I can remember myself as a kid in the back seat of my parents car repeating the jingle “Two all-beef patties, special sauce, lettuce, cheese, pickles, onions – all on a sesame seed bun” as we drove through the McDonald’s drive through. To this day I can’t help but crave that special sauce on the Big Mac burger from time to time. The slogan dates back to 1975 and maybe at that time the secret sauce was truly “secret.” But in today’s world, secrets just don’t seem to stay very secret. It’s really just thousand island dressing with a twist. You can even purchase a similar sauce from the grocery store called the “Not So Secret sauce.”
Like the Big Mac’s secret sauce, long term investment success for many years has seemed a secret, when in fact it’s not. I’m going to let you in on one of the key “secret” ingredients needed in order to achieve above average long-term investment success. It’s likely an ingredient you are not expecting. The ingredient is underperformance.
It seems counter intuitive to think underperformance is an ingredient needed in order to achieve outperformance, but it’s true.
We’re often told most active investment managers don’t outperform their benchmark’s, which is true for the most part. Some recent data from Vanguard laid out some the numbers behind US active management equity funds over a fifteen-year period. These numbers are worth highlighting to help illustrate my point.
Vanguard looked at the total number of U.S. active equity funds during this period and found by the end of the period that 54% of these funds closed shop, 32% survived but underperformed their benchmarks, and only 14% of actively managed mutual funds survived AND outperformed. On the surface this number doesn’t sound very good active management, but you must dig a little deeper before ruling out active management altogether.
Of the 14% of funds that outperformed over this period, 72% of them had THREE CONSECUTIVE years of underperformance. Not just three years of underperformance, but these years were in a row! If you were going to benefit from these actively managed funds outperformance, you would have had to stick with them for three years of underperformance.
So why is underperformance seemingly required in order to achieve outperformance? This is a tough question to answer in one blog post, but I can provide one major fundamental reason I believe this to be the case.
Whenever you make a good investment, good meaning an investment that produces above average returns, the lower the price you pay, the better your returns will be. If you purchase company X for $50 and it goes to $100, you’ll have achieved a 100% return on your investment. All else being equal, if you purchased the same company X at price of only $40, and the company hits the same $100 price, your returns will be 120%. The objective of investing is to buy good businesses at the lowest possible price. All else being equal, paying a lower price results in better returns than paying a higher price 100% of the time.
In the short-term, markets are based more off investor sentiment than the fundamentals of businesses in the market. The best prices come during the times where the market is the most pessimistic, which is why experiencing underperformance becomes so important to long term outperformance.
For professionals who manage money, using this basic yet not widely followed philosophy means buying into bad markets when the general public is most pessimistic about the future. This is where real deals happen. Predicting when and why investor sentiment will change is hard to do with any reliability and accuracy. But history, and the world’s best investors continue to prove, that it does change and those who understand this benefit, will earn some of the best returns.
There are many studies, (not just the Vanguard one referenced) that demonstrate this point. I’ve read multiple articles which examine the performance of funds versus the performance the individual investors of the fund experience (for example a fund may display an average annual return of 10%, whereas some of the investors in the fund experience a return much lower than this). This is likely a result of investors not sticking with the strategy or discipline they’ve chosen, and selling out or holding back during periods where returns are not what investors want them to be.
Not all investment professionals use the same approach, nor do they have to. Investment success requires solid processes and discipline. It can be easy to lose confidence in approach when a requirement to achieving long term investment success is suffering through bad markets, but as the data shows if you want outperformance, you’ll likely need to experience periods of underperformance. Don’t replace a professional or fund just based off of underperformance alone (this is usually the worst time to be doing so). Replace them for reasons like not following the processes you hired them to follow. Once you’ve found a professional who’s process makes sense to you, or a professional that you trust, do yourself a favor and stick with them for some time. You’re a lot more likely to end up ahead.
- Brandt Butt, Investment Advisor
Brandt Butt is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Brandt Butt who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.