Earlier this week I had a conversation with a client about a mutual fund that under-performed its benchmark and peers in 2011. Over the last 5 and 10 year periods this fund has had exceptional performance.

So, the question was, has this manager lost his touch? Should we sell our position in the fund because of one bad year?

After a year like this, it is common for investors to lose thier conviction in the manager and be tempted to switch to the manager with the hot hand. Unfortunately, this kind of performance chasing is destructive and often leads to bad results. In reality, when evaluating managers, short-term performance is a poor indicator of long-term success.

A recent study from Davis Advisors shows that nearly all the investment managers who had stellar long-term performance over a 10-year period had atleast one three year period within that decade where they underperformed their peers.

Out of 192 managers whose 10 year average annualized performance ranked in the top quartile (25%) from 1/1/01 through 12/31/10:

  • 93% of these top managers’ rankings fell to the bottom half of their peers for at least one three year period.
  • 62% of these top managers ranked among the bottom quartile of their peers for at least one three year period, and
  • 31% ranked in the bottom decile for at least one three year period.

Although each of these managers delivered great long-term returns, almost all went through a difficult period of underperformance along the way. Stretches of dissapointing results are inevitable. It is rare for a manager who has a great track record over a decade to not have had a period of disappointment.

My answer to my client: No, we should not sell a fund just because a manger had one bad year of performance. There may be other factors that would make a case for selling, but you need to look at more than performance alone.

In my next post I will discuss what you should do when a manager has a stretch of under-performance.