By Athena Invest via Iris.xyz

The perfect portfolio may not look like what you think. A common fallacy is that good active equity funds should deliver consistently good short-term performance with smooth upward trending returns. Investors who believe this have unrealistic expectations and often dump good investments too quickly thereby losing out on great long-term returns.

In his article, Even God Would Get Fired as an Active Investor, Wesley R. Gray, PhD examined the performance of a perfect-foresight fund showing that even with a perfect ‘look-forward’ view, returns would be fabulous, but would also produce significant drawdowns.

Ten Largest Drawdowns of the “Perfect Portfolio” Versus S&P 500 (1927 – 2009)

The construction of the fictitious perfect foresight fund is a simple rebalancing on July 1st every fifth year beginning 1/1/1927 through 12/31/2009. Each five-year period, there is a new selection of stocks for which there is 100% certainty they’ll be the best performing 500 stocks over that 5-year period. All returns are gross of transaction costs, taxes, and fees. Wesley Gray, February 2016.

The compounded annual growth rate for the “Perfect Portfolio” over the period 1/1/1927 through 12/31/2009 was 28.89% compared to 9.63% for the S&P 500 Index.  While the returns are great, clients would also have to tolerate large drawdowns, the worst being -76%.  In fact, this portfolio experienced many dramatic drawdowns over the measured period, the ten worst averaging  -34%. In other words, an active manager who knew with perfect clairvoyance which stocks were going to be long-term winners would likely get fired because investors would not be able to stay invested through the downturns.

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