By Michael W. Roberge, CFA, Chief Executive Officer of MFS Investment Management
Please note: this piece is based on the work of MFS Investment Management; a U.S. based sub-advisor of Sun Life Global Investments, and therefore is written from a U.S. perspective.
- At this point in the cycle, investors should consider focusing on risk management and mitigating downside risk in investment markets, a process inherent in active management.
- Active managers have historically performed better in difficult markets and top-quartile active managers have historically had positive returns in down markets (Exhibit 1).
- Even top-quartile active managers routinely underperform. Investors should consider developing a tolerance for underperformance and consider a long-term performance time period to assess skill.
- Identifying the attributes of a skilled active manager may be critical to driving long-term outcomes.
Without a doubt, 2020 will go down as one of the most remarkable years on record, marking the end of the longest-running bull market and all-time-high spikes in volatility. In a few short weeks, the coronavirus pandemic revealed to all what we have been pointing out for some time: that investors have been paying above-average prices for below-average earnings. As the rosy outlook on earnings disintegrated, investors rushed to the sidelines, stocks fell into bear market territory and bond yields declined to levels few expected. Despite economic and earnings uncertainty, the easing of lockdown restrictions and US Federal Reserve actions have catalyzed a second round of risk taking and a rapid market rebound. For investors with a long-term horizon, sticking with a disciplined plan and keeping emotions in check is important.
The importance of alpha
Alpha is the amount of excess returns earned on an investment above the benchmark return. While no one knows with certainty if we have entered a prolonged economic downturn or if economies may bounce back once reopened, three things seem clear to us:
- The low-volatility environment of the past 10 years has likely ended, capital market returns may be low over the next 10 years and finding alpha during difficult markets may become increasingly important for driving long-term results2.
- The opportunity for alpha generation for active managers that invest over a complete market cycle could be powerful.
- Moreover, in a more volatile environment that has investors waiting for the other shoe to drop, we believe that they should consider focusing on risk management and mitigating downside risk. Active management may play a critical role in doing so.
Active managers have delivered in tough markets
Strength in stocks and bonds over the past decade has coincided with a large shift from active management to passive management. For some, the move has suggested a desire to reduce fees; for others, the move has shown that many active managers have trailed their benchmarks. However, looking back at the 20-year period from 2000 to 2019, active managers generally performed better in tough markets1. Put another way, active managers have shown their value during the downside. Given the current environment and likelihood of more bad news, the ability to preserve capital in down markets may be key to driving excess returns over a full market cycle.
Active skill and risk management matters
More to the point, not all active managers are created equal. As Exhibit 1 shows, from 1990 to 2019, top-quartile active managers added value above the S&P 500 Index in all market environments. In rising markets, median managers typically have had trouble keeping up with skilled managers, while top-quartile active managers have both added value in up markets, and in our view, shone in down markets. In poor markets, active risk management has historically shown to be rewarded, a process that is less robust in passive portfolios. For example, active managers select securities rather than "owning the index" and can avoid companies or industries with low-quality, unsustainable earnings. Passive does not allow the same risk assessment. In other words, what you don't own is just as important as what you do.
Exhibit 1: Top-quartile managers outperformed in rising and falling markets from 1999-2019
Source: Analysis using Morningstar data. Excess returns of top quartile (25th percentile) and median (50th percentile) active managers taken from the Morningstar Large Blend Category, 1990 to 2019. Rising and falling markets based on calendar year returns when the S&P 500 Index rose or fell (1990 to 2019). Excess returns, net of all fees (including 12b-1) but excluding sales charges, calculated against the S&P 500 TR Index. Analysis covers all share classes and excludes index funds. The falling markets are 1990, 2000, 2001, 2002, 2008 and 2018. Past performance is no guarantee of future results.
At MFS, rather than chasing short-term gains, we actively manage risk when the markets are inefficient and seek to add value by managing volatility and navigating changing market cycles more effectively. Because if you can lose less value in a down market, you can begin to grow it from that higher capital base. That is how you compound long-term returns and how we believe investors should consider thinking about risk.
