Chasing Performance: Why Money Arrives at the Top

*Money flows into investments after they have performed well and out of them after they have performed badly. This is not a description of some investors. It is a description of the aggregate.*

One of the most reliably observed patterns in finance is that money follows performance. When an asset or a fund has performed well, capital flows in; when it has performed poorly, capital flows out. This is not an occasional tendency or a description of unsophisticated participants. It is an aggregate pattern, visible in the flow data across decades and across markets, and it is how a great many investors ensure they buy high and sell low.

The behaviour is comprehensible, which is why it is so difficult to escape. Strong performance appears to be evidence of something. It attracts coverage, the coverage generates interest, and the interest generates flows. An investor reading about an approach that performed excellently over five years is not irrational to take an interest; the record is real. What they fail to ask is whether the conditions that produced it are still present, and whether the price now reflects everything they admire.

The arithmetic problem is that a strong record and an attractive entry are frequently in tension with one another, and the tension is invisible to most people. An asset that has risen substantially has, by definition, become more expensive relative to whatever it produces. The very performance that attracted the investor's attention is what has removed the attractiveness of the price. This is not always true, and there are cases where strong performance reflects genuine improvement that continues. But an investor selecting purely on the basis of past returns has selected on the one criterion guaranteed to be highest at the least favourable moment.

The pattern is visible in the timing of flows around market extremes. Money committed to equities has historically tended to peak near market peaks and to trough near market troughs, which is exactly the wrong shape. Investors were most eager to participate when prices were highest and most eager to withdraw when prices were lowest, and the aggregate result is that a large quantity of capital experienced the declines and missed the recoveries.

It is worth understanding why this feels so reasonable in the moment, because the reasonableness is the trap. At a market peak, the news is good, the recent record is excellent, and the investor who commits is doing so with abundant evidence that they are participating in something that works. At a trough, the news is terrible, the recent record is dreadful, and the investor who withdraws is doing so with abundant evidence that they are escaping something that does not. In both cases they are responding sensibly to the available information, and in both cases the information is systematically misleading about what comes next.

The mechanism operates on professionals as well as individuals, which is worth noting because it removes the comfortable assumption that this is a retail failing. Investment institutions that have performed poorly lose their clients, and those that have performed well attract them. The professionals managing money are therefore subject to precisely the same flows, and they must manage the consequences, receiving large sums after a good period and facing redemptions after a bad one, which constrains their ability to act contrarily even when they wish to.

The effect on the investor's own returns is the gap examined elsewhere in this series, and it is where the abstraction becomes concrete. Because their capital was committed after the good periods and withdrawn before the recoveries, the return they experienced is materially worse than the return the underlying asset produced. The asset did not fail them. The timing of their participation did, and the timing was determined by exactly the information that felt most compelling.

The specific mechanism most worth guarding against is the extrapolation of a recent record into the future. A fund that has performed excellently for five years may have done so because its approach is sound, or because conditions favoured its approach, or because of chance, and these are extremely difficult to distinguish. A period of five years is short enough that chance alone will produce a number of excellent records among any large group of participants, and those records will be indistinguishable, at the time, from records produced by genuine skill.

The defence is the same one that appears throughout this project, and its repetition is not an accident. A framework decided in advance, specifying what one will own and in what proportion, and maintained through rebalancing rather than revised in response to recent results, removes the mechanism entirely. The investor who is committing the same sum on the same schedule regardless of what has recently performed well is not chasing anything. They have made the decision once, and the decision does not depend on the news.

This requires no belief that recent performance is meaningless, which would be an overcorrection. It requires only the recognition that recent performance is a poor basis on which to allocate capital, that it is the basis most investors use, and that the aggregate consequence is measurable and negative.

The pattern extends beyond individual funds and into entire categories, sectors, and themes, and its operation there is more visible because the products themselves are created in response to it. When a particular sector or theme performs strongly, new investment products are launched to provide access to it, and they are launched precisely because the demand exists, which is to say precisely after the strong performance has already occurred. An investor observing a proliferation of new products devoted to a single theme is observing evidence that the theme has already been rewarding, and that a great deal of capital is now arriving in pursuit of that reward. This is not a forecast that the theme will disappoint. It is an observation about where in the sequence the investor is standing, and the answer is usually late.

At VESTFY™ performance chasing is presented as the behaviour that connects every other failure in this section. Overconfidence produces activity, the disposition effect distorts what is sold, and performance chasing determines where the money goes next. Together they describe an investor who is perpetually arriving late, and the record of arriving late is not ambiguous.