T. Rowe Price’s Strategic Investing Approach Has Benefited Our Results

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.

Relative Performance Is Often 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).²

While aggregate relative outperformance has tended 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 Has Typically Outperformed

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, have been more likely to outperform.

These include:

• 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.³
• High return dispersion: Historically, when the correlation of returns within a benchmark was low, active managers as a whole may have had more opportunities to add value through security selection or sector rotation (Figure 3). However, this trend did not hold amid the market disruptions associated with the pandemic and the subsequent market recovery. It remains to be seen whether the historical pattern will reassert itself if dispersion remains elevated going forward.
• 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.

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.⁴ The influence of longer‑term cyclical factors is now more visible.

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.

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, 2021.

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.⁵ The composites included in our study represented approximately 80% of total U.S. equity assets in the domestic and global equity composites advised by the firm as of December 31, 2021. The designated benchmarks for each composite, as well as the dates of their inclusion in the study, are shown in Figure 5.

For each composite included in the study, we examined performance over rolling 1‑, 3‑, 5‑, and 10‑year periods (rolled monthly) from December 31, 2001, through December 31, 2021. 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).⁶ The results are displayed in Figures 6 and 7.

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) were 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. Fourteen of the 18 composites outperformed in more than half of all one‑year rolling periods, while only four composites 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. Fourteen of the 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 14 of the 18 composites had positive active success rates (i.e., higher than 50%) over rolling three‑year periods, all but two had positive active success rates over rolling five-year periods, and 17 out of 18 had positive active success rates over 10-year rolling periods.
• Nine of the 18 composites outperformed their benchmarks over every rolling 10‑year period covered by our study. Four more composites outperformed in at least 82% of all rolling 10‑year periods.
• Fourteen 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 need 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.

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. The results of our category analysis are shown in Figure 8 (average active success rates) and Figure 9 (excess returns).⁷

• As one might reasonably expect, excess returns for T. Rowe Price’s small‑cap managers were, on average, stronger than for large‑cap managers.
• Average active success rates for seven of the 10 T. Rowe Price large‑cap managers were positive (above 50%) over all time horizons. Average excess returns also were positive over all time horizons for eight of the 10 large-cap managers.
• Average 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.⁸

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 disappeared, on average, after trading expenses and fees are subtracted.⁹ 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 historically strong relative performance.

These include:

• Stock selection skill: Some researchers have concluded that active equity managers as a group have the ability to select stocks that outperformed the broad market on a before‑cost basis.¹⁰
• Manager tenure: Active managers with stable, experienced management teams that have been in place for some time appear to be more likely to have outperformed.¹¹
• Management structures: Teams that featured clear lines of authority appear to have outperformed those with less well‑defined organizational roles.¹²

To the extent that 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 prior to the pandemic, over 530 of our investment professionals saw firsthand how the companies we invested in were performing, in order to make skilled judgments about how they thought they’d perform in the future.¹³ We seek to uncover more opportunities for our clients and are constantly on the lookout, analyzing the markets and the companies within them. By speaking 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. During the pandemic, these research activities are being conducted virtually.

Experience has been a critical component of our success as well. Our skilled portfolio managers have deep experience—an average of 22 years in the industry and 16 years with T. Rowe Price.¹⁴ Significantly, many of our analysts go on to become portfolio managers, which we believe creates a strong foundation on behalf of our clients.

We also don’t wait for change; we seek to get ahead of change for our clients. We assess 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 seek 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 8.52% annualized total return on the S&P 500 Index over the 20‑year period covered by our study. A portfolio that achieved 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 more than 20% (Figure 10).