Leave it to the team at Morningstar to throw another potential wrench into the way FAs and investors evaluate mutual funds, a wrench that raises complicated questions specifically around active management. Fundsters at actively managed mutual fund shops should consider learning (and perhaps loving?) two new acronyms: LUP (longest underperformance period in a given time period) and LOP (longest outperformance period).

Paul Kaplan, director of research at M* Canada, and Maciej Kowara, senior manager analyst at M*, authored the 20-page "How Long Can a Good Fund Underperform Its Benchmark?" report that introduces LUP and LOP and digs into them a bit, both through historical performance data and through simulations. M* veteran John Rekenthaler offers an article-length take on Kaplan and Kowara's ideas and findings.

The upshot of M*'s findings about LUP and LOP seems to be two-fold, even double-edged, for active asset managers. On the good news side, even funds that outperform over the long-term tend to have long periods of underperformance, too, meaning FAs and investors should cut them some slack when the going gets rough. On the bad news side, funds that underperform over the long-term tend to have long periods of outperformance, too, meaning that FAs and investors may pick long-term lemons that look like long-term gems. To tell the difference may take a lot more time than investors are likely to have.

"On the bright side, Paul [Kaplan] and Maciej [Kowara] did conclude that over a 100-year simulation, one could generally tell the difference between their managers who were programmed to be strong, and those who were programmed to be weak," Rekenthaler concludes. "I will leave the task to you, dear reader, to determine the disadvantages of investing with a 100-year time horizon. I believe that there are some."

For their historical research, the M* folks drew on gross performance data (i.e. fees stripped out) on 5,500 equity funds from the U.S., Canada, Europe, and Asia (not including Japan) from January 2003 through December 2017. They found that funds that outperformed for the full 15 year period still ended up underperforming for nine to 12 years in a row (on average) within that same time period. On the flip side, funds that underperformed for the full 15 year period still managed to outperform for 11 to 12 years in a row within that same time period.

"Hence, on average, investors who were hoping to hold outperforming funds over this 15-year period not only needed to pick the right funds but have the patience to endure periods of underperformance of nine to 11 years at some point within that period!" Kaplan and Kowara write, while also adding that "it would be a mistake to judge a fund's ability to outperform its benchmark on a track record as long as 11 years."

The researchers do caution that outperforming funds going through an LUP tend to underperform by small amounts (thus making outperformance over the long-term possible). So perhaps FAs and investors will use this research as justification to forgive funds that underperform by small amounts but not for ones that fall far behind for long periods of time. 

Edited by: Neil Anderson, Managing Editor


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