Short-termism: Why have average investors underperformed?
It is a fact that even skilled active managers underperform at times. This can be challenging for investors. Mutual fund flows have shown that many investors chase performance, investing near market peaks only to bail out close to market bottoms3. As a result, the average investor has underperformed.4
We think that a misalignment of time horizons is one of the reasons why. Most skilled active managers look to generate consistent alpha over a full market cycle, which typically takes 7 to 10 years.5 However, the industry has anchored around three- and five-year performance time periods to assess skill. In reality, a 3-year time period is less than half of the historical time period of a full market cycle. While a majority of investors know this, few seemingly may tolerate negative alpha on a 3-year basis.6 Yet when discussing objectives, not many — financial professionals or asset managers — discuss the metrics to measure skill and the time frame of a "full" market cycle. To us, however, it does make sense to discuss the use of longer-term-performance time periods when assessing skill. The average asset-weighted holding period for a US equity manager is only 2.8 years. While this does align with a 1- to 3-year performance period, it does not align with investors' long-term goals. MFS' average asset-weighted holding period for US-registered funds is more than double the industry average and more closely aligned with investor goals. We have high confidence in our long-term performance, where fundamentals typically prevail. Market sentiment, rather than fundamentals, is more likely to drive what our performance may look like over the next quarter or year. Investors may be better served by developing a tolerance for underperformance — what we call countercyclical courage — that may potentially lead to more value creation and a potential better outcome over time. When markets sell off, good active managers often use weakness as a rationale for buying when they have conviction in a company and the patience to ignore market noise and wait for a potential rebound. The recent downturn is a prime example and demonstrates what separates above-average active managers from median managers. MFS investment teams understand their companies, their operations and their best- and worst-case scenarios. During a downturn, our teams can quickly assess what has changed and what companies are attractive long-term buying opportunities. To take advantage of a decline, your analysis — especially scenario modeling — needs to be in place. If you wait until volatility occurs to analyze companies, you will be too late.
Identifying skilled active managers
We believe that skilled active managers — those who demonstrate conviction through high active share and long holding periods, manage risk thoughtfully and bring together different perspectives — can add value in all market environments. MFS has always adhered to this philosophy and a single purpose: to create value by allocating capital responsibly for investors. Our focus on the long term has been part of our history for nearly a century. And as we think about sustainability, we actually believe it is synonymous with long-term investing. So rather than approach sustainable investing as a separate practice, MFS has integrated material Environmental Social Governance (ESG) factors into our research process; it is part of how we analyze investments from many angles. As an active manager, we believe this drives long-term returns and is a critical part of being good stewards of capital and investing responsibly. Allocating capital responsibly also relies on a differentiated investment process and culture. At MFS, our process and culture are built on three distinct pillars: collective expertise, active risk management and long-term discipline.
We believe that teams of diverse thinkers, contributing different perspectives and actively debating them within a shared value system are more likely to understand and incorporate all financially material factors, enabling better investment outcomes. The goal of our investment teams is to uncover sustainable opportunities or identify pitfalls that other managers may have missed. Our investors engage directly with the companies we own to understand what could impact the sustainable value of those companies, and they use our voting power to influence issues that matter.
Active risk management
Our risk aware culture leads us to try to understand which risks — whether fundamental, secular, macroeconomic or ESG — are material to a company's long-term sustainability (rather than just noise) and how those risks may evolve over time. It is about thinking through the risks that you see and trying to anticipate the risks you do not see — e.g., the coronavirus. We believe the pandemic may have long-lasting impacts on governments, consumers, companies and industries. Active risk management is essential in accurately assessing risks in this uncertain environment, as well as avoiding entities that may stumble or fail. And we cannot stress enough that owning the index — passive — does not allow for the same risk assessment. Risk management is also about understanding how those risks we anticipate compare with the risks our investors are taking. In other words, we leverage our risk capabilities to fully understand the risks inherent in investors' portfolios, because we recognize that, for our investors, how you get there is just as important as getting there. That is why we closely monitor capacity management and close strategies to help protect the interests of investors and the management of the long-term performance of their assets.
