“Why are we still invested in this underperforming manager?”
Sound familiar? You have already looked into the cause of the underperformance and remain confident in the manager, but your client is still raking you over the coals. You don’t want to fire the manager, and sense that his or her investment style is due to come back into favor. After all, even the best ones can hit a dry spell.
To show the value of patience, consultants can analyze how frequently successful managers endure meaningful stretches of underperformance. If your clients can use more perspective and patience, too, read on.
Let’s review Morningstar Direct data on mutual funds with a 10-year track record (From April 1, 2004, to March 31, 2014) and the same portfolio manager, looking at several domestic equity, international and fixed-income categories. In that data set, 26% (224 of 856) of those funds experienced notable success over the past 10 years, outperforming their benchmarks by at least 1% on an annualized basis.
What your clients might find interesting is that nearly all (98%) of those “outperformers” experienced at least one three-year period of underperformance over the 10-year period. Only five managers out of 856 were able to generate outstanding returns without experiencing at least one of these lengthy lulls. Many of the managers experienced several of those three-year dry spells. In fact, over two-thirds of these successful managers experienced between five and 12 three-year periods of underperformance. That means investors likely need to find the patience to look past multiple periods of weakness.
And if you think trailing three-year performance is tough to stomach, how about five years? Seventy-six percent of outstanding managers experienced at least one five-year period of underperformance during the last 10 years. Obviously, these occur less frequently than the three-year periods, but they are still surprisingly frequent. Investors hoping to earn excess returns over 10 years should expect at least one five-year period of underperformance from their managers.
Successful managers’ ups and downs are a lot like those of top-tier professional golfers. Look no further than the current World No. 1 golfer, Rory McIlroy, who has won the last three tournaments he has entered.
McIlroy’s recent string of successes comes as no surprise to most golf experts. Yet his ability to remain at the top of the game was strongly questioned by some in the lead-up to the 2014 Open Championship in England. McIlroy hadn’t won a PGA event since September 2012.
It turns out that his last three wins all occurred on golf courses on the longer end of the spectrum at 7,300 yards or greater -- Royal Liverpool Golf Club in Merseyside, England (the site of the 2014 Open Championship), Firestone Country Club in Akron, Ohio (the location of the 2014 WGC-Bridgestone Invitational) and Valhalla Golf Club in Louisville, Ky. (the site of the 2014 PGA Championship). As one of the longest drivers of the ball, McIlroy’s style of play worked in his favor and helped him overcome his two-year tournament slump.
Similarly, investment styles regularly fall in and out of favor. While McIlroy doesn’t have the luxury of playing on a long course every week, mutual fund managers don’t have the luxury of always operating in markets that are conducive to their investment style. For example, equity managers with high-quality biases will likely trail their benchmarks during a low-quality stock rally. That doesn’t make them bad managers. In fact, they could still be outstanding managers while trailing their benchmarks over a five-year period when low-quality stocks soar.
High-quality managers experiencing underperformance often bounce back, just like the talented golfer. When your client is comfortable with your manager selection process, understands performance expectations and possesses additional context (like this analysis), patience comes naturally. Poor three-year or five-year numbers should not, on their own, discourage investors or lead to the termination of managers. Almost all “outperforming” managers experience them at some point. Just like Rory McIlroy, they may bounce back. And don’t count out Tiger Woods’ eventual return to top form either.
Tanner Howard is a consulting analyst with Envestnet | PMC.