In her latest blog post Tina Beltrone, our senior investment analyst, rightly notes the following: “Active and passive strategies unquestionably offer both advantages and disadvantages. If active management is selected, choose managers that offer lower-cost funds. The funds should have well-conceived philosophies with reliable and repeatable investment processes backed by a tenured team of portfolio managers and analysts who have the tools in place to yield strong performance in the long run.” The importance of Tina’s statement sets the core of our investment philosophy – that qualitative assessment of managers plays a critical role in guiding our judgment.
One particular reason why we rely on our judgment is that using recent performance and benchmarks alone to understand a manager’s performance can lead to the wrong conclusions. In 2014, we made the recommendation of a Core Plus bond manager to replace PIMCO’s Total Return Bond Fund. Unfortunately, our newly recommended manager did not perform well immediately following our suggestion to switch to the fund. This manager was early in their increasing exposure to energy related bonds and emerging markets bonds, in particular local currency bonds. This shift in positions was not made on a whim, but made after considerable amount of analysis. The poor timing of a major shift in the portfolio led to an underperformance relative to the Barclays Aggregate Index of nearly 5.0% in 2015.
This drives home the importance of knowing your manager from a qualitative perspective. This amount of underperformance on a purely numerical review may lead some investors to redeem their money. However, our judgment told us to stay the course. As Tina said, “well-conceived philosophies with reliable and repeatable investment processes” provides us comfort in sticking with managers who have short term periods of underperformance. And, we also know that solely relying on relative performance to benchmarks can lead to wrong conclusions.
This fund is a Core Plus bond fund, which means the fund will tend to exhibit greater variability of returns than the benchmark. This higher volatility comes from overweight bets in riskier securities such as high yield and emerging markets debt. However, we also know security selection in these types of instruments may generate excess returns as they tend to be less researched and thus less competitive to find undervalued securities than in, for example, U.S. Treasuries or investment grade corporate bonds.
Our quantitative tools confirmed our thoughts. Utilizing rolling regression statistics to separate returns from the market (or index), security selection, and timing, this quantitative review showed that their issue largely came from poor timing of increasing wagers on high yield and emerging markets bonds. Security selection remained strong. In fact, despite this short period of substantial underperformance, their five year security selection has provided excess returns to the benchmark and total excess returns of more than 1.5%.
Active funds will go through periods of sustained underperformance to passive investments. During times when active management is attacked, it’s important to keep focused on the long-term thesis behind investing in active funds.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.