17 December 2020 / U.S. EQUITIES
T. Rowe Price's Strategic Investment Approach Has Benefited Our Results
Discipline has brought long‑term rewards for clients.
- Research has shown that active manager performance can be cyclical and that some specific manager characteristics may contribute to long‑term success.
- We reviewed 18 composites within our institutional diversified active U.S. equity strategies to quantify the value added by our strategic investing approach.
- We found that the vast majority of composites within our strategies generated positive average excess returns, net of fees, over their benchmarks across multiple time periods.1
- We credit our success to our efforts to go beyond the numbers and get ahead of change, which we believe leads to better decisions and prudent risk management.
(Fig. 1) Relative Performance Can Be Volatile Over the Short Run
Percentage of managers in eVestment Alliance database outperforming their category and style benchmarks (net of fees)
Most sophisticated investors are aware of the pitfalls of overreacting to short‑term market trends—a habit that can lead to disappointing long‑term returns. Capital markets are volatile, and investors who rush to sell or buy assets based solely on their recent performance may find they’ve taken on more risk than they expected.
The same principle applies to actively managed investments—those that seek to add value for clients through security selection, sector rotation, factor weighting, or other techniques. Like the markets themselves, relative performance tends to be volatile. Evaluating managers based on quarterly or even annual results can be difficult and potentially misleading. Successful strategies often take time to bear fruit, and contrarian bets are rarely rewarded immediately. Attractive growth opportunities may be prospective, not immediate, and undervalued companies may remain undervalued for months or years.
The academic literature is clear about the obvious problem that the “average” active manager faces in seeking to generate excess returns, especially net of fees and other costs. Over time, the positive and negative excess returns of active managers as a group have tended to balance out, leaving fees and other costs as a net drag on relative performance.
However, while we recognize the virtues of passive index strategies—and employ indexed components in some of our asset allocation strategies—we do believe strongly that a skilled strategic investing approach has the potential to add value for clients over longer‑term time horizons.
Evaluating manager performance requires investors and/or their financial advisors to distinguish between the signal and the noise—that is, to see past the many factors that may generate volatility in relative returns and paint a distorted short‑term picture (either positive or negative) of manager skill.
(Fig. 2) Active Managers May Lead in Bear Markets, Lag in Bull Markets
Manager performance versus benchmark performance (net of fees)
Relative Performance Is Noisy in the Short Term
The first point to recognize is that relative performance—equity performance, in particular—can be extremely volatile over the short run, as seen by the trends in manager rankings in four key size/style categories in the eVestment Alliance database over the past two decades (Figure 1).3
While aggregate relative outperformance will tend to equal aggregate underperformance over time, that may mean a relatively small number of managers outperforming a benchmark by wide margins while a large majority of managers slightly underperform—or vice versa. This balance can reverse very quickly. When return dispersion is low, manager and benchmark performance may differ by only a handful of basis points, further magnifying the volatility of relative performance rankings when return differentials widen again.
Times When Active Outperforms
Within that short‑term noise, more predictable—or at least more cyclical—patterns also may be found. Research has identified several broad market environments in which active equity managers, in general, may be more likely to outperform.
- Bear markets: Research suggests that active U.S. equity managers have had a relatively higher chance of outperforming when market performance is poor (Figure 2). One study has argued that this effect persisted even after differences in exposure to market risk (i.e., beta) were taken into account, suggesting that active managers have provided a certain amount of relative performance improvement in more volatile markets.4
- High return dispersion: When the correlation of returns within a benchmark is low, active managers as a whole may have more opportunities to add value through security selection or sector rotation.
- Volatile markets: Active U.S. equity managers as a group have been somewhat more likely to outperform in periods when market returns have been more variable (Figure 3).
Over longer time horizons, periods of extreme relative underperformance or outperformance have tended to revert toward the mean, smoothing out some of the noise that dominates quarterly and annual results. This tendency is highlighted in Figure 4, which shows relative manager performance in the same four eVestment Alliance categories as in Figure 1, but across progressively longer rolling time periods.5
(Fig. 3) When Return Dispersion Is High, Active Managers May Have More Opportunities to Add Value
Active manager performance versus return dispersion (net of fees)
The influence of longer‑term cyclical factors is now more visible. Over the entire 20‑year time frame, the percentage of managers outperforming their benchmarks in most of the eVestment Alliance categories shown has typically fluctuated around the 50% mark.
Study of T. Rowe Price Diversified U.S. Equity Strategies
Looking at broad historical trends can be enlightening when it comes to evaluating the performance of active managers as a group. But it doesn’t tell us much about the question investors are probably most interested in: Can my manager generate positive excess returns after management fees and other costs?
For investors with longer time horizons—such as pension plan sponsors—we believe this question is best answered across multiyear periods (or even multiple market cycles) to filter out the short‑term relative volatility described above. However, the standard 1‑, 3‑, 5‑, and 10‑year return histories typically shown to clients and prospective investors—and used in many industry performance studies—provide only snapshots of past performance as of a current date. To gain a clearer picture of manager skill, we believe more intense investigation is required.
