Based solely on the amount invested by institutions in Canadian equity mandates, it would appear that most Canadian institutional investors still prefer active management to passive benchmark replication in this particular asset class.

There are two fundamental reasons why it can make sense to hire an active manager. They are as follows:

  1. As an investor, you believe the active manager will be able to provide higher returns than the passive benchmark index on an after-fee basis; or
  2. You believe that your active manager will be able to manage the inherit risk of investing more appropriately than the passive alternative.

Fortunately, in the highly concentrated and highly cyclical Canadian equity market, many managers have been able to deliver on #1 above by also delivering on #2 (the S&P/TSX Composite’s performance falls in the third quartile over the 10-year period). The managers who have outperformed have done so by avoiding (to a varying degree) the big ‘blow ups’ of the last decade plus (i.e., Nortel) and often by being more diversified by sector (i.e., having less than 75% to 80% of the portfolio in the three sectors that dominate the Canadian equity market—financials, energy and materials).

Many equity investors around the world refer to the last 10 years as a ‘lost decade’ for equities. However, it certainly was not a lost decade for investors in the two top-performing ‘traditional’ long-only Canadian equity institutional pooled funds. These achieved identical annualized 10-year returns of 10.4%—beating the benchmark index (S&P/TSX Composite Total Return) return of 7.2% by 3.2% (all data to March 31, 2012).

Unfortunately, the actions of many investors who employ these (and other) active managers can make it difficult for investors to actually achieve the outperformance they desire. By definition, a long-only manager can only outperform a benchmark if they have a portfolio that looks different from the benchmark from time to time. Given this, I thought I would examine the characteristics and track records of the two funds noted above, to see how their performance was achieved and if there were any common themes investors may learn from.

To begin, even though both funds achieved the same 10.4% annualized rate of return over 10 years, the funds are actually managed quite differently, as follows:

  • Fund 1 employs bottom-up fundamental research, has a strong ‘absolute value’ style bias and had a lower standard deviation of returns than the index (94% of the volatility).
  • Fund 2 uses a mix of bottom-up and top-down quantitative portfolio management techniques, employs a highly growth-oriented style and had a much higher standard deviation of returns than the benchmark (136% of the volatility).

However, there were also some similarities: both funds are ‘all-cap’ (one more so than the other), both have taken very active positions against the benchmark, both have relatively concentrated portfolios (again one more so than the other), and both have had relative performance that has looked quite miserable from time to time.

Another interesting similarity is that, on a year-by-year basis, the manager either looked really smart by ranking in the first quartile, or the opposite by ranking in the fourth—there was no middle ground. Even the best managers cannot always be expected to outperform year in and year out.

# of 4th Quartile Rankings # of 3rd Quartile Rankings # of 2nd Quartile Rankings # of 1st Quartile Rankings
Fund 1 2 0 0 8
Fund 2 3 0 0 7

Through the use of active management, many institutions strive to achieve the same kind of long-term outperformance delivered by these two funds. However, in reality, I’m sure many of the institutions that employed either of these two managers at the start of the 10-year period would not have benefited from the 10.4% holding period return because, at some point or the other, many institutions would have fired either one of these managers.

By way of example, I ran a year-by-year comparison of each of these two fund’s performances versus the S&P/TSX Composite. In the case of Fund 1, there was a one-year time period (April 1 to March 31) where the fund underperformed the index by 15.4%. In the case of Fund 2, it underperformed over a one-year basis by 12.3%. This level of underperformance, even on a one-year basis, can be tough for many committee members and/or institutions to stomach.

Moving to a three-year annualized return horizon, there was a point over the last 10 years where Fund 1 underperformed the benchmark by a whopping -7.3% annualized. As well, Fund 2 underperformed the benchmark by -4.0% on a three-year annualized basis.

Worst Relative 1 Year Return Worst Relative 3 Year Annualized Best Relative 1 Year Return Best Relative 3 Year Annualized
Fund 1 -15.4% -7.3% +11.9 +7.9%
Fund 2 -12.3% -4.0% +34.1 +19.3%

It is often the case that committees and other decision makers will give a manager, at most, three years of underperformance before a review (or firing) is triggered. Thus, although it is widely accepted that a manager must look different than the benchmark to outperform the benchmark, with the above two managers underperforming by over 700 basis points and 400 basis points, respectively, on a three-year annualized basis, there are few committees that would not have felt compelled to act—based on their emotions, lack of understanding of the manager’s strategy, changes in the make-up of committee members, feeling compelled to address the ‘obvious problem’ or simply a collective lack of patience.

As well, human nature often makes it difficult to truly act as a long-term investor when faced quarter after quarter with performance reports showing a manager who is underperforming to such a large degree. Though not often quoted for his investment insights, the boxer Mike Tyson summed up the feeling aptly when he noted that, “Everybody has a plan, until they get punched in the face.”

This tendency has been noted by Amit Goyal and Sunil Waha in their widely cited study of U.S. institutional investors’ hiring and firing decisions, entitled The Selection and Termination of Investment Management Firms by Plan Sponsors (The Journal of Finance 2008), and summarized in the chart below:

Performance around hiring and firing decisions (%)

Source: Goyal and Wahler, James Montier and CFA Institute

The average institution can fall into the trap of firing a manager after a period of poor performance, often replacing them with a manager who has outperformed strongly over the past one to three years—only to see the new manager achieve similar performance as the fired manager over the ensuing one to two years and worse performance over the ensuing three years. This research illustrated that many entities fall into the classic “buy high and sell low” investment trap, which is certain to lead to underperformance over the long term.

As a final note, after reviewing the year-by-year performance track record for the two funds (which, as I noted earlier, are managed quite differently), I wondered what would have happened if you had held both funds and employed a very simple rebalancing scheme of a 50/50 holding in each fund once a year, on a set date. If you had done so, you would have turned an already excellent 10.4% annualized rate of return into an 11.1% rate of return. This result helps demonstrate the value of a systematic rebalancing program which I explored several articles ago. It also demonstrates that even in a highly homogenous market such as Canada, diversification by manager style can add value from a return enhancement and/or risk reduction basis, if two truly different active managers are employed.

Ryan Kuruliak is a Toronto-based vice-president with Proteus, an investment and governance specialty firm. He has more than 14 years experience in the pension and investment consulting industry.

These are the views of the author and not necessarily those of Benefits Canada.

Copyright © 2019 Transcontinental Media G.P. Originally published on

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