Clients must understand that underperformance is a reality even for outperforming funds
Active management has earned a dubious distinction for not meeting investors’ return expectations in recent years. Still, they shouldn’t throw the baby out with the bathwater; not all active funds are underperformers, and even outperformers go through periods of underperformance.
That’s a guiding principle that Doug Grim, senior investment strategist at Vanguard Investment Strategy Group, said advisors may have to tell clients who feel overly fearful on the active-management roller coaster.
“A period of underperformance alone is not a good reason to fire a successful manager,” Grim said in a recent note. "What is needed is patience and, perhaps for some clients, passive investments.”
Looking at 2002-2016 performance numbers of all US active equity funds, Vanguard found that 54% did not survive, 32% survived and underperformed their prospectus benchmarks, and 14% survived and outperformed. Among the survivor/outperformer funds, 72% experienced at least three consecutive years’ worth of underperformance.
“Many investors struggle to retain an active equity manager if the manager is inconsistent or underperforms significantly in a given year,” Grim said. Citing a 2015 State Street study of 400 institutional investors across the globe, he said that nearly 90% started looking for a replacement manager after just two years of underperformance.
“Yet our analysis suggests that relative underperformance of sizable length and high degree, is actually quite normal,” he said. Even if a manager underperforms for an extended period, a proper manager review may reveal that they still have what it takes to potentially produce attractive results — particularly if they’re low-cost.
To help clients deal with the ups and downs of investment better, Grim suggested that advisors add passive investments such as cap-weighted stock- and bond-index funds to their portfolio mix. Including such investments could dilute the magnitude of periodic underperformance, though it can’t address the frequency or length of that underperformance.
“So even though investor cash flows have headed strongly toward index funds and ETFs, that doesn't mean you should eliminate your active lineup,” he said. “If you like your low-cost active funds, feel free to keep them. We like our low-cost active funds as well.”