Regression to the mean, luck and picking hedge fund managers

There are few statistical facts more interesting than regression to the mean for two reasons. First, people encounter it almost every day of their lives. Second, almost nobody understand it. The coupling of these two reasons makes regression to the mean one of the most fundamental sources of error in human judgment.
-Anonymous from What the Luck? The surprising Role of Chance in our Everyday Lives by Gary Smith

Baseball players have hot bats. Basketball players get into the zone. Gamblers have their lucky streaks. There are players who choke and those that step-up at the right time. There are jinks, slumps, and superstitions in sports. Money managers win awards for their good year of performance and then have it "go to their head". The top managers of last year fall below the pack and expectations next year. All may be falling for the problems with regression to the mean. Too many follow the "law of small numbers" and make faulty statistical decisions.

This is the time for making new hedge fund allocations. Many investors in managed futures and hedge funds in general will be down in Florida for some big conferences to size up managers. Who gets a lot of meetings? The hot managers with the strongest performance from last year will be too busy and have a crowd surrounding them during the cocktail hour. Which managers will be disappointed? The losers with below average returns over the last year will be drinking alone.

Everyone wants to talk with the manager with the current high Sharpe ratio greater than the industry average. Everyone wants to talk with the "manager of year" award winner. What happens next is inevitable. The "hot manager" from last year is not so hot this year. Managers don't meet expectations after their awards and their new "rock star" status.

This problem applies for both hiring new manager and firing the old. So many times the manager you fired last year has a good year right after you kick them to the curb. Investors are frustrated. Managers don't understand it, and the process is repeated again next year. It is human nature and it is being frustrate by the regression to the mean.

Before you make your next hedge fund investment, ask a simple question, "Am I accounting for the regression to the mean?" If you are not, take a step back, review the numbers, and see if you are being hasty. There is a reason to hire and fire but don't do it because you are making an error in statistical reasoning.