While most investors employ active management in an attempt to achieve market beating performance, I don’t believe investors fully realize just how likely it is that they will have to endure bouts of short to longer term underperformance in order to achieve superior results.
Underperformance will happen—even if investors do everything correctly and hire managers that possess true market beating skills. It would be great if we could select managers who will consistently outperform, however this utopian scenario does not seem to occur in the real world where everything, including relative performance, tends to be cyclical.
Read: A tale of two funds: Assessing performance
In a fascinating study profiled in ‘Behavourial Investing’ by James Montier, researchers created a hypothetical universe filled with managers that, by design, had only positive alpha versus the benchmark. The characteristics were as follows:
| Number of managers | 100 |
| Manager alpha | 3% |
| Tracking error | 6% |
| Information ratio | 0.5 |
Source: Adapted from DrKW Macro Research / Montier (2005)
A simulation of these clearly fictional managers was run over a 50-year period. Here are the results for this test.
| Managers underperforming in a given year | Almost one in three |
| Benchmark outperformance at end of 50 years | 1% to 5.2% |
| Number of years of individual manager underperformance | 15 of 50 on average |
| Range of years underperforming (of 50) | 9 at minimum / 24 at maximum |
| Number with 3 years or more cumulative underperformance | About 7 of 10 |
Source: Adapted from DrKW Macro Research / Montier (2005)
The study notes that even though each manager has 3% alpha by design “that doesn’t stop them from encountering bouts of up to eight years of back-to-back underperformance. Despite the fund managers having a high alpha and high information ratios, it wouldn’t have been enough to prevent almost every one of the fund managers from being fired by their clients at some point.”
Of course, in the real world, we know that not all managers have the ability to outperform.
Death, Taxes and Short-Term Underperformance, group of studies conducted by the Brandes Institute, examined performance over 10 year periods for actual mutual funds available to American retail investors.
The study examined the top 10% of managers with the best performance in three separate universes (U.S. equity, Non-U.S. equity and bonds).
| Rolling 1-year underperformance vs. index | Rolling 3-year underperformance vs. index | % Decile 6 or below median manager on a rolling | ||||
| Average | Maximum | Average | Maximum | 1–Year | 3-Year | |
| U.S. equity funds | -22.4% | -40.5% | -8.3% | -17.8% | 100% | 81% |
| Non-U.S. equity funds | -25.1% | -32.4% | -9.3% | -14.6% | 100% | 82% |
| Bond funds | -8.4% | -21.85% | -2.9% | -6.6% | 100% | 77% |
Source: Adapted from Brandes Institute (2007, 2009 &2009)
Similar to the hypothetical universe, it is clear from the data above that even if the ‘best’ managers are selected at the outset, there will be a very high chance of underperformance versus the index and peer-funds at some point in time.
In fact, over a rolling one year horizon, 100% of the funds in each asset class underperform their peers, while 77% to 82% underperformed over a rolling three-year basis. The magnitude of short- to mid-term underperformance versus the benchmark would likely be surprising to many, given we know these were first decile managers over the full 10 year period.
This second study concluded, “while short-term underperformance may be frustrating, our findings suggest underperformance tends to be an endemic element of investing in actively managed mutual funds…even the funds with the best absolute and relative performance over a 10-year period. In our opinion, investors who keep this in mind when evaluating short-term underperformance will be better positioned for long-term success.”
The conclusion of the first study echoes this: “As long as the majority of market participants remain obsessed with the short term, the opportunity for exploiting mispricing for those with a longer-time horizon must surely exist. However, the ability to exploit this opportunity will need to be accompanied by re-education of the final investor and internal management. Until these two groups realize that short-term performance is an illusory veil and has almost nothing to do with long-term performance, the obsession with hitting short-term targets is likely to remain.”
The message here isn’t that active management does not work—clearly it can and will for some. But, even when active management does provide exceptional results, getting results that will impact a pension plan’s bottom line requires not only hiring quality managers, but also understanding their investment process and when the investment results should be expected to underperform. Patience and conviction are required to stick with an underperforming manager and it requires employing a longer-time horizon than would otherwise feel comfortable to most pension committees. Failure to do anything else, will likely lead to disappointing outcomes.