Active management is difficult.  Only a minority of managers outperform after fees over the long-term and it is difficult to identify those which will ex-ante. Whilst this dominant critique undoubtedly has validity, there is another major hurdle for active management, which relates to the perceptions and behaviour of fund investors.  It means that even if we can successfully isolate managers with skill, there are no guarantees that we will reap the benefits of it.

There is a paradox at the heart of active management; to justify its existence the focus should be on differentiated and high conviction approaches; however, the more genuinely active a strategy is the greater the likelihood that it will experience spells of pronounced and often prolonged underperformance, which will be unpalatable for many investors.  There is a justified clamour for high active share managers; but little consideration as to whether we are behaviourally disposed to owning such investments.

Let’s take an example; in a twenty-year period ending in 2007 a prominent active equity fund delivered an annualised return of 15.0% compared to 10.9% for its benchmark comparator. This meant the closing value of an initial investment in the active fund was over double that of a passive holding in the index.  This is clearly a compelling outcome (net of fees), however, it is also important to look at the return profile through a different lens; somewhat unfortunately, even as long-term investors we have to ‘experience’ the vicissitudes of shorter-term performance:

– Across rolling one year periods (shifting one month forward) the fund underperformed its benchmark on 34% of occasions.

– On 17% of the rolling one year periods excess returns were more than 10% behind the index.

– For 29% of rolling three year periods the fund trailed the index.

– On 16% of rolling three year periods the fund trailed the benchmark by more than 20%.

Highlighting these features is not designed to be a slight on the strategy; rather it is a reflection that even successful active funds will suffer protracted periods of challenge.  Indeed, if a fund is truly active and idiosyncratic then such spells of poor performance are inevitable and have to be withstood to garner the longer-term benefits.

Historic performance numbers seem anodyne written on the page and we often focus purely on the ultimate outcome delivered rather than importance of the path; yet it is crucial to consider what is likely to occur during those days, months and years of owning an underperforming strategy, and how it might influence our behaviour and decision making:

– Outcome bias will lead us to doubt the quality of the manager and find problems even if they possess significant skill, and nothing has materially altered in their approach.

– Myopic loss aversion will mean that short-term (relative) losses will weigh heavily, even if we are investing with a long horizon.

– A disproportionate amount of time and focus will be spent on the strategy through exacting periods – the emotional and cognitive load will be high.

– If the fund manager has a high profile they will be subject to significant industry media scrutiny, poring over individual decisions and highlighting every stock disappointment. Persuasive narratives will be formed about decline of the manager or style adopted.

–  For professional fund investors there will be constant scrutiny from colleagues, risk teams and clients.  Continual justification for the decision will have to be provided.

– The fund may suffer from outflows – do we want to be the last person remaining in the fund?

– Other flavour of the month funds / strategies will attract attention (many of which will be generating outperformance through sheer chance or some favourable style bias).

Then there is, of course, the additional problem that it might not be an ’admissible’ period of underperformance – something about the philosophy, team or process may have changed to its detriment, or our initial analysis about the skill possessed by the manager may have been incorrect. Thus, whilst we may retain belief in a struggling manager, we could be wrong and facing the worst possible situation – consistently expressing commitment to our initial view before finally capitulating and acknowledging a mistake (or concocting a rationale as to why now is the right time to sell).

It is far easier to buy outperforming funds and sell the stragglers – it is simple, appears ‘sensible’ and is behaviourally comfortable – this type of performance chasing is covered in a 2008 paper by Goyal and Wahal.  Conversely, it requires a great deal of fortitude to persist with a manager that is materially underperforming – even when we know that the shorter-term outcomes are not inconsistent with reasonable expectations given the approach adopted. The psychological and potential career pressures / costs of owning a high conviction manager and persisting with them through underperformance are stark.

