Sadly, this doesn’t happen for a vast majority of funds but this isn’t necessarily a bad thing. In fact, there is a compelling argument for why fourth quartile funds shouldn’t be ruled out just because of their recent underperformance.
Marcus Brookes (pictured), head of multi-manager at Schroders, said: “The best time to buy a manager might be in their own bear market.”
“Most fund selectors know that even their most trusted fund managers fail to outperform every quarter, indeed some have managed significant, prolonged underperformance relative to benchmark only to be proved absolutely correct.”
The prime example of this which will stick in every investor’s mind is Neil Woodford and his Invesco Perpetual Income and Invesco Perpetual High Income funds.
During the dot com bubble, Woodford famously avoided the tech stocks fuelling the rally and missed out on some of the high returns that came with them.
In 1999, Invesco Perpetual Income was in the UK Equity Income sector’s bottom decile but it held up much better than its peers in the sell-off that followed and made investors top-decile gains over the years that followed.
Performance of funds vs sector and index after 1 Jan 1999
Source: FE Analytics
Apollo Multi-Asset’s Ryan Hughes, a firm believer in mean reversion, highlights Woodford’s judgement calls as a reason why poorly-performing funds shouldn’t be discounted.
He said: “Every fund goes through a period of poor performance, the key is to understand why. Neil Woodford underperformed the FTSE All Share by 25 per cent in 1999/2000 and it would have been easy to sell based purely on the relative performance. Those that didn’t sell were rewarded with outperformance of the FTSE All Share by 153 per cent over the next 13 years.”
“The market is littered with other examples, most often found in sector specific funds such as biotech, resources or technology. All of these have suffered the extremes of enormous underperformance and huge outperformance over the past 15 years.”
Parmenion’s Meera Hearnden also cites Woodford and the tech bubble as a classic example of when investors would have been right for overlooking short-term underperformance.
In the late 1990s when the technology boom took off, Neil Woodford’s funds suffered a prolonged period of underperformance. He stuck to his guns by avoiding investing in overpriced technology stocks and this paid off in subsequent years,” she said.
Had an investor bought either of these funds at the end of 1999, they would have made around 300 per cent return up until the point Neil Woodford stopped managing these funds in March 2014.”
Hughes added: “With markets being cyclical, asset classes that are performing well are likely to fall down the performance charts sooner or later and, conversely, things that are doing badly are likely to climb back up the performance charts.”
“The challenge of course is to decide when these mean reversion events are likely to happen. Over many years, investing away from the crowd and into unloved asset classes or sectors has proved to be a highly profitable approach.”
Of course, it’s not only buying underperforming funds during a rally to protect against a looming sell-off that can work – there are examples where a portfolio that suffered heavily in a downturn can go on to make huge gains when things turn around.
Paul Mumford’s Cavendish Opportunities fund offers an example of this. In the brutal sell-off of 2008 the fund was down 50.36 per cent and was in the UK All Companies sector’s bottom quartile; as a point of comparison, Woodford was first quartile in his sector with a loss of around 12 per cent.
Given Mumford’s focus on smaller companies, which are more sensitive to market downturns, this was not surprising. But investors who were confident of a coming rally would have been better buying than selling this fund despite its poor ranking.
Granted, a seriously strong stomach was needed to keep hold of this investment and not to abandon ship. However, those who managed this were greatly rewarded with a top quartile return of 135.75 per cent over the following three years. Within five years, this rose to a hefty 307.13 per cent return.
Performance of funds vs sector and index after 1 Jan 1999
Source: FE Analytics
However, there is more to it than blindly choosing a fourth quartile fund in the hope it will improve. Hearnden notes that it’s important to look under the bonnet of the fund and identify any potential reasons for underperformance.
She said: “If you own a fund that is underperforming, a knee jerk reaction would be to sell it. However, every good fund manager can go through a bad period, which is why it is important to know the reason for the underperformance in case it is temporary.”
“If it is a fairly new investment, it doesn't make sense to immediately sell based on short-term underperformance and bear the cost of the spread which can be expensive. It makes sense to understand the reasons for underperformance as it could actually be an opportunity to top up the holding rather than sell.”
Does it pay to go hunting in the fourth quartile? The consensus is that it certainly can do – provided the investor does their research and have an understanding of how that fund is managed.
Brookes said: “Our view is that the very best fund managers add most value when their investment style is in favour, which probably means their poor returns occur when their style is out of fashion.”
“It is entirely possible that a high quality fund manager languishing in the fourth quartile could be about to return to form, so rather than sell perhaps adding might make more sense if the fund selector can identify a change in market environment.”
“The key here is the old football maxim of ‘form is temporary, but class is permanent’.”