Dan Kemp: The next decade, underperforming managers and risk-adjusted returns

In his latest column, Dan Kemp addressess three key investments topics: the outlook for the next 10 years, underperforming fund managers and risk-adjusted versus returns. 

It is incredible to think we are already near the end of a stellar decade for investors. In this sense, we would prefer to reframe the typical '2020 outlook' as the '2020-2030 outlook'.

In this light, the only way we can explain our outlook at this time is to set the background. Following the global financial crisis in 2008, interest rates sank across the developed world and stocks launched a 10-year bull market run. Markets have cheered rising earnings and lower interest rates, but seemingly few people have paid attention to how long this accommodating landscape could last.

Put frankly, markets are out of balance. And we expect rebalancing to come in the next decade. Performance gaps today between value-style stocks and their growth counterparts and between US and non-US stocks have widened to historical extremes.

The good news for our investors is that these rare extreme performance gaps have historically been followed by high relative returns for valuation-driven investing approaches. While these periods of strong cyclical returns leave investors susceptible to performance chasing they can bring the best long-term opportunities for contrarians. In this sense, we believe benchmarks are susceptible to larger downside risk than normal, although we do see opportunities by favouring unloved markets and diversifying in a manner that protects against the risks ahead. 

As for how 2020 itself will play out that is anybody's guess. But there should be opportunities for investors willing to be patient and stick to a valuation-driven approach.

If a manager trails the benchmark over three or five years, despite delivering positive returns, should we be worried?

The question here is really about measuring investment success. So, let us start with a sanity check - people are not usually investing for the sky. More often than not, people are not motivated by beating a benchmark or their friends, but rather, reaching their goals.

Benchmarking tools - such as those we use - are powerful, but you cannot unshackle the backward-looking nature of them. What matters to an investor is whether their investment might be expected to help them achieve longer-term gains into the future. This mismatch requires care and highlights an important point around process versus outcome. There are many moving parts, some of which you can control - risk taken, assets held, timeframe considered - and many others you cannot.

Three to five years is a decent progress check but looking backwards is unlikely the answer. We would not be so worried, as long as the inputs continue to stack up. Remember that you cannot reap the benefits of a manager's strong past performance.

Why are 'risk-adjusted returns' more important than just 'returns'? 

As humans, we like what is easy and try to avoid what is not. For investors, returns are easy, while risk isn't. Risk analysis feels opaque, theoretical, and even counterproductive during the good times. So when returns are rolling in, it is easy to ignore risk, then a crash happens and it feels as important and alive as ever.

The lesson is simple: ignore risk at your peril. But we would add that you need to focus on the right types of risks. We can usually bundle this into two core forms:
1) downside risks to your portfolio, or a permanent loss you cannot make back, and
2) behavioural risks, including poor timing decisions that trigger a permanent loss (especially those that would otherwise be temporary).

So, yes, risk-adjusted returns are important, as long as they are defined in the right way. We would even say risk management can make you money, as minimising drawdowns in market falls can be as important (if not more so) than keeping up with the market as it rises. This is especially true when you consider things like sequence risk, which is important for retirees. If your investment collapses by 50% in year one (from a market crash), it takes more than a 100% return to get back even, as you will be drawing on the capital when the balance is low.

Do not be fooled into thinking goal attainment is all about catching positive returns. Those that think this way are procyclical, which is a risky way to invest. Markets are unpredictable, and investors can only take what they give us. 

Dan Kemp is chief investment officer, EMEA at Morningstar Investment Management Europe

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