Our goal is to invest with some of the best managers in each investment universe, which we define as achieving top quartile performance over a market cycle, typically three to five years.
Residents of the United States, please read this important information before proceeding
Please read this important information before proceeding.
That’s an important definition, and one that’s grounded in empirical evidence. Historically, top quartile managers within each asset class peer group have outperformed the respective index, despite the issues cited in research around survivorship bias4. That’s why it’s worth spending time and effort on manager selection. Figure 1 shows mutual fund ‘excess returns’ (i.e., the return of the fund minus the return of the relevant index) by peer group across a number of common asset classes over the 10 years ending 2010.
Figure 1: Net excess returns (%) of top quartile mutual fund managers by investment style
There are a number of conclusions to draw from the data:
- Over the past 10 years, the 5th and 25th percentile managers in each asset class have outperformed (i.e., had a positive excess return) on a net-of-fees basis over long-term periods and in each calendar year.
- The degree of excess return diminishes over longer time periods. This suggests even if individual managers generate substantial short-term outperformance, they often revert to the mean over time.
- The average (or median) manager’s performance, even without taking into account managers who may have dropped out of the peer group, is often at the index or slightly below the index.
Top quartile managers within each asset class peer group have outperformed the respective index
The compounding effect of these excess returns can have a meaningful impact on a client’s wealth over time. Consider Figure 2, in which we map the nominal growth of £1,000,000 over 20 years, assuming an annual return of 6% and varying levels of excess return. The outperformance over time results in significantly more value.
Figure 2: Growth of £1,000,000 based on various return assumptions
Over 10 and 20 years the power of compounding at a higher rate is substantial, with more than a £3.5MM difference in the end value based on a 10% return versus a 6% return on an initial £1MM investment. Obviously this difference can work in both directions, as poor manager selection leading to a lower annual return would have the opposite impact.
Past performance is no guarantee…
If you do buy into the premise that there are managers who can outperform on a long-term basis, and that this can be meaningful to the value of an overall portfolio, then can you just invest in managers who have done well for long-term periods and expect the performance to repeat itself? This paper answers that question on many levels, but an illustration of actual manager returns can help explain why it’s not as simple as relying on a manager’s past performance.
In Figures 3 and 4, we show Investworks data from the US Large Cap and US Small Cap manager peer groups that can be used to answer the question: do top quartile managers tend to stay there? The data represents all mutual funds still in existence at the end of 2010 that had at least 10 years of actual past returns. The calendar year data was then grouped into pairs of contiguous three-year and five-year returns.
For the first time period in each pair, managers were grouped into quartiles; the performance of the top quartile managers was then analysed in the second time period. Based on this data, it’s clear that top quartile managers do not tend to stay there.
Figure 3: US large cap top quartile managers’ subsequent performance
Figure 4: US small cap top quartile managers’ subsequent performance
Consider the “average” data for the three-year periods for both Large Cap and Small Cap mutual funds; on average, only about 28% of top quartile managers in one three-year period remained in the top quartile in the subsequent period. The data was even worse for the five-year periods, where 22% and 17% of the top quartile managers stayed there.
In other words, as you have read over and over again, past performance is no guarantee of future results. While this data focuses on long-only US stock mutual funds, the conclusion holds true for non-US equity funds. The conclusion is less true for hedge funds and not applicable to private equity.
Despite data like that in Figures 3 and 4, performance continues to be the most important aspect in most investor decisions whether to invest with a manager or not. And that’s the biggest reason why most investors fail at manager selection. This paper details a different approach.