Stay or switch?

Investments in active fund managers provide the opportunity for superior long-term returns. However, investors should expect to experience volatility in their portfolio. Therefore, periodically reviewing an investment portfolio is an important exercise for investors to understand the drivers and detractors of performance.

Often in a diversified portfolio, one or more investments will typically underperform. Further analysis is required to understand the underlying dynamics affecting the underperformance.

When a fund manager underperforms, one of the biggest decisions for an investor is to decide whether to remain invested in the fund or switch to another. Below are some factors to consider before switching out underperforming managers.

Short-term underperformance

Active management requires a fund portfolio to be different from its benchmark. This differentiation provides the opportunity for a fund manager to outperform the benchmark and its peers. This may also lead to periods of underperformance. Even the most skilled managers go through lengthy periods of underperformances. For example, Warren Buffett, widely considered to be one of the best money managers in the world has gone through multiple periods of 50% or more drawdowns. Yet those who remained invested with Warren Buffet have been rewarded for their patience. An investor who invested $10,000 in 1965 will now have a portfolio valued at over $200 million.

In order to achieve long-term investment performance, volatility of returns within a portfolio should be expected. These periods of underperformance may be due to short-term misjudgements or mistiming of the investments leading to poor performance. Often the short-term performance does not give the fund manager enough time to allow the investment thesis to play out or to correct any misjudgements.

Studies have shown fund managers are more likely to outperform over the long term following a period of below-average performance, see the below chart. Managers who ranked in the lowest decile tended to outperform managers in the top decile in the subsequent three years. If the original investment strategy remains intact, underperformance can be an opportunity to buy more into the strategy.

Understanding the original reason for investing in a fund manager is important when re-evaluating the investment. A manager whose investment objective is to offer capital protection during volatility markets will often be invested conservatively and underperform in bull markets.

It is also important to evaluate the fund’s performance relative to the overall economy and current market conditions. Certain investment styles may be out of favour for a long period of time, as has been the case with value managers. Therefore, it is important to have a diversified portfolio to ensure when one strategy is performing poorly, another is performing well.

Recency bias – recent performance is no indication of future performance

Investors are influenced by several cognitive biases that may unknowingly and negatively impact their investment decisions. Recency bias occurs where the most recent observations have the greatest impact on an individual’s decision. This may lead to investors buying what has done well recently and selling what has done poorly recently. In other words, buying high and selling low as investors move in and out of the fund at the wrong times.

This tendency to chase recent winners and exit the losers often leads to long-term underperformance. In his book ‘The Big Secret for the Small Investor’, Joel Greenblatt, co-founder of Gotham Asset Management and Professor at Columbia Business School, looked at a study of fund manager performance over the decade ending in 2009. The study found that even though the best performing fund was up 18% p.a. during the 10-year period between 2000-2010, the average investor in the fund managed to lose 11% p.a., see the below chart. The large variance in performance between the fund manager and the investor was due to timing of entry, as the fund outperformed investors entered, and as the fund underperformed, investors exited.

Investors need to be mindful not to make investment decisions on a fund manager’s recent performance.

Warning signs – manager style drift or poor stock selection

Every investment should serve a place within a diversified portfolio. Some investments offer capital protection while others provide the opportunity to capture particular sectors. Investors should be concerned when a manager has sudden or unexplained changes to their investment strategy or portfolio, therefore, affecting its place in the portfolio. For example, given the recently prolonged underperformance of value investing, if a value manager unexpectedly started investing in growth stocks. Or a large-cap manager increasing its small-cap exposure. In these instances, further analysis is required to understand the reasoning for such changes.

The fund manager’s performance should also be evaluated against its peers. In the example of value investing where the strategy has underperformed the market in recent years, it is important to review a value manager against other value managers. If the manager has continually underperformed against its peers, it may be due to poor stock selection. Considerations arise if the analysis indicates poor stock selection over an extended period.

Other considerations

There are also several non-specific fund manager related considerations to think about before switching a fund manager, these include:

Fees - relating to the switching of a fund manager including exit and entry fees. These fees can impact investor returns.
Time and opportunity costs – switching from one fund manager to another requires significant time to perform due diligence on potential investments. In addition, investors may potentially miss market movements during the switch.
Taxation issues – while taxation issues should not form the basis of an investment decision, investors should be mindful of the tax implications from exiting or switching a manager.

Summary

It is important for an investor to remain patient with managers during periods of underperformance. Often these periods are followed by periods of outperformance. Having a well-diversified portfolio offers investors superior risk-adjusted returns to ensure they are not relying on one particular investment strategy. Each fund manager should have a place within a diversified portfolio. However, sudden changes in investment style or prolonged poor stock-picking choices should be a cause for consideration and further investigation.

AJ Ginh has over 10 years’ experience in the investment management industry including investment consulting, private equity and private banking.