Why schemes waste money switching managers too often

In my 25 years in this industry, both as a consultant and as a manager, I have met enough individual investors and teams who seem to me to have exceptional talent that I am undoubtedly a believer in investment skill, and hence a believer in active management. But if you have taken a different view, so be it.

My argument is about how you can maximise your chances of success in pursuing active management. And there I believe passionately that, more important than anything else, it is essential not to react hastily to medium-term underperformance by shifting managers.

We have allowed rolling performance periods to take too great a hold in our thinking

This is not because the act of change costs real money, although it does, but rather because far more often than not the timing of that change will prove to be extraordinarily expensive.

Why is this? Well some of the time that underperformance may simply be bad luck from good managers who will naturally return to their predicted path.

However, we do know that much more often the behaviour of markets goes in cycles. These may be up versus down markets, or outperformance of particular sectors, or styles, or investment factors.

The cost of switching

If you make a move when your manager is subject to some aspect of a cycle at its low point you will miss the upturn, and that is usually exceedingly expensive.

Let me illustrate this with a simple practical example, based in this case on the consultancy Mercer’s performance universe of UK equity managers.

Let us say that 10 years ago you decided to choose an active manager and you picked right, ie a single upper quartile manager over the whole period.

Over the past 10 years there were 20 such managers, and their average net outperformance over the All-Share Index was a cumulative 39 per cent.

Now let us add a seemingly simple constraint that perhaps captures typical behaviour in our industry – if the manager is in the bottom quartile over some rolling three-year period, they would be replaced by an index manager for the rest of the period.

This hardly seems on the surface an extreme constraint and yet it has a profound impact on the outcome. Of those 20 managers – remembering that all of them proved to be good choices – only seven would make it through to the end of the 10 years.

Worse still, the average performance foregone on each change is nearly 6 per cent a year in the period after their replacement. You would have virtually eliminated the outperformance over the whole 10-year period of those 13 managers.

While many trustees conceptually acknowledge the risk of acting hastily, this example illustrates very powerfully how a seemingly reasonable performance-driven reaction can be incredibly expensive – and spoil an otherwise good choice.

Governance pressures

So why is it that trustee boards continue to make such decisions and pull the trigger too soon? There is immense pressure to act in the face of underperformance. It takes a lot more courage to stick to a conviction than to change it.

We have allowed rolling performance periods to take too great a hold in our thinking. Rolling periods in a cyclical discipline are an invitation to step away from the long-term perspective that is needed.

I am certainly not arguing that you should never fire a manager, but if you make the primary trigger for such actions non-performance-based your results will improve hugely.

For example, you could focus on changes in personnel or on a lack of discipline in managing investment capacity. These are events which typically mean the original investment thesis behind your choice of manager has changed.

In summary, if you are going to adopt active management, it is essential to give yourself the maximum opportunity for success.

This means learning to sit on your hands when facing medium-term underperformance. It may not work every time, as indeed nothing will, but if you can manage it you will both increase your chances of making a good selection and avoid the huge costs of mistiming change.

Andrew Dyson, head of global distribution, Affiliated Managers Group