You may be one of those advisors who, despite the changes in the advisory profession, has largely kept your practice the same.

That is, your investment value proposition is built around selecting active managers. You see little reason for your investment philosophy to change. It has worked well for you and your clients for a long time. Yet you also know active managers have had disappointing results at times, and after a run of some bad years, you’ve had to have a “let’s fire the fund manager” conversation with your clients. Even when you believe in a manager, your clients don’t always have the same level of patience that you do.

Our extensive analysis shows even successful active managers often have lengthy or frequent periods of underperformance. A period of underperformance alone is not a good reason to fire a successful manager. What is needed is patience and, perhaps for some clients, passives. Let me explain.

 

Patience is key

Riding active management can be like riding a roller coaster. Some of your clients may be like my kids when they rode roller coasters the first few times: anxious on the way up and scared on the way down. We at Vanguard know something about this ride. We have been hiring external advisors to run many Vanguard active equity funds since the very beginning of our company’s existence 40-plus years ago. We currently partner with more than 25 external advisors, and, on average, the record of our active funds is not too shabby.

We analyzed the performance of all U.S. active equity funds over a recent 15-year period. The graphic below shows what we found:

 

Most outperforming funds experience lengthy underperformance

U.S. active equity fund performance, 2002–2016

U.S. active equity fund performance, 2002–2016

 

Sources: Vanguard calculations, using data from Morningstar, Inc.

Notes: Figure covers the 15-year period ended December 31, 2016, with 2,224 initial funds. Successful funds are those that survived for the 15 years and also outperformed their prospectus benchmarks. Our analysis used expenses and fund returns for U.S. active equity funds that were available to U.S. investors and in existence at the start of the analysis period. For a fund with multiple share classes, the oldest and lowest-cost single share class was used to represent it. The performance of a fund was compared with that of its prospectus benchmark. For this analysis, funds that were merged or liquidated were considered underperformers. The following fund categories were included: small-cap value, small-cap blend, small-cap growth, mid-cap value, mid-cap blend, mid-cap growth, large-cap value, large-cap blend, and large-cap growth.

 

Successful active funds typically have talented managers and are reasonably low cost. Even so, of those that outperformed their respective benchmarks over the full period, there were two startling statistics about their path to success:

  • More than 70% underperformed their benchmark for three consecutive calendar years.
  • More than 50% trailed their benchmark by 9 percentage points or more in a single calendar year.

Many investors struggle to retain an active equity manager if the manager is inconsistent or underperforms significantly in a given year. State Street conducted a study in 2015 of 400 institutional investors around the world and found that close to 90% of them looked for a replacement manager after just two years of underperformance.1 Maybe some of your clients have shown a lack of patience as well.

Yet our analysis suggests that relative underperformance of sizable length and high degree, is actually quite normal. Before firing any manager, you should look at the key qualitative and quantitative criteria in order to conduct a proper manager review to determine whether the manager still has what it takes to potentially produce attractive results over the long term. Our paper Keys to improving the odds of active management success discusses those criteria. Evidence also suggests it is important to make sure a manager is low cost. If a manager is high cost, you may want to make sure the manager passes the factors test.

This means that if you have a high degree of confidence that a particular low-cost manager or set of low-cost managers will add meaningful value over time, then you and your clients will need to stick with them through the inevitable down periods. Admittedly, few clients will get to the point where, like my kids on roller coasters, they will enjoy the down cycles. But you can coach them to enjoy the ride up and close their eyes when volatility spikes.

 

Passives can help

There’s another way to help your clients deal with the active roller coaster. That is, put them on a coaster with smaller peaks and shallower valleys, so their portfolios track the overall market more closely. The way to do that is to add some broadly diversified, capitalization-weighted equity and bond index funds, so-called passive investments, to the mix. Those funds can help to reduce the ups and downs relative to a broad-market benchmark, which may be easier for some clients to stomach. Supplementing with some passive can only dilute the magnitude of periodic underperformance.  It can’t address the frequency or length of underperformance.

The graphic below illustrates this, but with a bit of an optical illusion. The bottom graphic, at first blush, may look as if it offers a steeper roller-coaster ride than the top graphic. But because these are classic bell curves, the bottom graphic really shows a client portfolio that tracks the broad market more closely and, thus, potentially offers a client a smoother ride.

 

Often short- to intermediate-term active performance can make or break an account

Often short- to intermediate-term active performance can make or break and account

Source: Vanguard.

 

So even though investor cash flows have headed strongly toward index funds and ETFs, that doesn’t mean you should eliminate your active lineup. If you like your low-cost active funds, feel free to keep them. We like our low-cost active funds as well.

Just make sure your clients have sufficient patience, maybe add passives, and enjoy the ride.

 

I would like to thank my colleague Tom Paradise for his contributions to this blog post.

 

1 State Street Global Advisors, 2016. Building bridges: Are investors ready for lower growth for longer? How are they working to bridge the performance gap? Boston, Mass.: State Street Corporation. p. 16.