One of the most commonly employed methods for judging whether an active equity fund manager possesses skill is monitoring performance consistency – that is the regularity with which a particular manager outperforms their benchmark index over specific time periods (frequently calendar years, but often briefer).  This shorthand gauge of quality is pervasive across asset management groups (sellers), fund selectors (buyers) and the media.  The use of such a context free number is deeply flawed.  Not only does it disassociate process from outcome, and lure investors into strategies with a high probability of mean reversion; but it biases us against the distinctive, high conviction equity managers that better justify the use of active management.

Although the pull of performance ‘reliability’ is difficult to resist; the use of short-term excess return consistency measures to assess active equity managers is predicated on two flawed notions:

– Active equity managers have the ability to dependably predict short-term market behaviour.

It is surely now incontestable that the short-term movement of equity markets is highly unpredictable.  For an active manager to deliver consistent returns across discrete time periods through the application of skill, they must hold the uncommon ability to anticipate market direction and drivers, and appropriately shape their portfolios to benefit.

– The market consistently rewards good investment decisions.

To believe that short-term performance consistency can be employed to identify skill, one must contend not only that a manager makes consistently good investment decisions (on average) but that the market duly rewards these judgements in the near-term.  Markets are reflexive and for sustained periods can be driven by narratives and momentum, detaching dramatically from any semblance of fundamental reality.  Objectively robust decisions can go unrewarded for prolonged periods.  The implicit assumption embedded in performance consistency analysis of an active equity funds is that the market has unerringly validated the manager’s investment decision making.

Although the point of this post may seem relatively minor, it is critical to how we view and assess active equity management.  Performance consistency is employed in marketing campaigns, is frequently used by fund selectors to ‘screen’ sectors for talented managers, and often drives the external ratings given to funds.  This widespread acceptance of consistency as a robust indicator of skill exacerbates the damaging focus on short-term outcomes and leads to extensive attribution errors.  Furthermore; it must reduce the opportunities available for genuinely long-term focused active equity investors.

As difficult as it is to separate performance consistency from the skill of any active equity manager, unless a specific link can be drawn between the outcomes delivered and the underlying investment process, this should be our default stance.  Markets embark on prolonged trends and are driven for sustained periods by in-vogue themes;  against such a backdrop it is inevitable that groups of active managers will deliver consistent headline performance as they (often inadvertently) hold style biases that benefit from the prevailing tailwinds.  Given the structure of the market it would be surprising if there were not clusters of equity managers exhibiting consistent excess returns.

The behaviour of financial markets creates patterns of outcomes that are ideal for establishing a mirage of skill, and whilst we are hardwired to draw links between these outcomes and the related process, the simple fact is that skill in active equity management cannot be gleaned from performance alone, irrespective of the form it takes.

It is not only that headline performance consistency is a deeply misleading means of assessing the ability of an active equity manager, but as a characteristic it is the exact opposite of what fund selectors should be seeking.  By definition, long-term, high active share, conviction investors will not deliver performance consistency over the short-term.  There will be periods (often prolonged) when their style is out of favour and the ‘market’s perception’ diverges materially from their own.  Through such spells of challenging performance we should expect them to remain disciplined and faithful to their philosophy and approach; not wish them to latch onto the latest market fad in an effort to achieve improved short-term returns.

Consistency is absolutely paramount to the assessment of active equity managers, but we are focused on the wrong sort of consistency.  Rather than obsess over the persistence of short-term outcomes; we should focus our attention on the consistency of manager behaviour relative to their stated philosophy.  Doing so would improve the probability of achieving excess returns from holding active equity managers over the long-term.