Outperformance: Why dull isn’t always boring

Lazard’s Aaron Barnfather explains why it is important to focus on how and why fund managers outperform, rather than simply relying on the headline figures.

A colleague recently asked me: “Which is more important: the amount of outperformance a fund manager delivers, or when and how the outperformance is achieved?”

It caused me to think back to the first time I walked on to a fund management floor 20 years ago.

One of the first things I was told, in no uncertain terms, was that it is extremely important to outperform a rising market. On reflection, I have spent the subsequent 20 years broadly ignoring that advice, treading instead a very different path to this widely accepted wisdom.

The industry generally accepts that returns should be considered in the context of the level of risk taken to achieve them. But what is less widely accepted or understood is that outperforming a rising market and outperforming a falling market are also not equal.

I believe that delivering a consistent pattern of returns with a bias towards defending capital in difficult markets can mean a better long-term result.

The longer view

As an industry we tend to look at periods of time in isolation, without considering that what happens in one year impacts upon how much capital we have to deploy the next year.

Underperformance this year might be forgiven in the light of outperformance the year before, but we forget that any outperformance in challenging conditions means more capital preserved to participate in subsequent rising markets.

We tend to undervalue the importance of protecting capital in falling markets, and it is human nature to be fascinated by the extremes rather than the average. We are enthusiastic about funds that post big numbers in a rising market. We are transfixed by disaster stories in a falling market.

Meanwhile, those that outperform the falling market, or deliver an average result in a rising market can be overlooked. Posting strong numbers in a bull market is sexy and exciting. Posting strong numbers while market falls can be considered, frankly, a bit dull.

But sometimes, not being sexy and exciting is a good thing. If we can preserve capital in falling markets, we do not need to take aggressive risks to deliver more on the upside, and still deliver outperformance.

Case study

Consider two theoretical fund managers over a two year timeframe where the market doubles in one year, but then halves the next. After two years, the market is flat.