The recent “shock exits” we have seen at Wimbledon give us an opportunity to discuss how we deal with failure in an investment context, and how that determines our future success.
As recent research by Investit noted, underperforming fund managers have a propensity to take on progressively increased risk in their portfolios in an attempt to claw back performance. Such acts of desperation may stem from a desire to keep one’s job, or simply to try for a reasonable bonus. Whatever the cause, panic has an unfortunate tendency to set in when fund managers sharply underperform, and the result is that their behaviour changes, to the benefit of neither themselves nor their investors.
Good sportsmen and women will know that this is not the answer. For sure, a loss may spur even harder training and even more focus. But how often does a losing tennis player decide to switch to playing football instead, or vice versa? Of course, this sounds ridiculous, and perhaps a better analogy would be the baseliner in tennis who decides to become a volleyer (when was the last time you heard this happen?). But this is exactly what we can observe with many underperforming fund managers: they stray into areas unfamiliar to them, and rarely with positive consequences.
There is no shortage of examples: think of managers who suddenly decide, after a period of underperformance, to expand their remit and buy stocks in a different country, or to buy gold as a “tactical hedge”, or the equity manager who buys corporate bonds. Ucits limits generally permit these types of positions at reasonably sizeable weights, and there are managers with demonstrable ability in all of these areas. But a manager who drifts into these fields for the first time in the anxious search for performance recovery is a danger.
As with all such dangers, however, it is the hidden type – the iceberg with four-fifths under water – that is the greatest risk of all. It can be very difficult, particularly without detailed and regular data on fund managers, to spot those who are changing their approach to recover from underperformance, and to differentiate from those who are “sticking to their knitting”. Statistical analysis of portfolios, and pre-set (at purchase) expectations of the likely bounds in which a manager should move – allow these hidden dangers to be spotted early.
Having said all of the above, we must not forget those managers who triumph in adversity. Managers who consistently apply a proven process may still have periods of significant underperformance, but sticking with them through the tough times can reap rewards when their approach comes back into favour. This is why indiscriminate selling on short term underperformance is typically a losing strategy in fund manager selection, but equally maintaining exposure to a manager without good insight into their portfolio, and the ability to discriminate between those maintaining or changing their approach, is essential.