August 2023 - Thoughts on underperformance by an active manager

This article takes a closer look at what a period of underperformance means for an active manager. I would point out that first and foremost there is no such thing as good underperformance, however periods of underperformance are unavoidable for a truly active manager. Indeed, the more active a manager is the greater the possible quantum of unavoidable performance.

Saying that a manager is an active manager is not saying that they do a lot of trading. They may trade very little or a great deal that has nothing to do with being active, the key is that they are taking active positions that deviate from their benchmark, which for most local equity managers will likely be some blend of the S&P/NZX 50 and S&P/ASX 200 indices. To state the obvious, a manager that holds the same stocks in the same proportion as their benchmark (aka Passive) will never outperform, but tantalisingly they will also never underperform. Another approach a manager can take is to have a very low tracking error by taking only small deviations from their benchmark. These managers have reduced the potential for returns significantly greater than the market but again they rarely have to endure criticism relating to periods of significant underperformance.

Right now, I’m experiencing an element of jealousy for managers that take the passive or very low tracking error approach because Castle Point is currently enduring a sustained period of underperformance in its flag ship fund, the Ranger Fund. That’s because periods of underperformance, especially sustained ones, are truly unpleasant experiences for all parties concerned. The fact that it’s inevitable for a truly active manager is of zero consolation. But the reality is that if you have built your portfolio with little or no regard to a market benchmark you will perform differently. And not always in a good way. At least for certain periods of time.

Sadly, this is not my first rodeo of underperformance and no matter how much I may hope, it won’t be my last. And the experience of the past three decades has taught a few lessons.

Don’t make dramatic changes. This is a key lesson and one I learnt early in my career, as I saw what damage changing horses in mid-stream can do. It is totally understandable on many levels why a portfolio manager is tempted to get rid of what has caused underperformance and jump into what would have performed better. Right now, this would be an equity fund that has underperformed in recent times due to holding Australian small cap companies, selling those and buying the US mega caps that have been up a lot this year. That would seem like the most natural move and emotionally satisfying action to take right now. You’ve turned your portfolio from a pack of underperforming small companies to the best ones in the world and getting some AI exposure in the mix. But you’ve just done two things neither of which generally end well. You’ve probably sold companies that are trading miles below their intrinsic value, locking in that loss in the process. And secondly you’ve paid a very high price to own the most in favour companies in the world. It might feel good for a few months, but the chances are extremely high that you’ve sold low and bought high which doesn’t work out great.

Don’t keep doubling down. To be a truly active manager you must have conviction in the companies you own and often they won’t be market darlings. In fact, often they will be out of favour. Another lesson that has been hard learnt is that respecting the market, and not being a perpetual buyer of a company whose share price keeps falling, can avoid some extra pain. You may have a positive view on a company but if everyone else in the market seems to hate it, there is almost no limit to how low the share price can go. This is a subtle lesson because in many ways it contradicts the first lesson, because you have stopped buying when a company is getting even cheaper. I tend to think about it as being a situation where you allocated a certain amount of capital to a company and then it has to fend for itself. If it’s coming back to you all the time for more capital something may be amiss, a research error may have been made, certainly the market is telling you that not all is going to plan. That is not to say we will never top up a position on price weakness, just that its done selectively and with care.

Do your own research. This seems obvious but you would be surprised how many professional investors take positions in companies mainly on the back of broker recommendations. If you’ve built conviction on a company because of your own research, you are much less likely to bail out when you have a period of underperformance. In essence this is a lesson that helps avoid making the cardinal sin of reinventing yourself in a crisis.

Try and understand what is going against you. Sometimes a fund gets unlucky and has a cluster of companies that conspire to deliver bad news at the same time. Provided these are short-term glitches these companies share prices should recover. But in the meantime, that fund will be enduring its own personal bear market which is a distinctly unpleasant period of underperformance. Other times the trouble may be more thematic, for example a value manager will struggle with performance during a big run up in growth companies. Currently the main issue for our flag ship fund is the market is shunning small cap value in preference for mega cap growth. Frankly underperformance in this scenario is not a jot easier to bear but at least its not a mystery which would tend to be even more psychologically challenging.

Stick to your investment philosophy. This, yet again, is an iteration of lesson one. If you are a manager whose philosophy favours smaller companies, often value ones, then a period of underperformance is not the time to change your approach.

Be very afraid if you win industry awards. It’s amazing how often winning an investment industry award for your strong performance, heralds in a period of underperformance. It seems to be a curse. I’m considering doing a Marlon Brando and not accepting any awards in the future.

All things must pass. If you’ve been investing in the share market for a long time you learn that an episode of underperforming eventually passes, often around the time you wonder if it will ever pass. And just quietly, I don’t want to upset the gods of investment, when they pass, there is often a period of great returns that more than compensates for the previous tough times.