Investment Lessons Learned from the Tour de France

Summertime marks the arrival of one of the world’s most famous sporting events, the Tour de France. The Tour is, by far, the most well-known cycling event and requires tremendous will, heart and determination by the competitors to complete the three week and 2000+ mile race. In recent years the romanticism of the race has sadly taken a back seat to various doping scandals, that of Lance Armstrong being the most famous, but certainly not the only, example of cheating at the highest levels of professional cycling.

Perhaps we should not be surprised that cyclists, in such a competitive and high pressure event as the Tour, or professional cycling in general (where significant dollars are at stake), turn to any advantage available to them, including doping and then lying and denying any wrongdoing.

There are some parallels to be drawn between professional cycling and the investment management industries. Both are high stakes games with significant wealth and fame on the line for both cyclists and advisors or mutual fund managers. Both have rules and regulations that govern activity that is legal and ethical but do little to stop those who are determined to push beyond the boundaries. It is speculated that much, if not most, of illegal and unethical behavior in both cycling and professional investment management goes unreported and undiscovered. When discovered it is usually after the fact when the damage has already been done.

While the Tour creates an ideal environment for the use of performance enhancing drugs (PEDs) to deal with the rigors and injuries during a long and arduous cycling season an investment manager can’t turn to pharmaceuticals to improve the performance of assets they manage. But, unlike in cycling where a photo can dispel any controversy surrounding who finished in what order, investment management allows for much more creativity when it comes to reporting performance.

Just as doping has become an unattractive part of cycling which casts a shadow on all competitors, both clean and dirty. So too has performance reporting in the world of asset management. Take for example mutual funds which usually report their returns relative to a benchmark, such as the S&P500 Index. Sometimes managers will buy securities that are not part of the S&P500 yet they still compare their returns to the index. The logic is that they are buying the best stocks available, regardless of index membership. If we believe that then the S&P500 is absolutely the wrong index to use in the first place. If, like me, you are skeptical of such claims, you may not be surprised to learn that managers use off benchmark securities to goose their returns.

Small caps have traditionally outperformed large caps over time. Knowing this little piece of information, all else equal, a portfolio manager can improve their relative performance over the index by allocating a portion of their portfolio to small cap securities. The majority of the time these managers then claim they generated alpha, or excess return over the benchmark due to their superior security selection.

What is often not mentioned is the fact that small caps have a higher risk than large cap stocks and an investor buying a large cap product (say one that was benchmarked to the S&P500) would not knowingly be investing in riskier small cap securities unless they looked into all the fund holdings. Needless to say this type of “alpha” is not really outperformance in most cases, certainly not on a risk adjusted return basis.

Outperformance, or alpha, is a rare occurrence. After fees are considered there are few managers who manage to deliver returns in excess of a market index, particularly an efficient one like the S&P500. Moreover, returns are a zero sum game. Outperformance by some managers by definition means underperformance by others. Which should lead us to question whether the appropriate index is being used or whether off benchmark securities are being used.

In investing, just as with cycling, particularly in the Tour de France, too many excellent and consistent performances, while not necessarily a guarantee of cheating, can be a sign that something is not quite right.