Gambling on your gambler

Caroline Ritchie.

What a year! As I flit about at home, scooting between this and that, upending things as I do, I like to reflect. Hindsight (though I declare to my clients never to indulge in it), sneaks up on me. So, let's cut to the part where we dutifully adhere to that well-worn disclaimer: past returns are no indicator of future performance. That's what they say so it must be true, right?

That is what the small print burbles on every fund document and prospectus in the land. Shame it's not true. Mostly.

That line, that you can't judge a book by its cover or an investment by the trail it leaves behind, is rubbish. You totally can and you should. The investment people sometimes put that badge on things as a bit of a cop out, frankly.

When I see it, it says to me -- "We absolve our responsibility if this thing performs poorly". Predictably, I am referring more to active fund managers who tote their skills as market beaters, rather than the trundling index ETF. Of course they have to label things, just like in the supermarket, or people will complain when things go bad.

But this is not like buying a leg of lamb and being able to determine the fat content, this is your money. And the disclaimer especially gets a lot of prominence when the investment is chasing masses of something called alpha.

Alpha, or more accurately positive alpha, is the holy grail of the stock picker and the active fund manager. Alpha is what is called the risk adjusted performance of a fund, compared to a benchmark index. Alpha, should you achieve this, is the extra bit on top, what the clever boys supposedly make over and above just sitting in a low fee index. Alpha is the cherry, the bonus, the theoretical golden goose that keeps the entire global funds management industry afloat. You can pay through the nose for alpha. Or, more specifically, you can pay through the nose for the PROPOSITION of alpha.

It is a lure. A good one. Because, as you'll discover when you sign up for some lovely alpha-seeking investment stuff, it will say on the box that past performance is no indication of what may happen in the future. What a great wheeze!

Imagine if you bought a car and slapped a sticker in the glove box that said "I may or may not start tomorrow, just depends ... you know ... on how things go out there". We would laugh ourselves silly.

Of course, you're thinking to yourself that obviously the two things aren't the same. And, naturally, you are right and I'm being overly strenuous (as usual) in my observations of active fund managers.

But two and two needs to add to four, and in this case the promised alpha needs to appear with some decent regularity or you should look elsewhere. In other words, you must get what you pay for.

Also, this stuff works both ways -- let me introduce you to negative alpha. Negative alpha, the less delightful cousin, is what you get when you reimburse someone to UNDERPERFORM a benchmark. Heaps of funds chug along quite nicely, clipping the ticket, on negative alpha for years. They survive because of the promise of positive alpha to come in the future. All on the back of wanting us to believe that past performance is no indication ... blather, blather.

Here is the really funny part: the manager loves the disclaimer when things go badly -- "Don't blame me!" but you just watch it vanish when he makes a winning bet, "Look how good I am, expect more of the same!"

As always, investors, your mileage may vary, but I say, past performance is a very good indicator of what lies ahead ... Happy holidays!

Caroline Ritchie is a former AFA, sharebroker & portfolio manager. She runs Investment Stuff, an investment coaching service. Visit her at www.investmentstuff.co.nz. Statements in this column are not financial advice.