Excellent Managers Can and Will Underperform
If you’ve ever invested in a mutual fund then you’re likely familiar with the disclaimer statement about past performance not being a good indicator of future returns. This language is included for good reason and is especially true when forecasts are predicated on recent performance data.
Virtually every manager will underperform at some point in their career, especially over periods of three years or less. The chart below incorporates data to December 31st, 2010 and shows that every single manager included in this study underperformed by at least one percent during any one-year period. And, the managers included here were top performers, initially culled from a group of more than 1500 mutual funds with at least a 10-year track record, which was reduced to the 600 that outperformed their benchmark by at least a percentage point on an annualized basis over 10 years. This was further winnowed down to 370 funds by eliminating any with volatility that exceeded the benchmark index.
Many investment advisors and other decision makers will often have established criteria that require a manager review if there is a prolonged period of underperformance, which is around three years in many cases. At T.E. we appreciate that three years is a long time, but it should be stressed that this is actually a fairly short period of time in the investment world. Think about those account applications and investor questionnaires you’ve filled out over the years and you might recall that a long-term investment horizon typically exceeds five years and oftentimes seven years.
Mutual fund flows prove that investors tend to pile into a recent star performer, but the results of this study show that investors who stick with a top manager through difficult times are likely to achieve superior returns versus those who chase top performers. In fact, most managers are ultimately able to make up lost ground and add value following periods of weakness. Investors need to avoid knee-jerk reactions to underperformance and give their managers a chance to prove their mettle…over the long haul. This is quite simply because the odds of a manager beating the benchmark increase with longer holding periods. In fact, the data shows managers outperformed (versus the benchmark) nearly 75% of the time when evaluated over a 5-year period and more than 80% of the time when evaluated over a 7-year period. Meanwhile, over a single quarter or year the odds are closer to 50%!
The market and economy move through long cycles and given the varying styles and approaches employed by different managers it is imperative that investors understand and accept that there could be underperforming manager(s) in your portfolio at any given time. In fact, after the Global Financial Crisis you have undoubtedly heard a lot of talk about heightened market volatility, which highlights an even greater need to avoid group think or the herd mentality. Provided a manager is adhering to their stated style, methodology and portfolio construction process then you can likely stay with them through the difficult periods and reap the rewards thereafter when they regain their performance advantage. We understand that our clients want to see both short-term and long-term performance; however, we really want to caution against making changes based on short-term returns. TEIC’s investment counselors participate in regular meetings with our managers and the research group regularly monitors and reviews the various investment teams, which enables us to ascertain whether or not there are any issues beyond underperformance that might actually warrant a manager change or replacement.
These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.