Almost universally weak performance of fund managers over the last two months has left many advisers and their investors in shocked disbelief, or hiding under their sheets unwisely hoping for a change in market conditions. It has been almost impossible for those with active manager portfolios to avoid at least some additional portfolio losses from manager underperformance, which has exacerbated the pain from the dreadful performance from capital markets more broadly. What on earth is going on? How can so many active managers be underperforming at once? Will performance improve?
Few have provided much insight in to the issue of widespread underperformance – after all, fund managers are currently fighting trench warfare with nary the time to rise above the fray. Active managers can and do of course underperform and outperform their asset class benchmarks on a regular basis, often cycling between the two. In crisis like periods, they should be expected to perform in accordance with their market exposures as gross market movements tend to dominate their relative performance and any “alpha” contributions. In recent times, however, managers have often performed more poorly than this.
Broad manager underperformance over short time periods can simply be noise or bad luck; indeed, it may be foolish to draw conclusions from very short time periods, much as the media is often creatively producing explanations for every dip or rise in the market. Nonetheless, when under-performance is widespread and correlated – as it has been - it suggests to investment researchers and consultants that managers may have been exposed to some common risks and/or exposures, and/or that too many managers are pursuing undifferentiated investment strategies. Considering what these common manager factors may be can be helpful in analysing managers and ensuring your manager portfolio is indeed as diversified as it can be.
Some factors that may be contributing to fund manager losses include:
1. Many managers have been taking too much risk
Years and years of bull markets and constant government intervention in markets to push them ever upwards have left many managers wary of ever de-risking. Fund managers who have been more conservative have consistently been punished with underperformance. Investors themselves have increasingly become infected by short-termism, punishing and unfairly labelling more prudent positioning by any of their managers. “Buy-the-dip”, yield chasing and a perennially bullish attitude has worked for so long that it has become the dominant manager approach. Many managers considered by their investors to be more value or fundamentally orientated or risk aware have increasingly drifted styles towards a more growth and momentum orientation, and become more trend following in nature – in a desperate bid to stay in the game and produce better performance, albeit at higher risk and heavily dependent upon style persistence. Other managers have become captured by headlines, and promoted various market fads and themes. In many cases managers have been over-levered and become entirely dependent on strong market conditions to perform. Unsurprisingly then, a fundamental change in market conditions has caught out many managers in crowded style, sector and stock positioning.
2. Defensive assets have become overpriced
Few managers have been positioned defensively. Indeed, traditional defensive assets have become difficult to justify as even being reliably defensive in today’s “bubble in everything” markets. Bonds and cash have been at the centre of central banks’ market manipulations - they have become increasingly difficult to justify exposures to (particularly for return seeking investors) given their low yields and ever-increasing supply. Defensive equity sectors and credit markets have become increasingly expensive globally as money has crowded in to low volatility and yield themes, with ‘higher volatility’ and more cyclical sectors offering more fundamental valuation support on a relative basis. We have hence seen some risk aware and more valuation focussed managers suffer in the short term from underperformance of more volatile and cyclical sectors in recent times.
3. Concentrated portfolio exposures and misplaced trust in capital markets
Many portfolios today have become overly dependent on equity risk to achieve their objectives, believing in many cases (mistakenly) that there is no alternative. Should equities underperform and disappoint, as they are currently doing, these heavily equity dependent portfolios will also reliably disappoint, and potentially excessively so. Some multi-asset portfolios are promoted and labelled as ‘balanced’ or ‘diversified’ options, yet in many cases are almost entirely reliant on being long equities to achieve results - and might be better considered pure ‘growth’ options.
Equally, an excessive focus on cost instead of value has resulted in many cases in portfolios populating their exposures with “cheap” beta exposures. Opportunity costs and value are not being considered in this superficial analysis of costs. Indeed, thoughtful research pays over time but too many have been willing to forgo the extra cost in rising markets when everyone is a winner (for a while). Unfortunately, paying peanuts has arguably resulted in what one might expect - a proliferation of monkeys, and generic “volume dependent” strategies among managers to meet the markets’ demands.
