Time to Align | Changing the Conversation About Active Management

February 6, 2020

“Misalignment has crept into the system,” suggests Carol Geremia, President of MFS Investment Management, and it has led to short-termism that has “cost investors a fortune.”

Geremia expressed her concerns in a webinar in January 2020 for independent fund directors sponsored by the Mutual Fund Directors Forum. The webinar was moderated by Karen Barr of the Investment Adviser Association and also featured presentations by Dave Lafferty of Natixis Investment Management and Darby Nielson of Fidelity Investments.

In Geremia’s view, the problem arises from a misalignment of goals and the measurements used to assess progress toward those goals.

With regard to goals, active managers typically are hired to produce returns over a full market cycle, meaning from peak to peak of an economic cycle, or from trough to trough. According to an MFS global survey, investors estimate that a full market cycle lasts about 7 years. That’s consistent with economic data from the last century, which indicates that a full cycle has normally lasted 7 to 10 years.

But the same MFS survey shows that, while investors believe that managers should be judged by performance over 7 years, they’re willing to tolerate underperformance for only 3 to 5 years, which is just half of a full market cycle.

And it’s not just investors who have misaligned goals and measurements. Financial advisers, investment consultants, boards of trustees and even asset managers themselves are focused on 3- and 5- year performance, rather than longer-term returns.

The result of this short-term focus? A lot of performance chasing. Investors are “hiring and firing active managers at the wrong time,” says Geremia. Investors have a tendency to take money away from managers who have underperformed in the short-term and give it to managers who have done well over that same short period.

Unfortunately, MFS’ analysis shows that this kind of reallocation is rarely a winning strategy. Geremia notes that, “Over every 5-year period, close to half of top-quartile managers move into the bottom half in the next 5 years.” At the same time, bottom-quartile managers in any 5-year period are just as likely to move into the top quartile in the subsequent period.

Of course, some investors have given up on active management altogether, which Geremia calls “liquid alpha.” Some have moved into index funds or “bulk beta.” But not everyone has given up on trying to outperform. Some investors have shifted toward “illiquid alpha,” such as private equity investments; others have focused on ESG investing, as a separate category from active management.

Geremia argues that active management, as “liquid alpha,” plays a critical role in investor portfolios by providing both the opportunity for outperformance and liquidity. But, because of the misalignment in goals and measurements, investors are questioning its value.

“Identifying skill is a matter of what you measure,” notes Geremia. “We’ve been avoiding true conversations around time horizons and alignment.”

Put simply, it’s “time to align.”

Mutual Fund Directors Forum members can listen to a complete recording of the webinar on the Forum’s website at mfdf.org. Visit the Forum’s websitefor information on its extensive webinar program, including upcoming and archived events.

Active Managers Council members can also listen to a complete recording of the webinar in the members-only section of the Council’s website at activemanagers.com.