategies, buying less liquid bonds that mark their price less frequently, which lowers the volatility. It’s kind of like your house, you only check the price of your house when you go to sell, but you should know in the background, it’s doing a lot of
Moving the (Benchmark) Goal Posts 6, 7 – underperforming funds change their benchmark to something they historically beat…
a lot of volatility. So this concept of benchmark relativeness is really important. And there’s this also, there’s this research around moving the goal post. And what this is, fund companies, this happens on average, 7 % of all funds are doing this in each year. 37 % over the sample period, they change their benchmark. And the rules for changing the benchmark, for one year, you just have to put both benchmarks.
and then you could strip out the other benchmark. Only 25 % of the funds that do this are actually saying why they’re doing it in their prospectuses. The only way for individuals to know it was benchmarked as something previously would be to go back and look through an old prospectus, which by the way, if you haven’t read a prospectus, they’re about 150 pages and it’s all legal terms that roughly tell you what the strategy is, but you still have to call the manager.
To ask exactly what they’re doing. So what do you think? Do funds that are beating the benchmark change their benchmarks? No. Funds that tend to underperform tend to change their benchmark. Then historically they look like they’re outperforming better. The average one-year change, looking back, was 0.8%. 2.4 % over three years. Almost 5 % over five years.
So they’re changing their historical performance. They still did the absolute, the same as it’s the same performance. They’re just changing the relative nature. What happens is going forwards, we know investors, everybody likes to buy something that did well in the past. It’s pretty tough to go tell your wife, hey, I bought something that hasn’t done that well, but I’m very confident in it. So this actually changes. They measure these researchers, the fund flows. They got about 10 % more fund flows.
then they would have you go from outflows to inflows. So about $80 million on average per fund that did this gets put into this investment. Lo and behold, you look going forward, hey, does the fund actually beat these benchmarks going forward? No, they don’t. Sometimes it’s to get a more accurate benchmark, better benchmarks come about. So there’s good reasons to do some of this. But definitely when you look in aggregate, it seems pretty suspect. So you just got to be
You got to be aware that there’s these games happening behind the scenes. They’re more prone in some strategies than others. The strategies we use, right? They’re much less prone. Anytime there is a change, we’re on it. We’re understanding why are you doing it? it’s to add a better one, to add a better fit. That makes sense. Turns out when you build a fund in 1994, you don’t have that great of benchmarks to select. So that’s, that’s my rant. Cause I think that’s a…
It’s pretty suspect what’s going on behind the scenes in those cases.
Patrick Collins (33:12)
Yeah.
Even Institutions Funds Can’t Find Performance Persistence 1, 8, 9, 10 – they also buy good looking past performance that becomes average performance
Fascinating that, you know, I didn’t know the stats and I think it’s really interesting. And it really should make you question if you’re going to evaluate either an advisor or an investment and you’re basing it on their outperformance over a benchmark, there’s decent chance that that has kind of changed over time as far as what their outperformance has been. just switching gears a little bit, I think.
There again, this idea of using the past to help predict the future, which is kind of how we’re all, I think, wired in some ways. And it’s rooted in the question, how have you done? What’s your past performance been? It’s very much rooted in, you’re saying that obviously, because you want to know, but you’re also going to extrapolate that in your mind to say that if they’ve done well in the past, they should continue to do well. so I think there’s some really, you mentioned it before, there’s some really interesting research.
that’s been done that maybe you can talk about ⁓ at the institutional level. And so this is my understanding when I’ve read the study is this is large
institutions they did an analysis to decide to look at when they made changes in their portfolio. So when they were to take out a fund and bring a new fund in, maybe most likely they took somebody out because they were underperforming and they brought somebody new in, tended to be active managers. ⁓ What they measured was
What was the performance of the manager prior to being kind of put into our portfolio? And then what happened after? Because we only get what happened after. We don’t get the past
as returns. We only get future returns when we select a manager. So maybe you can talk about this because this is some of the smartest people in the world too that are making these moves. These are institutional consultants and asset managers.
and pension funds and whatnot. And it is really large pools of money. So it’s not, hey, this person was just unskilled. They didn’t know what they were doing when they hired this manager. These are really smart people. maybe you could talk a little bit about the research.
Marcus Schafer (34:59)
Yeah,
yeah, I think
What the research shows, number one, why are they doing it to the biggest institutions? It’s something that we talked about on our episode, think it was five around elite institutions. They have dedicated processes that enable researchers to better understand, hey, what was your criteria? What was the effort? What was the diligence that goes into this? And some of that information is public who
who wins, who gets the position, who’s fired, oftentimes that gets public. But what it goes to show is the pure volatility of stocks that it’s just super unpredictable. It reinforces what you were talking about before, which is some funds continue to do great, other The research I was reading that was from my…
my former professor, they looked at these big institutions. It was about $1.6 trillion of mandates that were being assigned. they were essentially, they’re asking this question, hey, when you select a manager, do they have good historical outperformance relative to the opportunity set or bad? They have good. And then going forwards in the next one, two and three years, do they continue to have good performance or do they not?
