Why Do Some Investors Underperform Their Fund Manager?
As Baron Rothschild famously said, “buy when there’s blood in the streets.” Despite many investors being aware of this phrase, it is often ignored in practice as acting in this way during these times can feel counterintuitive. There are however, some interesting statistics from studies that support this philosophy, which we focus on in this article.
Joel Greenblatt, co-founder of Gotham Asset Management and Professor at Columbia Business School, looked at a study of fund manager performance over the decade ending in 2009, a time period where the S&P500 had an average annual return of close to -1% per year. The study found that the best performing managed fund* over the same period returned 18% per annum, a significant outperformance of the market and subsequently significant outperformance over passive or index funds over the same time period. Despite this outperformance, the average investor in that fund over the same period managed to lose 11% per annum on a dollar weighted basis.
How is this possible? The study found that when the fund was outperforming investors tended to buy in and when the fund underperformed investors sold out. Investors were moving in and out of the fund at all the wrong times. While the returns from this fund with its concentrated active strategy were spectacular over the longer term, investors seemed to lose faith when the fund was underperforming or not keeping up with the broader market.
A study by Davis Advisors over the same decade revealed the following regarding the best performing (those in the top quartile) institutional fund managers over this period:
- 96% of those who ended up with the best 10-year record spent at least one three-year period in the bottom half of the performance rankings;
- 79% of those who ended up with the best ten-year record spent at least three of those 10 years in the bottom quartile (bottom 25%) of fund managers;
- But what is probably the most amazing stat is that 47% or close to half of the top performers over 10 years, spent at least three of those 10 years in the bottom decile, the bottom 10% of performers.
In an attempt to counter the negative impact of the investor psychology outlined in Greenblatt’s study, it may serve investors to run through a checklist before they consider selling out of a fund during a period of underperformance or buying into a fund during a period of outperformance.
Prominent US fund manager Jim Chanos, founder and managing partner of Kynikos Associates believes most people simply look at performance and then follow the hot money into a strategy that is outperforming at the time. Chanos believes tremendous value can be found by investing in funds which may not be flavour of the month, however before allocating capital to a fund he asks the following:
- Does the manager have a valid process?
- Are the people and the process consistent?
- When will this process work and when shouldn’t it work?
- Does the manager have a definable and sustainable edge?
- At a particular point of time is the fund underperforming the market despite having a superior long term track record?
Chanos would also remove managers who track the market and borrow money to invest, noting that:
“paying big fees to people who are either matching the market with no edge or leveraging the market to get outperformance is a fool’s errand.”
In our view, all this data makes perfect sense because in order to beat the market, you have to invest differently to the market. Even the best performing fund managers can go through periods of underperformance, and these periods may present an opportunity for investors.
*Morningstar Study quoted in the Wall Street Journal, December 31, 2009, “Best Stock Fund of the Decade”
By Scott Hildebrand | Distribution & Sales Manager at NAOS Asset Management
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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