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Resource Library
When Is Patience Warranted?
By Jim Miller, CFP, Senior Trust Officer
In past articles, I have discussed how individual investors frequently miss out on the returns of the broad investment markets because of decisions driven by fear and greed. Studies of investor behavior have revealed that the strength of our emotions often defeats the logic of our reasoning. Far too often investors abandon well-reasoned, carefully structured investment strategies because of the fear of loss or to pursue fast gains. They often display a lack of patience by chasing performance—selling investments that decline in favor of those that have recently increased in value.
Most of the readers of this newsletter understand that successful investing requires patience and a disciplined process for making changes; but how can we distinguish between a situation that calls for patience and one that calls for a change? For example, three of our fund managers have underperformed their respective market benchmarks year-to-date by 10% or more. Should they be replaced after nine months of poor results? Or should we give them more time? How much time should be allowed for these managers to demonstrate their skills and expertise in the form of superior performance? Should we wait one year? Two years? Three years?
The most important question in our minds is not how long we should be patient. The key is to know when patience is warranted. This requires an in-depth understanding of the investment and what has caused the change in value.
Some investors make the mistake of firing an investment manager or selling a mutual fund solely because of a period of poor performance without having a complete understanding of what is behind the performance. What they fail to understand is that any investment manager that has an objective of outperforming a benchmark (for example, the S&P 500 Stock index) can only do so by investing differently than the benchmark. Investing in a manner that differs from the benchmark guarantees the performance will differ. While it would certainly be preferable to only have performance variations on the upside, in reality that is not possible.
Our investment advisor, Litman/Gregory, recently analyzed the performance history of the most successful mutual fund managers. Their objective was to determine how often the managers with the best 10-year investment records underperformed along the way to their superior long-term results. The results of their analysis are summarized on the following chart.
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An explanation of this chart follows:
- This chart includes the 135 funds that outperformed their benchmarks over the 10 years ending 12/31/2005. Of the 556 Large-Cap mutual funds with a 10- year track record, only 135 outperformed their relevant benchmarks. (The benchmarks used are unmanaged index funds that represent broad exposure to the asset class. For example, the S&P 500 is the benchmark for the Large Blend category).
- Over 90% of these out-performers experienced a three-year period during which they trailed their benchmark by at least 2% per year. One-hundred percent of the Large-Cap Value funds trailed by at least 2% per year throughout a three-year period.
- More than 64% of these out-performers experienced a three-year period during which they trailed their benchmarks by at least 5% per year. Seventy-one percent of the Large-Cap Blend funds trailed by at least 5%.
- More than 20% of these out-performers experienced a three-year period during which they trailed their benchmarks by at least 10% per year. Thirty-nine percent of the Large-Cap Blend funds trailed by at least 10%.
The bottom line is that a large majority of the most successful fund managers have extended periods where their performance lags, followed by periods of significant out-performance. To be successful, investors need to be there for that out-performance. This suggests that investors should be clear on their reasons for selling a poor performer and those reasons should go beyond performance.
This chart only shows the funds with the most successful long-term performance. There were also 421 other fund managers who underperformed over both short and longer periods. So how does one know when a one- or three-year period of underperformance will not continue 10 or more years?
We have confidence in our fund managers’ ability to generate strong long-term performance because of our due-diligence process. Following a comprehensive quantitative and qualitative analysis to select a fund, our due diligence process continues with ongoing monitoring of all our funds, regardless of whether they are beating or lagging the benchmark. In either case, our goal is to be sure we understand what is driving performance.
We focus our initial analysis on getting to know a manager’s investment approach and defining the “edge” that we believe will enable the fund managers that we hire to outperform over the long term. To do this, the managers and analysts for these funds must make their process transparent for us. The advantage (both for them and for us) is that we should be able to distinguish between times when it is the market environment which does not favor a team’s edge and times when that edge has disappeared due to inconsistency, a lack of discipline or various other reasons.
In cases where the market environment does not favor a manager’s edge, we believe patience is warranted. We know of several managers who have suffered through periods of poor performance, but maintained their disciplined approach and were eventually rewarded. Managers that have low turnover and make concentrated investments in areas where they see value (such as many of the managers in our clients’ portfolios) are also more likely to have multi-year periods of relative underperformance. Loomis Sayles Bond Fund expected the U.S. dollar to depreciate and had very large weightings in foreign bonds in 2000 and 2001. It underperformed its benchmark for almost two years because of those positions; but this investment ultimately paid off. Over the next four and one half years, the fund more than doubled the annual return of its benchmark (12.9% versus 5.4%).
In a more dramatic example, Longleaf Partners underperformed its benchmark by over 4.5% annualized for the five years from 1995 to 1999. During the next four years, the fund returned over 13% annualized compared to a 2.5% annual return on its benchmark. Examples like the above lend support to our belief that managers who maintain a disciplined approach through periods of underperformance ultimately position their portfolios for later out-performance.
We will remove an underperforming manager if we determine that we were wrong in assessing a manager’s edge or if our due diligence uncovers any factors that lead us to question the validity or sustainability of that edge. Our investment process provides protection in the event that a fund manager goes through an extended period of underperformance by hiring multiple managers. For most of our client portfolios we hold between 10 and 14 different managers. Where we have large allocations to an asset class, we seek to reduce the portfolio-level risk of manager underperformance by using a combination of our highest-conviction managers.
We are not claiming that our patience will in all cases prove to be successful. We hope and expect, however, that in the aggregate, it will be profitable over the long run.
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