When constructing portfolios, we often look to active management as a means to build wealth more quickly, even though, as I’ve written before, higher returns are not necessarily how we should define investor success. Regardless of the risk-and-reward dynamic, many often forget that active management also introduces behavioral triggers that need to be managed, and doubt is ever present.

Contrary to what you might think, this isn’t to say that active funds can’t be successful. However, many are often too impatient. We can improve investors’ odds of success if we not only help them understand, but also understand ourselves, the behavioral challenges that active funds entail.

Even when we’ve followed rigorous due diligence to select actively managed funds, any fund will inevitably experience periods of relative weakness, whether actual or perceived. It’s not uncommon to succumb to what I call “my fair share” risk, when we wonder whether some other fund might have done better.

In that moment, when we’re evaluating a fund manager whose relative performance did not meet expectations, how can we differentiate a “bad” manager from a “good” one? How can we remove doubts about the fund manager’s abilities? Or about our selection process? How can we differentiate a manager who deserves our patience from a manager who should be replaced?

How do we know if it should be out with the old, in with the new?

 

Do we have the patience to benefit from active risk?

Part and parcel with active investing is active risk, which can create doubt about an individual fund when its performance lags either a benchmark, its peers, or, simply, an investor’s expectations. This doubt can be a distraction from what really matters: the aggregate portfolio’s progress toward the investor’s goals. (For the record, it’s just as easy to add active risk with index funds or ETFs, but generally speaking, that’s the result of how those funds are used, rather than the funds themselves, which generally add little active risk on their own.)

While active risk has more than one definition, in this case, let’s define it as the uncertainty of performance due to active management. While we hope for outperformance, oftentimes it doesn’t happen. Or maybe it just hasn’t happened yet.

The chart below illustrates this conundrum. It measures not only the funds that survived for 15 years ended 2015, but also those that outperformed their benchmarks over the period. The vast majority of funds that ultimately outperformed for the full 15 years underperformed frequently during the 15 years, and not one fund outperformed its benchmark in each of the 15 years.

With investing, the path to ultimate outperformance is frequently blazed through periods of underperformance.

 

Long-term outperformance has required years of underperformance

Total individual years of underperformance for active stock funds that outperformed over 15 years ended 2015

bennyhoff_long-term

 

Are we adding seeds of underperformance?

It makes you wonder how many ultimately “winning funds” were replaced because of impatience. A historical view of investors’ returns compared with funds’ returns shows that investors rarely fully participate in the returns of the funds they’re invested in (chart below), which, clearly, isn’t very conducive to wealth creation.

When we build portfolios exclusively or primarily with actively managed funds and strategies, are we adding the seeds of behaviorally based underperformance too? Will we allow the time and patience necessary to fully judge the return on that active risk to determine whether a fund should stay in the portfolio, rather than falling victim to the temptation to make a change?

 

Impatience has led to lower actual return

Investor returns versus fund returns, ten years ended December 31, 2015

bennyhoff_impatiencev2

 

 

We can better serve investors by helping them understand—and understanding ourselves—the behavioral challenges that result from dealing with uncertainty, such as active risk. The sooner we agree that the solution isn’t always “out with the old fund, in with a new one,” the better off we’ll be.

 

I’d like to thank Andy Clarke for his much-appreciated contributions to this piece.

While investing in actively managed funds is, indeed, challenging, outperformance is attainable. Our Keys to improving the odds of active management success research has more.

For more on the importance of inhibiting investors from making undisciplined and emotional decisions based on headlines, ads, and short-term market actions, read our Advisor’s alpha research.

 

All investing is subject to risk, including the possible loss of the money you invest.

Past performance is no guarantee of future returns.