Even the most successful fund managers can suffer years of underperformance
At Vanguard, whether we're utilising our own internal expertise or commissioning external fund managers, we look at three factors when we're assessing active managers–talent, patience and cost.
Last time I shared our thoughts on the importance of talent. This time I'd like to discuss the second element critical to improving the odds of active management success–patience.
Many investors assume that if they are able to select a talented manager, a relatively smooth stream of excess returns awaits.
Unfortunately, we find the opposite to be true. Even the most successful funds experience frequent and sometimes extended periods of underperformance along the way.
Expect the unexpected
Considerable research shows that on average, actively managed funds underperform their respective benchmarks over the long term.
The latest SPIVA Australia scorecard for 2016 produced by S&P Dow Jones indicates that more than 80% of international equity and Australian bond funds, and more than 70% of Australian general equity and A-REIT funds underperformed their respective benchmarks over the previous 10 years.
So it makes it quite a challenge to base your criteria on historical returns when you're selecting active managers.
Survival of the fittest
An analysis of Australian active equity fund managers highlights that historically investors have had to be very patient to collect on their success.
Part of the challenge relates to underperformance. But part of it relates to what's called survivorship bias.
Of the 534 active equity funds in existence at the start of 1999, only around half even remained in existence 15 years later. The rest had been merged or liquidated, typically due to poor performance or lack of assets.
And of the remaining 266, just 121 managed to outperform their benchmark during the period. Almost all of these experienced at least three individual calendar years in which they lagged their benchmarks during the 15-year period.
In fact, more than half the successful fund managers had six or more individual years of underperformance.
Now, for many advisers, three consecutive years of underperformance represents a signal to start looking at changing managers.
And here the picture is even bleaker. Only 23 funds survived for 15 years, beat their benchmarks, and avoided three consecutive years of underperformance. That's just 4% of the original 534 funds.
Just add time…
The lesson is that even when you've run the due diligence and selected a talented active manager with a low-cost philosophy to manage the active portion of your client portfolios, you still need to be patient.
To increase the odds of success, your clients must be willing and able to endure numerous and potentially extended periods during which the fund will lag its benchmark.
Bucking the trend
At Vanguard we're proud of our track record in delivering outperformance–particularly over longer timeframes.
We don't establish funds based on short-term fads. We design and build our funds for the long term. And we're now bringing this low-cost, high-quality active approach to Australia.
You can read more about the keys to improving the odds of active management success in our updated research paper.