If we are lucky, we will buy into a differentiated manager with skill who has historically outperformed (because, let’s be honest, nobody buys underperforming funds) and the pattern of excess returns persists with few meaningful blips. This, however, should be treated as an anomaly.  When owning a genuinely active fund we are likely to experience numerous and sometimes severe bouts of underperformance; unless, that is, we have managed to identify a style that is always in favour or a soothsayer who can foretell short-term market movements (I am still searching).

Much attention is lavished on the difficulties of identifying a skilful active manager with the potential to deliver excess returns, but that is only the beginning. As markets don’t provide consistent short-term rewards for the talented – you need to be able to hold for the long-term whilst bearing the inevitable periods of poor performance and all that entails. If you cannot, then you should avoid active management.

Key reading:

Goyal, A., & Wahal, S. (2008). The selection and termination of investment management firms by plan sponsors. The Journal of Finance, 63(4), 1805-1847.

It has been a propitious period for equity investors; over the previous five years they have enjoyed stellar returns, depressed volatility and relatively few instances of material drawdown. The prolonged nature of this environment risks the abnormal coming to be seen as normal, and our bias towards what is recent and available leading to expectations becoming untethered from reality. This could have profound implications for how we perceive (or ignore) risk and how portfolios are constructed.

The success of equities on a risk-adjusted basis in recent years can be framed in a different fashion – the failure of diversification. Against a backdrop where equities have delivered strong performance with reduced risk (compared to history) there has been scant reward for holding assets that are regarded as diversifying or that may offer insulation in a more inclement economic landscape. Indeed, diversification has come at a cost.

There is a real danger that the current environment is leading investors to worry about the wrong things. Rather than believing that prudent diversification is evermore important because of the unusually strong results delivered by equity markets; we do the opposite and start to question the role in our portfolios of those assets that have failed to keep pace with the ascent of equities. In recent years very few assets compare favourably to equities – so why hold anything else? We spend far too little time critically assessing the things in our portfolios that are out/over performing.

Arguments in support of diversification are made all the more difficult by the fact that equities have exhibited such low ‘risk’ in recent years (by way of realised volatility and drawdowns), a scenario that inescapably breeds complacency. There are technical and psychological aspects to this problem. From a technical standpoint, it is possible to build equity heavy portfolios with low ex-ante risk (in terms of volatility) if their look-back period is only three or five years. From a psychological perspective, memories of the stress and fear that can at times characterise the ownership of equities have been all but extinguished. We can easily recall equities makeing consistent upwards progression, not them halving in value.

The unusually strong risk-adjusted performance of equities has also created a process versus outcome problem, where simply being long equity risk has been consistently rewarded, irrespective of whether it was a prudent course of action ex-ante. Our pronounced tendency to judge the quality of a decision or process simply by its outcome means that we will look more favourably on less diversified, equity-centric portfolios. The corollary of this is that the pressure of unfavourable performance comparisons could lead to diversified portfolios being ‘forced’ to assume more equity risk.

The idea of diversification is to create a portfolio that is designed to meet the requirements of an investor through a range of potential outcomes – it should be as forecast-free as possible. It is also founded on the concept of owning assets that not only provide diversification in a quantitative sense (through low historic correlations) but also sound economic reasons as to why their return stream is likely to differ from other candidate asset classes. Crucially, in a genuinely diversified portfolio not all of the assets or holdings will be delivering strong results at any given time, indeed, if all of the positions in a portfolio are ‘working’ in unison – it will feel like a success but actually represent a shortcoming.

That is not to suggest that we should persist with assets or positions in a portfolio simply because they are diversifying (or have not gone up as much as equities). Rather that we should always remember the long-term benefits of diversification, and consider the merits of all holdings in a portfolio based on their own characteristics and their role amongst a mix of assets or strategies.

Our obsession with outcomes, focus on spurious reference points and our desire for action, makes remaining diversified incredibly challenging. In an equity bull market, we often struggle to see the laggard assets in our portfolio as distinctive and differentiated – serving the role they were required for – we instead identify weakness and something that needs to be addressed. This is exacerbated by the fact that in such periods the returns of everything gets compared to equities – whether the comparisons are valid or not is irrelevant.