And the answer is they don’t continue to have great performance. It kind of reverts back to where it was. And it goes back to all the things that we were talking about where they like fees are big. This is tough. It’s still, I think what the number one thing investors, ⁓ it is really tough to understand is three years in stock markets tells you almost nothing about the longterm expectations.
It is just the volatility is just really tough on an individual, on a concentrated basis to really tell. So you kind of go from, hey, this was doing two or 3 % better than everything else in the past three years. Fast forward the next three years, it’s doing about a percent worse than everything else. In the cases where the strategies do, and there some instances where, especially in the top, I think it was quartile, could have been decile.
But there are instances where it looks like, some people found some great strategies. There’s this one theory in finance that there’s diseconomies of scale. So this is Burke Green. And essentially what they talk about is there is skill, a lot of money chases that skill, right? And the way you make more profits in the industry, you don’t have to raise your fee. You get more assets and that pushes up your fee. The more assets you manage, the different…
more difficult it is to implement your strategy. So then your future returns tail off, which necessitates this consultant game of always rotating in to new strategies, which it just doesn’t pan out.
Patrick Collins (38:14)
Yeah, a it’s
really it kind of goes back to that ideal idea of persistence and whether managers that have outperformed in the past can persist into the future. And I think there’s a few things there that just maybe to summarize one is we don’t really it’s really hard to distinguish between luck and skill. And so if it is luck, then you shouldn’t expect persistence. And that’s kind of what we’ve seen in the few cases where there may be a skill for manager. The
the flows, it’s almost like investors won’t allow it to happen because they are going to flood that manager with assets. Once the assets comes in, it’s very hard to implement because what do they need to do? Whatever their strategy is, they have to buy more of it. They’re gonna bid prices up and it starts to water down performance. So it’s really, really difficult. That’s why you tend to not see managers outperform. The managers, you could say, well, then maybe one of the strategies will don’t allow new money to come in.
which I don’t know how that helps current investors if you’re not already invested, but even if you’re not, there’s examples of this. One really specific, probably one of the best performers you’ve ever seen or at least that we’ve seen like from a track record is a hedge fund called Renaissance Technologies. And they’ve closed their fund. You can’t even invest in it. Only if you’re actually an employee of the company can you invest. But it’s something like 5 % fees plus 40 % of the profits.
So yes, maybe they have developed some strategy that can be replicated. But at that point now, you have kind of that scarce resource as the manager. Everybody wants it. So you can start to raise your fees. And all of a sudden what happens is that you end up getting a return that’s not that much different than what the market is. it is really tough if you do find somebody that’s skillful, most likely they’re not going to be that skillful for long because they’re going to flood it with assets or they’re going to raise their fees.
Even Institutions Funds Can’t Find Performance Persistence 1, 8, 9, 10 – they also buy good looking past performance that becomes average performance
Patrick Collins (40:03)
Maybe us shifting a little bit now is talking about, you know, we’ve talked about this idea of how hard it is for both stock pickers, even allocators to try to outperform and how hard it is to kind of decipher that as an investor. so what should you think about if instead of, you’re not asking the question, how have you done? Which again,
I don’t think there’s anything wrong with asking that question of an advisor. I think if somebody comes to you and says, this is how I’ve done and gives you a number, I’d be wary I’d be very cautious of that. I think they probably want to have a little bit longer conversation of why, like kind of in this context, why it’s so difficult. But what are the things that you should think about when you’re evaluating hiring an advisor? So one is, that, you know, does, does everything match up? Do they say, did they do what they say they’re going to do? So.
You you can kind of look
at maybe their long-term track record. Do they- Have they been able to retain clients? Have they been able to retain employees and staff? Like did people stay there basically, or did they have a lot of turnover? So you could ask that, what’s your attrition rate? A few other things that I would ask about is maybe not what have you done or how have you done in the past? Can you explain it? That would be the thing that I would be really interested in is
How have you invested your portfolios and can you explain why your performance has either been good, bad, average? And all of those answers could be okay. They could have had maybe slightly underperformed. Now, if they’ve significantly underperformed a benchmark, I’d be wary of that. But at the same time, I get really concerned when I see managers that have drastically outperformed. And that seems strange to a lot of people. Like, wait, why would you be concerned about that?
because I know that, I know this is the kind of statistics around, around kind of luck and skill. And so I know that there’s a very good chance that it was based on luck. I also know that the only way to outperform is to deviate significantly from the market. So you can’t hold the market portfolio or an index and outperform it. You have to change something significantly. So that means I’m gonna either concentrate my assets, or it means I’m gonna take one asset class and go all in on it.
