I have written previously about the central challenges of utilising active managers, namely:
- There are few skilful managers and they are difficult to identify. The odds of successful selection are often stacked against us.
- There are major behavioural challenges to owning the type of active managers most likely to deliver excess returns – those running distinctive, conviction-driven, high active share strategies. Even if we are able to find them, we are unlikely to persist with them through difficult periods.
There is also a third major issue and it relates to timing. Trying to successfully time anything in investment markets is a fool’s errand, albeit a very common and alluring one. The same applies to investing in an active manager – it is impossible to predict with any level of confidence when a particular manager or style will generate strong returns. However, whilst we may not be able to gauge when an active strategy will deliver, it does not follow that we should ignore the issue of when to invest in such a fund.
For example, if we assume that the average skilful manager can generate 2% annualised excess returns over the long-term*, investing in a fund following a three year period where it has outperformed its benchmark by 5% annualised has material implications for the likely path of future returns and the probability of success for our own investment. Such a scenario means that even when we have made a strong manager selection decision (i.e. we have found a talented individual); it can still result in us holding an underperforming strategy if performance reverts towards the mean.
This issue is created by the fact that excess returns are uneven – a skilful manager will not generate consistent outperformance each year (unless they are incredibly lucky); there will be periods of feast and famine. Whilst an accomplished manager is likely to deliver positive long-term outcomes, we might not enjoy the benefit during our ownership period.
To invest in an active strategy subsequent to a period of outstanding results we need to assume not only that we have found a manager with skill, but a truly exceptional individual that can produce and sustain returns well beyond what we might typically expect, even if our reference class is only that rarefied group of skilful managers. When making such an investment decision it is crucial to be acutely aware of the assumptions being made and the base rates potentially being ignored.
I always find it troubling that we feel more comfortable investing in a fund that has very strong performance before we invest – this is other peoples’ alpha, returns that we will not be receiving when we buy the strategy**. That we have not benefitted is a negative, not a positive.
The ideal scenario is to identify a manager that possesses skill and invest following a spell of weak performance, but this is a rare occurrence. As we overweight the importance of outcomes and tend to greatly understate the role of randomness in financial markets; we associate poor relative returns from an active manager with a broken or flawed investment process. Persuading clients and colleagues that investing in an underperforming fund is a prudent course of action can be a herculean task. The reputational risk is also great – buying a strongly outperforming fund that then deteriorates is acceptable and common, buying an underperforming fund that keeps getting worse is unconscionable.
Although we cannot forecast when an active strategy will work, the timing of an investment can materially alter the odds of success. Even if we find a skilful manager, our propensity to buy after periods of abnormally strong performance can still lead to poor outcomes.
* For long-term, let’s assume ten years. The average return of successful active managers will vary by asset class.
** Understanding how a manager has delivered outperformance and whether the positions / factors that are the most meaningful contributors to returns still feature in the portfolio is an important aspect of such analysis.