One of the most destructive behavioural traits of investors is to constantly make investment decisions by looking at recent past performance. It is not uncommon to see investors switching between funds and fund managers on an ongoing basis, because their current choice of fund is underperforming the current “hot favourite”. What many do not fully understand is that there may be a very good reason why their fund manager is underperforming and it could well be not due to a lack of skill. Too often performance is seen as one dimensional and no cognizance is taken of the environment in which this performance was generated. Performance without context is meaningless and can lead to value destroying behaviour in investors. As we will point out it is essential to understand how your fund manager is likely to perform through different cycles, in order to make sound decisions regarding your investment portfolio.
A case in point is the current extreme underperformance of many of the deep value managers. At first glance an investor may be very tempted to sell out of the deep value manager and invest with one of the fund managers that is outperforming the equity market and the peers. The problem with this approach is that it ignores the reason for the underperformance of deep value managers at this point in the cycle. This leads to investors doubting whether these managers actually have skill and whether the value style can actually add value over the longer term. Those of you who have seen a number of equity market cycles will realise that the current underperformance of deep value managers is not too dissimilar to previous cycles. Despite these same fund managers being ridiculed in the previous bull market for not latching onto the commodity super cycle, sticking to their investment process meant that their performance during the financial crisis was in line with what was expected of them.
The unfortunate consequence of this behavior involving switching out of the current underperformer, is that investors can end up with the worst possible outcome. This could manifest in them enduring the underperformance of the deep value manager and then decide to sell out of this strategy as they no longer can tolerate the relative underperformance. Investors could then quite likely end up switching into one of the strategies that is currently enjoying a period of strong relative outperformance. Where this often goes spectacularly wrong is that the investor is not switching from a manager with little skill to one who is very skillful. The investor is switching from a style that has been out of favour to one that has been in favour. Invariably the investor then endures the proverbial double whammy by ending up exposed to the strategy that is about to go through its own period of relative underperformance.
When partnering with a discretionary investment manager, they really should fully understand these style biases of managers and construct a robust portfolio comprising several different styles, so that the overall portfolio is not beholden to one specific style or outcome. A portfolio well diversified across different equity styles, can likely provide investors with a performance experience that is less volatile and more importantly, can help to keep clients invested through the cycle. This is extremely important in order to avoid the very costly mistakes that investors make by switching between funds. This can however only be achieved if your discretionary investment manager has a robust manager research process that focuses on both the qualitative and quantitative aspects of the respective fund managers. High level quantitative analysis, will not put you in the position where you have strong conviction in your chosen asset managers. Without this level of conviction you may fall into the trap of losing faith in one of your current underperforming asset managers. There is a great deal of research available that quantifies the effect of investors switching between funds and this has proven to be one of the largest value destroyers for investors over time. Importantly, a robust disciplined investment process can go a long way to eliminating this behavioural bias that is responsible for so much value destruction.
Article by Mr. Ronnie Retief - Independent Investment Partners