How Can Track Record Be “Gamed”: Part Three

Previous posts discuss how investment managers sometimes manipulate the way they present their track records. The objectives of these posts are to (1) help you become aware of when you are face-to-face with a deal that is too good to be true; (2) keep you from treasure hunting rather than investing—designing a prudent portfolio to meet future economic needs; and (3) persuade you that, no matter how an investment has worked out in the past, you cannot count on success continuing automatically into the future. This said, there’s a tremendous temptation to buy investments with good track records. Why should Uncle Joe be the only one in the family to feel great about his investment?

We mention one more strategy used by investment sponsors to produce an attractive looking performance. Perhaps the most difficult aspect of assessing a track record is to determine if the rate of return is a product of a successful investment strategy, or of leverage [leverage = using borrowed money].

EXAMPLE: suppose I have only mediocre skill and I can earn only 4% on an investment when comparable investments are earning 5%. No one would buy my investment program. But suppose I use investor’s money as collateral for a loan (this is perfectly legal as long as it conforms to certain SEC requirements). Suppose, further, that I start with $1 million and borrow an additional $500 thousand for a total investment fund of $1.5 million. Now, because of the “extra” borrowed money, investors in my program are earning 4% on the original million ($40,000), plus another 4% on the $500K that I borrowed ($20,000). So thanks to my loan, I’m reporting return of $60,000 on a $1 million investment: a 6% return! I am beating my competition not because of my skill, but only because I increased the risk of the investment program.

But, if the program declines in value, the bank can call the loan. Guess where the bank is going to get its money—from the investors. If the bank calls the loan when the fund is valued at $500,000, the investors will receive nothing –a 100% loss! The investors incur the catastrophic loss simply because they believe that a 6% return is better than a 5% return.

Bottom Line: Here is an important investment principal: Risk and return are related. An investment with a good track record is one with an attractive return. In hindsight, the investment does not seem risky because the embedded risks did not manifest themselves — YET. “Yet” is the key word. Don’t make investment decisions based solely on track record. Often, a good track record merely indicates that the manager employs risky strategies. Thus far, the bets have paid off; but there is no guarantee that fortunate results will continue.

Investor Protection: There is a professional organization that sets standards for the legal and ethical reporting of investment track records. The organization is the CFA Institute [CFA = Chartered Financial Analyst]. Make sure that when you are shown an investment track record, there is a footnote or other written notation to the effect that the calculation methods and presentation standards are in compliance with CFA Institute guidelines. This is important—too many investors have been scammed.

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