Morningstar Magazine - August/September 2018 - 45

EXHIBIT 4

Monte Carlo Simulation Results: Distributions of 15-Year LUPs
Percentiles

Incomplete

Complete

Average

5

10

25

50

75

90

95

Positive Skill

132

60

74

99

140

170

177

179

No Skill

142

73

88

115

154

174

178

179

Negative Skill

152

89

108

133

164

176

179

179

Positive Skill

115

50

60

81

114

150

170

175

No Skill

129

62

74

97

135

164

175

178

Negative Skill

140

74

89

115

148

170

177

178

Source: Authors' Calculations

This, then, is the nature of active management.
Even in the presence of skill, there can be long
periods of underperformance. To further
bolster this result, we extended the simulation
study to 100 years; here, the "skilled" manager
was very skilled indeed, with only a 5%
chance of underperforming the benchmark over
15 years. It turns out that even such an extremely
skilled manager would, on average, have
a 25-year-long stretch during the 100 years in
which they underperformed the benchmark.
It's a Long Game
These are unexpected results, both on the empirical
front and on the stylized simulation front.
Before we invest them with too much meaning,
let us clarify two things.

First, while it is true that even the good performers
can go through long stages of underperformance, this does not necessarily reflect
the experience of an investor. Even for an investor
who held a given fund through the whole
15-year period, a LUP of, say, nine years would
not be experienced as a continuous series
of worsening performance relative to the
index. There would almost certainly be ups and
downs along the way.
A more conventional analysis brings this out.
For the outperforming funds in our sample,
we calculated the percentage of three-year periods
(overlapping, with the three-year window rolling
monthly) that outperformed the index. Even
funds with an average LUP of 119 months (average

of complete and incomplete LUP averages)
outperformed their benchmark in some 65% of the
rolling three-year periods. Thus, long periods
of underperformance come with a good dose of
shorter-period outperformance within them.
Second, because of the very definition of LUP,
the severity of underperformance incurred over
the LUP is typically small. LUP is the longest
period of index underperformance. Hence, adding
just one month to the beginning or end of
the LUP would result in a period of outperformance.
Heuristically, one could say that the LUP's
cumulative underperformance is in order of
magnitude of one month's worth of a given fund's
outperformance. LUPs may clock in long
time frames, but the drawdowns incurred over
their duration are small.

given the results we presented. Investors should
not pick funds based on their three- or five-year
records. Asset-management firms should
not pay their managers based on the same periods.
And investors need to arm themselves with
a big dose of patience. Even funds with
Morningstar Analyst Ratings of Gold that beat
their benchmarks over long time periods
went through extremely long periods in which an
investor would have been better off with a
passive offering.
Active investing is a long game. K
Maciej Kowara, Ph.D., CFA, is a senior analyst with
Morningstar Research Services.
Paul D. Kaplan, Ph.D., CFA, is director or research with
Morningstar Canada. He is a member of the editorial board
of Morningstar magazine.

With all that said, the results presented here are
more than just a statistical curiosity and should
encourage investors to recalibrate their
expectations. It turns out they need to be even
more patient than we thought. Standard
performance evaluation periods-three, five, even
10 years-are far too short to make well-informed
judgments about a manager's skill or lack
thereof. Performance is just not a reliable guide to
assessing managers unless one extends the
time frame to decades.
Every prospectus and marketing piece out there
proclaims that "Past performance is
no guarantee of future performance." It seems
like no one believes it, but they should,

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