Instead, most equities active managers underperform over the long term, with 80 to 90 per cent of active equities managers underperforming their benchmarks over 10 and 15 years, according to SPIVA data from S&P.
While the S&P/ASX 200 ended 2023 up 12.4 per cent, most Australian equity funds struggled to match that; the one-year underperformance rate of 77 per cent was the second highest in S&P’s records. Longer term, underperformance rates were even higher for Australian equities managers, rising to 85 per cent of funds underperforming the benchmark over 15 years. For international equity general managers, around 94 per cent underperformed over 10 to 15 years, while last year, 81 per cent of funds trailed the S&P Developed Ex-Australia LargeMidCap’s total return of 24.1 per cent. It’s no wonder that investors are increasingly allocating capital away from active fund managers towards ETFs and passive investing – up from 25 per cent of global assets in 2018 to 34 per cent by 2022, according to PwC’s 2023 Global Asset and Wealth Management Survey.
Asking why a fund manager underperforms is a critical question. One of the key assumptions in financial markets is that professional investors are perfectly rational – continually optimising long-term, value-maximising decisions across stock selection and portfolio allocation.
Yet in reality, investor psychology can dominate. In bear markets, for example, retail investors experiencing the pain of losses increasingly optimise decisions towards wealth preservation, striving to reduce the growing discomfort with uncertainty. Institutional investors “get defensive” looking to minimise underperformance, client outflows, and career risk. While this example depicts psychology through a larger market cycle, the same behaviour manifests itself at the individual stock level.
To overcome the nature by which humans are hard-wired to adapt decision making in response to recent experiences and sustain outperformance over the long-term, an investment process needs to be dehumanised – that is, insulated from the practitioners conditioning by recent experience.
A skilled manager selection process is a necessity. There are three key factors investors should look for when assessing managers. The first is to include a firm-wide articulation of why and how they invest. Every manager must have a clear articulation of why their investment philosophy drives alpha over the long-run and must be able to articulate how this is captured within their investment process.
The second factor is that fund managers need structures to overcome human decision-making flaws. All managers are fallible humans, susceptible to emotions and bias. To manage these shortcomings, systems and processes are essential to create guardrails that hold an investment strategy to account. Structures allow for the repeatability of an investment process to maximise the durability of long-term alpha. At the other end, over-reliance on discretionary judgement can lead to a spiralling of poor decisions and underperformance.
Finally, investors should seek cultural comfort and transparency in the investment processes, from idea generation, research to portfolio management. They should look back to check audit trails that provide any evidence of how those processes were used through periods of heightened market volatility, when episodes of misjudgement are more likely.
Investors should also check how the fund manager admits mistakes or discloses bad news. The psychological factors that prevent acceptance and communication of bad news can come from multiple places: a fear of looking stupid or being wrong or an urge to appear consistent with previously stated beliefs, to mention some. Optimal cultures accept mistakes and embrace bad news so that teams can move on to make better decisions.
Equally, managers should be able to demonstrate a clear understanding of what could go wrong with existing investments and showcase proactive research to evaluate the potential risks they’re exposed to. Rather than ask, “why is XYZ stock one of your biggest positions?”, one could ask, “given XYZ is one of your biggest positions, please walk through what could go wrong, and the research you’ve completed to understand the risk?”.
I would encourage all investors to test all fund managers along these frameworks and see what they uncover.
Damon Callaghan, partner, investments, ECP Asset Management
