To stand out in investing, being different isn’t just acceptable—it’s often necessary. However, standing out has both advantages and disadvantages. In our industry, evaluating investment products is typically done through a performance comparison. This simplified approach is often presented as a few squiggly lines, one for the fund of interest and others for competitors, over a set time frame. The analysis often centers on whether the fund’s line outpaces the others, with the higher-performing line seen as the “winner.” Yet, even if you select a strong performer for your model portfolio, there will inevitably be times that challenge your decision. Those periods are common, even for the best fund managers out there, because if they truly are different, it’s largely impossible to be the best every year.
Even the most diligent portfolio managers face a significant challenge: the cyclical nature of investment performance. Despite thorough due diligence and the selection of historically top-performing funds, even the best investments can experience temporary periods of underperformance. This can be particularly frustrating, as it highlights the unpredictability of the market and the limitations of even the most sophisticated investment strategies.
There are a few reasons for performance cyclicality. For one, funds that take contrarian or concentrated positions may not always align with broader market trends in the short term, leading to potential underperformance. Funds with high-conviction strategies, where managers heavily focus on specific sectors or assets, can experience great returns when the market is favourable. However, if the market shifts in an unexpected direction, these funds can place poorly among peers.
The chart below highlights Canadian and US equity products with a 10-year performance history. While only 23 Canadian funds made it to the top decile, there were 169 US equity funds in that category. Upon examining their annual performance over the 10 years, 20-24% of the time, these top-performing funds were in the bottom quartile. Additionally, 30-32% of the time, they fell to the bottom half of the performance rankings. Those might not seem like detrimentally high percentages, and you would be right; they’re not. These funds still posted top decile performance numbers over their 10-year annualized period. But if you're being truly honest with yourself, imagine experiencing back-to-back years in the bottom quartile. Would you have enough conviction to hold on through those tough periods? Consider if you had bought the fund right at the start of that challenging stretch—the mental toll of portfolio management can be significant during those times.
Performance cyclicality can be explained by many attributes, but what if it is simply a leadership change? If we focus on US equities over the last 10 years, there were only two calendar years where growth underperformed value, a dominant decade for the growth style tilt. Unsurprisingly, many of the top-performing managers during this time fell to the bottom quartile during those years of value leadership. These anomaly periods are inevitable, but the real question is whether you would have the conviction to hold through those tough stretches, knowing now that growth would likely resume its dominance in the years that followed.
In hindsight, the short-term leadership change had little impact—growth continued to outperform in the following years, and the managers returned to their former selves. The fact is, even if you weren't focused on growth over the last decade, you were almost compelled to invest in large growth stocks just to stay competitive with peers. The real concern looking ahead is whether we might experience a long-term shift in the tide. If the tide shifts from what has worked the last decade, many of these high-performing funds will have to shift with it; it remains to be seen whether they will.
And there you have it—the classic conundrum of portfolio manager performance analysis. Up until this point, we had discussed avoiding overreaction to short-term periods of underperformance for strong managers. Yet we iterated that if those short-term struggles extend into long-term trends, a different set of questions will be raised.
This is where manager due diligence becomes crucial. Are they truly active managers, or are they simply riding the coattails of what's working in the market? It's important to distinguish how much of their performance stems from a style tilt versus genuine active decision-making. After all, you're paying higher fees for active management, so if the manager isn't offering something beyond what the index could provide, the question becomes: What’s the point of paying those extra costs? That's why we believe in looking beyond just performance and, instead, examining how actively the manager has shaped the portfolio through strategic decisions and allocations.
Stick to your due diligence process, trust in your managers, and consistently evaluate whether you’re getting true active management. If they underperform for multiple years in a row, it's worth reassessing. But overall, stay focused on where you believe the economy and markets are headed. This proactive approach helps you avoid reacting impulsively to temporary challenges.
Final Thoughts
At the end of the day, investing requires patience and conviction. If your manager has a proven track record of active decision-making, it's okay if they don’t outperform every year. Performance comes in cycles, and long-term success often depends on sticking to a disciplined strategy through both good and bad times. It’s good to be different. Understanding that occasional underperformance is a natural part of the process can help you stay focused on the bigger picture and remain confident in your approach.
— Brett Gustafson is a Portfolio Analyst at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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