Investors have a tougher job today than ever before. They're taking more risk than in decades past in order to achieve similar returns. And they're doing so against a backdrop of geopolitical and market uncertainty — things they cannot control, but still must take into consideration. Understandably, that sense of uncertainty, coupled with the need to take more risk, is driving investors to focus on what is tangible and easy to measure — in an effort to gain some sense of control. We see investors spending a lot of time anchored to short-term past performance — three year returns dominate decision-making for example — as well as tracking traditional, price-momentum benchmarks that point more to changes in prices than true, long-term value. But these metrics don't matter as much to investment outcomes.
So it's time to have a disruptive conversation. We want to help investors get back to spending time on what they know has always counted more — people, process and philosophy, but also a healthy dose of honesty around time horizons.
However, in a world that has become so short-term focused, that is a significant hurdle. Lack of clarity around time horizons appears to be a growing convention, and it's tough to break with popular sentiment, especially at a time of greater angst. Markets are more complex and finding returns is more challenging. But here is an important truth. Looking at what is easy to measure (e.g. endless data comparisons) only creates the illusion of control, and feeds into ambiguity aversion — a known behavioral bias that kicks in because we don't like uncertainty.1
Also, short-term micro-measurement doesn't help forecast the future, generate returns or meet investors' long-term goals. Rather, it causes pro-cyclical (herding) behavior among investors, which, as noted by the International Monetary Fund in a paper on countercyclical investing, takes them away from their inherent "edge as long-horizon investors." 2
While investors do spend considerable time evaluating the harder to measure key attributes of investment managers during their search process, they tend to brush those metrics aside in post-hiring evaluations, especially in times of short-term underperformance. It may be common practice to revert back to performance measurement, but there is a danger in relying too heavily on what doesn't persist.
As you can see in the exhibits below, even the top-performing managers don't stay on that pedestal from period to period. For example, of the managers who performed in the top quartile from October 1990 to September 1995, only 25% remained in the top quartile in the subsequent period from October 1995 to September 2000, while the rest dropped down to lower quartiles. On the other hand, looking at the second exhibit, which shows what happened to bottom quartile managers over the same time periods, 27% of these managers went from the lowest performance ranking to the top performance ranking in the subsequent period.
Source: eVestment Alliance. Data Analysis: MFS Investment Management.
The universe includes 456 strategies in the eVestment Database with a Universe included in All US Equity and an inception date on or before 09/30/1990. Rankings include both surviving investments and those liquidated and/or merged prior to the end of the full calculation period (10/1/1990-09/30/2015). Each quartile represents 25% of the universe (i.e. top 25% down to bottom 25%). Performance is utilized for periods where it is available. Performance is calculated gross of fees. The entire universe of funds is analyzed during each five year period. Analysis tracked movement of top quartile of universe from period to period, and used the historical 25-year period ended 9/30/2015, to illustrate full market cycles.
Source: eVestment Alliance. Data Analysis: MFS Investment Management
The universe includes 456 strategies in the eVestment Database with a Universe included in All US Equity and an inception date on or before 09/30/1990. Rankings include both surviving investments and those liquidated and/or merged prior to the end of the full calculation period (10/1/1990-09/30/2015). Each quartile represents 25% of the universe (i.e. top 25% down to bottom 25%). Performance is utilized for periods where it is available. Performance is calculated gross of fees. The entire universe of funds is analyzed during each five year period. Analysis tracked movement of top quartile of universe from period to period and used the historical 25-year period ended 9/30/2015, to illustrate full market cycles.
An investment manager's people, process and philosophy — which reflect the strength of its collective intelligence, culture and the management of its talent and business, tend to be far more persistent. Why does that matter so much to investors? Because these qualities may reflect a manager's ability to go against the grain when necessary, applying its insight toward finding opportunities other managers may be missing and potentially recognizing risks that others may not. In short, investors want to see signs of a manager's power to be countercyclical.
The harder-to-measure manager attributes are also highly relevant to the environmental, social and governance (ESG) conversation. We believe ESG is often misconstrued as more of a social/responsible investment decision. That has driven some investment managers to respond with a relevant product set. In reality, ESG is much more about trying to invest in good businesses rather than bad — finding those with true long-term value by understanding what factors (e.g. good management, effective capital allocation and superior products and services) are material to a company's sustainability and competitive advantage. Integrating those considerations into the investment process — whether you're an investment manager selecting securities or an asset owner selecting an investment manager — could reduce risk and potentially improve returns over time. But it takes patience and robust research to understand what is material over the long term.
Passive management typically does not integrate ESG factors, and yet we believe these considerations are more important than ever to "getting it right" for the investors we serve. But getting it right depends as much on the investor as it does on the investment manager. Investors' time tolerance has to align with how their investment managers make decisions within their portfolios, or the resulting misalignment could damage both expectations and outcomes. For example, portfolio turnover is an important consideration in aligning investor horizons and manager decision making. When investors see an active manager with low portfolio turnover (i.e. a longer-term focus), they can better understand why that manager would need a full market cycle to generate alpha.
The work we do as an industry to improve the misalignment between investor time horizons and investment manager decision making is really about improving trust. Because ultimately investors need to trust a manager's skill long enough to allow it to work.
1 Risk, Ambiguity and the Savage Axioms, Daniel Ellsberg, The Quarterly Journal of Economics , Vol. 75, No. 4 (November 1961)
2 "Institutionalizing Countercyclical Investment: A Framework for Long-term Asset Owners," Bradley A Jones, International Monetary Fund, February 2016
The views expressed in this post are those of MFS, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any other MFS product. 37041.1
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