John Husselbee

The active argument: patience required

John Husselbee

Amid the reams of debate on the active versus passive question, it is odd to find perhaps the most perceptive understanding of active fund management in new research from the best-known name in passive-land.

To be fair, Vanguard has its own burgeoning active funds business but the company, and particularly founder Jack Bogle, is credited with launching the first tracker back in the 1970s and widely considered the standard bearer for index investing. As evidence, Bogle was the passive representative in 2015’s so-called ‘great fund debate’ versus stockpicking advocate Jim Grant.

In a recent piece of analysis, however, titled Patience with Active Performance Cyclicality, the group absolutely nails the key fact about investing in active managers – only do so if you have the patience to withstand potentially lengthy periods of underperformance on the way to long-term wealth generation. This, in essence, is what we refer to as noise-cancelling investment, which is central to our patient multi-asset approach.

It is worth reading the report in full but we have picked out three headline stats from a fund selection perspective. Based on a data set of more than 2,500 actively managed US-domiciled funds over 25 years to the end of 2019, the research found almost all the outperformers experienced drawdowns versus their benchmarks and peers over several one, three and five-year periods. Meanwhile, 80% of the outperforming funds also had at least one five-year bottom-quartile spell and top managers can expect a continuous drawdown lasting at least two years every decade and a worst fall of at least 20%.

For us, this data reiterates one of the core messages underlying our fund selection: while consistency of performance is ultimately impossible over every timeframe, consistency of investment process – for our chosen managers – is essential.

These findings also reminded me of a similar piece of work presented by Morningstar at an annual conference I was lucky enough to attend in Chicago a few pre-Covid years ago. As part of efforts to improve performance measurement and give a more comprehensive picture of manager skill, the company proposed two new metrics called longest underperformance and outperformance periods (LUP and LOP respectively). Morningstar’s data examined active funds over a shorter 15 years to the end of December 2017: around two-thirds of those analysed – 3,790 out of 5,500 – beat their benchmarks over the period but, of these, the average longest underperformance period ranged from nine to 11 years.

Using simulations, Morningstar also showed that even a very skilled manager, over a span of 100 years, would underperform their benchmark for a two-decade period during that time.

What this means in practice – and this is also the ultimate conclusion from Vanguard’s data – is that investors not only need to pick the right active managers but also have the patience to endure long periods of sub-par returns. If unable to do either, fund selection becomes a very challenging, and essentially fruitless, exercise.

Morningstar’s numbers also show the opposite: a fund that underperforms its benchmark over 15 years could well have gone through an eight-year period of outperformance during that time, enticing return-chasing investors to buy, only to be disappointed by subsequent results. 

What can we take from all this and how should these figures shape the debate on active management? A key point, which chimes with our investment process, is that patience has to be a watchword when it comes to fund selection – but this is increasingly out of step with the short-termism of markets and the behaviour of many investors. As we always say, there is a library’s worth of books for anyone keen to get into the detail of behavioural investing but the forces of fear and greed can be found at the root of most decisions to sell or buy assets, many of which are taken at precisely the wrong time.

Active investing – and picking active managers – is a long game but many of the standard performance metrics that measure it are not built around this. Alpha, beta and information ratio, for example, all typically use three or five years as their default timeframe but these periods are clearly too short to evaluate managers with any degree of confidence, and differentiate luck from skill.

Fund selection requires a rigorous process and, despite the challenges, we believe it is possible to identify genuine manager skill via our Spurs system which focuses on the following five attributes:

Stamina – We favour patient, long-term investors from a similar mould to us and prize managers who can point to endurance and experience

Process – A robust and repeatable investment process is a must for our chosen managers: while consistency of performance is impossible 100% of the time, consistency of process is a must

Understanding – Among the softer attributes we look for are knowledge, insight and wisdom

Resoluteness – Along with courage and conviction, determination and decisiveness

Stimulus – Another factor to consider is a manager’s environment: what are the incentives and motivations for them to perform and what is driving them.

We are often buying particular managers to fit a style requirement in our portfolios and therefore need them to keep to that approach whatever the backdrop. Baked into that is the understanding that managers with a strong style bias can go through lengthy periods of underperformance and, to cope with this, there are two things we can do.

First is as simple as setting realistic expectations at the outset: if we understand how different conditions affect funds of a certain approach, we should have a decent idea how our holdings are likely to behave. If we have picked a skilled manager, they should ultimately outperform, even if it requires patience to see that come through. We would also expect to see the asymmetric return profile we require, with our managers leading their particular style cohort whether conditions are favourable or not.

A second tactic – again, integral to our investment process – is selecting funds and managers that complement each other in terms of style, which not only provides diversification but should also give a smoother ride in terms of performance. In basic terms, and while the interplay between our holdings is considerably more nuanced, if a growth manager is struggling, for example, more value-oriented funds would typically be doing better.

To give an example from our Multi-Asset portfolios, within UK equities, we currently combine two more value-oriented funds, Schroder Income and Fidelity Special Situations, with two more growth/quality offerings in the shape of Lindsell Train UK Equity and Axa Framlington UK Select Opportunities. For a full breakdown of how we analyse Axa and Schroders in the context of our portfolios see here, but, in short, getting the right blend is all important. As would be expected, the former pair have both been among our stronger holdings so far this year, for example, while the latter duo had a slower period.

Multi-asset funds and portfolios that are able to tilt between styles while keeping a foot in all camps offer a compelling and diversified risk/reward balance. This is exactly why consistency of investment process is so important: our managers have to demonstrate a long track record of maintaining their approach and not drifting away to chase short-term performance; if they do, this is a reason for us to sell.

While passive funds play an important role in our funds and portfolios, we have always believed that picking active managers – by definition – is the only way to generate long-term outperformance. As long as we see consistency of investment process, we are prepared to tolerate periods of underperformance from our chosen managers, keeping faith with them as we hope our clients will with us. Key to this is transparency throughout, making sure everyone understands the path towards the ultimate goals, which is why initial suitability and know your client work is so important to successful target risk investing.

For a comprehensive list of common financial words and terms, see our glossary here.

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Tuesday, October 19, 2021, 9:09 AM