Here’s The Problem With Underperformance

“A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular.” – Seth Klarman

Active mutual funds continue to lag the market this year. This chart from BMO Capital Markets, courtesy of MarketWatch, shows the percentage of active stock managers that are outperforming the market over the past six years or so:

This is nothing new, but there are some risks for investors in active funds to consider that can result from this underperformance. Brian Belski, the chief investment strategist at BMO, had this to say about the implications of these numbers:

We believe fund managers being too inactive and defensive with their portfolio positioning this year is largely responsible for this. However, given the level of underperformance, fund managers will likely have an added incentive to position portfolios more aggressively between now and year-end to play “catch-up” – something we believe will be a strong positive for market performance.

Ignoring the market implications (why would the market go up just because portfolio managers shift their stock holdings around?), this brings up a risk that few investors consider when making fund selections – career risk.

Whether right or wrong, if you underperform the market for an extended period of time, it will be much harder to attract new investors and keep current investors from selling out of the fund. Lower assets means lower fees which all compounds into more and more pressure on the manager to bring returns back up to stop the bleeding.

The risk for investors in underperforming funds is exactly what Belski outlines here – which is that portfolio managers take more risk to try to make up for their underperformance. Once a manager becomes fixated on short-term relative performance, risks can become magnified. Instead of performing rational analysis, they turn into speculators. They speculate on what other investors are going to do and try to get their first. They’re trying to forecast what the other forecasters are forecasting.

In essence, when you play the short-term relative performance game, you have to be able to guess the psychology of other people…not an easy task.

Obviously, this isn’t an optimal way to run a portfolio. This is why it’s so important for investors to understand what they are getting themselves into with any fund offering. A few points to consider when you’re involved with an underperforming fund or strategy:

Does the portfolio manager/firm have a disciplined process? A deep understanding of the fund and strategy is always important, but this is especially true when a period of poor performance hits. You must consider whether the manager will stick to their knitting or change course and go a new direction. Style drift is acceptable when it’s been sold as part of the strategy, but that’s rarely the case. More often than not style drift is a huge red flag for an underperforming fund.

Do you have the correct expectations for fund performance? Being out of favor isn’t that surprising. Nothing outperforms forever. Just as markets are cyclical, so too are strategies and investment styles. These things go in and out of style. It all depends on how willing you are to wait for things to turn around, which may or may not happen.

Do you have a plan for an underperforming fund? There’s no easy answer to the question of when to cut your losses in an underperforming fund. Investors always preach process, process, process until a bad outcome hits. At that point, process goes out the window and emotions take over. Emotions are the enemy of buy and sell decisions.

Playing catch-up to the market isn’t a great position to be in from a fund manager’s perspective. But adding risk for the sole purpose of getting even is not the solution.

Remember, trying harder doesn’t lead to better returns in the market.

Source:
Playing is safe isn’t an option for lagging portfolio managers (MarketWatch)

Further Reading:
Excuses for underperforming the market
Unintended consequences of risk avoidance

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