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.