The average fund manager delivers small and inconsistent outperformance and can underperform for longer periods than most people think, according to a new study by Frontier Advisors presented at its annual conference.
The study, which found the average Australian and global equity fund manager delivered outperformance of less than 1 per cent a year, after fees, suggests that there is a low margin of error for active managers.
On top of this, the new study also found that active managers commonly underperform for around four years over an equity product’s life time. Frontier isolated the longest underperformance period for large numbers of equities products and generated quartiles based on those periods, as shown in the diagram below.
A Long Wait: Fund Manager Underperformance Periods (Years)
Frontier Advisors Consultant, Zong Aw, said the study reinforces the need for investors to rebalance their portfolios as even strong performing products experience multi-year underperformance periods over their life time.
“That would help you avoid those situations where your managers experience a reversal in performance so you can capture some of the outperformance, rather than giving it away when that cycle turns,” he said.
CareSuper Chief Investment Officer, Suzanne Branton, said taking money away from a skilled manager who had recently outperformed was difficult but necessary.
“Being disciplined about that sort of thing is really important,” she said.
The Frontier study found significant ‘reversion to the mean’ effects on fund manager investment returns.
For example, the lowest-quartile performing managers in Australian large and small cap equities over a three-year period had around a 40 per cent probability of reverting to the top quartile in the following three-year period.
Conversely, a top-quartile small cap manager over a three-year period had about a 50 per cent chance of falling to the bottom quartile in the following period.
In contrast, upper quartile global equity managers had around a 40 per cent chance of maintaining their top performance in the following three-year period but an almost 40 per cent chance of then dropping to the bottom quartile in the next three-year period. Frontier suggested that much larger style factors in global equities were a likely driver of this different pattern of global equities active manager returns.
Aw said the study reinforces a second significant finding that investors commonly hear: past performance is a poor indicator of future performance.
“If the only reason to retain a manager and let an allocation build over time is past performance alone, this study shows that it is not a very good strategy, which again emphasises the need to rebalance your portfolio.”
The panel agreed investors should be wary of picking style-based managers that had done very well recently instead recommending investors be more open to picking underperforming – but skilled – managers.
The relationship between the manager skill and length of time investors should give them (how long they’re underperforming for) is not a stable function. Unpacking that is the key
Investors should consider a number of factors when deciding how long to stick with an underperforming manager, including the trend in managers’ ability to generate excess returns, team dynamics and potential fund outflows.