Executive Summary
Unless you manage to purchase an index fund that produces zero tracking error, at some point the investments you own will deviate from their associated benchmark. Whether it's the tracking error of an index fund, or the relative under- or out-performance of an active fund manager, returns can vary over time. And while most of us don't fret over small deviations from a benchmark - nor do we mind when the deviation is due to outperformance! - but at some point, a fund may underperform its relevant benchmark by enough, and for a long enough period of time, that you have to question whether it's time for a change. But the caveat is... what IS a big enough underperformance deviation, and how long must it persist, before you actually do decide to make a change? What is the best practice for deciding when a fund has lost its Mojo?
The inspiration for today's blog post comes from a lunch meeting I had with Knut Rostad and several other members of the Committee for the Fiduciary Standard. During the meeting, the question arose about why so many employer retirement plans have "bad" investment options, since the plan trustees are typically fiduciaries who may be held liable for the bad investment choices they provide in the plan. Yet in reality, poor investment choices persist. Some thought the issue was that the trustees weren't actually fully aware of their own fiduciary responsibility (and liability), and therefore didn't take it upon themselves to do the proper due diligence, not realizing the obligation that they had. But I had another take: maybe the primary problem with "bad" investment offerings in employer retirement plans is simply that we can't actually agree on what "bad" actually MEANS.
Of course, the problem is not unique to employer retirement plans. It's an issue every investor must face. Yet we seem to have surprisingly little consensus about what best practices actually are on this particular issue. Certainly, investments themselves will go up and down. If the fund is invested in equities, and there is a bear market, it's probably going to go down. We don't necessarily get rid of the fund for that reason alone. Instead, the issue is about relative underperformance to a chosen benchmark.
But what does it take? Do you remove a fund from a 401(k) offering - or your client's investment portfolio - after it underperforms by 100 basis points? 300 bps? 500 bps? 1000 bps? Is that annual underperformance, or cumulative? Does it have to underperform for 3 months? 6 months? 12 months? 3 years? More? And what benchmark should you use to measure? If the fund is large cap stocks, maybe it's easy to measure it against a large cap index like the S&P 500. But does it have a growth or value tilt? Should it be measured against a more growth- or value-specific index? What if the fund has shifted from growth to value? Do you measure it against the value index it lines up with now, or the growth index it matched against before? What if the investment manager just buys whatever companies are most appealing, such that this year it's a large-cap fund but last year it was in small-cap? How do you decide if a manager is doing a good or bad job when you're not even certain what the benchmark should be in the first place?
Accordingly, if there's no agreement on what best practices are for determining when a fund is actually "bad" then how can you hold a fiduciary responsible? Against what standard will you judge their behavior to determine if their actions were negligent or a breach of fiduciary duty? How will you determine damages to the people affected?
I suppose we can all come up with some particular example that is outlandishly extreme and "clearly" bad, but in the radical overwhelming majority of situations, the case is not so clear-cut. What is a bad, underperforming fund to one advisor is simply a brilliant manager "whose strategy is currently out of favor" to another. What for some advisors is an untenable period of underperformance is for other advisors just reasonable prudence in giving the manager a chance to demonstrate the value of his/her strategy.
So what do you think? Where should we draw the line? Where do YOU draw the line? How do we hold fiduciaries accountable for offering "bad" investment offers in an employer retirement plan (or fiduciary advisors recommending "bad" investment choices) when we can't agree on what the standard should be? Is the murkiness around being unable to judge what is marginally bad fund or not the reason why so many apparently mediocre funds end out in employer retirement plans, with little actual liability for the plan fiduciaries?
Michael, I think you touch on a very interesting point in this post. Any actively managed fund will have periods of underperformance – that’s the price you have to be willing to accept if you want a shot at beating the index.
Given the fact that, as we all know, there is very poor correlation between past performance and future performance or an actively managed mutual fund, we need to evaluate our decision to keep a fund based on more than its recent performance.
In a well designed portfolio, each piece should have a purpose. The style factors taht you mentioned (growth/value, market cap, how valuations are made etc.) should have been part of the reason for purchasing the fund. Therefore, if the underperformance is associated with a shift in that style (or even if the style shifted and the fund is still performing well), consider dumping it. It is no longer playing the role in your portfolio for which you bought it. However, even if the fund is underperforming, if you still believe in the underlying mandate, consider holding it, unless all the other funds with those same style characteristics are soaring.
P.S.: Other factors that may have influenced the performance should be considered – i.e. changes in key personnel, ownership/management structure, etc.
Another major concern. Nearly 100% of the time advisors are evaluating funds on their individual merit. Possibly the most significant thing to come out of Modern Portfolio Theory that everyone can agree to is that the characteristics of the portfolio as a whole is not merely the sum of its parts. The best individual funds don’t mean the best portfolio. The decision to keep a fund should start with a top down portfolio approach. Not bottom up. IMO. This makes things like Style Drift extremely problematic when creating an efficient portfolio.