Matt Pauls 2010

THE DIFFICULTY MEASURING PERFORMANCE

 Matt Pauls 2010

of derivation and of practical and sensible

T H E D I F F I C U LT Y application?

MEASURING How does experience then, relate to

investment management? Does an individual
PERFORMANCE.
with 10, 20, or 30 years of investing
experience make him more skilled? Does it
make him better qualified? Does it provide
him with a deeper understanding of the
In many aspects of life there is a positive
correct facts, truths, or principles? Does it
correlation between length of time performed
give him better judgment? Does it make him
and competency. That is, people tend to
more expert? The answer is plainly, no. Were
follow the general premise that having done
this true we'd find clear evidence of steadily
something with a greater frequency or for a
increasing absolute investment performance
greater length of time makes an individual
over each investors lifetime. But this is just
more qualified, better skilled, and more
not the case measured by empirical evidence.
knowledgeable. This rule of thumb may be
Superior investment results have very little
reasonable some of the time, but it isn t
to do with the length of one's track record. Of
universal. Human nature being what it is,
the best investors, to my knowledge, they all
often causes us to base decisions upon habit
did well right from the start, irrespective of
not reason.
their age or background. What is important in
In the investment management business,
investing is a thorough understanding of the
the validity of experience as qualified simply
proper facts, truths, or principles as can be
by an act of having done something with
sensibly applied toward investment decisions.
greater frequency or for a greater length of
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time is unfounded. An individual may be well
practiced, even veteran, but to deem them
skilled or expert is of poor judgment. The flaw

But what can be

is in the assumption that having practiced
something over time provides the individual
with an increased knowledge of the subject. said of knowledge
(Webster defines Knowledge as, an
acquaintance with facts, truths, or principles, based upon the
wrong set of facts,
as from study or investigation.) But what can
be said of knowledge based upon the wrong
set of facts, truths, and principles? What can truths, and
be said of an acquaintance of facts, truths, or
principles only, without thorough investigation principles?
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It would be a fair argument, generally, to suggest that an investors

track record is the best measurement of correct investment
knowledge, but this would only hold up as a broad claim especially
when the record is of short duration. This is almost always overlooked
or misunderstood. I m of the opinion that historical returns may or may
not be important and are more often misleading when the record is
shorter then 15 years. Which is the better choice, a fund earning 10%
over the last 5 years or a fund earning 15% over the last 5 years? Well
most people would probably quickly choose the 15%. But this is way
too little information. The fund manager earning 10% for 5 years could
very well be the better of the two investors. It s very easy for a 5 year
track record to go from 15% per annum to a 6 year track record of
well below 10%. Similarly 10% can very easily go to 20%. There are
other factors like leverage, which can t be ignored, can take many
forms (Margin, derivatives, but also could be levering of the general
partner). Though it s erroneous to overweigh the importance of a
short track record, it s similarly wrongheaded to completely assume
that nothing can be made of a short track record. Performance is
generally useful as a short-cut or rule of thumb-think earnings/price
yield-it s a good place to start, but it s crazy to use this as the most
important measure.
Investment performance must be measured with respect to the
investors systematic approach: what the investor is doing, why they are
doing what they are doing, and they must be able to clearly identify
and explain why their investments turned out well or badly.
Ultimately, Investment knowledge must eventually converge with
investment performance, but they don t necessarily converge right
away. In some (often many) cases, an investor may possess the
correct knowledge, but performance lags. In other cases, an investor
may initially perform well, but may not understand that his returns were
akin to gambling, leverage, or both. I d say at any given moment over
the first 15 years or so, it is incredibly difficult (for most) to recognize
the difference between the two hypothetical fund managers above and
others like them.
Why is this so hard for so many people, (so called) professionals
included? It s a problem of both perception and a lack of relevant

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Matt Pauls 2010

knowledge. To illustrate, take just about any wealthy local

businessman. It is commonplace for most people to assume that if a
person of business is wealthy he is wealthy because he was or is a
good businessman (or has good business sense).
That is, it is hard to correctly identify a know-nothing
businessperson from a know-something businessperson if you either
know nothing about business or are otherwise a know-nothing business
person (yes I m differentiating between the two). My point is that it s
critically important to separate out those who do well by chance and
those who do well for identifiable (often repeatable) reasons. All
investors (both know-nothings and know-somethings) want to make
optimal, rational investment decisions, but rarely do. Some do well
strictly from the law of large numbers. If enough people throw a dart
some, of them will get pretty close to the bullseye, but not all are
skilled. If you were a dart champion and I asked you to select a few
people from a large group you thought would advance to the finals of
an amateur dart competition, would you prefer to see the results of a
single throw without seeing the throw or would you prefer to see the
technique of the contestant without knowledge of the result?

The point of this rather elaborate discussion is that good investors

are easily identified by good businessmen (smart private business
owners) because good investors are good businessmen.

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Let s review the performance

of one fund from 1991 through
2001 relative to the S&P 500:
Annualized Returns 1991-2001

Fund X 12.83%

S&P 500 15.25%

Many individuals would be unimpressed by this record and

uninterested in investing along with this investor, because he
underperformed the market, but in my opinion, the more
important question is why he underperformed.
As it happens this fund is run by someone I consider one of
the top 5 best managers in the world after Warren Buffett.
From 1991-2001 his fund underperformed the market because
he looked around and said to himself, people are crazy, prices
are inflated, and there is little out there we find compelling. He
therefore simply said we re going to hold cash until things
change. In 1997 they had cash of 25%. By the end of April
2001, cash was nearly 50% of the entire portfolio.
Though he underperformed for 10 years, he hugely
outperformed over the 9 years that followed and therefore also
since inception. This is not contradiction, it would have made as
much sense to invest with him in 1991 as it makes to invest with
him now. Long-Term performance will always follow good
investors, what ultimately changed was the investment climate.

Fund X is Baupost Group, Managed by Seth Klarman.

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