December 2, 2010

How to Handle Underperforming Managers

Wealth managers must balance patience with action and dig deeper to understand the reasons for underperformance

We are swiftly approaching the end of the year, a time for annual portfolio checkups by both investors and advisors. Undoubtedly, during this process, you’ll find a mix of investment products that are exceeding, meeting, or missing performance expectations.  It is the disappointments that garner the greatest share of mental exercise.

A common first step in the monitoring process for many advisors is to set up a simple checklist that tracks whether or not a product is meeting certain quantitative performance criteria (i.e. three-month, one-year, three-year, five-year trailing returns, etc). If a product is trailing the benchmark over a market cycle (a three- to five-year period, generally), the question arises: Is it time to make a change? It depends…

As much as we here at Prima Capital would like to believe we would never pick a manager that would underperform over a market cycle, it happens.  It is not uncommon for a manager that has established a successful long-term track record to have lengthy stretches of time when they trail their best-fit benchmark. For instance, according to research we recently performed, there have been an overwhelming majority of top 10-year performers that have had bouts of three-year underperformance.

Across eight different Morningstar open-end mutual fund categories, we filtered for funds that have a 10-year track record, a portfolio manager that has been at the helm for the entire 10 years, and for those that have outperformed their respective benchmark by at least 1% on a 10-year annualized basis.  We then measured how many of those funds had a least one rolling 3-year period of underperformance (see table below).

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Stemming from our experience assessing the performance of managers, we offer general guidelines plus more specific considerations when evaluating underperformers.

First, we encourage advisors to look beyond point-in-time performance statistics (i.e. one-, three-, five-year trailing relative return). They don’t take into account risk, and can fluctuate widely, telling a different story from quarter to quarter. The fickle nature of point-in-time statistics is especially accentuated during shorter time periods. For example, as we head into 2011, be mindful that 2008’s disastrous results will begin to roll off the trailing three year performance (helping the relative results of aggressive managers that struggled in the down market). In our view, a more comprehensive performance evaluation is necessary to better understand why a manager may be struggling.

A process that emphasizes qualitative factors alongside rolling time periods analytics, risk-adjusted performance measures, and attribution analysis can help you better gauge what is driving performance. 

Patience may be warranted for an underperforming manager when:

  • The market environment does not favor a manager’s edge. Several managers maintain their disciplined approach and suffer, but are eventually rewarded. Quantitative managers have faced headwinds recently during the low quality rally.
  • The manager has a history of boom or bust cycles. Common traits shared by many deep value managers include a willingness to own unpopular names, making decisions based on long-term analysis, and having the discipline to ignore sometimes painful shorter-term swings. Managers that have low turnover and take big bets are also more likely to have multi-year periods of underperformance.
  • There is benchmark uncertainty. Certain investment strategies can be difficult to benchmark and an argument can be made for two or even more indexes to be considered in performance evaluation (growth at a reasonable price and dividend strategies come to mind). If you are receiving contrasting views on relative performance, additional analyses may be the best course of action.

Action may be needed when:

  • It has been a market environment when you would expect the manager to excel. Over recent years, macro-oriented money managers, those with the flexibility to tactically allocate to various asset classes and/or cash, have had an opportunity to add value due to the influence of macro events on market performance. If you find that your manager has been consistently a step behind the pack, it is a clue that he/she has executed poorly.
  • You find evidence to suggest the manager has been lacking discipline. At times managers will be tempted to gravitate to areas of the market that are perhaps outside their expertise. For instance, today many portfolios that you expect to be domestic-only are becoming heavily biased toward international markets, given growth prospects overseas. 
  • After reassessing the manager’s edge, you have uncovered new factors that make you question the validity or sustainability of the edge.  An example may be that you lost confidence in the manager’s ability to deliver alpha due to a shift to a more benchmark-aware, risk-adverse, or commonplace investment strategy.
  • There has been a structural change to the product, such as a portfolio manager change or substantial shift in the investment strategy, and performance has suffered as a result.

 

If you are about to fire a poor performer, make sure those reasons go beyond performance and are based on a manager’s forward looking prospects. Still unsure? Where you have large allocations to an asset class, consider diversifying across multiple managers until you are able to make a definitive decision. We are confident that you’ll find, as we have, that a surefire way to improve clarity and judgment is to apply the same rigor and tools to ongoing performance evaluations as you do with initial manager selection.

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