At this point in the cycle the temptation to abandon the concept of prudent portfolio diversification is likely to prove particularly strong; but unless a new paradigm is upon us, investors will be well-served remaining faithful to sound and proven investment principles.  Take the long-term view and remain diversified.

These are simply some musings on active manager research; seemingly random, but hopefully linked by a common thread:

– The more PhDs in a team, the greater likelihood that a fund will blow up. This is tongue-in-cheek comment, but underlying it there is an important point about complexity. It is perfectly acceptable not to invest in a strategy because you don’t understand it. Furthermore, academic pedigree can easily make investors unnecessarily complacent about the robustness of a fund.

– Fund groups will always find some room in their strategy for you, capacity limits are more flexible than you think.  Incentives matter – you should never be reliant on an asset manager to tell you when they have reached capacity in a fund (particularly if they are listed) and, if you are waiting for them to tell you, it is probably too late.

– Although the majority of active managers underperform the market, the majority of slide decks produced by active managers will show them outperforming. The slicing and dicing of performance numbers is a constant wonder.

– Just because a Brinson attribution report shows a positive ‘selection effect’, it doesn’t mean there is ‘alpha’ – it is probably just a style bias. The term ‘alpha’ is banded around with abandon when discussing fund manager performance often without any clarity about what that actually means. Perhaps the most common is stock / sector decomposition – which tells you nothing about style / factor skews.

– The majority of excess return in fixed income strategies comes from assuming additional credit risk. Another attribution problem – this time for credit – is the persistent overweighting of credit risk (relative to the benchmark). Attribution for credit managers is fiendishly difficult but is an investment grade manager permanently overweight high yield skilful?

– Unless you believe that many fund managers can time the market (they can’t), then performance consistency is an example of luck or the derivative of a persistent style bias. It is rarely skill.  I still don’t understand the obsession with short-term performance consistency in the industry – the focus on this does much more harm than good in promoting the right type of active management.

– You will never really know the inner workings of the team running the fund you are researching. No matter the quality of your due diligence, your understanding of the characters, relationships and motivations within an external team will always be partial.

– Diversity for many (UK) asset managers means hiring white men from both Oxford and Cambridge. There is too much virtue signalling and not enough action on diversity in the industry.

– Ego / arrogance is not a necessary or positive trait for a fund manager. I often hear people absolve certain fund managers for being ferociously arrogant on the basis that they need to have high levels of confidence to ‘bet against the market’. This is nonsense – good fund managers will be wrong (a lot) and need both humility and a willingness to learn; believing that their views are unimpeachable or that they are infallible is the obverse of this.

– At least 90% of equity managers say they are buying quality companies (barriers to entry etc…) that are undervalued.  This should tell you something.

I disagree with the majority of people I respect in the investment industry about volatility. This is an uncomfortable situation, as holding a view contrary to people more intelligent than yourself is rarely a sensible course of action.  Nevertheless, I shall persevere.

Most of the aforementioned investors have claimed at some point that “volatility is not risk”.  This is, of course, correct; risk is a multi-faceted concept, which no single metric can successfully capture, however, the implicit (sometimes explicit) extension of this argument is that volatility is not a valid measure of risk at all.  I do not believe this to be true.

The renunciation of volatility is often followed by the comment that “permanent capital impairment” is the only genuine risk. This view assumes that risk is based on the probability of the fundamental value of an investment being than less you paid for it.  The problem with this pure perspective is that it assumes that permanent capital impairment is solely about the asset and not the investor, and that the variability of an asset’s price through time is irrelevant.

From a behavioural perspective, volatility and permanent capital impairment are inextricably linked. I would assume that the most common cause of the latter is not a fundamental change in an asset’s intrinsic value but a decision by the investor to sell at an inopportune time.  The path of returns for any given asset is crucial; volatility is not simply about the variability of an asset’s price, but how those fluctuations impact investor behaviour and the resultant cost.