4. Illiquidity risk
There is a widespread notion in investment circles that there is an illiquidity premium that investors can profit from, used in many cases to explain the modest outperformance of certain multi-asset portfolios versus others. This assumes that less liquid positions will indeed outperform and that the illiquidity effect is even still present, which in many asset classes is now arguable. In a crisis illiquid positions may indeed remain illiquid or potentially become even more illiquid.If illiquid positions are priced fairly (e.g. on a transparent market with willing buyers and sellers) they tend to show significant underperformance in crises as investors shun the huge risks attached with illiquidity. In daily priced markets, smaller and more illiquid positions (where some managers might reasonably be biased in their search for inefficiencies) can hence underperform more liquid positions; more liquid positions become preferred by managers wanting to remain liquid for numerous reasons such as redemption risks.
5. Narrow markets
In recent months, performance has increasingly become quite narrow in nature with few stocks driving index performance. This can be common in late cycle markets, creating widespread underperformance by more active and diversified approaches for a period of time. Narrow market performance creates a substantial performance headwind for less index-based approaches in the short term, creating short term underperformance.
In essence, it appears many managers – in addition to mainstream asset classes themselves - have been badly affected by central banks globally intervening in markets and distorting fundamentals and price signals, as well as an excessively short-term focus by society and investors.
Cycles exist to remove the trash; if business cycles are artificially removed or delayed by constant market interventions and debt is too easy to access, trashy companies proliferate and poor management is rewarded.
Big problems then develop as capital markets become populated with poor quality credit instruments, debt dependent ‘zombie’ offerings and financial structures and approaches built for a continuation of current market trends. These approaches crowd out more forward looking, longer term and more prudent and researched ‘through the cycle’ approaches.
Portfolio underperformance from many managers affected by the above issues may well continue for a while yet. While some managers will adapt to changing market conditions; others won’t survive it. Many have failed to even recognise that market conditions may have definitively changed. If market conditions have indeed changed meaningfully from recent years, many investors are hence still invested in managers which are unlikely to deliver them the results they are expecting.
While some manager strategies have been legitimately weak as their styles have been disproportionately and probably temporarily punished by market conditions, others have little to differentiate themselves as worthy of capital allocation and of value for diversified genuinely outcome orientated portfolios.
Simply put, to expert eyes many managers are unfortunately demonstrating that they probably aren’t offering much other than excessive risk taking.
To expert eyes, if caught out with these exposures, investors might be wise to liquidate them in favour of more prospective and often less beta-dependent investments, and particularly so given current market conditions.
Importantly, this is not a good time to be a deer in the headlights and ignore the obvious and substantial issues. The challenges and problems are unlikely to resolve themselves. Judicious, thoughtful and researched assessments are required. It is unwise to make changes based on performance alone and a deeper understanding is required to ascertain whether manager underperformance is justified and reasonable (which it is in some cases) or not (which it is in many cases). Financial advisers really do need help from experts to be able to differentiate their manager performances at times like these.
Of course, the answer is not to simply avoid active management altogether and go ‘passive’ (itself a highly active decision), hoping that simple long only investments in overvalued equities, property and bonds will save you. Long only investing and binary bets in overvalued asset classes subject to severe bear market risks is quite possibly a guaranteed death sentence for performance, and is far inferior an approach to building more resilient portfolios should markets suffer greater losses. Instead, it is important to be selectively active in those strategies which are adding something different and meaningful to the overall portfolio over time and when it most matters to investors, and to stick with a longer term orientated and disciplined investment approach.
It is important to recognise that clients have become very short term in focus, biasing managers to provide them with short term outperformance most of the time – which has created a large manager pool dependent on momentum and carry trading styles. If advisers don’t take action soon to remove these biases from their portfolios, many of their clients who have a low tolerance for losses can be expected to commence sacking their advisers in a search for greener pastures!
Education and honest communication is part of the answer, but so is ensuring portfolios genuinely match clients’ real tolerance for losses - rather than their theoretical ones.
