Thoughts on underperformance by an active manager

By Stephen Bennie

This article takes a closer look at what a period of underperformance means for an active manager. I would point out that first and foremost there is no such thing as good underperformance, however periods of underperformance are unavoidable for a truly active manager. Indeed, the more active a manager is the greater the possible quantum of unavoidable performance.

Saying that a manager is an active manager is not saying that they do a lot of trading. They may trade very little or a great deal that has nothing to do with being active, the key is that they are taking active positions that deviate from their benchmark, which for most local equity managers will likely be some blend of the S&P/NZX 50 and S&P/ASX 200 indices. To state the obvious, a manager that holds the same stocks in the same proportion as their benchmark (aka Passive) will never outperform, but tantalisingly they will also never underperform. Another approach a manager can take is to have a very low tracking error by taking only small deviations from their benchmark. These managers have reduced the potential for returns significantly greater than the market but again they rarely have to endure criticism relating to periods of significant underperformance.

Right now, I’m experiencing an element of jealousy for managers that take the passive or very low tracking error approach because Castle Point is currently enduring a sustained period of underperformance in its flag ship fund, the Ranger Fund. That’s because periods of underperformance, especially sustained ones, are truly unpleasant experiences for all parties concerned. The fact that it’s inevitable for a truly active manager is of zero consolation. But the reality is that if you have built your portfolio with little or no regard to a market benchmark you will perform differently. And not always in a good way. At least for certain periods of time.