Underperformance
What Is Underperformance?
Underperformance, in finance, refers to an investment or portfolio generating lower investment returns than its chosen benchmark or a peer group over a specified period. This concept is central to Portfolio Performance Analysis, evaluating the effectiveness of an investment strategy or a portfolio manager. It signifies that the returns achieved did not meet the expectations set by a comparable standard.
History and Origin
The concept of underperformance gained significant prominence with the rise of modern portfolio theory and the increasing availability of market indexes. As investment strategies evolved beyond individual stock picking to include broader portfolios, the need for comparative analysis became crucial. The efficient market hypothesis, popularized in the latter half of the 20th century, posited that it is difficult for active management to consistently "beat the market" after accounting for costs and risks. This intellectual framework, along with the subsequent growth of passive investing through index funds, underscored the importance of benchmarks and made underperformance a quantifiable and frequently observed outcome. The Bogleheads community, for instance, emphasizes the long-term tendency for active funds to underperform their passive counterparts, further popularizing this perspective.5
Key Takeaways
- Underperformance occurs when an investment's return is lower than its selected benchmark or comparable peer.
- It is a key metric for evaluating investment strategies and managers.
- High expense ratios and active trading costs can contribute significantly to underperformance.
- Underperformance doesn't always indicate a poor investment, as varying levels of risk-adjusted return or investment objectives might be at play.
- Consistent underperformance often leads investors to reassess their asset allocation or investment choices.
Formula and Calculation
Underperformance is typically calculated as the difference between the actual return of a portfolio or investment and the return of its chosen benchmark over the same period.
Where:
- Actual Portfolio Return: The percentage gain or loss of the investment or portfolio over a specific time period.
- Benchmark Return: The percentage gain or loss of the standard (e.g., S&P 500, a specific bond index, or a custom blend) used for comparison over the identical period.
If the result is a negative value, it indicates underperformance. For instance, if a portfolio returned 8% and its benchmark returned 10%, the underperformance is 8% - 10% = -2%. This negative difference is also sometimes referred to as negative alpha in the context of the Capital Asset Pricing Model.
Interpreting Underperformance
Interpreting underperformance requires careful consideration of the context. A single period of underperformance might be due to market volatility or short-term deviations, which are normal. However, persistent underperformance over multiple periods or across different market cycles often signals a more fundamental issue with the investment strategy, the skills of the manager, or excessive costs. Investors typically look for consistency in performance, and consistent underperformance relative to a relevant and appropriate benchmark can be a significant concern. It is also important to consider the risk-adjusted return, as a portfolio might underperform in raw returns but take significantly less risk to achieve those returns, which could be acceptable depending on investor objectives.
Hypothetical Example
Consider an investor, Sarah, who has a growth-oriented portfolio managed by an active fund. Her chosen benchmark for comparison is the S&P 500 index.
At the end of the year, Sarah's portfolio had a return of 7.5%.
During the same year, the S&P 500 index returned 9.0%.
To calculate the underperformance:
Underperformance = Actual Portfolio Return - Benchmark Return
Underperformance = 7.5% - 9.0% = -1.5%
In this scenario, Sarah's portfolio underperformed the S&P 500 by 1.5 percentage points. This indicates that her active management strategy did not keep pace with the broader market index she used as her comparative standard.
Practical Applications
Underperformance is a critical metric across various facets of the financial world. For individual investors, it helps evaluate the efficacy of their chosen funds or advisors, prompting a review of their investment strategy. Financial advisors and portfolio managers routinely assess underperformance to identify areas for improvement in their asset allocation or security selection. Institutional investors, such as pension funds and endowments, use it to make decisions about retaining or replacing investment firms. Regulators, like the U.S. Securities and Exchange Commission (SEC), also focus on how investment performance, including instances of underperformance, is marketed to the public, ensuring that disclosures are fair and not misleading.4 Research frequently highlights the challenges active funds face in consistently beating the market, often resulting in underperformance against passive alternatives.3
Limitations and Criticisms
While a vital measure, underperformance has its limitations. Critics point out that the choice of benchmark is crucial; an inappropriate or irrelevant benchmark can make a well-managed portfolio appear to underperform, or vice-versa. For example, a global equity fund should not be solely benchmarked against a domestic stock index. Moreover, focusing solely on raw returns without considering risk-adjusted return can be misleading. A portfolio that slightly underperforms its benchmark but with significantly lower volatility might be preferable for some investors. Additionally, high expense ratios and trading costs inherent in some investment vehicles can create a significant hurdle for active strategies to overcome, often leading to underperformance even if the underlying security selection is sound.2,1
Underperformance vs. Outperformance
Underperformance and outperformance are two sides of the same coin when evaluating investment returns.
| Feature | Underperformance | Outperformance |
|---|---|---|
| Definition | Actual return is less than the benchmark return. | Actual return is greater than the benchmark return. |
| Implication | The investment did not meet comparative expectations. | The investment exceeded comparative expectations. |
| Goal of Manager | Avoided by active managers. | Sought by active managers. |
| Synonym | Negative Alpha | Positive Alpha |
Confusion often arises because both terms require a clear benchmark for context. Without a standard for comparison, neither underperformance nor outperformance can be meaningfully determined. Both are key indicators in assessing the skill of a portfolio manager or the effectiveness of a particular investment strategy in relation to its stated objectives and market conditions.
FAQs
What causes underperformance in investments?
Underperformance can stem from various factors, including poor security selection by an active management team, high expense ratios and trading costs that erode returns, an overly concentrated portfolio lacking sufficient diversification, or a mismatch between the investment's risk profile and the market environment.
Is underperformance always a sign of a bad investment?
Not necessarily. While consistent underperformance over long periods can be a red flag, short-term underperformance might be normal market fluctuation. It's crucial to evaluate underperformance relative to the investment's stated goals, its risk-adjusted return, and the suitability of the benchmark used for comparison.
How long should I tolerate underperformance before making a change?
There is no fixed rule, as it depends on your investment goals, time horizon, and the reasons for the underperformance. Many financial professionals suggest evaluating performance over periods of three to five years, as shorter periods can be too noisy to indicate a true trend. However, if the underlying investment strategy or manager's approach significantly changes or is no longer aligned with your objectives, a re-evaluation might be warranted sooner.