In my last article I highlighted the evolution in the way that assets have been managed and the growth in closet indexing in the investment industry.

As I noted, assets managed by the closet index group increased from under 2% in 1980 to more than 30% in 2009. At the end of the study period only about 20% of assets were managed by highly active managers (down from about 60% in 1980).

Clearly, the business preferences (i.e. not getting fired) of the investment industry are partly to blame for this dramatic shift. But, to a certain degree, the industry was also reacting to the realities of the investment decision makers (both individuals and institutions) who employ them. I liken the investors’ actions to a gardener “watering the weeds.”

Read: Failing conventionally or succeeding unconventionally?

Picture our hypothetical gardener who tends to his portfolio of plants on a regular basis. He knows they need water to grow and he supplies them with plenty, reviewing the results regularly. He takes great pride in watching things grow. The more one particular item grows the more he attends to it, encouraging his “winners.”

However, he doesn’t pay much attention to Gardening for Dummies or any other such resource to determine which plants are desirable and which plants are the weeds. He doesn’t recognize that the most prized flowers may take a lot of time to grow and that they need to be protected from the weeds. He also doesn’t recognize that by encouraging the weeds’ growth, they will crowd out all truly desirable plants with their prized characteristics. His lack of patience can even lead him to pull out the “underperforming” plants and in the end. For all his work, his garden is decidedly less appealing than average.

This has been the behaviour of many investors over the years: tending to their investment portfolios with rigorous oversight, setting benchmarks, hiring top performing managers, firing those managers who underperform and continuing to monitor the results. In other words, doing the things expected of good fiduciaries.

However, the actions of investors have not always been as thoughtful as they should be regarding which types of investments they were encouraging, which types they were crowding out or which they were discouraging.

In our personal and work life, we’re often taught to address and, in some instances, even attack a perceived problem or issue, whatever it may be. After all, people who take action are held in high regard. The problem with transferring this mode of operation to the investment world is that it can often lead to chasing performance and a “buy high, sell low” problem.

As I illustrated in a previous column, A tale of two funds, even the best managers can experience prolonged periods of underperformance. In that case, the two best Canadian equity managers over the decade had periods where their three-year performance (a very common longer term measurement period used by investors) lagged the S&P/TSX Composite by 7.3% and 4%, respectively.

Read: A tale of two funds: Assessing performance

To many investors and committees, the fact that top-performing managers can frequently underperform the benchmark and that the magnitude of underperformance can be so large is not well understood. It is also not easy to understand, in advance, just how uncomfortable it can be to maintain an underperforming position in a time of stress.

Often, the easiest action is to remove the “issue” and hire either a manager with less benchmark relative volatility or the latest star performer. The reaction to this phenomenon from many in the investment industry is to lessen the chance of being the firm fired by creating portfolios that should not underperform by much. The flipside is that these aren’t likely to outperform by much either, especially not after management and trading fees are accounted for.

As we have seen, both the investment industry and the investors who employ them share some of the blame for the growth in closet indexing. Understanding the issues at play is important; however, the blame game can only get you so far.

In my next article, I will explore some actions that investors can take to address the issues noted above and further shift the balance in their favour.

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.

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