Upside down: why trustees should be wary of unexpected outperformance

We have seen investors focus on building greater resilience and downside protection into their portfolios than they had before coronavirus. 

But what about the element of ‘risk’ that rarely gets attention, and that in hindsight would have allowed pension schemes to largely insulate themselves from what happened in March? It is not some arcane financial indicator, but rather one you have seen a thousand times: upside performance. 

Managing your downside risk is best done when things are calm, not while the house is on fire. Until the Covid-19-induced market turmoil, equity markets have had a storming decade, riding the wave of the greatest bull run in history, while volatility in most risky markets has been astoundingly low.

Asking the right questions about upside performance when times were good would have been a signal worth watching for trustees

However, in March they saw a sharp correction of pricing, and since then stock markets have been nearing their all-time peaks again in April and May. Investment returns, particularly from the stock market, have fooled investors into thinking that March was just an aberration.

However, this crisis is not nearly done; we have merely passed the first phase. 

Focusing on downside performance is de rigueur. You see it, you start asking questions, and you check if that level of downside performance was expected, by comparing it with a tracking error. Woe betide the manager who has not only underperformed, but also blown through their tracking error targets. 

But investors rarely fret about upside performance in the same way, since it is easy to ignore unexpectedly good performance. Investors are tempted to find all manner of ways to explain away why this outperformance was different.

Upside performance may well be something to cheer, but it should also warrant the same types of questions: was the manager taking too much risk in order to achieve that level of performance, or taking a risk no one realised – and is that risk-taking still appropriate?

More importantly, it should lead trustees to ask whether they would be happy with that same level of performance on the downside, and whether or not it would be more appropriate to run a less risky portfolio that still meets the investment objective.

Too much risk in the industry?

Let us look at a pretty recent (and still raw) example of the signal in the sphere of UK fiduciary managers.

For 2019, analysis from XPS Pensions shows that fiduciary managers’ growth-only portfolios produced positive performances between 8 per cent and 19 per cent over the year.

It is a fair assumption that these ‘growth-only’ portfolios are seeking absolute returns of around 4-5 per cent a year, net of fees.

Hence the entire field of managers are likely to have met their return objectives for 2019, but clearly some of them significantly overshot their targets – approaching a one in 20 upside event.

In the first quarter of 2020, performance varied between minus 15 per cent and minus 4 per cent – with the lower end of this range beyond the one in 20 downside. While the entire field of fiduciary managers lagged their absolute targets, the managers that suffered the worst underperformance were those who had the largest outperformance in 2019.

Trustees should have expectations met

Asking the right questions about upside performance when times were good would have been a signal worth watching for trustees working with these fiduciary managers. 

On the other side, a fiduciary manager should be mindful of how much risk they are taking anyway, if they can generate the target level of returns at a dramatically lower level of risk – for example, by holding less equities because they already have enough return from the portfolio. 

So counter-intuitive though it may be, upside performance is just as big an indicator for good risk management as downside protection.

Lastly, the most important aspect when you employ a fiduciary manager is that the specific target that is relevant for your scheme is the most important aspect to focus on. Significant upside or downside performance in comparison to that is not the objective that was mutually agreed.

Trustees should be focusing on risk-adjusted returns and ensuring they are comfortable that the portfolio their fiduciary manager is running is behaving within the expected range (or tracking error) that they had agreed to.

In the end, trustees will benefit from being less surprised by their fiduciary manager when the market winds change, which is likely to result in a more robust portfolio.

Nikesh Patel is head of investment strategy at fiduciary manager Kempen Capital Management