Luck, Skill, and Their Role in Portfolio Returns

Most investors are familiar with the phrase, “Past performance is no guarantee of future results.” A new study by researchers Corey Hoffstein, Nathan Faber, and Steven Braun provides interesting data supporting the often-used terminology.

In the study, the investigators wanted to measure how large a role is played by simple serendipity for the annual returns of passively managed index funds. Index funds have become increasingly popular over the years since Jack Bogle launched the Vanguard 500 Fund, which is designed to mirror the return of the S&P 500, in 1976.

As we all know, “hindsight is 20/20”; it is easy to identify the factors that led to past out-performance relative to standard benchmarks (often referred to as “alpha”). But investors and fund managers would like to be able to identify factors that can accurately predict future alpha in order to capture superior returns. The problem is, no one to date has demonstrated the ability to correctly and consistently anticipate future performance factors at a rate any better than pure chance (i.e., luck).

In the study, titled “Rebalance Timing Luck: The (Dumb) Luck of Smart Beta,” the researchers wanted to determine how much the timing of a fund’s rebalancing affected its total return. Note that “beta” refers to the movement of a particular stock price relative to the rest of the market. A stock with a higher beta is more volatile—either up or down—than the average for the market. Because the time intervals at which index funds rebalance their holdings (adjust the composition of the fund to mirror that of the underlying index) can vary from as infrequently as annually to as often as daily, the study was designed to determine the effect of such activity on the total return of various funds.

The study concluded, among other things, that the impact of “rebalancing timing luck” (RTL) was magnified for funds with fewer holdings (the fewer the holdings, the greater the impact of RTL), portfolio turnover (the greater the turnover, the greater the impact), and the frequency of rebalancing (the less frequent the rebalancing, the greater the impact). The researchers stated, “Our results suggest significant potential problems for return-based strategy comparisons and analysis.” Random factors such as rebalancing timing can, in the authors’ words, “cause a strategy to appear skilled or un-skilled by relative comparison, when the performance dispersion is actually an artifact of luck.” In other words, because of unforeseeable factors such as RTL, “past performance is no guarantee of future results.”

However, there are objective factors that investors are well-advised to take into account when making decisions about portfolio construction. The most important, perhaps, is how well the types of assets held in the fund conform to your long-term investment strategy and your risk tolerance level. Investors who exercise the discipline to maintain a close correlation between these factors and their holdings will generally achieve their most important goals, over time.

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