Superior investment performance relative to a given benchmark can be attributed to some combination of three basic drivers. The first is investor skill – the ability to find and exploit mispricing as it arises. The second is valuation changes combined with an investment strategy that diverges from market capitalization rates. For example, a manager who tends to purchase large cap growth stocks will outperform its benchmark, assuming its benchmark is broader than large cap growth stocks, when the valuation of those securities rises. The final is bearing risks that are not captured in the benchmark. For instance, a value manager who is measured against a CAPM benchmark will outperform, on average, if there is a risk premium associated with holding value stocks that is not captured by the CAPM benchmark.
What distinguishes the three drivers is that they have markedly different implications for whether the observed historical superior performance can be expected to continue. If performance is attributable to skill then clearly it should persist as long as the skillful managers run the portfolio, but with a caveat as described by Berk and Green (2004). Berk and Green note that skillful investment managers have an incentive to capture the return on their skill. There are two ways to do that – by charging higher fees and by accepting added funds to manage. The first method reduces the net performance, but not the gross performance. The second, however, could eliminate much of the gross outperformance because as funds under management grow it becomes increasingly difficult for even a skilled manager to earn superior returns.
To the extent that superior performance was a result of valuation changes, and to the extent that the manager continues with the same investment strategy, superior performance should not be expected to continue. Over the horizon on which most managers are evaluated, typically three years or more, there is no evidence of momentum in stock prices. In fact, academic research suggests that there is a slight tendency toward mean reversion. This implies that to the extent the past performance was a result of valuation changes, managers who outperformed in the past can be expected to slightly underperform going forward.
Finally, if historical superior performance was the result of bearing a price risk that was not reflected in the benchmark, that performance should be expected to continue. However, it is somewhat misleading to call it superior performance. Investors who interpret the higher returns as evidence of skill will be disappointed in those states of the world when the risks they did not recognize they were bearing are realized.