MFS believes in long-term thinking for two reasons. First, we think that it leads to better investment outcomes for our investors. Therefore, we focus on factors that create a sustainable enterprise capable of driving long-term returns. Factors like unit growth, pricing power, sustainable competitive advantages, free cash flow, debt levels, financial materiality and management strength, to name a few. Second, is time horizon. By holding stocks for longer, we take advantage of the greater return dispersion between the best- and worst-performing stocks and the potential to improve returns for investors. The strength of our research, garnered through collective expertise, gives us the conviction and patience to let investment ideas play out over time. Compensation for investment teams reflects this: we reward our teams for long-term performance, not for chasing short-term gains.
In our view, skilled active management is a critical component of any investment portfolio and especially relevant in the current environment. As active managers, we strive to identify companies that can sustain a competitive advantage over the long term. For us, active management is our culture, our DNA and how we create long-term value for our investors responsibly. At a time when the industry is facing great pressure and consolidation, our focus is on allocating capital responsibly over the long-term for the end investor. Period. We operate from a position of strength — our process, our people and our clarity of purpose — to seek the best investment ideas for the benefit of our investors. For nearly a century, we have aligned our active investment approach with the way we serve investors: bring together different perspectives, have conviction in our investment ideas and thoughtfully manage risk, all with the goal of delivering long-term, sustainable outcomes for investors.
MFS or MFS Investment Management refers to MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc. This article was first published in the United States by MFS. in September 2020 and is distributed in Canada by SLGI Asset Management Inc., with permission. This document is provided for information purposes only and is not intended to provide specific financial, tax, insurance, investment, legal or accounting advice and should not be relied upon in that regard and does not constitute a specific offer to buy and/or sell securities.
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The views expressed in this commentary are those of the authors and are subject to change at any time. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any mutual funds managed by SLGI Asset Management Inc. or sub-advised by MFS. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. Information presented has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made with respect to its timeliness or accuracy. This document may contain forward-looking statements about the economy and/or markets; their future performance, strategies or prospects. Forward-looking statements are not guarantees of future performance, are speculative in nature and cannot be relied upon. They involve inherent risks and uncertainties so it is possible that predictions, forecasts, and projections will not be achieved. A number of important factors could cause actual events or results to differ materially from those expressed or implied this document. The views expressed in this commentary are those of the authors and are subject to change at any time.
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Ratings and/or ranking information is subject to change monthly.
Morningstar Rating: The Morningstar RatingTM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.
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Morningstar Quartile Ranking: The quartiles divide the data into four equal regions. Expressed in terms of rank (1, 2, 3 or 4), the quartile measure shows how well a fund has performed compared to all other funds in its peer group. Peer groups are defined such that mutual funds are ranked only versus other mutual funds that are in the same category and segregated funds are ranked compared to other segregated funds in the same category. The top 25% of funds (or quarter) are in the first quartile, the next 25% of funds are in the second, and the next group is in the third quartile. The 25% of funds with the poorest performance are in the fourth quartile. The point at which half the funds had better performance and half had worse performance is the median.
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1 Source: Strategas Research Partners, December 2019. Analysis is based on US-based large-cap mutual funds from the Morningstar Large Blend Category, examining each calendar year (2000 to 2019) and identifying the percentage of managers that outperformed the S&P 500 TR Index during each year.
2 Annualized return over the next 10 years. MFS Long-Term Capital Market Expectations, January 2020.
3 Data sources: Strategic Insight Simfund/TD; SPAR, FactSet Research Systems Inc.
4 Source: Dalbar, 2020 QAIB Report, as of December 31, 2019. The Average Investor refers to the universe of all mutual fund investors whose actions and financial results are restated to represent a single investor. This approach allows the entire universe of mutual funds investors to be used as the statistical sample, ensuring ultimate reliability.
5 Source: "Defining a Market Cycle," Manning & Napier.
6 Source: 2018 MFS Active Management Sentiment Study (including 540 global institutional investors). (Q) How long are you willing to tolerate the underperformance of active asset managers before initiating the search for a replacement manager?