Three key ingredients to improve your odds of outperformance

01 October 2019 | Investment principles

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Is there a special recipe equity investors can follow to outperform the returns from the broader market?

Based on the latest performance scorecard of Australian active investment managers released in September by S&P Dow Jones Indices, if that recipe does exist, most professional portfolio managers don't have it.

The SPIVA Australia Scorecard covering the year to 30 June, 2019 shows that, on an absolute return basis, out of around 850 Australian active equity funds, only a small percentage outperformed the indices they use to benchmark their performance.

While it's probably cold comfort for most investors, the Australian results were not isolated. In fact, they were just a microcosm of similar underperformance trends recorded by active portfolio managers around the world.

Heightened global market volatility, fuelled by rising geopolitical tensions and weaker economic and business conditions, made last year particularly difficult for many active managers.

But what about the active fund managers who did outperform in the face of adversity? Were they doing something different to the majority by following a special recipe?

To answer that, one would need to look at the specific portfolios and strategies of each manager. However, what's more important to recognise is that, while it's interesting to measure short-term investment performances, active management is a long-term process.

An investment manager who outperforms over one year can just as easily underperform over the next, depending on a whole raft of factors.

Yet, there are three key ingredients investors should add to their investment recipe to improve the probability of achieving outperformance from actively managed funds over the longer term.

Ingredient 1: Identify top talent

Finding the best investment managers is critical to enhance one's prospects of better returns, but where should one start in the context that past performance should never be used to gauge future returns?

Here at Vanguard, we believe a firm and its people must demonstrate a culture of investment excellence, strong experience and stewardship, have a clear philosophy and sound processes that can be executed well and consistently over time.

It's also important that an active fund's historical portfolio holdings and characteristics align with the manager's overriding philosophy and processes, and that the drivers of past performance are logical and sustainable over the long term.

Ingredient 2: Keep costs low

The biggest quantitative ingredient that investors can control and use to improve the likelihood of outperformance is costs.

In effect, every dollar spent on investment-related costs including management fees is a dollar less in net return. So, it stands to reason that a lower-cost active manager will deliver better relative performance against a like competitor manager charging higher fees.

Of course, that's not the complete story on costs. On an active management level, costs by themselves do not lead to consistently identifying active funds that will outperform.

Instead, low costs need to be identified and blended with investment talent to give one the best chance of achieving success through managed funds.

Ingredient 3: Patience is key

As noted above, challenging market conditions can have a harmful impact on the performance of investment managers, irrespective of their past track record.

In fact, even the top-performing investment managers over longer periods are likely to underperform their benchmark at some stage due to unforeseen events.

While low costs and a rigorous, considered manager selection process can go a long way to improve your results using active management, those benefits can be eroded significantly if one fails to maintain a long-term perspective.

This is because there is inconsistency inherent in achieving excess returns. Returns will invariably differ from year to year.

Understanding this inconsistency is critical for those who may be tempted to use short-term past performance as a primary basis for entering and exiting active funds.

Conclusion

Successful active management needs to be driven by a combination of top talent, low costs, and patience.

While outperforming the broader market is the ongoing objective for all active fund managers, achieving outperformance consistently is full of challenges.

Vanguard has close to $2 trillion in active assets under management globally and, spanning back to our beginnings in 1975, our extensive research confirms that active funds that have shown better performance returns over time are those run by experienced and talented managers, have low cost structures, and take a patient rather than reactive investment approach.

Depending on one's investment strategy and risk tolerance, actively managed funds remain a good complement and diversifier to other types of products such as index-tracking managed funds and exchange-traded funds.

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Tony Kaye

Tony Kaye
Personal Finance Writer
Vanguard Australia