The Wrong Side of Historical Performance

by: Michael Eisenberg

The most banal, boring and, most people think, superfluous line in every prospectus is "Past performance is no indication of future returns." Duh.... Turns out, many/most people think that past performance is a good indicator of future returns. However, nothing could be further from the truth. In fact, I believe that there is an inverse correlation between "past performance" and "future returns."

In a terrific article entitled "Recipe For Disaster: The Formula That Killed Wall Street," Felix Salmon uncovers the quantitative exploits of David Li (at left), a quant who built a correlation algorithm for pricing bundles of mortgages. Read the whole article (it is terrific) but for the purposes of highlighting the folly of building an investment strategy based on past returns, see the highlighted section below:

When the price of a credit default swap goes up, that indicates that default risk has risen. Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. It's hard to build a historical model to predict Alice's or Britney's behavior, but anybody could see whether the price of credit default swaps on Britney tended to move in the same direction as that on Alice. If it did, then there was a strong correlation between Alice's and Britney's default risks, as priced by the market. Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly)....


The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was....


The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that

number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.


At the heart of it all was Li's formula. When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.


"The corporate CDO world relied almost exclusively on this copula-based correlation model," says Darrell Duffie, a Stanford University finance professor who served on Moody's Academic Advisory Research Committee......Li's copula function was used t

o price hundreds of billions of dollars' worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.

If you are a Venture Capital LP investor, this has to sound familiar. Strip away Felix's fantastic analysis of the wreck wrought by quants and what you see is a market fed on a decade of bullish data that caused every investor on the
planet to pile into CDOs. Then it came undone, leaving all of the followers of past performance holding the bag.
Similarly, the 90s were a roaring decade for Venture Capital. Everything seemed to go up. Based on a decade of data, LPs looked back on a decade of soaring returns and kept pouring money into the asset class. The extra money increased competition, which increased valuations, decreased returns etc...
Now, if you talk to LPs they are reducing their allocations to Venture Capital because if you look at the returns of the last decade, they are abysmal. Exactly. And this is exactly why this is the best time in a decade to invest in venture capital and to be a venture capitalist.
If the last decade's returns were poor, that will dry up the capital supply, bring out only the hardiest entrepreneurs, undermine currently large companies and industries and lay the groundwork for a great surge of innovation and opportunity. I am not the first one to invent this theory. Warren Buffet says that he tries to be "greedy when others are fearful and fearful when others are greedy." Quants and venture consultants with their rear view mirror, last-decade models do exactly the opposite. They look at the time during which people were greedy and conclude that they should continue to be greedy and, of course, vice versa. Investing is a contrarian business, not a herd business. Just ask the now heroic few hardy souls who were short the housing market when it was rising.
Which brings me to Sarah Lacy. Sarah posted a provocative piece about Israeli Venture Capital and Innovation last night. Hundreds of commenters and numerous bloggers are up in arms
about her stats (right or wrong) and her assertions about innovation. Her stats may be right or wrong. What is clear is that venture returns out of Israel have not been stellar for the last decade. For that matter, venture returns in Europe and the USA have not been stellar either over the last decade. There is no way to sugar coat that and LPs are hurting from that. But I guess this is why Sarah is a journalist and not an investor. Here is one piece of Sarah's post:

...Money continued to invest along the same $1.2 billion-to-$1.4 billion a year range, and returns fell off a cliff. Israeli companies have raised just over $10 billion since the beginning 2001, but acquisitions and IPOs have returned just over $860 million over that almost eight-and-a-half-year period. Bear in mind, the industry tends to measure performance over ten-year periods, and not many people expect a roaring acquisition or IPO market for the rest of 2009, and arguably 2010.

Compare those numbers to start-ups in Europe, a continent that has long been characterized as risk-adverse, thanks in part to labor laws that work against start-ups. Sure, Europe is a bigger place, so its to be expected that European companies have raised a much bigger 36 billion in Euros since the beginning of 2001. But European companies have returned $6.3 billion. If you do the percentages, Israeli companies have returned 8.6% of the money invested over the last eight-plus years.... (All stats are from Dow Jones VentureSource.)

Ten years after the peak of the last bubble, it’s clear that when foreign investment fell in Israel from about $4 billion a year to $1 billion a year, the country wasn’t just weathering a recession. Somewhere along the way, the entrepreneur scene here lost its mojo.

Now, before the hate mail starts, let me be clear, that numbers aside, I still believe Israelis are singular entrepreneurs. There is interesting stuff here and always will be. There’s an element of risk taking that even the Valley can’t rival, and it’s no secret Israelis are brilliant technologists.

So I don’t say this to trash Israel, but facts are facts. In sheer numbers, Israel’s place on the global scale of investing has been dwarfed by China, and matched by the United Kingdom. And after three days of talking to dozens of entrepreneurs and investors in Tel Aviv, this seems like a country wandering in the desert, looking for a new tech movement to own and dominate.

What happened to Israel is a bit like what happened to Boston—the story and opportunity moved away from what the city’s entrepreneurs were good at. In the case of Israel, security and encryption was always a strength, but that’s not the growth industry that it was. In the case of Boston, enterprise technologies and telecom were always strengths. Now, as media has become the story of the last boom, it’s not a surprise New York surpassed Boston in the amount of venture capital raised.

Internationally, China has become the new obsession, with India a close second. It’s not that Chinese entrepreneurs are better than Israeli entrepreneurs. And so far, there are certainly a lot of concerns about returns in China. But when it comes to international entrepreneurship—at least in terms of attracting those billions in U.S. venture dollars—entrepreneurs need to give VCs a compelling reason to come to them. In the 1990s, Israel gave them superior technologists. Now, China is giving them an exploding demographic that needs all manner of goods and services.

Was a booming Israel just a relic of the 1990s boom like Webvan and the Pets.com sock puppet? I don’t believe so. But I’m in Tel Aviv for the next two weeks looking for the company and the tech movement that will prove me right. If you find it, drop me a note.

If Sarah is beating the journalist's drum that Israel has lost its "mojo" then this is the time to invest in Israel. Scarcity of capital is a plus for investors; hardy innovators drive venture capital. In fact, this is a great time to be investing in Venture Capital because the rearview mirror is no way to build an investment strategy. Sarah's historical journalism is spot on but hardly relevant. Sarah and I will get to duke this out over dinner with some Israeli entrepreneurs next week but I need to remind her in advance "Past performance is no indication of future returns."