Bull markets, time horizons and the consequences of being rational
We’re now in the longest bull market of all-time, at least in modern history. The S&P 500 has not only made new highs, it’s done so without falling more than 20% for more than 114 months, with the previous record having been set during the great expansion of the 1990s.
But here’s my question: have investors benefitted as much as they should have?
The answer is clearly no in aggregate. The performance of many active managers has been disappointing, particularly after February 2014. While there are many explanations for this, my own opinion is that underperformance is generally attributable to emotions, time-horizon and rational behaviour. This is my qualitative judgement rather than scientific or statistical fact, but I think it offers us a useful framework to evaluate active performance.
Table 1: How have active US managers performed over today’s bull market?
|Percentage of active managers who outperformed the S&P 500|
|March 2009 – June 2018||39%|
|March 2009 – February 2014||42%|
|March 2014 – June 2018||39%|
Source: Factset, Lipper US Large Cap Equity
Emotions tend to make people do something
Let’s start by assessing the emotional aspect to all this. It’s clear to me that professional stock pickers are trying to beat the market with empirically backed philosophies. Furthermore, most of them have a relatively good understanding of balance sheets and income statements, a repeatable process to ensure consistency, and can combine their ideas into a reasonably robust portfolio.
The problem is they’re ‘active’, and with this comes the emotional connection that something has to be done. That is a dangerous emotion to have in a bull market built on a momentum, when often the best choice is to do nothing. It’s difficult emotionally not to take profits from your winners, not to buy more of your underperformers and most of all, to explain to clients why you’re not doing anything. Something must be done are often the four most dangerous words in investing.
Can time horizon be a competitive advantage?
Confusingly, most managers think their key competitive advantage is ‘time-horizon’. Yet if everyone’s ‘competitive advantage’ is time-horizon, it’s clearly not an advantage anymore. In active management, long term can be anything from two to five years. Very few think in terms of decades, and even fewer would actually hold their highest conviction investments for that long – and definitely not without taking profits or buying more at some point.
The perversity of rational behaviour
The last factor – rational behaviour – wouldn’t make most people’s list of reasons why active managers underperform, but it’s undeniable. John Maynard Keynes was one of the first to point out this factor when he said: the market can remain irrational a lot longer than most investors can remain liquid.
If you buy your stock when it’s trading at 60 cents to the dollar, the theory goes you sell it at $1. Maybe run it to $1.20. But few investors would not at least take profits, if not sell completely when $1.50 arrives. My point is, it’s quite rational to sell a liquid investment when valuations reach what you believe is relatively excessive.
For people running their own investment portfolios, however, the news is even worse. Asset weighted returns are generally worse than time weighted returns. Put another way, investor experience in mutual funds is significantly worse than the actual mutual fund performance.
If portfolio managers are not really long term, end investors tend to be even less so. Fund investors tend to buy high and sell low – you can see this by comparing the performance of active funds and their inflows. The general trend when funds outperform is for investors to realise this only belatedly, and start adding once rolling outperformance begins to fade.
Chart 1: Spot the behavioural error – investors only add to funds once they are already outperforming
Source: Research Affiliates based on data from eVestment Alliance
How do you get the most from active management?
In order to maximise the long-term benefits of active management, we probably need to redefine what long term is. While a longer time horizon in itself is not a competitive advantage, it at least allows the opportunity to maximise investment returns, rather than trying to time the market.
Related to that, we also need to understand that a bull market is not a full cycle. While a skilful and rational investor should outperform over a full cycle, they may struggle at some parts of the cycle. While underperformance over a shorter time horizon might be disappointing, it’s important to remember that past performance in itself is never a reason to make a decision about future outcomes.