As volatility is a somewhat nebulous concept, it is worth considering what drives fluctuations in asset prices.  I tend to think of three related aspects:

1) A change in the fundamental value of an asset.

2) Uncertainty over the fundamental value of an asset and our behavioural reaction to uncertainty.

3) Investors reacting to the behaviour of other investors (momentum) or anticipating how they think other investors will behave. Markets are reflexive.

Investors do not experience volatility in isolation, it is not simply about detached price movements – there are inevitably accompanying narratives that lure us into action.  Volatility is circular; it is created by our behaviour – our emotion laden decision making, our myopia, our loss aversion, our recency bias – and in turn it drives our behaviour. It is often absurd and frustrating, frequently bearing no relation to sound fundamental investment thinking, however, it is a reality and it matters.

In addition to the behavioural nature of volatility, it is also heavily reliant on technical factors such as how an asset is priced and how it is traded. To take an example of this, let’s assume that an S&P 500 index tracker only provided liquidity windows every five years and the underlying components were revalued quarterly based on some form of DCF methodology.  Given that the holdings are identical would the risk differ from the market priced, daily liquid version we have available today? It is almost certain that the volatility would be considerably lower*.

Someone from the ‘permanent capital impairment’ camp would likely argue that this proves the flaw in using volatility as risk – the same assets can exhibit different levels of risk if judged by their volatility just by altering how they are traded and valued. However, the notion that volatility should be ignored because it is about more than simply the fundamental features of an asset seems spurious – a sensible theoretical concept that does not match reality. Investors have to experience price variability when holding investments and that has material implications for their behaviour and decision making.

Volatility is an imperfect measure of risk, particularly in regard to the distribution of asset class returns (non-normality) and assumptions around correlation. It is also backward looking and insensitive to valuation. It is certainly limited in the following circumstances:

– Investments with significant tail risk (such as selling insurance). Volatility is a poor gauge to the potential risk in such situations.

– Undiversified portfolios with high idiosyncratic risk.

– Assets with stale / slow pricing such as direct property and private equity.  Assets which are illiquid or aren’t daily traded often benefit from compelling Sharpe Ratios, simply because volatility is subdued relative to more frequently priced counterparts. This is never a fair comparison.  There is certainly a behavioural return premium attached to illiquid assets because it is harder to make stupid decisions when you are unable to trade.

We should be measured when conflating investment risk with any specific metric, it is heavily dependent on the individual, the environment, the instrument and the asset(s). Each method we employ will have limitations, take the following two examples:

1) Assume that the long-term volatility of global equities is 17% and you make an investment when realised volatility has been 17% over the previous three years.  In the subsequent three year period, global equities rise by 50% (primarily through valuation change) with a realised volatility of 14%.  Given that the historic volatility (three year) is  lower than when you made your investment, is the risk, other things being equal, now reduced? Given valuations are significantly higher it would be difficult to make this case, although using a simple (short-term) standalone volatility look-back would suggest so.

2) The probability of realising a loss over a 30 year holding period for global equities is low; from a permanent capital impairment perspective, does that mean that for those with a 30 year holding period holding equity exposure is close to riskless? ** To believe so suggests that the path, distribution and sequence of returns are irrelevant, as is how an investor may react to these factors.

Investment risk is nebulous and difficult to define – there is no unimpeachable means of gauging it. Volatility certainly has limitations and it is not ‘risk’, but can be an important measure of it.  One should never view risk purely through the lens of volatility, but ignoring it is equally naive – permanent capital impairment is as much a behavioural phenomenon driven by the individual human reaction to price fluctuations as it is about the fundamental value of any asset.

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*We now have greater liquidity risk.

** Of course a 30 year time horizon is only such for one year, then it becomes a 29 year horizon.

Please note all views expressed in this article are my own and are not necessarily shared by my employer.