At the end of the Trojan War, Odysseus sets sail to return to his family, wealth and kingdom on the Greek island of Ithaca. The trip should have taken 10 days. Instead, it took 10 years.
Odysseus encounters unexpected challenges on his journey home. He is captured by a goddess. He fights the Cyclopes. He sails through terrifying storms. And while he struggles with these trials, his rivals at home in Ithaca consume his wealth and vie for his wife’s affections.
At the end of the decade, when Odysseus finally reaches Ithaca, he defeats his wife’s suitors and secures her wealth and inheritance.
My take on Homer’s epic poem? Ulysses would have made an excellent investor.
For what? Because patience is a virtue in investing. And even when we invest with an outperforming active manager, this virtue remains imperative. This is the conclusion of our research what kind of gut strength it takes to handle the ups and downs that come with actively managed strategies.
Set Patience and Withdrawals
We have defined patience along three dimensions:
- Probability of occurrence and frequency: Has the fund underperformed? How often did these periods of relative underperformance occur?
- Magnitude: What was the worst relative underperformance over different periods? Which funds have experienced withdrawals of a particular magnitude?
- Duration: What has been the longest period of relative underperformance, measured by the time between a fund’s peak and its subsequent return to that peak?
Historical Patience Results
So what does a patient investor in an outperforming active equity fund have to endure and what do they get in return?
To help answer these questions, we analyzed actively managed US-domiciled mutual funds with at least 10 years of returns in the 25 years ending December 31, 2019. The sample included 2,593 funds of which 1,173 outperformed their style benchmark, with the outperforming median fund generating nearly 1% annualized net excess return.
Overall, we have determined that almost all outperforming managers experience frequent periods of underperformance relative to their respective style or the benchmarks of their peers. Some of these periods of underperformance are significant and long-lasting.
We found that almost 100% of outperforming funds fell relative to their style and the median benchmarks of their peers over one-, three-, and five-year valuation periods. In addition, 80% of outperforming funds had at least a period of five years when they were in the bottom quartile relative to their peers. This is particularly important to understand given results of a 2016 State Street survey of senior executives with asset allocation responsibilities for large institutional investors. The survey found that 89% of these executives would not tolerate underperformance for more than two years before seeking a replacement.
Additionally, some investors lose patience if a manager underperforms by specific amounts. We found that more than half of outperforming active equity funds underperformed their style and median benchmark by 20% or more.
Most of the best performing funds had declines of less than -20%
Finally, of the funds that recovered from their biggest drawdown, three-quarters did so after three or more years of underperformance. A quarter of them have recovered after more than seven years of underperformance.
Three-quarters of top-performing funds had recovery times longer than three years
Investors who know what to expect and who have high conviction and appropriate risk tolerance are more likely to possess the necessary patience. They will have the ability to prepare for and tolerate the frequency, magnitude and duration of sampling.
Odysseus, too, struggled with anxiety and the urge to meet short-term demands. As he sailed towards Ithaca, the seductive song of the sirens tempted him to deviate from his course and sought to lure him into a shipwreck. But he had prepared: he had asked his crew to plug their ears with beeswax and tie him to the mast with orders not to release him or follow his instructions until the sirens were within earshot. So no matter how thrilled and drawn to the siren song he was, he couldn’t change his course. Odysseus recognized that impatience and panic would lead to disaster for him and his men.
His answer is a powerful lesson for investors looking to outperform with active strategies.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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