Successful active management depends on being different. Having a longer-term outlook automatically affords a degree of difference, which should therefore lead to greater success. But there is more to it, as Jeff Bezos knows only too well.
In an interview with Wired magazine in 2011, Amazon CEO Jeff Bezos said: "If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”
Successful active management depends on being different. Having a longer-term outlook automatically affords a degree of difference, which should therefore lead to greater success. But there is more to why a long-term outlook is necessary to achieve success.
First, there’s ‘alpha’; in other words increasing active returns and being able to recognise it. Compare the following charts. Both depict the investment performance of an actual manager we’ll call ‘XYZ Asset Management (XYZ AM),’ which has been rated ‘A’ by Mercer’s researchers since 2007. On the left, you see the manager’s performance over shorter time frames, expressed through the manager’s rolling one-year excess return. As you might expect, there have been many periods where performance has appeared to be good, but also periods where it was well below benchmark. Would you have been nervous about this short-term underperformance and considered looking elsewhere? Now compare that to the same manager’s performance when viewed through a longer-term lens, as depicted in the chart on the right. Here the manager has turned what is a reasonable return from equities (8.6% p.a.) to a very good return to equities, generating alpha in the form of an extra 3.6% p.a. over the life of the strategy. In this chart it is fairly obvious the manager has generated a strong return over the long-term. So we can see the consistency of the long-term excess returns, with the strategy delivering above 2% p.a. returns over nearly all 5 year periods. So a long-term perspective helps put performance into perspective.
Identifying managers like this one, who go on to outperform, is challenging because investing is a zero sum game where active investors, on aggregate, cannot outperform the market because they are the market. However, there are strategies and approaches that do outperform as a result of skill rather than pure luck, and it is possible to identify them by starting with a clear set of investment beliefs, then undertaking a program that is research driven, framed in a repeatable, consistent and robust framework, which remains flexible. Lastly, an evidence-based focus on characteristics shown to increase the chances of identifying alpha is critical. These might be characteristics of strategies, investment teams or businesses that have been shown to increase the chances of generating a better outcome.
So if you accept that investors should focus on the long term, what should you consider when selecting a manager for a long-term investment? Mercer’s 4-Factor Framework for researching and rating strategies contains four specific factors our researchers review and score in order to come up with an overall rating. These include:
1. Idea Generation based on the manager’s philosophy and its interplay with their investment process.
2. Portfolio Construction – how their ideas take form in an investment portfolio with regard, for example, to Environmental, Social and Governance (ESG) risks and opportunities.
3. Implementation – how they minimise leakages to the value added through their ideas and portfolio(s).
4. Business Management as measured by the overall stability of the firm, ownership and governance structures, people culture and how people are remunerated and incentivised.
Past performance is not one of the key factors we consider, because it’s not forward looking and long term in nature so is therefore not a key driver of future outcomes like ESG integration, which is a long-term initiative by its nature and typically requires a longer time horizon than pure financial investment criteria.
Performance monitoring through a long-term lens
Although not one of our four key factors, past performance monitoring remains an important aspect of the overall process. The important thing is not to be driven by short-term spikes and dips because, over 1 or 2 years, a very good return, or a very bad one, may have been generated more by luck than by skill. As we have seen, market conditions will favour or penalise different investment styles at different times. The opportunities for out performance often require patience because even the greatest investment ideas can’t be perfectly timed.
With that in mind, what should investors look for in short-term performance data? Having properly assessed a manager’s philosophy and process, the next step is to consider whether the performance is what would be expected given the market environment. Even the harshest critic couldn’t expect a deep-value Australian equities manager to outperform in the sort of conditions facing investors at the start of 2016. Similarly, it’s not all that surprising when bond managers who load up on credit outperform peers after a credit crunch.
However, if there are contributions to performance that are not a function of the manager’s philosophy and style, then these require further investigation and explanation to determine whether what the manager got right or wrong aligns with their active decisions. It’s also important not to lose sight of how the risk side stacks up. Is the risk taken commensurate with the returns generated? Is it in line with the manager’s process?
Therefore, a much greater focus should be placed on longer-term trends in performance. Hiring or firing managers on the basis of short-term returns is a dangerous tactic, akin to an investment manager buying at the top and selling at the bottom. Even more dangerous is the prospect that investment managers detect that clients will react to short-term outcomes and thus get discouraged from making the sort of longer-term strategic decisions that are in the best interest of clients over the longer-term.
Areas such as governance and alignment are often overlooked but are vital to achieving investors’ long-term outcomes. Indeed, there is a virtuous cycle, whereby a strong governance and alignment structure means that monitoring shouldn’t be as onerous.
Areas such as team dynamics and culture can be harder to gauge. However, regular engagement with all members of the investment team, not just the key decision makers, can help shape this view.
Overall, investors should monitor their managers to ensure they have at least three things:
- A clear philosophy.
- A robust process.
- Consistent decision-making framework highlighting the “why, what and how?”
Then they should take good care over the time period they are measuring the investment manager, ensuring this time period is consistent with the above aspects.