InvestmentsApr 2 2020

How long should you stick with an underperforming fund?

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How long should you stick with an underperforming fund?

In a recent call with investors, the chief executive of fund house M&G John Foley said he expected about 60 per cent of his company’s mandates to be beating the market over a three year time period at any one time. 

For most of the past decade, funds that deploy the value style of investing have underperformed

Charlie Parker, managing director at Abermarle Street Partners, says the first thing to do is understand the reasons why a fund is underperforming, and particularly whether the underperformance is related to the fund manager's style being out of favour with the wider market.

For most of the past decade, funds that deploy the value style of investing have underperformed.

Value fund managers place more emphasis on the valuation at which a company trades than on the growth rate of a company.

In a world of little or no growth, low bond yields and low interest rates, growth stocks and funds tend to perform best, and when those conditions are reversed, value funds perform better.

This is because in a world of higher interest rates, and bond yields, economic growth should be more robust, meaning more companies are growing, and so the rate of growth becomes less important than the price paid for the company.

Growth has outperformed value

The prevailing economic conditions of the past decade mean growth funds have generally outperformed value.

For this reason Mr Parker says: “As a general rule I don’t hold it against value managers that they have underperformed, because no value manager has performed for the past five years.

"I would look at it and say the fund manager has shown they are willing to be consistent, to stick to their beliefs, and that is important.”

He said that if a fund is underperforming but its style is generally in favour then he would want to know why.

Mr Parker says: “I would look at how they are doing compared to other managers with the same style, then I would look at what the context is.

"Are they being supported by their employer?

"What his going on in their lives, and in the firm in which they work.

"Of course there needs to be very good answers to those points, but there is no definitive answer in terms of what would make you sell a fund then, or what time period.” 

Alex Farlow, head of risk-based solutions at Square Mile Research, says a major red light for him would be if a fund manager changed the style of investing they have used throughout their career because they were underperforming.

He says: “It may be they tell you they haven’t changed anything, but then you notice they have invested in things that someone following that style would not be expected to invest in.”

Market cycles

Mr McDermott says: “Market cycles tend to run for seven to 10 years and that is how a fund should be evaluated if it is delivering on its investment philosophy.

"However, in practice that is not always the case and we will look at funds that have underperformed for three years or more in a bid to understand why – that in itself does not mean we will sell.

"The most important thing is to see a fund manager stick to their philosophy - the last thing we want to see is a change when things get tough.”

Gary Potter, joint head of multi-manager at BMO Global Asset Management, says that if a client's portfolio is properly diversified then there should always be some funds that are under-perfoming, but other funds that are in favour.

"He says this should allow investors to hold onto under-performing funds for an extended period of time as long as they are properly diversified.

"He says this ability to hold onto an underperformer could be very rewarding when the market cycle changes and the fund begins to perform much better.

Ben Yearsley, investment director at Fairview, says if a fund is underperforming relative to peers, then he expects to have a good line of communication with the manager and a clear explanation as to why the under performance is happening, then he is willing to wait as long as two years for an under-performing fund to turn around.

Ben Willis, head of portfolio management at Chase De Vere, says that while having a properly diversified portfolio has meant owning some value funds over the past decade, he adds that this logic has been “severely tested” in recent years by the sharp underperformance.

He adds: “Rather than setting a precise time limit, we need to analyse the overall portfolio and then make decisions on which funds to jettison.

"This will vary and will be subjective though, in essence, there is usually a very good reason to sell a fund that has underperformed for three years or more.”

Tom Sparke, Investment director at GDIM, says another reason a fund may be underperforming relative to its peers is that it may be taking less risk than other funds within its peer group, and a fund buyer must then decide if they are happy with the lower risk, and believe it is prudent, even if that means a period of underperformance that may last until market sentiment has become more cautious.

He says: “In terms of underperformance, it depends on numerous factors – is the fund taking less risk than peers?  Is the style causing the underperformance? What is the degree of underperformance? Many of the answers these questions may lead us to stay with a fund through weaker periods – it is often the case that a sustained period of outperformance follows a period of poorer growth”

david.thorpe@ft.com