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Short-term pain for long-term gain

Date: 02 December 2021

As style leadership has rotated in the last 12 months, so some of the best performing funds have suffered from weaker periods of performance. In today’s Fund Buyer, we explore how investors should think about short term difficulties versus longer term consistency.

In today’s podcast, I’m going to explore the thorny topic of short-term underperformance and whether it is something to be concerned about or ignored. Judging from a few recent headlines, others are certainly paying close attention, with successful funds being reviewed after weak recent periods. It also opens up the question of whether we need the funds we invest in to be persistently successful over every calendar year, for example, or if there should be a certain amount of leeway.

This year has been an interesting one for many reasons, not least because we have seen a certain amount of style rotation. For value managers, the end of last year and early this year was much more favourable after an extended period where growth investing was the only game in town. That has inevitably meant that some of the best performing funds have so far had a weaker year and may end up behind the index come December 31st.

We analysed UK and US funds within the IA peer groups to see how consistent they were over individual calendar years, including to end October for 2021, and how that compared to longer term track records. For UK All Companies funds, there were only 12 active funds out of 212 that outperformed over each of the last five calendar years, whilst a further 46 outperformed four out of the five years. So you might say the rest lacked consistency, but taking a longer term view, 121 funds were ahead over a five year period, which represented 57% of those funds with at least a five year track record. Personally, I think it is the latter figure that we should pay most attention to. Looking at the IA North America sector, the performance of the peer group as a whole was weaker, but nonetheless it was a similar story. Three funds were ahead for each of the last five years, another 19 were ahead for four out of five years, but led the market over a full five year period. The point here is that we should be focusing on the longer term and worrying less about the short term - unless performance is out of line with expectations.

There is plenty of commentary extolling the virtues of passive investing which highlight the inability to consistently outperform every year as being a reason to invest passively. But should we be seeking funds that offer us that consistency? Personally, I think not. The ability to move with style over time is one that I have rarely seen managers get right consistently, and for those that do have some ability, there is always the chance of an unexpected macro event rendering the ability to do so impossible. That said, there are managers who specifically target a style neutral approach, and in that case they are relying on their stock selection abilities to be the driver over each period. Often these managers are fairly diversified and will have a foot in both camps. However, the chances of being able to consistently outperform remains low in my view.

So how should we judge those underperforming managers? At a very basic level, many managers aren’t necessarily judged against the correct market index, perhaps with the exception of the US, where style biased indices are much more prevalent. There are plenty of good reasons for that, not least that most retail investors are focused on the broad market when buying a fund. For more sophisticated investors, considering whether a manager’s results have been flattered and hurt by the general environment is key. My inbox is full of emails extolling the virtues of yet another quality growth manager with a good performance track record, but it really would be a surprise to see such a manager lagging in the last five years. What would be more interesting personally is to see a fund which has not had these style tailwinds but managed to keep up with the market.

The way we tackle this issue is to be very clear at the outset of how and when we expect a fund to do both well and poorly.

If the fund has a strong style or market cap bet for example, this should be taken into account at least in the short to medium term. Longer term, barring very extreme markets, which we could certainly argue last year was, I would hope that most good active managers should outperform over five years. If their stock picking skills are sufficiently strong then a mild style headwind should be no impediment to long term outperformance. I think the numbers I mentioned earlier back that idea up, especially in the UK.

We have the luxury of numerous systems and portfolio analysis tools to help us judge how the manager is performing, but what might you do if you don’t have that at your disposal? There is plenty of help at hand. Let’s take the example of a UK Growth manager. A simple search on the internet provides me with the detail of the MSCI UK Growth Index and how it has performed against the broader market. Over the last three years, that happens to show outperformance by the Growth Index of 8% per annum, a pretty extreme result. How does your UK Growth manager stack up compared to that measure? If you spend enough time researching managers you will also find quite a cohort of similar growth managers, and a peer group analysis can also illuminate the best and worst.

More generally, I think some of the rhetoric around short term underperformance is wholly unhelpful. It encourages the very worst of fund investing, namely buying high and selling low, the propensity of all of us to think that the outperforming manager today is the one to be adding to, whilst the underperformer should be considered for exit. The results of the aforementioned US peer group recently gives us a good example of why this can be dangerous. Of the top 15 best performers in 2020, eight found themselves in the bottom 15 in 2021. Six of those eight were well ahead of the market over five years. That tells me two things. Firstly, that most likely this is the impact of style in both a positive and negative way, and the first reaction should not be to sell, unless of course you think their style is now permanently out of favour. Second, balance in any portfolio is key, albeit you may wish to actively tilt that, as we do.

What is the solution for investors? The passive industry might point to their investment vehicles as a way of ensuring consistency, but I’d argue that investors shouldn’t shy away from periods of underperformance and that even if fewer managers outperform than underperform, that is still a significant minority. Long term investors will inevitably suffer weaker periods, but most who are invested should have a time frame able to cope with this. As ever, aligning one’s own investment time horizon with that of the manager is crucial. We also have it in our hands to benefit from the magic of diversification. Many of us will have reached September 2020 wishing we had more invested in those lockdown beneficiaries, but that soon dissipated as the opening up trade led the way. Simply balancing out exposures across active funds, and potentially taking a view in one direction or another, is more sensible.

So what do we conclude from all this? It’s pretty simple really. Most funds don’t perform in all environments. The managers usually don’t claim that they can, and investors need to be patient. Let’s see if that happens – certainly recent days have provided yet more data to analyse as we go into year end.

On that note I’m going to close today’s edition of the Fund Buyer. As ever, thanks for listening and stay safe!

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