Consistency is overrated

16 April 2019

By John Husselbee, Co- Fund Manager HC Verbatim Portfolio Growth Funds

Over more than 30 years analysing fund managers across the world, one of the most important lessons I have learned – and a key mantra behind our multi-asset approach – is that consistency of performance is close to impossible over any decent timeframe.

Despite this, and repeated warnings about relying on past returns as a measure of future success, we continue to see a raft of studies based on consistency, showing which managers have been able to post outperformance over consecutive years. As very few can show such consistency year after year, this has been used as evidence to support a passive approach.

With this is mind, I was interested to read new research from Morningstar under the intriguing title of Quit chasing unicorns: consistent fund performance is overrated, taking aim at exactly this kind of consistency-based data, such as S&P Dow Jones’ bi-annual persistence scorecard. This works out how many funds outperform over a certain timeframe then tracks these names to see how many repeat this over subsequent periods, and broadly speaking, the vast majority of active funds have failed that simple test.

According to Morningstar, however, even the most successful active funds over meaningful periods have not been ‘persistent’ according to this narrow definition and most index funds also fail such consistency tests – and we would concur on both points.

While based on US data, these findings are clearly relevant for mutual fund investing around the world and many fund selectors – including us – have done similar ‘do winners repeat’ work over the years. Morningstar’s research looks at the ten-year period to the end of November 2018 and finds close to 1200 funds in the top quartile of their respective sectors. Of these however, around 60% were never able to post three consecutive years of first-quartile performance during this period: with eight possible ‘three-peats’ in a decade (from year three onwards), just 73 funds managed this feat four or more times.

What is important to take from this data is that these funds are top-quartile over the full ten-year period and the average outperformer has five top-quartile years overall (so over 50% of the time). But three consecutive standout years is rare and if investors are trying to buy based on that, they will struggle to put a portfolio together.

Again, this chimes with what we call the ‘six out of ten rule’: we have found the very best fund managers out there, with the strongest long-term track records, will tend to outperform six years out of every ten.

Putting paid to the idea this ‘lack of consistency’ automatically opens the door to passive alternatives, the data shows index funds were even less likely to post three consecutive top-quartile years than active funds over the period: just 16 of 58 top-quartile index funds managed this at least once, equating to 27% (versus 41% of active funds).

To quote from the report, many performance studies “put consistent performance on a pedestal. It doesn't belong there. Even the most durably successful funds have bouts of underperformance and thus flunk tests like these”.

This all fits into Morningstar’s efforts to revolutionise performance measurement, which we have discussed in previous pieces, proposing metrics called longest underperformance and longest outperformance periods (LUP and LOP respectively). To recap, this acknowledges that a fund that ultimately beats its benchmark over a certain timeframe may go through stretches of underperformance within that period. These stretches can be particularly stark if a fund has a strong style bias and the market goes against that approach at particular times.

Around two-thirds of the funds analysed in this study beat their benchmarks over the 15-year period but of these, the average LUP ranged from nine to 11 years. What this means is that investors not only needed to pick the right managers but also have the patience to endure long periods of sub-par returns. And the opposite is also true: a fund that ultimately underperforms its benchmark over a 15-year period could well have gone through an eight-year period of outperformance, enticing return-chasing investors to buy the fund only to be disappointed by subsequent results. 

So what can we take from all this and how does it inform how we continue to select managers? A key point, which has always been central to our process, is that patience has to be a watchword when it comes to investing – but unfortunately, that is increasingly out of step with the short-termism of markets and much of the commentary about them.

Right at the start, I said experience has taught me consistency of performance is all but impossible; the second, and ultimately more important, part of our mantra is that consistency of process is an absolute necessity. The majority of our favoured managers tend to be those willing to be contrarian and back their ideas with conviction.

We often buy managers to fit a style requirement in our portfolios and therefore want them to keep to that approach. Baked into that is the understanding that managers with a strong style bias can go through periods of underperformance but we want to see a consistent process whatever the market is doing in the background.

Ultimately, we look to select funds that complement each other so it is key the managers have a record of maintaining their style and do not drift away from it. If they do, that is a much clearer reason to sell out of a fund than lack of persistency or reasonable fluctuations in performance.

The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.