We see that now, right now with US stocks. So a lot of times we’ll see portfolios that come to us and they have significantly outperformed, let’s say the world stock market because they are almost 100 % invested in US stocks. And you could say, well, that’s been very skillful of somebody to do that. Maybe, but I would say the more likely scenario is it’s probably been very much luck too that they’ve been able to pick one stock market in the entire world that has done really well.
because we know there’s all sorts of time periods where the US underperforms a global, you know, kind of the global markets. So again, could you pick up an advisor that can get you in and out of that when it’s, when it’s the right time to get in, when’s the right time to get out of these different asset classes? It’s really hard to do. You know, I think the better strategy, if you found an advisor and they said, well, we’ve had performance that looks more like the world stock market. I think that’s a reasonable.
uh, you know, kind of a tactic to take as far as our strategy is we’re going to own a lot of stocks and be globally diversified versus we’re going to concentrate all of our assets in 500 stocks in the US I just think it’s a really tough thing to, you know, to, to, uh, uh, persist on. So anyways, those are a couple of things. I know there’s anything other things, other things you think people should be looking at when they’re evaluating an advisor or, or, uh, you know, or, or stock, you know, stock manager.
Marcus Schafer (43:25)
Yeah
I think what you said is perfect, is great question to ask. If you get the answer you’re looking for, probably not going to be persistent. If you say, hey, how have you done? And you’re thinking, I really want somebody to crush the S&P 500. And they say, we could do that. Then you really should say, okay, well, I would like to see proof of that. How can you explain that to me?
If you go and you ask somebody, have you done? And they say, we own broadly diversified portfolios. Every client’s a little different, depends on what you come in with, how willing you are to incur taxes to get more diversification in your portfolio. But we’ve done about what a globally diversified stock and bond portfolio would be. That seems to be actually what you want to hear. And a lot of this commentary around the…
the difficulty of outperforming by selecting managers, by doing it based off of past performance, there is an antidote. And the antidote is just to buy the benchmark as a starting point. And this is what more and more investors are choosing throughout the time. it doesn’t diminish the merits of it. But for our endowment episode,
We had numbers, I think they went through 2012, which was most endowments were essentially a 60-40. We had the latest numbers from the study come out from the NACUBO study that was through 2024. It’s weird fiscal years through June 2024. And it was now about the 70-30, but you look at the change of asset allocation, bonds dropped from 30 % to 10%. So, hey, that kind of makes a little bit of sense, but you can just buy these benchmarks.
and go out there and live your life. And I think, you know, the other question, most people when they ask this, they’re really saying investment returns. But my personal belief, if you’re an advisor offering only investment value proposition, then you should be a registered mutual fund and publicly say your performance like the rest of them. And you’re going to find out it’s a really, really tough game once you have to do that. Or
You could do something like we do, which is, yeah, we build portfolios. Yes, we manage them every day, but we’re also helping you think about taxes. We’re also helping you do insurance analysis. No, we don’t take a commission off that. So there is other value propositions that you should be asking, hey, how can I know that you’re helping me get value in other aspects of my financial life that are in conjunction with the investment portfolio, not just the investment portfolio? ⁓
Patrick Collins (46:35)
Yeah, there, there,
I can tell you kind of, there’s probably four or so things that I look at when I, if, a client comes to me or a prospective client comes to us and says, Hey, you know, you take a look at how, know, my, I’m invested. ⁓ there’s a few things that I look at. Performance is probably the last thing that I look at. but I really start with a few things. One is fees.
I think there’s, you buying high cost products? That is a, to me is a kind of an auto, that’s an area where that’s ripe for just improvement in portfolios if you are buying high ⁓ cost expensive products.
The second is how well diversified are you? Do you own 10 stocks? Do you own 50 stocks? Do own 500 stocks? None of those in my opinion. And on top of that, are you invested only in the US? Are you invested internationally? Do have small companies? Do you have large companies
There’s so much diversification benefits that you can have. Do you own bonds? Do you own real estate? You know, there’s so many areas there. If you’re really concentrated, that’s a concern of mine. Obviously concentration can come great wealth and can come, can come
ruin too. You know, both things can happen. And so for most of our clients, they’ve made most of their wealth. They want to earn a really nice return, but they don’t need to take the type of risks that could ruin them if it goes wrong. So I think diversification.
is another thing that you really need to keep an eye on. The third is just structure. So ⁓ it kind of goes hand in hand with diversification, but let’s say I do own US stocks, international stocks. Well, how much of large
companies do I own versus small companies? And how much do I own of international value stocks versus growth stocks? Those types of things. There’s a lot of evidence. And we talked about this.
in one of our episodes around how to kind of tongue in cheek, how to outperform, but it’s important to understand these factors because they do have a factor on what my future expected returns are going to be.
