Why In The Kentucky Derby, As In Investing, Track Records Can Mislead

More than ever now, in both cases

This Saturday is the 145th running of the Kentucky Derby. Louisville, home to iconic Churchill Downs racetrack, will be buzzing with over 100,000 fans, there to see the “fastest 2 minutes in sports.” Twenty 3-year old horses will compete for a total of $3mm in prize money.And for the 3rd year in a row, I had the pleasure of discussing the big race with Caton Bredar, one of the racing industry’s most noted handicappers. And for the 3rd year in a row, I have made an analogy between horse racing and investing, which is the purpose of this article.Note that none of this relates to the gambling aspect of racing. And as a 33-year investment industry veteran, I don’t see prudent investing as gambling pursuit. As with handicapping a horse race, there is a potential return, risk management, and tendencies that help inform us of how we might increase our odds of success.But let’s face it, both investing and horse racing have elements speculation, greed, careless use of precious capital, overconfidence, and plenty of “buyer’s remorse.” And with the otherwise obvious point that a race is over in 2 minutes, and investing (not high-frequency trading) is a weeks to months to years-long analysis and tracking of a single position, there is a balance to each pursuit that draws me to write about it once a year, in advance of horse racing’s biggest day.This year’s Kentucky Derby focus for me is on the issue of “track records.” After all, investors use the phrase constantly, and it was taken directly from the horse racing business. The chart below shows the 5-year return of a variety of different investments, portrayed through ETFs. They cover different areas of the stock and bond markets, as well as commodities. At the far right you can see the annualized returns of each one. As you can see, there have been some clear investment “winners” over the past 5 years in this particular field of 12. But what does that tell us about the future, which is all that matters for an investor, whether they own these investments or are considering them for their portfolio.Perhaps the most often-ignored warning I have seen in investing is the one that appears at the bottom of every single investment advertisement that features a portfolio manager’s track record: “Past Performance is not Indicative of Future Results.” But it is human nature to look at what happened and extrapolate it forward. Past winners are assumed to be future winners, and past laggards are assumed to lag going forward as well.In the investment management business, this creates opportunities for the patient, because simply investing in what has done well as far back as your memory goes is a strategy that typically ends badly. I am not against “momentum” investing at all. What I am against is assuming that there is a magic profit bullet, whether it is S&P 500 Indexing, 60/40 portfolios, sector rotation schemes, Dogs of the Dow or whatever. As they say, trees don’t grow to the sky.Think about that, and let’s spend the rest of this space getting Caton’s insight on the 2019 Kentucky Derby.Related: Destroying The 60/40 Portfolio Myth

PAST PERFORMANCE IN HORSE RACING, AND IN THIS YEAR’S KENTUCKY DERBY

Caton starts by explaining that in her opinion, in horse racing, “past performance is the single most important factor in determining future performance.” That said, this Saturday’s Run for the Roses “is not an exact replication of conditions that these horses have seen in their prior races.” For instance, the race is 1 ¼ miles long. None of the prep races over the past several months have been run at that distance.This year is also different because many of the prep races were run on very wet days at tracks around the country. Thus, we don’t really know which horses will run well in whatever conditions exist this Saturday.Caton also points out that the horses in this year’s field have not run much against each other, and with a crowded field of 20 horses (roughly double what is typical in a regular race), it could lead to chaotic conditions. All of this makes the past performance of these horses less reliable in predicting the outcome of this specific event. And oh, by the way, this is horse racing we are talking about…so as with all sports, there is an element of luck involved here too.As for those prep races, they were formally combined into a points system back in 2012 and this determines which horses are eligible for the Kentucky Derby. Caton notes that there are a few historical trends regarding that points system that could be broken this year, or already have. First, since the system was created, the race time odds favorite has won every year. In addition, all past winners won their last start. Many of the horses in this year’s field did not win their last race, so that trend is less likely to continue. And, since another past performance trend is that the Derby winner was undefeated as a 3-year old entering the race, that streak is also in jeopardy. Only 2 of this year’s 20 entrants are perfect as 3-year olds (Roadster and Maximum Security). Think of this year’s race as akin to the NCAA Men’s Basketball Final Four coming down to a group of #3 and #4 seeds…good teams, but none that have blown away their competition all year.Caton note that “there is no dominant horse this year” and the early-season favorites did not end up dominating the prep races. So, this is about as wide open a race as you can expect for the most famous race of the year. I would typically now draw a parallel to some similar patterns I see in the stock and bond markets, but that’s for all of my other articles…this one is about the Kentucky Derby and our expert’s views…so on we go to the race itself.

CATON BREDAR’S KENTUCKY DERBY 2019 PREVIEW

Omaha Beach is the horse Caton expects will be the favorite going in. He has won his last 2 races and star Jockey Mike Smith chose to ride him over another horse. Caton notes that the horse was “an impressive winner in the Arkansas Derby.” Tacticus was of the top qualifiers via the points system, and while veteran trainer Bill Mott is an excellent one, he has not trained many Kentucky Derby entrants. This adds to the intrigue of this year’s race. Roadster is the horse that Smith decided not to ride, and if not for that, Caton believes this horse would have been the favorite. However, Roadster will be ridden by Florent Geroux, an outstanding rider who was aboard last year’s winner of the Kentucky Oaks, which is essentially the Kentucky Derby for female horses (fillies). Legendary trainer Bob Baffert, who has 3 entries in this race, also makes Roadster one to watch. Maximum Security, winner of the Florida Derby, is undefeated in 4 races, and is certainly a threat to win Game Winner is another Baffert-trained horse. A 2-year old champion, Caton thinks that the 1 ¼ mile distance could have him at his best. Improbable, the third Baffert entry, has “looked sensational” as a runner-up in his last 2 races, after 3 wins to start his career. Vekoma will probably be the biggest long shot among the top 10 horses in the point system, according to Caton. She said that “his pedigree harkens to horses with a lot of stamina” which could make him a threat here. “He has an atypical stride and sometimes lacks focus” which could make him one of the better value plays in this year’s race. By My Standards won the Louisiana Derby, and that is where he earned all his Derby points. Caton believes he has a chance to win, but will likely be over-bet, and thus not a value situation. CATON’s PREDICTED ORDER OF FINISH Maximum Security Omaha Beach RoadsterAs always, there was a lot of value to me and I hope to you in my latest conversation with Caton Bredar. I thank her for once again treating us to her insight into the sport of horse racing in anticipation of its biggest day. And as with investing, the rules of engagement are pretty straightforward: look for value, do your homework, take nothing for granted, and remember that past performance is not only not a guarantee, but it can also lead you astray if you don’t keep your emotions in check.