We often remind clients of the importance of not using past returns to predict an investment manager’s future success. Instead, investors should focus on an investment manager’s process; a sound, repeatable investment process should lend some predictability to future fund performance through different market cycles. Additionally, you can’t fully explain a market environment by benchmark returns alone. In no recent time has this been made more evident than in the market volatility of 2020 and its impact on small cap value managers. The performance of the small-cap value benchmark, the Russell 2000® Value, and the median performance of the small-cap value peer group provide a window into how a manager’s performance can be impacted by systematic risks not reflected in fund and benchmark performance.
For 2020, the small-cap value benchmark, the Russell 2000® Value Index returned 4.75%, but the median small-cap value manager returned 3.69%. Why were small-cap value managers so challenged by 2020’s investment environment? We can’t look at benchmark performance in a vacuum; we need to consider the market environment. In 2020, the market environment was defined by the concentration of returns. Of nearly 1,800 positions in the Russell 2000® Value benchmark during the year, the top 20 positive contributors to performance added 4.28%, nearly all of the benchmark return for the year. Over 950 stocks in the benchmark had negative returns for the year.
With returns concentrated in such a small section of the market, not owning the right stocks – or owning the right stocks but in the wrong amounts – had an outsized impact on fund returns. Even investment managers who would normally outperform in high-flying, high beta markets like we’ve seen in the fourth quarter of 2020 saw some degree of underperformance depending on their holdings. Highly concentrated portfolios lost out on single stock risk if they didn’t hold any (or enough) of the top 20 contributors. Highly diversified portfolios lost out as they largely held too little of the top names.
Investors need to understand both the investment manager’s process (and how that is expected to perform through various market cycles) and the market factors underlying benchmark performance to evaluate how well a manager performed. In this example, managers with attributes that we generally like (diversified portfolio, lack of concentration in the top holdings) underperformed precisely because they managed the way we expected them to when we hired them. Focusing on performance alone, and chasing outperformance, would likely lead us to end up with managers that we weren’t comfortable with for the long-term.