How to Pick Managed
Investments
Travis Morien
Compass Financial Planners Pty Ltd
travis@travismorien.com
http://www.travismorien.com
Types of Managed Funds
There are two types of fund:
• Index funds seek to capture the performance
of an asset class as cheaply as possible
• Actively managed funds seek to add extra
value on top of asset class performance
through selection and timing, using a
variety of research strategies
Index Funds
• Adopt a passive approach.
• Main focus is on achieving maximum diversification at
a minimum expense by holding a fixed percentage of
every security in the market, or a representative basket.
• Performance is determined by the asset class, index
funds make little attempt to do better. If the asset class
does poorly, index funds do poorly. If the asset class
does well, index funds do well.
• These funds are quite boring because they offer no
potential to beat the market, most investors aren’t even
aware they exist. Many “sophisticated” investors (and
those that aspire to be) flatly refuse to even consider
indexing because it is just too mediocre and too dull.
Active funds
• When you buy an active fund, you are making a
bet on a team of professional investors, and their
ability to generate high returns.
• May perform quite differently to the asset class as
the manager adjusts the portfolio based on their
research.
• You pay extra for this research, usually about an
extra 1%pa.
• It seems defeatist to settle for asset class returns.
Why would anyone settle for average performance
when you can be above average?
What people think of active fund managers
• Active fund managers enjoy a strong
marketing edge over passive
managers. Many attain celebrity
status and their opinions on what the
market is doing are highly sought after
by the media.
• Great faith is often placed in their
abilities, and what they do is often
portrayed as glamorous.
• Some fund managers are paid seven
figure salaries and bonuses and are
often aggressively headhunted by rival
firms.
• Above all, active fund managers are
usually perceived to be “interesting”.
Picture by Vanguard Investments.
What people think of passive fund managers
• In contrast to their more colourful active counterparts,
passive fund managers are seen as the “nerds” of the
investment business.
• Their performance objective is only to match an
index. Is this deliberate mediocrity bordering on
negligence?
• You probably wouldn’t want to be stuck next to a
passive fund manager on a long flight, because all
they ever talk about is tax efficiency, cost
minimisation, diversification, asset allocation and buy
and hold investing. Where is the fun in that?
• Passive fund managers claim to have no special
insights into what the market is going to do, and have
no clever strategy that they intend to employ to “beat
the market” by a large margin, often recommending
investors “stay the course” and hold a diversified
portfolio through thick and thin.
• Above all, passive fund managers are usually
perceived to be “boring”.
Picture by Vanguard Investments.
Percentage of active funds
underperforming their benchmark index
after fees in the 5 years to 31 March 2004
100%
80%
60%
40%
20%
0%
100.0%
51.0%
52.0%
Aus shares
Intl shares
75.0%
76.0%
Aus listed
property
Aus bonds
Underperforming
Source: Mercer/Morningstar IDPS Survey
Aus cash
Outperforming
Median fund manager return vs comparable
index 5 years to 31 March 2004
15.00%
10.00%
5.00%
Active fund
Source: Mercer/Morningstar IDPS survey
Index
Cash
Aus
bonds
Listed
property
Intl
shares
-5.00%
Aus
shares
0.00%
A portrait of failure: the performance of every US large cap fund with a 15
year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31
December 2001 (285 Funds)
Picture credit: Dimensional Fund Advisors
It gets a whole lot worse!
DALBAR Inc wanted to work out how much of a return retail investors were actually
getting from their US mutual fund investments.
The return they get isn’t necessarily the same as the average return of mutual funds
because hardly anyone buys and holds, they usually chase the performance of funds that
appear to be doing well, selling their funds that lag. They also have a tendency to sell
(or cease contributing) during weak markets, but buy enthusiastically during strong
markets, especially when those strong markets have run for several years.
Figures show that the average time retail investors hold US Mutual funds is only 29.5
months, this has been trending downward for many years.
DALBAR, Inc. have been tracking monthly inflows and outflows by retail investors
since 1984, in the 1997 update of their Quantitative Analysis of Investor Behaviour
Study, they concluded that:
“Mutual fund investors earn far less than reported [fund] returns due to their investing
behaviour. In their attempt to cash in on the impressive stock market gains, investors
jump on the bandwagon too late, and switch in and out of funds trying to time the
market. By not remaining fully invested for the entire period, they do not benefit from
the majority of equity market appreciation.”
