Patience with Active Performance Cyclicality: It’s Harder Than You Think

Abstract

Patience in investing is the capacity to endure periods of underperformance in hopes of achieving an investment objective. For many investors, outperforming the broad market through traditional active management or factor-based investing is a key goal—and one that requires significant patience to achieve. In this article, the authors quantify the wide range of frequencies, durations, and magnitudes of underperformance that both equity factor tilts and outperforming traditional active managers experience. Their findings show that almost all outperforming traditional active equity managers and equity factors have frequent periods of underperformance relative to the equity market, some of which are long in duration and large in magnitude. Investors can expect to experience a drawdown of between 40% and 60% for all one-year evaluation periods. Additionally, an outperforming manager can expect to experience a continuous drawdown lasting 2 years or more every 10 years and a drawdown of at least 20% over time.

TOPICS: Factor-based models, security analysis and valuation, performance measurement

Key Findings

• ▪ The authors found that close to 100% of outperforming funds have experienced a drawdown relative to their style and median peer benchmarks over one-, three-, and five-year evaluation periods.

• ▪ Eight out of 10 outperforming funds had at least one five-year period when they were in the bottom quartile relative to their peers. This is especially important to understand given an industry survey that found that 89% of senior executives with asset allocation responsibilities would not tolerate underperformance for more than two years before seeking a replacement (State Street Global Advisors 2016).

• ▪ More than half of outperforming active equity funds have underperformed their style and median peer benchmark by at least 20%—and three-quarters of funds that recovered from their largest drawdown took more than three years to do so.