CEO of ECP Asset Management, Dr Manny Pohl, explains the ‘style creep’ trap and how investors can avoid succumbing to it.
Regardless of underlying market movements, it is important for fund managers to remain true to label to ensure investors’ portfolio construction strategies continue to meet their long term needs.
Equally, investors shouldn’t ditch a particular strategy or investing style based only on the previous year’s performance. The decision – both to invest in the first place, and to subsequently exit the investments – should be more considered and rational than that.
Of course, this is easier said than done. For many investors, the most recent performance figures are the primary source of information about their investments, and it can be difficult to remember the long term investment strategy when a fund manager’s performance is lagging its peers. But it is important to look at the reasons behind this, and fully understand the basis for any underperformance.
Take 2016 for example. It was a very unusual year for growth style managers, with all the usual sources of risk in many portfolios experiencing negative payoff. Stock selection, sector allocation, style and market beta all contributed negatively to active return. This type of positive correlation in any calendar year is highly unusual.
But this kind of outcome is unlikely to be repeated, so making investment decisions today based on last year’s performance is not going to produce the expected – or desired – result.
On average, the market undervalues extremely high quality, capital efficient organic growth businesses. And the market tends to over-emphasise temporary themes and short-term factors.
In this environment, investors – be they institutions, superannuation funds or retail – mustn’t let short-term performance distract from their original long term goals. And money managers must resist the urge to change their strategy and they must stay true to label.
Style drift concerns
Indeed, style drift is an important issue for investors to be aware of. There are times where when going gets tough for asset managers – and the temptation is to change their approach in order to deliver better performance for investors. For example, a growth manager sees that growth assets are getting hammered, so they try to buy some value stocks to recoup that loss. While this may create a short-term benefit, the long-term consequences can be significant, and it is a time when investors should be concerned.
Managers have to be clear about their investment parameters and what they have promised investors, and they have to stick to them, in the best interests of their investors.
After all, timing markets is difficult and market upticks can happen suddenly.
As the above table shows, small and mid caps have outperformed in 69 per cent of years, but they also had significantly greater variance of returns. They tend towards higher highs, as well as lower lows – so the timing of entry and exit had a big impact of returns. If an investor had exited the small cap asset class in December 08 – when returns were minus 53 per cent – they would have missed out on the following year’s recovery and returns of 57 per cent.
Ditching growth stocks based on a previous year’s performance means that investors may miss out of the benefits of the eventual upturn in this sector.
There will be times when the best money managers in the world – as judged by various market metrics – nevertheless get absolutely battered in markets. For instance, if you were invested in the small to mid cap space during the global financial crisis (GFC) your portfolio could have been down as much as 50-60 per cent, because the performance of small to mid sized companies in that time was hammered.
So investors need to consider more than just past performance when choosing a manager. Equally, they need to consider more than past performance when making the decision to ditch a manager. Someone who invests in a fund manager because they are outperforming the market, but then ditches the manager when they underperform, will miss out on the upturn when the market conditions change and the manager is in a position to outperform again.
Staying the course, of course, means ensuring you are with the right manager in the first place.
If you are invested in a fund manager and the fund is putting in poor performance, it is important to consider the underlying reasons for the poor short term performance. If it is economic impacts outside of the managers’ control – such as the United Kingdom deciding the leave the European Union, or the people of the United States voting for President Trump – further evaluation is necessary. If the manager is still investing in the way that was promised, and is still on track for the long term returns expected – investors should think carefully about exiting.
Sophisticated investor behaviour
A good lesson for investors is looking at the behaviour of the more sophisticated institutional managers, such as some of the big superannuation funds.
They have a very detailed and exhaustive due diligence process when it comes to selecting fund managers to invest with, but once they have made their decision, they are more likely to abide by it. This is because they have done their research and they know the manager has the skill to do the job, and it’s likely to just be a systemic issue that is causing a problem with performance. They understand the reasons behind the performance, whether good or bad.
Retail investors can also apply these lessons and remember why they chose the fund manager in the first place – and it shouldn’t just be because they were topping the performance tables in one particular month.