- Even with a disciplined selection process, the odds against hiring equity managers who will outperform the market are prodigious. It makes sense for investors to monitor their actively managed funds.
- Many institutional investors place “on watch” any managers who underperform their benchmark on a rolling three-year basis, updated quarterly.
- The historical record demonstrates that even funds with sterling long-term track records would have spent many consecutive quarters on a hypothetical watch list.
- Fiduciaries seeking to hire active managers should not only refine their selection skills but also strengthen their commitment to keeping them.
Our society has become fast-paced, data-hungry, and health-conscious. With advancing sensors and wireless technology, an array of wristband products and phone apps can now track our every movement, monitoring our steps, distance, calories burned, and even sleep patterns. Diligently collecting and analyzing data, these portable trackers like Fitbit, Fuelband, Up, and i-Watch can display our progress, reward us when we meet a goal, and encourage us when we fall short. At a whim, we know how we stack up against our goals: The data are readily available at our disposal at any second (so long as the battery’s been charged!).
We have an insatiable urge—or dare we say addiction?—to track and evaluate our stats frequently, whether they pertain to calories burned, daily Fantasy Football rankings, or investment portfolio values. In particular, keeping tabs on our investments has never been easier. The large mutual fund databases can tell us how our funds are performing against peers to the percentile. Popular software programs can run attributions over custom periods to tell us that our manager added x basis points of stock selection effect in the technology sector. And the list goes on.
But, what do we do with this information? Does it make us better investors? Does it lead to better decisions? Does it enrich our experience as investors? Led by industry pioneers like Jack Bogle and Burt Malkiel, the data suggest it is daunting to select managers that will outperform ex ante. But even if we do hire them, chances are we won’t stick with them. Even the most sterling of long-term track records is pockmarked with performance potholes, sometimes sizable in length and depth. And in today’s age of a virtually continuous loop of performance measurement, the chance of weathering these stretches for meaningful end investor benefits seems remote. A rethinking is in order. Ironically, the policies and procedures designed to protect investors from getting “taken” by active management may well make long-term excess returns virtually unachievable. The active management game may be even harder than we thought.
A Handful of Superstars
As Burton Malkiel noted,1 we can count on the fingers of one hand the number of equity mutual funds that have beaten the market by at least 2 percentage points over more than a 40-year period. In 1970 there were over 350 U.S. equity mutual funds available to investors; of those, 30% have survived the entire 45-year period. The rest—nearly 250 funds—were merged or liquidated, presumably due to poor track records.
What are the chances of selecting a fund that has survived the full period and outperformed the S&P 500 Index? Of the initial 358 funds, 45 have both survived and outperformed. Of these long-term outperformers, only three achieved an excess return of 2 percentage points or more. This suggests that the odds of identifying a long-term superstar who outperformed by 2 or more percentage points is a mere 0.8%, a 1-out-of-119 chance. With these odds, you actually have a slightly better chance of collecting a cash prize on the multi-state Powerball lottery (not the Mega Millions Grand Prize, but still a payout!).2
Forty years seems lengthy, but the equity exposure in our retirement portfolios can be meaningful throughout our lifetimes. For instance, 30-year-old workers picking a standard target date fund3 could have a substantial equity allocation of 90% until age 55 and a still sizeable 30% once they reach 85 years.
Can skilled managers be selected in advance? Yes, quite possibly. Keith Ambachtsheer and his co-authors demonstrate that institutional plan sponsors with a disciplined approach to manager selection outperform sponsors with less focus (Ambachtsheer et al., 1998). But other studies, principally by Goyal et al. (2008) and Jenkinson et al. (2014), show that institutional investors don’t select winners ex ante. So, while it can be done, we acknowledge that the chances of selecting a long-term superstar are slim.
The Watch List
With such daunting odds, it makes considerable sense that investors monitor their line-up of actively managed funds. If you’ve got a better than 8-in-10 chance of picking a loser, it’s better to realize the mistake early—before losing the big bucks!
To monitor their roster of investment managers, institutional investors increasingly rely on an old standard: a watch list policy. How does this policy work? Once a pension fund or endowment hires a fund, it measures the manager against guidelines which generally consist of performance criteria versus a benchmark or peer group over a defined evaluation period. If the manager doesn’t meet the specified yardstick (e.g., its relative performance declines over consecutive evaluation horizons), it is placed on a list for more intensive scrutiny.
In light of its prevalence, does a watch list policy make the fund monitoring process more effective? How would our sample of long-term funds have fared under a typical policy guideline? A commonly-used rule among pension funds is to place “on watch” managers who underperform their benchmark on a rolling three-year basis, updated quarterly. This benchmark-centric guideline has certain advantages: It is objective, easily testable, and free of survivorship bias and other limitations inherent in peer group comparisons (West, 2010).
Applying this guideline, we find that, on average, winners do indeed spend less time relegated to a watch list than do their lagging peers, and vice versa, as shown in Figure 1. The time that one of Malkiel’s long-term superstar managers spends “on watch” is half the time logged by a dreadful one (e.g., one with a 3% negative excess return over a 44-year period). In fact, under this guideline, it appears the linkage between a manager’s time under watch and the manager’s long-term value-added return is quite strong, as evidenced by a 78% correlation. So, in addition to clarifying the review process, watch lists do a reasonably fine job in discriminating among managers by keeping the laggards under heightened review for longer periods than the stars.