(Fig. 4) Relative Performance Has Been More Stable Over Longer Time Horizons
Percentage of managers in the eVestment Alliance database outperforming their benchmarks (net of fees)
As equity managers, we are primarily interested in whether our own investment process—which emphasizes bottom‑up fundamental analysis, in‑depth research coverage, and collaboration across size and style categories—has created long‑term value for our clients. For a better understanding of this issue, we conducted a rigorous study of the performance of T. Rowe Price’s institutional diversified U.S. equity composites over the 20 years ended December 31, 2019 (or since inception for composites that lacked a full 20‑year track record).
Our study included 18 of the 24 composites within the institutional diversified U.S. equity strategies currently advised by T. Rowe Price. In instances where a portfolio manager managed multiple strategies in the same sub‑asset class and/or style (e.g., U.S. small‑cap growth), we used only the composite with the highest assets under management to avoid double counting.6 The composites included in our study represented approximately 78% of total U.S. equity assets in the domestic and global equity composites advised by the firm as of December 31, 2019. The designated benchmark for each composite, as well as the date of its inclusion in the study, are shown in Figure 5.
(Fig. 5) The Performance Study Universe
T. Rowe Price composites, benchmarks, and inclusion dates
For each composite included in the study, we examined performance over rolling 1‑, 3‑, 5‑, and 10‑year periods (rolled monthly) from December 31, 1999, through December 31, 2019. We then calculated excess returns (positive or negative) for each composite for each time period relative to the appropriate benchmark—the designated style benchmark used in T. Rowe Price performance reports and disclosures. Composite returns were calculated net of fees, based on the highest breakpoint fee for T. Rowe Price institutional U.S. equity clients.
For each composite, we calculated active success rates (the percentage of periods in which the composite outperformed its benchmark) and average returns relative to that benchmark for each time frame (i.e., over all rolling 1‑, 3‑, 5‑, and 10‑year periods).7 The results are displayed in Figures 6 and 7.
(Fig. 6) and (Fig. 7) Positive Results for Most T. Rowe Price Diversified U.S. Equity Strategies Over Longer Time Horizons
Active success rates: percentage of rolling periods with returns higher than benchmark (net of fees)
Average annualized excess returns over benchmark (net of fees)
Results of T. Rowe Price Performance Study
We found that for most T. Rowe Price institutional diversified U.S. equity composites, shorter‑term active success rates (over rolling one‑year periods, in this case) averaged significantly higher than the 50% mark one would normally expect for the average active manager over an extended time frame—like the 20 years covered by our study. Seventeen of the 18 composites outperformed in more than half of all one‑year rolling periods, while only one composite underperformed half the time or more.
Short‑term excess returns, net of fees, also tended to be significantly more positive than for the average active manager. All 18 composites showed positive excess returns, on average, across the one‑year rolling periods covered by the study (Figure 7). Active success rates and excess return results may differ depending on a particular composite’s overall performance pattern—a composite that outperformed its index by a large margin in a relatively small number of periods, for example, might show positive excess returns but a negative (i.e., below 50%) active success rate.
One of the more consistent findings in the study was that the likelihood of outperformance tended to improve over longer time horizons.
- While 17 of the 18 composites had positive active success rates (i.e., higher than 50%) over rolling three‑year and five‑year periods, all 18 had positive 10‑year active success rates.
- Eleven of the 18 composites outperformed their benchmarks over every rolling 10‑year period. Two more composites outperformed in more than 90% of all rolling 10‑year periods.
- Seventeen of the 18 composites had positive excess returns, on average, over every time horizon studied (one, three, five, and 10 years).
- Seventeen of the 18 composites had positive excess returns, on average, over every time horizon studied (one, three, five, and 10 years).
Our study indicates that a majority of T. Rowe Price’s institutional diversified U.S. equity composites generated positive relative performance, net of fees and trading costs, over the past 20 years. However, there were some potential biases inherent in the study that we needed to address.
While we have provided broad-based averages, the diverse range of investment objectives represented in the study provided an opportunity for us to dig deeper than just calculating simple performance averages across all 18 composites. The universe of smaller stocks is typically less deeply researched than the large‑cap market, potentially making it easier for small‑cap managers to generate excess returns by exploiting informational inefficiencies. Thus, the excess returns for the small‑cap managers in the study could have biased a simple average higher, concealing relatively weak results for large‑cap managers.
Performance averages could also be distorted by the fact that three of the 18 composites did not have histories that spanned the entire 20‑year study period, resulting in an extremely small number of longer‑term performance periods for some composites.8
As of December 31, 2019, for example, the U.S. Large‑Cap Growth Equity Composite had completed only 98 rolling 10‑year periods since its inception at the end of November 2001. Yet results for all 18 composites would have equal weight in a simple average, whatever their longevity.
To correct for these potential biases, we divided the 18 composites in the study into three capitalization categories—large‑, mid‑, and small‑cap—based on the designated benchmarks for the composites. We then calculated average active success rates and average excess returns for each category. These averages were time weighted—that is, the results were weighted by the percentage of the total performance periods in each category that were provided by each composite.9 The results of our category analysis are shown in Figure 8 (average active success rates) and Figure 9 (excess returns).10
- As one might reasonably expect, time‑weighted excess returns for T. Rowe Price’s small‑cap managers were, on average, stronger than for large‑cap managers.
