You get 1st quartile, you get 1st quartile, everybody gets 1st quartile!

By Jason Swartz – Investment Strategist at SATRIX

Some might remember the day Oprah Winfrey gave every member of her audience a free car in 2004. “You get a car, you get a car, everybody gets a car!”

Sadly, not everybody gets to win something, even though we think we will. So too in the case of investment performance: not everybody gets first quartile performance. By construction, only a quarter of investors can achieve this. The rest will have to be satisfied with either second quartile performance or underperforming their peer groups. This is an unfortunate statistical fact.

To be fair, first quartile performance may not be the objective of all investors. Importantly, we have to consider the retirement fund member and his/her financial journey, and devise solutions to increase the probability of meeting their specific retirement goals.

Nevertheless, strictly deploying active managers to achieve retirement goals is exceptionally challenging. Here’s why.

Active fund managers do not perform consistently

History that proven that it is highly unlikely that the same group of active managers will persistently deliver first quartile performance consistently into the future. While excellent managers do exist, the difficult question is: ‘Will it be the same group next year? Or in five years’ time?’

Our research has shown us that over one-year periods, the percentage of first-quartile managers who remain first quartile in the next period is only one in three (based on history).

Table 1: Inter-quartile movement of equity funds in subsequent year since 1990

Source: Morningstar, ASISA, Satrix calculations (2016)

To confirm our findings further, we discovered that consecutive yearly rankings of fund performance were also poorly correlated.

Graph 1: Correlation between quartile ranks of equity funds each year

Source: Morningstar, ASISA, Satrix calculations (2016)

Over longer periods (five-year non-overlapping periods), this average correlation drops to around zero. This implies that no relationship exists between prior and future performance of active equity managers. In our view, this evidence points to a strong case that active managers’ performance rankings are not consistent, making choosing the best performing managers exceptionally challenging.

Investors do not have the ability to consistently select top performing managers

It is also interesting to note that a large proportion (40% based on history) of next year’s winners are in fact underperforming (quartile three and quartile four) this year. By implication, if you constructed a perpetual first quartile group of funds (in other words, with absolute perfect foresight), you would have to have employed a largely contrarian strategy of selecting underperforming funds. In reality, no judicious investor would feel comfortable betting on losing managers becoming winning managers. We all love winners.

A far better approach is to temper the expectations of investors in so far as the fact that choosing persistent winning managers is no easy task. Our proposal would be to combine the skilful manager(s) of choice with that of a passive solution to improve investment performance consistency. Typically, the types of managers that blend well with passive solutions are those who demonstrate strong capabilities to deliver pure alpha (returns in excess of the market and commonly accepted risk factors).

Both disciplines (active and passive investing) have shown, that in combination, the blend can greatly assist reaching investment objectives with enhanced predictability and reliability. Relative to active managers, passive vehicles will offer a fee advantage where the lower cost associated with a blend of active and passive funds would come with no performance compromise. In addition, this combination offers diversification across individual stocks, sectors and styles.

Ultimately, the most important aspect of a well-balanced investment portfolio is defining a set strategy and sticking with it, regardless of whether that strategy is an active one or a passive one. Those institutional investors who make the poorest decisions tend to be those with no strategy at all. Investors who blindly make choices without a clear path for arriving at those choices will almost always lose the battle.