Poor performance is often right manager, wrong house
Short term underperformance of an index in not the key to judging a fund manager’s performance.
There is a smorgasbord of apparently Buffett-inspired investment philosophies out there. And with some recent downbeat articles surrounding Warren Buffett’s performance over the past three years it seems an opportune moment to think about how we judge an investment manager, and whether levelling criticism at Mr Buffett is justified.
There are whole books devoted to Mr Buffett’s approach, and lengthy documents produced by many other fund managers explaining their interpretation of his strategy, so any attempt I make to summarise is inherently inadequate, but here goes. Buffett aims to maximise growth of “intrinsic business value” through “owning a diversified group of businesses that…consistently earn above-average returns on capital”. Nowhere does this say that his aim is to outperform the S&P 500 index on an annual basis: in fact, if you read on in his Owner’s Manual, Buffett directly states that this is not his aim but it is a probable outcome over the long term. And, indeed, when we look over the long run, Berkshire Hathaway’s outperformance of the S&P 500 index is quite breathtaking.
Why does this matter? Because time and again we see fund managers criticised for their performance over one year, or even at times one quarter. But any criticism of performance needs to be made with consideration of their objectives. While marketing departments frequently like to downplay this, the fact is that apart from heavily risk-controlled strategies (which in reality often perform similarly to – or worse than – index trackers), investment performance versus a benchmark is volatile and needs to be viewed on a multi-year horizon.
Consider the practical application of Mr Buffett’s philosophy. He likes to own “wonderful businesses”, perhaps best shown by what is probably a genuine statement on the Berkshire Hathaway website encouraging readers to consider products or services from three of his companies. But buying, either the whole or a part, of “wonderful” businesses, and holding them effectively forever does not deliver returns proxying an equity index. Taxation treatment aside (Buffett explains this in detail on the Berkshire Hathaway website and it’s a secondary consideration), sitting in “quality” companies for the long term might well be a sound investment strategy, but it does not have, at its core, a consideration of benchmark-relative volatility.
Mr Buffett, along with many other talented investment managers, probably offers (on average) lower absolute volatility by paying less attention to the index. The headline-writers trying to penalise him for what is really (in the span of his investment career) short term underperformance of an index he does not tie his performance to are doing what some investment management company business heads also do: applying pressure when short-term performance is poor, even when the underlying investment philosophies are sound. Perhaps this is why some large investment houses have a dearth of consistent long-term performers in equity fund management. There is no one who can or does tell Mr Buffett how to run the business, as evidenced by his recent response to the (apparently disappointing) short-term share price performance. An investment house should do likewise: give its investment managers the freedom to manage their assets in their true style without pressure to achieve the probably impossible aim of consistent short term outperformance.