Reasonable Expectations, Warren Buffett and Active Management

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According to the ongoing SPIVA analyses, most equity mutual fund managers have failed to keep up with their respective benchmarks recently. In fact, roughly 60% of domestic managers and 65-70% of international managers underperformed in 20141 – a phenomenon that most investors observed in their own portfolios. But that is not a reason to abandon active management, assuming you own active managers for the right reasons.

Percentage of a ctive managers that have outperformed their benchmarks
Source: S&P Dow Jones Indices, CIO WMRA, Data reflects period ending 12/31/2014.

Although such underperformance is undoubtedly disappointing, it shouldn’t be completely unexpected. How often should you expect a high-quality active manager to underperform on a year by year basis? The short answer is roughly 4 out of every 10 years. The longer answer is a bit technical;2  feel free to skip the next paragraph if you want to trust me on this point.

If we assume a manager can achieve a pre-fee information ratio (IR) of 0.5 (for context, Warren Buffett’s IR was 0.663 over his career), that means a 0.5% alpha for every unit of tracking error from the benchmark. Looking at the probability distribution of that information ratio and assuming reasonable fees, roughly 40% of the occurrences, or 4 out of 10 years, will fall below the benchmark. Since the popularity of many strategies is cyclical, we can expect some of those underperforming years to happen at the same time.

Buffett is a good example for setting expectations. By many accounts he’s the greatest investor of the last 50 years. However, over the last 20 years he underperformed the S&P 500 about 35% of the time on a calendar-year basis. On a quarterly basis, he underperformed 53% (yes, more than half) of the time!  It’s only once the time horizon is extended that his brilliance becomes evident. Over five-year rolling periods, he outperformed 73% percent of the time (which means he still underperformed in 23% of them) – beating the S&P by a cumulative 450% over 20 years. An investor with a rear-view mirror that only looks back one quarter would find the Buffett experience mediocre at best. But an investor judging success over multiple market cycles would be well rewarded for his or her patience.

Figure 2: Berkshire Hathaway – Frequency of outperformance 1995-2015

Berkshire Hathaway – Frequency of outperformance 1995-2015
Source: Bloomberg, CIO WMR

  1. SPIVA data is available through mid-2014. We have no reason to believe the fortunes of active managers improved during the second half of the year.
  2. Crook, Michael. “An equity portfolio framework for combining active management and index-based implementation.” Journal of Index Investing, Summer 2014.
  3. Frazzini, Andrea, David Kabiller, and Lasse H. Pedersen, "Buffett's Alpha," NBER Working Paper No. 19681, 2013.