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:

Active

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

Subscribe to receive email updates and my monthly newsletter by clicking here.

Follow me on Twitter: @awealthofcs

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

The Compound Media, Inc., an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. For additional advertisement disclaimers see here: https://www.ritholtzwealth.com/advertising-disclaimers

Please see disclosures here.

What's been said:

Discussions found on the web