“History shows that even the most successful investors have encountered periods of poor performance. Such periods are inevitable and will measure whether an investor has the conviction, courage, and discipline necessary to beat the market over the long term.”
These words, which come from noted investor Shelby Cullom Davis, highlight a fundamental tension in active management—success in the long term often requires periods of underperformance in the short term.
Every successful active manager needs ample supplies of patience, discipline, and intelligence. These laudable traits, however, often place an active manager at odds with an investment community that is increasingly—some might say desperately—searching for consistent and predictable returns.
In a world that has only grown more volatile and uncertain over the last five years, the natural tendency has been to shorten the time horizon over which performance is measured and to tolerate less and less deviation from benchmark indexes.
The mushrooming popularity of passive investment strategies only reinforces this point. At any moment, the performance of a passive strategy should match that of its benchmark index (the expected return), which appears to add a level of comfort and predictability.
For active managers, including ourselves here at Royce, the rules and objectives are quite different.
Although our own emphasis is on long-term absolute returns, we are comfortable being judged on our ability to better the return of a benchmark while taking a comparable (or often lower) amount of risk, thereby justifying fees that are often higher than those charged by our passive competitors.
The challenge is that in order to beat a benchmark, we as active managers must construct and manage portfolios with markedly different compositions and weightings than that of a Fund’s respective benchmark. This naturally leads to divergent performance
Substantial variations in both positions and weightings, which can be gleaned from The Royce Funds’ capture ratios, make it highly unlikely for any actively managed portfolio to consistently outperform a benchmark over all short- and long-term periods.
Inevitably, there will be bouts of relative underperformance that will have unpredictable durations. Many investors have grown increasingly uncomfortable with this fundamental proposition, particularly as many active managers have failed to keep pace with index returns over the last several years.
The Royce approach is based on the idea that high-quality, mispriced securities can be found at all times in the marketplace. Of course, how and when these bargains materialize varies dramatically with company, market, and economic conditions, as well as with investors’ shifting preferences and levels of risk tolerance. One constant theme is that investors tend to follow prevailing trends when allocating for the future.
Extrapolating current performance into the future often creates mispricing—companies that are performing poorly are thought to keep doing so while companies that are performing well are too often seen as unassailable. Seth Klarman said it well when he opined in June, “Investing, when it looks easiest, is at its hardest.”
While unpleasant, we accept that out-of-sync periods are a natural byproduct of our active management approach. Indeed, we believe they are inevitable over the course of periods of long-term outperformance.
Short-term underperformance and long-term outperformance, though they make strange bedfellows, are not mutually exclusive. Quite the opposite, they are inextricably intertwined. In fact, it is often in the midst of these challenging periods in which some of the best opportunities present themselves.
Importantly, we recognize that short-term performance is not terribly important—it is only the long term that truly matters. As Warren Buffet so aptly surmised, “It is only the price on the final day that counts.”
Important Disclosure Information
Chris Clark is a portfolio manager and principal of Royce & Associates, LLC. Mr. Clark's thoughts in this essay are solely his own and, of course, there can be no assurance with regard to future market movements.