As a parent of identical twins, I’m well versed in the phenomenon of two lookalike entities exhibiting vast dispersion in behavior at any given time. So, when I encounter substantial short-term performance differences between investment strategies in the same asset class, I am disinclined to infer one is better than the other without more information.1 Indeed, even strategies with nearly identical construction rules and long-run average returns can deviate meaningfully through time. The lesson for investors is to remain cautious, as always, when interpreting past performance.
US small cap value research simulations rebalanced in different months provide perspective on the variation in outcomes arising from minute changes in methodology. Average monthly returns in Exhibit 1 reveal an 11 basis point range in long-run performance depending on the choice of rebalance month, despite identical stock selection criteria, a point we’ve used to highlight the need for caution when interpreting simulated outperformance. But even the simulations with the same long-run average returns have diverged markedly over shorter periods.
Rolling 12-month absolute return difference between US small cap value simulations rebalanced in February and November, December 1975–December 2020
Given the range of outcomes for such similarly constructed simulations, it should be no surprise we observe short-term dispersion between commercial small cap value indices, even ones with nearly identical names. Average calendar year returns for the MSCI USA Small Value Index (gross div.) and the MSCI US Small Value Index (gross div.) from 1998 through 2020 were close, at 10.04% vs. 9.97%, respectively. But calendar year observations illustrated in Exhibit 3 have on occasion revealed meaningful deviations in performance. The average annual magnitude of the return spread between these indices was 2.11%, maxing out at over 13% in the year 2000.
Calendar year returns for the MSCI USA Small Cap Value Index (gross div.) and the MSCI US Small Cap Value Index (gross div.), 1998–2020
Making a Short Story Long
Noise in returns limits the usefulness of short-term performance in manager evaluation. Because even minute, arbitrary differences between investments can drive huge differences in realized returns, eye-catching short-term relative performance observed in the past may offer little insight into expected value-add. Longer-term results, particularly when achieved across a suite of investment strategies, offer a more reliable evaluation framework. Investors should also consider the manager’s investment process—a robust process built on decades of expertise can add value that is observable without looking to noisy market returns.
3 Based on monthly observations for trailing 12-month return spread and trailing 12-month average of monthly cross-sectional standard deviation of US stock returns from December 1975–December 2020. US stock sample formed each month using data from CRSP and includes all common US stocks (share codes 10 and 11) listed on the NYSE, AMEX, and NASDAQ exchanges with non-missing monthly return data.
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Past performance is not a guarantee of future results. The data and information set forth herein are provided for educational purposes only and should not be considered tax, legal or investment advice; a solicitation to buy or sell securities; or an opinion on specific situations – as individual circumstances vary. There is no guarantee an investing strategy will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate risk, including the risk of market or systemic loss.
Please consider the investment objectives, risks, and charges and expenses of any mutual fund and read the prospectus carefully before investing. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
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