Should this Year’s Large Sample of Upsets Change your Bracket Strategy?

This year’s NCAA tournament has seen more than its fair share of upsets. For example; a #16 seed took down a #1, and a #11 seed made the final four—only the fourth time in tournament history.

These things are bound to happen, right?

As I contemplated the implications on my bracket, my mind drifted off to what this suggested about investing, particularly in the Small Cap space, and how #1 seeds (of funds) fare relative to the Russell 2000 Index.

If investing is anything like the Men’s NCAA tournament, you would want to stick with the #1 seeds as they represent the biggest pool of consistent winners over the long run. A quick look at this website says that your best odds of picking the winner are with #1 seeds. The author of the article puts the “true odds” of picking a winner from #1 seeds at 60.6%.  However, in any given year it is anybody’s guess which team will prevail. For example, over the past 20 years only the University of Florida has repeated it in back-to-back years, but there have only been 12 unique teams to win during that period. What are these teams doing that the others are not, and why do people bet on them year after year? I believe that their success is attributable to having a system and a process that is repeatable. A simple Google search for “repeatability and success” leads to hundreds of articles on the subject and its importance.

At 361 Capital, we are firm believers in creating objective systems and processes. However, when creating a robust process there is still going to be variability around the objective. This cannot be avoided, only reduced. I ran a test to see just how much the performance of the top performing Small Cap Blend Mutual Funds can vary vs the Russell 2000 Index on a rolling 6-month basis. I defined top performing as those funds that beat the 10-year annualized return of the Russell 2000 Index ending Dec. 31, 2017.

Below are the eight mutual funds and their distribution statistics, as well as histograms of three. I looked at the rolling 6-month return of each of the funds below relative to the Russell 2000. What I found, which should not be surprising, was that there is a great deal of over- and under-performance by each of the funds. At one point one of the funds was down ~17% relative to the Russell, while another was up ~20%. We cannot predict what these funds will do, but what we can say is that the best performers do not always look like the best in the short run.

Small Cap Fund Comparison
* Rolling 6 month returns relative to Russell 2000 rolling 6 month returns

There is always going to be variability around which fund will be the best each year and who wins the NCAA tournament in any given year. However, over the long haul if you pick those funds and teams with a consistent repeatable process then you can stack the probabilities of long-term success in your favor.

For more background on behavioral biases and how they influence March Madness picks, read our article on the topic >

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