Daily News Aerts
Joe Hornyak
Former editor of Benefits and Pensions Monitor and founder of Joe Hornyak Communications
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Skill or luck determines performance
S&P Dow Jones Indices ‘ Canada Persistence Year-End 2022 Scorecard’ for 2022 shows that top-ranked Canadian managers find it nearly impossible to maintain their position in the first quartile.
Among funds in the Canadian equity category, only 7.7% were able to outperform the benchmark for three years in a row. The percentage of funds maintaining a ranking in the top-half of managers was slightly higher, but still below the 50% rate suggested by random chance. Among Canadian equity funds ranked in the top-half of peer rankings over five years ending December 2017, 45% remained in the top-half while 55% fell to the bottom-half, merged/liquidated, or changed investment styles.?
Both in equities and fixed income, it is unlikely a manager will remain in the top quartile. “We see it generally in every asset class over time,” says Joe Nelesen, senior director, index investment strategy, at S&P Dow Jones Indices.
“The story we find with persistence is skill persists, but luck dissipates,” he says. If you take a selection of managers that manage to make it to the top quartile for a given year, and then you ask yourself, what proportion of those managers will be in top quartile the following year, if everything were random, you would assume 25%. If it's more than that, then we could say that's skill. What we most often see is there really is no evidence to show that there are particularly skilled managers who maintain an advantage over time.”
That means if there is true skill or someone truly has a systematic advantage in how they're managing funds over others, that should be evidenced by outperformers staying fairly persistent. “The fact they don't suggests that luck is much more involved, or at the very least, there are real headwinds to winning in a very competitive, active management environment.”
There are other reasons a manager may show skill one year and then a lack of luck the next. In his experience, there are cases in certain markets, Canada for instance, where the absence of a single stock like Shopify makes a huge difference.
Active managers may also find it challenging to consistently outperform.
“The first thing we could call the professionalization of asset management. You can think about these Nobel Prize economists who've written about how alpha is distributed. They say if someone's winning, someone else has to lose. But as the industry gets more intensely competitive, as it has over the years, there are more funds than stocks in certain markets in the US and there is very great diminishing performance, especially in markets that may be more efficiently priced with the advent of faster technology and more people looking at stocks through an index.”
The second aspect is fees. Fees for active management are typically many times higher than typical index fund fees. “So for a manager to outperform the index, they have overcome that hurdle,” says Nelesen.
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The last factor is called positive skew and is present in most markets most of the time. “It refers to the fact that if you take all the securities on the TSX or the S&P 500 and rank them by return, you'll find they're a very small number of stocks account for a lot of the outperformance. We find that, on average, well below half of the stocks outperform the index. So mathematically speaking, if you're picking bonds or stocks, you’re more likely to pick an underperformer than an outperformer.”
The Persistence scorecards go back to around 2005. During that time, it is not unusual for managers to be top quartile one year and not the next. “Over a shorter time horizon, you can find a lot of different results. But by and large, if there's any rule that we see in these data, it's that the longer that time period, the more managers fall by the wayside. You can find some cases where more than 25% of managers stay in the top quartile for more than one year. When you go out one year more and then more after that, it dramatically diminishes, in many cases, to zero,” he says.
Financing actuarial deficits creates better plan management
The use of reserve funds to cover up to 100% of the amortization payments required to finance an actuarial deficit in Quebec municipal and university sector defined benefit pension plans would allow for much better management of financial risks and would be potentially beneficial for everyone (sponsors, active members, and retirees), says the Association of Canadian Pension Management (ACPM)
In its comments on the initiative, which aims, among other things, to harmonize certain legislative provisions applicable to pension plans in the municipal, university, and private sectors, it says this provision was removed from the draft regulation after the consultation period.
Maintaining the limit of 50% of amortization payments financed from the reserve will mean that once the prior component is well funded, plan sponsors will probably want to eliminate investment risks as much as possible to avoid any future deficit, which will also significantly reduce the potential for gains that could lead to the improvement of benefits.
It says it understands that this provision was not changed due to lack of consensus. However, if there were flexibility to fund up to 100% of the amortization payments from the reserve, then those who do not want to increase the 50% limit could maintain the current provisions.
“Considering that the reserve is only composed of technical gains and not of additional contributions, if one wanted to better protect the rights of members, this flexibility could be permitted only after reaching a minimum funding threshold (for example, when the reserve reaches the threshold of the provision for adverse deviations, or any other minimum financial threshold deemed sufficient),” it says.
It recommends that the draft regulation be amended to provide this flexibility.
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