(Clark Capital) One of the more durable impacts of the global financial crisis is the narrative that active managers, particularly in U.S. equity, have failed to consistently outperform benchmarks and justify their fees. Of course, active managers have hardly helped their cause in this regard. In their desire to attract new capital, they tend to focus on prior returns, awards, manager experience, etc. — all with the underlying message that they will be able to provide a better return to the benchmark portfolio going forward.
Unfortunately from our perspective, what has been lost in the passive/active debate is the true purpose of active management to begin with: if a market represents the entire basket of risk, an active manager can exclude certain risk factors on behalf of the investor that are inappropriate given their objectives or risk tolerance. The obsessive focus on short-term benchmark performance by both managers and investors overlooks this crucial component of active management, which has nothing to do with relative returns, but instead focuses on individual goals with an emphasis on risk.
The purpose of this paper is not to argue against benchmarking, which has broadly been a tremendous public good for transparency and accountability. Rather, it is to contend that an evolution in how these tools are understood and utilized will be necessary to mitigate inadvertent and needless risk taking in client portfolios in the name of exceeding benchmark performance.
Consider that the performance metrics that are widely used today were created in the late 1960s and early 1970s. Critically, they make key assumptions about the behavior of market participants and price discovery. As Michael Green of Simplify Asset Management points out, a market is just a history of transactions. To understand what is happening at any given period, you need to consider who is transacting and why they are transacting. Today’s market looks very different from the participants 50 years ago, and the catalysts that cause them to transact are increasingly dissimilar.
This paper will examine how managers are currently evaluated, the assumptions underlying those performance metrics, and where those assumptions conflict with how market participants truly behave. We will then observe how that may inadvertently be increasing investor risk exposure, and lastly, how investors should consider evolving their view of manager performance.
Are Three Years Enough?
Today, investors are provided with a tremendous amount of data in the manager selection process. Managers are not only evaluated on their absolute return relative to a benchmark, but are also assessed on various risk metrics to determine what risk was taken to achieve those returns. It is an accepted practice to use three years as a significant enough period to determine manager skill. Now if we put ourselves in the place of an investor seeking to hire an investment manager, how would we utilize this data? Well, naturally we would segregate out the top performing managers from the poorer performing managers over that period and hire the winners.
If only it were so easy. It is universal to disclose that past performance does not equal future returns, yet past performance regrettably remains the guiding light for investment decision making. Research Affiliates conducted an eye-opening study of all the actively managed U.S. Equity funds in the Morningstar universe from 1990-2016. They found that the top 10% of performers over the prior rolling three-year period ended up in the bottom 10% during the following three-year period. What were the results for the bottom 10%? They ended up being in the top 10% of performers during the next three years.
Want more? Download the full paper HERE or reach out to the Clark team directly HERE to discuss.
