How to Pick Last Year’s Winners

For several years now, I’ve been encouraged that Canadians are coming around to the idea that trying to pick winning funds or this year’s hot asset class is a loser’s game. And then I read something like Gordon Pape’s recent Fund Library article, ETF Winners,  and I realize that we have a long way to go.

The article looks at the “outstanding performances” of three ETFs this year: the Claymore Gold Bullion (CGL), the Horizons COMEX Gold (HUG) and the iShares S&P/TSX Capped REIT (XRE). What makes these funds winners? They had the highest returns, of course.

For a distressingly large number of media commentators and investors, recent performance is still the only criterion that matters. If you invested in gold and real estate this year, you were a winner. If you owned a globally diversified portfolio of stocks, you were a loser. Better luck next time.

Let’s start by pointing out that the three ETFs that Pape names are passively managed. So the fact that gold had another great year and real estate outperformed other sectors does not make these particular funds “outstanding” in any way. The measure of any passive ETF is how well it tracks its index, regardless of whether that asset class has a good year or a lousy one. If these ETFs had large tracking errors (for the record, they did not), their absolute returns would still have been very high, but they would have been losers for not delivering on their mandate.

I realize this kind of thinking doesn’t come naturally to most investors who focus only on outcomes. But if you’re going to be a Couch Potato investor, you need to understand the best investing strategy is the one that gives you the highest probability of long-term success. It’s not the one that would have delivered the highest return over the last 12 months, because that is always unknowable in advance and has no bearing on the future. Identifying winners and losers after the fact is a favourite pastime of the financial media, but it has absolutely zero value to investors.

A bad sailing metaphor

Think of investing as a journey across the ocean. As a passive investor, you’ve decided to travel in a well-built sailing vessel designed to capture as much of the prevailing winds as possible, with a hull that glides through the water with a minimum of drag. You know a ship like that is likely to arrive at your destination more swiftly and efficiently than a small motorboat. But you need to be prepared for the inevitable days where there is no wind, and for the gales that will temporarily blow you backwards. During these periods, it makes no sense to kick yourself for not buying an outboard.

Clearly many people disagree: they think it makes more sense to try to predict the direction of the wind, and to jump from boat to boat. “I have always believed that ETFs are much better trading vehicles than buy-and-hold funds,” Pape writes in his article, “and the mediocre performance of the Couch Potato Portfolio that we have been tracking on the Fund Library bears this out.”

This logic is flawed from the start. It’s mathematically impossible for a diversified portfolio to outperform the year’s hottest asset classes. By design, a Couch Potato portfolio will always fall somewhere in the middle of the pack over short periods, but over the long term it is likely to beat the vast majority of active strategies. That’s not good enough for some investors. Instead, they feel they must move in and out of asset classes in search of the “winners.”

How hard can that be? Have a look at this periodic table of investment returns, which shows the best and worst performing asset classes over the last decade. Do you see a pattern? Think you can use this information to predict the top asset class of 2012? I know I can’t, and neither can anyone else. But I have no doubt we’ll be able to read about next year’s winners after the race is over.