“Past performance is not indicative of future results” is a commonly cited but underappreciated risk warning. Empirical studies suggest that recent winners often underperform in the subsequent period. There are many reasons for it including luck (or randomness), market style change, style drift due to asset growth, complacency and so on.
The statement is particularly true for the Chinese market given rapid changes of the market itself and the macro environment. And yet we saw many investors, including sophisticated asset owners, chase performance during the bull phase of consumer and internet companies over the last decade. Even some mediocre fund managers delivered outstanding results. Since 2015 it was extremely hard to beat any portfolio that held Tencent, Alibaba, Moutai and a number of other outstanding large consumer companies.
However, everything shifted last year as the market environment changed through a combination of regulation and a slowing economy. Very few of the winning managers of the previous five years were nimble enough to alter their positioning and those hoping for a turnaround this year have continued to underperform. For some, the underperformance is substantial enough to threaten their business.
Times like this remind us of key manager selection principles like emphasizing skill, diversification and risk management.
The orange and blue circles in the charts below represent the top and bottom quartile managers respectively for the three years up to January 2021, when share prices of Chinese technology companies reached their peak, and for the subsequent 18 months.
All China universe
China A universe
Source: RisCura, eVestment; 121 funds in All China universe, 57 funds in China A universe; 1 dot represents 2 funds
Most top quartile managers not only failed to stay at the top but actually moved to the bottom quartile – and vice versa. Underperformers became winners. This phenomenon is consistent for A-share and Greater China managers. More than two thirds of the bottom quartile managers have outperformed the median since January 2021. Some of these managers had delivered poor returns for a long time. Many of them are value-biased managers whose style meant that they ignored the high-growth companies which went on to become very successful. These same companies have now seen their fortunes demise as the government started to introduce stringent regulations to curb the excesses in certain sectors.
We now look at 3 specific case studies of how managers have performed over these last 18 months:
Impacted by the change of market environment
One manager, a large global brand, was a popular choice for global institutions for their implementation in China. Their buy-and-hold strategy of large blue-chip stocks in the Consumer and TMT sectors delivered outstanding returns for a prolonged period. Other managers struggled to match their returns and we spent many meetings trying to build confidence in their team. They had benefited from the rapid growth and rerating of large consumer brands such as Tencent, TAL and Moutai, but it all changed for them in 2021 as these sectors went out of favour and they are now fourth quartile.
Bad operating decisions kill a business
Another case is a high-profile boutique with strong investment performance and rapid asset growth before this year. Within just 6 months, their AUM fell by 80%: half due to poor performance and the other half due to redemptions. There were bad trades, but performance alone is not enough to explain such a sudden downfall. They also made poor operating decisions, such as not having a side-pocket for illiquid positions and allowing in-kind redemptions, which led to an exit stampede by investors. This reminds us that the operational setup can be as important as the investment acumen when evaluating a manager. A poorly structured fund matters especially during challenging times.
Recovery of value style
Selecting a value manager with deep expertise in traditional sectors such as financials and mining at the height of the growth market meant that this manager would have treaded water while its style was out of favour. It had to wait for the market to turn (as it did at the end of 2020) and rich valuations tumbled. The value manager in question has been a top performer since then. Finding the right value manager to invest in a growth market is tricky but important to maintain a balanced portfolio across styles.
Other managers who are more sensitive to valuation also outperformed in the last 18 months as they had been underweight to the expensive areas. Most of these were the bottom quartile managers in the left column above and are now delivering top quartile returns.
Top and bottom quartile managers that remain there…
Inevitably there will be exceptionally good (and bad) managers that have continued to deliver (or not) as they had done in the past. We have researched a number of fund managers who used “style” as an excuse for lacklustre performance and who continue to post mediocre returns even though the market environment has changed in their favour. This suggests an absence of skill but bad luck can also contribute. It may sometimes take many years to build up full confidence in such managers.
Underwriting fund managers is a hard task especially in a country like China. It requires local expertise, patient research and close monitoring, ideally in person. A specialist partner with experience and a local presence makes that much easier.
Lars Hagenbuch who is an Investment Consultant, Riscura