So understanding that about your portfolio. And then the last thing is kind of all the like the minor things like tax efficiency and is my portfolio tax efficient? So all of those things, those are the types of things I would be asking an advisor about is
Pat’s 4 Questions To Ask Advisors – Fees, Diversification, Structure, and Tax-efficiency
What are the fees? ⁓ How diversified am I going to be? How do you structure these portfolios based on my personal circumstances? And then what’s the tax efficiency here? And so there’s all sorts of other things that advisor can do, but when it comes to investing,
to me, those things are so much more important than performance. Performance will come if you get those things right. If you get them wrong, you could show great performance. It’s one of those things we’ve talked about this a lot on the podcast, but it’s this idea of divorcing
decision-making from results. I can make a really good decision, but because there’s so much uncertainty, I can get a bad result, at least what I view as a bad result. And conversely, I can make a really bad decision and
get a good result. And so the thing is, I would wanna know from an advisor, are they making really good decisions? Are they gonna help me make good decisions? Because I know over time, performance will come and I’ll have more consistency with my performance versus
They make these really crazy decisions and it seems like it’s worked out. That’s probably bad decisions that maybe have worked out, but that doesn’t mean they’re gonna continue to work out. Most likely you’re putting yourself at a disadvantage. So those
are the things I would try to understand is how do they make decisions? Are they rooted in evidence research? Is it pretty robust? And that’s the kind of things I wanna understand about my advisor.
Marcus Schafer (50:03)
Yeah, that’s a great list to come out with because if you come and you take a portfolio and it has 25 % Nvidia in it and you give somebody a statement and you say, compare this, compare what I’ve done to what you’ve done.
You don’t really know what they bought in Nvidia It wasn’t 25 % of the portfolio 10 years ago. I’m not saying it wasn’t a great outcome. I’m just saying you can’t take that 25 % and go back 10 years and assume you had 25 % because guess what you have today? You have 99 % of your portfolios in Nvidia because it did amazing and that’s just theoretically not possible. So some of these challenges about looking back at performance are really, really difficult to untangle. But when you
When you can have the freedom and the flexibility to say, hey, I actually, I want to be less concerned about my portfolio and anything that’s driven great outcomes can also go the other direction. It is a tough to take risk chips off the table. Sometimes it is tough, but, um, we think it’s well warranted. think the research backs it up. Um, Pat, I think we’ve, uh, I think this conversation has temporarily run its course.
I’m sure you’ll get me fired up on the shady things happening in the mutual fund and ETF industry once again at a later episode.
Patrick Collins (51:42)
All well, thanks. Great conversation.
Marcus Schafer (51:44)
All right, thanks Pat.
Sources:
1 What Can We Learn from Elite Endowments? (Greenspring, 2025) – https://youtu.be/2wXKgVGUmyo?si=5hd-pN_GUv_fUtO5
2 SPIVA Persistence Scorecard (2025) – https://www.spglobal.com/spdji/en/spiva/article/us-persistence-scorecard/
3 Fund Landscape (Dimensional 2024) – https://www.dimensional.com/us-en/insights/the-fund-landscape
4 The Arithmetic of Active Management (Sharpe, 1991) – https://web.stanford.edu/~wfsharpe/art/active/active.htm
5 Fund Mergers and Liquidations (Dimensional, 2024) – https://www.dimensional.com/us-en/insights/mergers-and-liquidations
6 How To Beat The Stock Market Without Even Lying (WSJ, 2024) – https://www.wsj.com/finance/investing/stock-market-fund-benchmark-change-11660940613
7 Moving the Goalposts? Mutual Fund Benchmark Changes and Relative Performance Manipulation (Mullally and Rossi, 2024) – https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4145883
8 Performance Persistence in Institutional Investment Management (Busse, Goyal, Wahal, 2006) – https://ssrn.com/abstract=890319
9 Choosing Investment Managers (Goyal, Wahal, Yavuz, 2022) – https://ssrn.com/abstract=3651476
10 Mutual Fund Flows and Performance in Rational Markets (Berk, Green, 2003) – https://papers.ssrn.com/sol3/papers.cfm?abstract_id=383061
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