The argument against the use of active management is often focused on the difficulty of identifying a fund manager with the requisite skill to outperform the market. This perspective, however, ignores a critical element of employing active fund managers. It is not simply about finding the right ones, it is about being able to stick with them over the long-term. An elegant study recently released by Vanguard put this into sharp contrast. It showed that even successful active funds endured protracted, multi-year spells of underperformance. The message is simple: if we are not able to withstand years of under-par returns, we should not be using active managers at all.

The Vanguard study, which looks at the performance of open-ended actively managed equity funds with US domicile, covers over 2,500 funds across a 25-year period. The entire piece is worth reading but there are some critical observations:

– “Close to 100% of outperforming funds have experienced a drawdown relative to their style and median peer benchmarks over one, three and five year evaluation periods”.

– “Eight out of ten outperforming funds had at least one five year period when they were in the bottom quartile relative to their peers”.

Underperformance is an inevitable and expected part of the return profile of all active managers, even those with skill who manage outperform over the long-term. Hopefully, the study lays to rest the spurious but pervasive notion that years of consistent outperformance is either a reasonable expectation or anything more than random patterns being weaved.

Identifying a skilful active manager is incredibly difficult; but even if we can do it, it will not matter if we are unable to cope with the barren periods. The first question we ask before considering investing in an active manager should not be – do we have the ability to find one? Rather, are we in a position where we could hold them for the uncomfortable and volatile long-term? If the answer is no, we should not even begin the search.

It is easy looking at historic underperformance on a screen before we invest; living through it is an entirely different proposition. The doubts about the quality of an underperforming manager or their suitability for the prevailing market environment are relentless. Fund investors spend most of their time worrying about the managers who are underperforming. It is difficult to overstate how behaviourally taxing it is. The easy option is always to switch from the bothersome laggard and into a flavour of the month leader to make the questions and concerns disappear, at least for a time.  

Persisting with an underperforming active fund as an individual is extremely challenging, but even if we have the personal wherewithal, the problem does not vanish.  It is not just us that has to endure it – it is the other stakeholders too.

The underperforming fund manager and the firm they work for must also retain conviction. It is of little use if we stand firm only to see the manager change their approach or their employer fire them.  The incentive of the fund manager is to keep their job and for the asset management company to preserve assets; keeping faith with an under-scrutiny investment strategy which has delivered years of poor results is not aligned with either of those. Unfortunately, for a fund manager, possessing investment skill might not be enough.

For professional fund investors, the final hurdle is the people we are accountable to. Do we work in an environment that is supportive of adopting a long-term approach and willing to endorse investment decisions that will look wrong, often for sustained periods?  There is no point investing in active funds if we will repeatedly be forced out of them (due to pressure from others) after three years of underperformance. As a pattern of investment behaviour, it is hard to think of a more pernicious strategy.  

There are no easy solutions to the problem of persevering with a struggling but skilful active fund manager. The temptation to sell will often be overwhelming. There are two ways of giving ourselves a fighting chance. The first is setting the correct expectations at the outset – we need to be abundantly clear about the prospects for a fund or manager with all interested parties. Even if we are right, multiple difficult years are inevitable.

The other potential ameliorative is manager blending. Combining active fund managers of different styles should not only smooth returns and provide diversification benefits; if done well it is an effective behavioural tool. When one manager is experiencing a fallow period, another is likely to be enjoying a tailwind and delivering superior results. The whole concept of blending is built on the notion that not everything will work, all the time. Even attempting it helps in setting the correct expectations. Furthermore, the pain of the underperformance from one fund will be offset (somewhat) by its more productive counterpart.

Blending is no panacea. It is far from a precise science and if it is done too well, we will end up owning an expensive version of the market. It will also not stop us and others worrying about the straggler. The pain felt about the underperformer is likely to be more acute. These issues notwithstanding, it is the best option available to investors in active funds.

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Unfortunately, even if we can hold active funds through tumultuous periods of performance it is not enough to guarantee positive outcomes. The manager we invest in might actually be underperforming because something has gone wrong, and the right course of action is indeed to sell.

Nobody said it was easy.

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Vanguard Study: Patience with Active Performance Cyclicality