Predictable underperformance

By Ryan Kuruliak | February 8, 2013 | Last updated on February 8, 2013
3 min read

This article was originally published on

Most investors employ active management in an attempt to achieve market beating performance, but I don’t believe investors fully realize just how likely it is they’ll have to endure bouts of short- or long-term underperformance to achieve superior results.

Underperformance will happen even when investors do everything correctly and hire managers that possess true market-beating skills.

Though it would be great if we could select managers who consistently outperform, this utopian scenario doesn’t occur in the real world where everything—including relative performance—tends to be cyclical.

In a study profiled in Behavourial Investing by James Montier, researchers created a hypothetical universe filled with managers that had only positive alpha versus the benchmark. The characteristics were as follows:

Number of managers 100
Manager alpha 3%
Tracking error 6%
Information ratio 0.5

Source: Adapted from DrKW Macro Research / Montier (2005)

A simulation of these clearly fictional managers was run over a 50-year period. Below are the results for this test:

Managers underperforming in a given year Almost one in three
Benchmark outperformance at end of 50 years 1% to 5.2%
Number of years of individual manager underperformance 15 of 50 on average
Range of years underperforming (of 50) 9 at minimum / 24 at maximum
Number with 3 years or more cumulative underperformance About 7 of 10

Source: Adapted from DrKW Macro Research / Montier (2005)

The study notes even when managers have 3% alpha by design, it “doesn’t stop them from encountering bouts of up to eight years of back-to-back underperformance. Despite the fund managers having a high alpha and high information ratios, it wouldn’t have been enough to prevent almost every one of the fund managers from being fired by their clients at some point.”

In the real world, we know not all managers have the ability to outperform.

For example, a group of studies conducted by the Brandes Institute examined performance over 10 year periods for actual mutual funds available to American retail investors. They looked at the top 10% of managers with the best performance in three separate universes; U.S. equity, Non-U.S. equity and bonds.

The results are below:

Rolling 1-year underperformance vs. index Rolling 3-year underperformance vs. index % Decile 6 or below median manager on a rolling
Average Maximum Average Maximum 1–Year 3-Year
U.S. equity funds -22.4% -40.5% -8.3% -17.8% 100% 81%
Non-U.S. equity funds -25.1% -32.4% -9.3% -14.6% 100% 82%
Bond funds -8.4% -21.85% -2.9% -6.6% 100% 77%

Source: Adapted from Brandes Institute (2007, 2009 & 2009)

In fact, over a rolling one-year horizon, 100% of the funds in each asset class underperform their peers, while 77% to 82% underperformed over a rolling three-year basis. The magnitude of short- to mid-term underperformance versus the benchmark would likely be surprising to many, given we know these were first decile managers over the full 10-year period.

This second study concluded, “while short-term underperformance may be frustrating, our findings suggest underperformance tends to be an endemic element of investing in actively managed mutual funds…even the funds with the best absolute and relative performance over a 10-year period. In our opinion, investors who keep this in mind when evaluating short-term underperformance will be better positioned for long-term success.”

The conclusion of the first study echoes this, saying “As long as the majority of market participants remain obsessed with the short term, the opportunity for exploiting mispricing for those with a longer-time horizon must surely exist.”

It adds, “The ability to exploit this opportunity will need to be accompanied by re-education of the final investor and internal management. Until these two groups realize that short-term performance is an illusory veil and has almost nothing to do with long-term performance, the obsession with hitting short-term targets is likely to remain.”

The message here isn’t that active management doesn’t work, as it can and will for some.

What I’m demonstrating is that getting active management results that impact an investors’ bottom line requires both quality managers and an understanding of their investment process. This includes being aware of when the investment results might underperform.

Patience and conviction are required to stick with an underperforming manager and it requires employing a longer-time horizon. Failure to do anything else will likely lead to disappointing outcomes.

Ryan Kuruliak is a Toronto-based vice-president with Proteus Performance Management Inc.

Ryan Kuruliak