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Persevering with your underperforming fund manager

“Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat the market.”

Charles D Ellis, “The Loser’s Game”, The Financial Analysts Journal, July/August 1975.

Asset consultant, Mercer, recently released its fund manager performance survey for the year to 30 June 2013, and the Australian equity numbers showed extraordinary differences. In a year when the S&P/ASX300 Accumulation Index rose a healthy 21.9%, the top fund (Lazard Select Australian Equity) was up 41.8%, while the bottom (Independent Asset Management) was up only 2.8%. That’s a 39% range in what is reported as the same asset class.

So much for asset class selection being far more important than manager selection in determining a portfolio’s performance. It’s not always the case if an investor is at extremes.

(In fact, the top Australian equity fund was the Colonial First State Geared Share Fund, up 73.9%, but that’s really in another category, as explained in Cuffelinks of 7 March 2013).

Reasons for performance differences

There were two main reasons for the massive performance differences:

  • Managers who were underweight mining stocks (Australia’s largest gold producer, Newcrest, was down over 50%) and overweight large banks (Westpac up 45%) did especially well.
  • Managers who bought large stocks and avoided small stocks also outperformed, with companies outside the ASX100 falling in value over the financial year.

In addition, last year was a particularly good one for active managers overall, with the average delivering a splendid 24.7% and outperforming the index by 2.8% (all numbers quoted are accumulation, not price).

But the past is just that, and the only thing that matters in investing is the future. There is a tendency by both professional asset allocators and eager self investors to extrapolate recent performance and jump into last year’s winners – and out of last year’s losers.

Let’s take a quick look at the bottom five fund managers in the Mercer survey for 2012/2013:

Clime Australia Value Fund (+12.9%, or 11.8% below the average manager)

Clime’s Chief Investment Officer is one of Australia’s most prominent and respected fund managers, John Abernethy, and the Value Fund carries a five-star rating from Morningstar. A listing of Australian share fund performance over five years in Money Management in February 2013 ranked the fund first.

Northward Capital Australia Equity Income (+11.8%, 12.9% below average)

Northward is an independent boutique of eight investment professionals with average experience of 19 years. It is one of the boutiques part-owned by the National Bank subsidiary, nabInvest. Northward’s fund is a good example of how an income fund can underperform in a strong market. It aims to have lower volatility with higher income by using some of its cash to buy index puts (giving it the right to sell if the market falls), plus selling calls over its stocks (giving others the right to buy). These protection measures take the top off performance in very strong markets.

SGH20 (+9.5%, 15.2% below average)

This fund is managed by SG Hiscock & Company, and in 2012, it was a finalist in the large cap category of the AFR Smart Investor Blue Ribbon Awards. The fund has a strong long term track record since its inception in 2004, but it was underweight banks, telcos and REITS in 2013, damaging recent performance. Prior to last year, it was a consistent top quartile fund.

Katana Australian Equities (+6.5%, 18.2% below average)

Katana was founded in 2003, although its Australian Equities Fund was only launched in 2011. Perhaps influenced by its Western Australia base, it had large exposures to resources stocks which have underperformed the general market. Katana’s team was lauded for its stock-picking ability in the year to 30 June 2010 when one of its funds returned 24.3% and outperformed the market by over 10%.

Independent Asset Management (+2.8%, 21.9% below average)

In 2012, Morningstar ranked Independent as first among Australian fund managers based on a survey of institutional investors. Founded by the eccentric Greg Matthews, Independent had a formidable track record prior to the last year following its establishment in 2001. Matthews is a big believer in the China growth story, leading to value in resource stocks, as shown by his top six holdings: BHP, Woodside, Rio Tinto, Santos, Fortescue and Bluescope.

If you had been a member of an investment committee in June 2012, you would have found it extremely difficult to argue against the appointment of any of these managers faced by an eager Chief Investment Officer and his 20-page report. A trustee of a superannuation fund, legally obliged to act in the best interests of the fund’s members, could justifiably have selected a manager who then delivered almost 40% less than the best and 20% less than the average active manager.

Retail investor response to short-term underperformance

So what should retail investors without direct access to their manager do when their fund manager has just delivered 10-20% below the market average?

First, accept that there’s a lot of luck in this business. These funds are run by smart people who live and breathe investing. They rise early each morning to hear the latest from overseas markets, and are at their desks analysing stocks while most other people are wiping the sleep from their eyes. They work late, attend company briefings, argue with their colleagues and analyse numbers. They trawl through annual reports and stare at screens looking for opportunities. They are the best educated people in the country, and if they were not fund managers, they would be doctors, lawyers and engineers. It only takes a couple of incorrect calls, or a market bias against their style, for a manager to have a poor year, or maybe several. I have been involved with talented managers who strongly believe in underperforming stocks like Fairfax and Qantas, and to date, their careers and funds have suffered for their beliefs. It is difficult to foresee a Fukushima and its effect on uranium prices, a product recall, a law suit or adverse legislative changes.