Simply put, most clients these days can’t tolerate large losses and the risk of large losses is very real. Market conditions are highly and unusually challenging currently. Portfolios need to be suitable for the new times we find ourselves in i.e. portfolios in general may need to be much more conservative. Lower exposure to straight long only equity risk may be necessary for risk intolerant investors.
Fortunately, there is some good news - for those on the front foot – which has come out of the October and November performance results. Select fund managers have performed admirably at protecting capital over these difficult market conditions and clearly differentiated themselves from the pack and their competitors, providing investors with some compelling options for genuine portfolio diversity. Resilient performance over this period relative to their peer group suggests that a manager may have something different to offer from the trend following momentum junkies and investment approaches that appear so widespread currently. Focussing one’s efforts on understanding the stronger managers in October and November, and their value proposition in a portfolio, may provide important information to those wanting to survive the ongoing and upcoming periods of market weakness.
Managing money at the moment is unquestionably difficult, but remaining in the game is crucial and opportunities to add value will arise for dynamic investment approaches. Some losses may be unavoidable and understandable, but very serious losses by managers should be avoided. Manager underperformance is so widespread that it has been almost impossible to avoid in entirety. Investors should avoid jumping to conclusions about short term performance alone, but instead look to understand why that performance has occurred. They should assess whether the investment processes of their managers are being diligently and thoughtfully applied in a “true to style” manner, and indeed whether managers are behaving consistently with their longer-term risk and return objectives.
Are your managers truly cognisant of current market risks and conditions, or are they blindly always overly optimistic? Are your expectations for your managers realistic and are your managers performing as you would expect given their prior communications and stated investment approach? Can you do more to build greater portfolio resilience by considering the managers that are differentiating themselves through this period?
Over coming years, we expect that the more diligent, research based and insightful tortoises may indeed surprise, and produce superior results to generic risk-taking hares. Hares are at risk from their denial of likely market conditions, crowded and leveraged positioning, and of sudden or continual underperformance as the bubble in everything eventually or suddenly subsides under its own weight. Unfortunately, too many fund managers have been caught out as risk seeking junkies! Don’t be a deer in the headlights - seek expert help from skilled advisers.
Jerome Lander is Managing Director of boutique investment firm Procapital and an Authorised Representative of Harvest Lane Capital Pty Limited AFSL No. 425334, which manages the Harvest Lane Absolute Return Fund. This communication is for informational purposes only and is a thought piece which represents the views of the author alone. It is not intended as an offer for the purchase or sale of any financial instrument. It does not constitute personal or formal advice of any kind and should not be relied upon as such – investors should talk to their financial advisers before making any investment decision. This article’s accuracy cannot be assured. All opinions and views expressed constitute judgment as of the date of writing and may change at any time without notice and without obligation.
What we need now is an update on the Canstar website with 1 month/3 month performance figures as the current list showing 5 year performance will highlight the biggest risk takers. We we go back and select the poorest performing managers instead of the "hares"?
"Select fund managers have performed admirably at protecting capital over these difficult market conditions and clearly differentiated themselves from the pack and their competitors, providing investors with some compelling options for genuine portfolio diversity." Who?
Hi John and Mark Thank you for your comments. Performance needs to consider the risks taken to get that performance and whether it is sustainable. PoorIy performing managers frequently don't improve unfortunately - a deep researched understanding of the individual manager is required to make this assessment. My livewire article "Making money through the cycle" provides investors (through their advisers) with some pointers and ideas to help them carefully select the better alternative managers. I am also happy to be contacted by your advisers, and may be able to help advisers improve their offering to their clients. I will also aim to write more on selecting fund managers for Livewire in due course given the strong importance and expressed interest in this area, both from yourselves and from others directly contacting me.
John and Mark both raise points that I agree /relate to so look forward to Jerome bringing more on fund manager selection advice, as it is not exactly easy to sort the chaff from the hay!
All that you write 'seems' to make sense. However, I find it difficult to find information about individual funds and how they operate and what their philosophies actually are. Whenever they start to go badly there are always excuses and 'double dutch' financial statements which generally mean nothing.