- Time‑weighted average results for small‑cap managers were somewhat stronger (relative to mid‑ and large‑cap managers) over longer‑term periods. However, average excess returns for large‑ and mid‑cap managers weakened slightly at three and five‑year time horizons.
- Time‑weighted average active success rates for T. Rowe Price large‑cap managers were positive (above 50%) over all time horizons. Average excess returns were positive over all time horizons.
- Time‑weighted active success rates for all three manager categories consistently increased as time horizons were extended.
Disciplined Investing for the Long Run
Although the study appears to confirm that T. Rowe Price U.S. equity managers, on average, have been able to add value net of fees and trading costs, especially over longer time horizons, the same is clearly not true for all our strategies across all time periods. Like other investment managers, we have encountered prolonged market environments that were unfriendly either to our overall philosophy or to specific size and style disciplines. A number of composites within T. Rowe Price growth strategies, for example, underperformed in the 1990s after their managers, concerned about lofty valuations, declined to match the soaring weights for technology stocks in capitalization‑weighted growth indexes.
However, underperformance turned into relative outperformance for composites within some strategies when markets normalized and cap‑weighted benchmarks were dragged lower by their heavy exposure to deflating technology stocks. That episode suggests that a disciplined investment approach can pay off over the long run. Still, the fact that cyclical market factors can have such persistent effects suggests that the performance of composites within individual strategies also should be interpreted with caution—especially for those with track records that do not span the full 20 years covered by our study.
A Focus on Long‑Term Value Creation
If, as our study suggests, it is possible for active U.S. equity managers to add value over longer time horizons, what factors might influence their degree of success? Academic research indicates there are some common characteristics associated with relative outperformance.11
One of the most important factors, obviously, is cost. While studies have suggested that some active managers do exhibit skill in outperforming the market before costs, that performance edge typically disappears, on average, after trading expenses and fees are subtracted.12 Accordingly, active managers that can hold costs down would appear to have an advantage over their peers. But more substantive, investment‑related factors also have been linked to strong relative performance.
- Stock selection skill: Some researchers have concluded that active equity managers as a group have the ability to select stocks that outperform the broad market on a before‑cost basis.13
- Manager tenure: Active managers with stable, experienced management teams that have been in place for some time appear to be more likely to outperform.14
- Management structures: Teams that feature clear lines of authority appear to outperform those with less well‑defined organizational roles.15
To the extent composites within T. Rowe Price’s institutional diversified U.S. equity strategies were able to deliver strong long‑term relative performance, net of fees, over the past two decades, we believe it reflects the strengths of our investment process in these key areas.
Fundamental analysis, backed by a well‑resourced global research platform, is the core of our approach, providing a strong foundation for bottom‑up stock picking. We go out into the field to get the answers we need. That means that over 430 of our investment professionals see firsthand how the companies we’re investing in are performing today in order to make skilled judgments about how we think they’ll perform in the future.16 We seek to uncover more opportunities for our clients and are constantly on the lookout, analyzing the markets and the companies within them. By going on the road to meet with executives and employees, our professionals can ask the right questions to get a deeper understanding of where a company stands and where it could go in the future.
Experience has been a critical component of our success as well. Our skilled portfolio managers have deep experience—an average of 23 years in the industry and 18 years with T. Rowe Price.17 Significantly, many of our analysts go on to become portfolio managers, which we believe creates a strong foundation on behalf of our clients.
(Fig. 8) Positive Long‑Term Average Active Success Rates and Excess Returns Within U.S. Equity Strategy Categories
Time‑weighted average active success rates
(Fig. 9) Positive Long‑Term Average Active Success Rates and Excess Returns Within U.S. Equity Strategy Categories
Average annualized time‑weighted excess returns (net of fees)
(Fig. 10) Hypothetical Results of a USD 10M Investment Versus the S&P 500 + One Percentage Point Over 20 Years
We also don’t wait for change, we seek to get ahead of change for our clients. We know when to move with the crowd and when to move against it. Our people have the conviction to think independently but act collaboratively. This means we’re able to respond quickly to take advantage of short‑term market fluctuations, or we can also choose to hold tight.
By remaining focused on the underlying factors that support strong relative performance, T. Rowe Price will continue to seek long‑term value creation for our U.S. equity clients.
The excess returns shown in Figure 9 may seem rather modest relative to the absolute returns that investors typically have been able to achieve in the U.S. equity markets over longer periods. However, even a small improvement in annualized returns can make a significant difference in ending portfolio value over longer time horizons.
Take, for example, a hypothetical equity portfolio that appreciated at a rate equal to the 6.06% annualized total return on the S&P 500 Index over the 20‑year period covered by our study. A portfolio that achieved even a 100‑basis‑point improvement in annualized return over those same 20 years, after all fees and costs, could have increased its ending value by almost 21% (Figure 10).
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
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