This is not to say all fund managers are created equally, or that all fund managers will survive over the longer term. Some are certainly more astute and insightful than others. I worked at a wealth management business where an underwhelming fund manager left, and a few months later he set up a boutique asset manager and obtained seed funding and capital under an alliance agreement with a major competitor. We would not have helped him to set up a corner fruit shop!

Second, ignore short-term numbers. Anyone who carefully selects a manager then sacks them after a year does not understand the nature of the business. In the recent past, journalists were writing stories about some of the above managers as if they were demi gods of the market with an uncanny ability to predict global trends and stock successes. Has their mojo suddenly gone?

Thirdly, investors should be satisfied the factors that made the manager attractive in the first place remain on track, such as their investment style, process, risk-taking ability and compliance.

Finally, if short-term underperformance is a major cause of heartache, it might be more appropriate to save the angst and take index performance. In most years, the average active manager does not outperform the index after fees. By definition, despite the considerable talent on the table, most managers will underperform after fees. Do you have some special talent in knowing which managers will be the winners? This is one reason why many industry funds are moving asset management in-house, and why retail investors do their own investing.

If you go down the active management route, consider it a long-term decision, barring a major change in personnel or style at the fund manager. Even a portfolio manager change may not be cause to act, as a succession of high profile fund managers leaving Perpetual (Anton Tagliaferro, John Murray, Peter Morgan, John Sevior) does not appear to have dented their ongoing impressive performance. You can almost guarantee that the manager you flee after one year will do well the next, assuming of course that they have not been forced to close up shop.

The issue is not that the people with solid track records who go through a poor year or two are suddenly bad managers, but more likely, they have misjudged some short-term event. As Charles Ellis says about his experience with investment managers:

“Their brilliance in extending logical extrapolation draws their own attention away from the sometime erroneous basic assumptions upon which their schemes are based. Major errors in reasoning and exposition are rarely found in the logical development of this analysis, but instead lie within the premise itself.”

But next year, the basic premise might be right. If you’re not prepared to select a manager and hang in there for at least three years and preferably five, index and save yourself some fees.


Harry Chemay
August 01, 2013

If I repeatedly call "heads", flip a fair coin 9 times and get 9 heads in a row, am I an exceptionally skilled coin tosser, or was I just lucky? Is the probability of the 10th toss also being a head now greater than 50%, given my 'hot hand'?

The above (admittedly grossly simplified) example serves to illustrate a point; that it is extremely difficult to determine whether the past performance of an active managed fund was due to manager skill or to luck. To do so would require a track record of relative return 'outperformance' far longer than most strategies have been around (between 7 - 9 years would be preferable, depending on the level of confidence desired).

Issues such as survivorship bias, key person departures and style drift make the task of confirming true investment insight within the ranks of active managers highly problematic. This is not to denigrate the role of active managers in any way. They are a vital part of any functional market. Their actions form a key part of the price discovery process, ironically driving markets to be more efficient than they might otherwise be.

And so to my concerns. As you rightly posit, sacking an active manager on the basis of relative under-performance over the short term (and 12 months is exceeding short) is grossly unfair, given that chance and not a lack of skill could have accounted for the sub-par performance.

Even more troubling however is the practice of viewing short-term return data in isolation and making investment decisions on the basis of returns only, without any consideration of the risks taken in achieving them. If an active manager outperforms its benchmark by 10% over a 12 month period but takes on 20% more risk to get there, that it not a cause for congratulations. Quite the opposite actually. Yet the investment press is filled with stories of Fund X delivering Y return over the past month/quarter/year, without any mention of risks borne in producing said return.

One can't lay the blame at firms (like Mercer) who produce these league tables. In addition to relative return 'outperformance', data is also released for the amount of relative risk taken by active share managers, only to be broadly ignored.

Whether in the form of tracking error or risk-adjusted return (eg Sharpe or Sortino ratio) astute investors should make themselves aware of how much risk their active managers take in attempting to 'beat the market'. To be fair self-directed investors should also put their own investment calls under the same scrutiny. The results may prove illuminating.

As it so happens the Mercer survey quoted contained a table for the top 5 and bottom 5 Aussie share managers ranked by 5 year Information Ratio (IR). Active share managers may dislike this ratio (outperformance / tracking error, or in plain speak active return / active risk) but it is one way to determine if an active manager is delivering 'return bang for the risk buck'.

The top 5 table for 5 Year IR makes for interesting reading. The number 1 ranked fund was also number 1 last year. If it holds onto a top quartile position for the next 5 years, then I'm more likely to consider the performance attributable to skill rather than luck (and thus worthy of the fees). As for the 1 year IR number? It's worth about as much as the toss of a coin.


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