Absolute versus Relative Performance

Many times when investors review marketing material, especially from the larger investment houses, the focus is on relative performance. Our funds have outperformed their relative benchmarks over a certain time frame, is the common phrase. In fact, the entire institutional, mutual fund, and consultant world is based on this mindset. However, this may be a serious mistake in thinking. If one thinks about investing in any asset class (stocks, bonds, real estate) the main consideration is the allocation of capital to achieve a sufficient rate of return for risk taken. Furthermore, the returns must be evaluated over a sufficient time period five years, not five months. The relative performance trap can lead to short-term think. An excerpt from Seth Klarmans Margin of Safety; Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative performance derby. Who is to blame for this short-term investment focus? Is it the fault of managers who believe clients want good short-term performance regardless of the level of risk or the impossibility of the task? Or is it the fault of clients who, in fact, do switch money managers with some frequency? There is ample blame for both to share. There are no winners in the short-term performance derby. Attempting to outperform the market in the short-run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. The effort only distracts the money manager from finding and acting on sound long-term opportunities. As a result, clients experience mediocre performance. Only brokers benefit from this high level of short-term think. An interesting experiment was conducted by Dresdner Kleinwort Wasserstein to study the obsession with short-term performance. An artificial universe of 100 fund managers was created. Each manager had a true alpha of positive 3% (meaning they had added an additional 3% of return above market returns). After fifty years (o.k. thats a pretty long time horizon) the best managers had a positive 5% alpha, while the worst was still positive 1%. These results seem encouraging. Active managers can indeed outperform the market. But heres the catch. In every year, roughly one in three of the managers underperformed. Perhaps more interesting was the risk of back-to-back years of underperformance. Almost half of the universe experienced a run of three years of three years back-to-back underperformance according to the study. In fact, runs of four or five years were not uncommon. The irony is that of all these managers who added a great deal of value over the years, many would have been fired many times over. One can understand the investors concern regarding the nature of comparative results. We humans are creatures of evaluating our own self worth as relative to those around us. Combine this with our myopic view of the world and we cannot be blamed for this short-term think. But for those few that can overcome this inherent bias, the rewards may be great.