Michael Lipper: 5 tips for avoiding a performance trap

All US investment performance advertising is required to contain a caveat that past performance is not a guarantee of future performance.  Some substitute the word ‘indicative’ for guarantee.

Analysts are not as skilled as actuaries in drawing future trends out of past data, but they, as well as portfolio managers, sales people and investors take comfort in investing in securities and funds that have performed well in the past, particularly the immediate past.

Increasingly I have a problem with this somewhat comforting approach.

While cheering for a continuation of a winning streak, those of us who follow various sports know that all streaks get broken.

One of the many lessons I paid for at the race track was to avoid odds-on favorites to continue their streaks, and to look for horses which fit the current race conditions better than their last several win and loss records.

In the current global investment environment I believe we are currently in a period where simplistic extrapolation of the past may well be counterproductive.

Counter-indicators

In the first week of the year the value of the yield on long term US Treasuries was lost in price declines.

Indicator 1

The stretch for yield has led one bank to recommend 15% of clients’ fixed income to be invested in leveraged loans. As some are predicting no gain in investing in government paper after the impact of inflation this year, the relative risk in the fixed income allocation of portfolios is likely to approach or perhaps exceed the risk in conservative stock portfolios. (Outside of very low yielding cash there are no large places to hide-out.)

Indicator 2

At the end of December the short positions in the NASDAQ Capital Markets were on average 4.79 days compared to 5.47 days as of December 14th.

Part of the decline could have been year-end trading influenced by taxes including the expected rise in ordinary rates for some traders and a drop in volume running up to year-end.Nevertheless a 12.5% drop is worth noting. Most NASDAQ stocks are more speculatively priced than those listed on the so-called “Big Board” (the NYSE). They tend to be more volatile.

One of the reasons to pay attention to this data point is that every short position eventually needs to have an offsetting purchase. Thus a short position eventually means some buying. With shorts declining there will be less demand for some stocks, not a good sign for a long-only investor.

Indicator 3

Large, in theory conservative, banks and other wealth management organizations are recommending hedge funds or worse, funds of hedge funds. One bank has recommended that 20% of clients’ balanced allocations be in alternative investments (largely hedge funds). Even the sage Byron Wien is recommending 15% in hedge funds.