How do you deal with underperformance?

Alfredo Granata

• Location: Rome
• Invested assets: €8bn 
• Membership: 170,000 
•  First-pillar fund for self-employed engineers and architects 

“For both our passive and active mandates we set a reference benchmark and a maximum level of tracking error. 

Our custodian bank supplies the technology to monitor these aspects closely and we look at daily performance and monthly tracking-error levels. If we observe either absolute or relative underperformance of a strategy, or we find that a manager is exceeding the tracking-error levels, depending on the extent of the underperformance, we will complain to the manager. 

We do not react to every instance of underperformance by managers. Our minimum time horizon for each strategy is 12 months, so we can tolerate some underperformance and non-compliance with tracking error during a similar period. But if we observe an extended period of underperformance or tracking error exceeding expectations we will request a report from the manager on the reasons for that situation. We will also expect the manager to take steps to reduce the tracking error immediately.

If compliance with the tracking error requirement is not restored there are grounds to discuss replacing the manager with the board of directors.

Similarly, if we observe prolonged outperformance and also continued non-compliance with tracking-error requirements, we will ask the manager to review this and to explain why. 

If the underperformance occurs but the limits to tracking error are respected, we simply ask for an explanation, and accept that it may be due to a temporary weakness of the strategy. In this case, underperformance may not justify changing the strategy, as it is still be an integral part of the overall portfolio strategy, which may not be affected by the temporary underperformance.

For example, we would accept that an active bond manager has decided to reduce the duration of the portfolio without informing us, so long as the portfolio is not positioned too far from our initial indications. 

A real-life situation that occurred concerns an active equity manager which, at one stage, regularly outperformed and underperformed its benchmark index – the S&P500. We realised that situation was due to the manager integrating small-cap stocks into the portfolio. The manager was cautioned against doing that again, as it conflicts with our strategy of giving mandates for special asset classes, such as small-caps, to specialised managers.”