Annual returns of “buy and hold” index vs actual
annual returns enjoyed by US mutual fund investors
from 1984 to 2002
14.00%
12.22%
11.70%
12.00%
10.00%
8.00%
6.00%
4.00%
4.24%
2.57%
2.00%
0.00%
US Stocks
Index
US Bonds
Mutual fund investor
Source: DALBAR, Inc. Media release of 2003 update of study.
Frightening thought….
• The average American mutual fund investor only managed to earn
2.57%pa during one of the strongest bull markets US equities have ever
seen, underperforming the S&P500 index by a truly staggering 10%pa.
Inflation was about 3.14%pa over this period!
• The most inept investor in the world could have made about 12.22%pa
by buying and holding an S&P500 index fund.
• Dalbar Inc place the blame squarely on the shoulders of market timing.
The pattern is always the same: investors are notorious for buying in
during the dying moments of a bull market and tend to get in near the
top. Then the market falls and investors react by selling. They then stay
out of the market for a long time until another long bull market has
convinced them it is once again “safe” to invest, just in time to catch the
next big fall!
• If these levels of market timing skill and fund selection prowess
continue, what kind of return will these investors earn if the market isn’t
as strong? The 1990s were a truly fantastic time to be invested in
equities. Despite the strong markets, investors still managed to snatch
defeat from the jaws of victory.
• Incredibly, these figures don’t take into account taxes, advisor fees, wrap
account fees or transaction fees. OUCH!
Inflow and outflow data has been suggested to be useful as a
“contrarian” timing signal. Unusually high mutual fund inflows are
often a sign of an impending market top, serious outflows often auger a
market bottom. Although exactly how much money one could make by
doing the opposite is questionable, there is little doubt that performance
chasing is historically a bad strategy.
"Investors continue to sour on stocks. So far this year, investors have
made net withdrawals of $11.3 billion from their stock mutual funds
according—including a hefty $3.7 billion just last week—according to
AMG Data Services.” Source: Gregory Zuckerman, "Investors Rush to
Buy Bonds, Fleeing Stocks," Wall Street Journal, March 11, 2003
S&P500 index 2000 - 2003
1/10/03
1/07/03
1/04/03
1/01/03
1/10/02
1/07/02
1/04/02
1/01/02
1/10/01
1/07/01
1/04/01
1/01/01
1/10/00
1/07/00
1/04/00
1/01/00
1550
1450
1350
1250
1150
1050
950
850
750
Is index tracking more risky?
You’d think that with diligent professionals at the wheel, even if they can’t
outperform indexes after costs at least they can manage risk properly by prudently
avoiding risky companies. Are active funds less volatile?
Actually, active funds on average are more volatile than index funds because they
are less diversified.
18
16
14
12
10
8
6
4
2
0
16.9%
17.8%
14.5%
12.7%
Return
S&P500 index
Std deviation
Average active fund
Source: TAM Asset Management, Inc “Investment Policy Guidelines & Strategies Within the
Context of The Prudent Investor Rule, “average active fund” = average of 7125 US domestic equity
mutual funds in the Morningstar Principia Pro Database July 1991 - July 2001.
• The average active fund does not outperform the index,
and the average managed fund unit holder does even
worse because they trade too much.
• Active funds are less diversified and therefore more
volatile than index funds and there is no evidence that
they outperform in down markets, quite the contrary in
fact.
• Especially in the conservative asset classes like bonds
and cash, and even property securities, there are almost
no outperforming active funds and based on the
statistical evidence it is very hard to justify active
investing in these sectors. The stock market has its
Warren Buffetts, Peter Lynchs and John Templetons, but
not other asset classes.
• Research houses in general refuse to even go near index
funds, they won’t rate them, insisting that their job as
researchers is to identify funds that will beat the index.
• While corporate pension funds are taking up indexing
enthusiastically, indexing is still anathema to financial
advisers and private DIY investors share no more
enthusiasm for index funds than the professionals.
• Index funds are unpopular with every type of investor
because almost 100% of investors think they are above
average and possess superior investment skills. Is this faith
warranted based on the evidence from Dalbar Inc and
others? Mathematically, is it possible for most people to be
above average or are investors deluding themselves?
The arithmetic of active management
• The average performance of all investors will be the same as the market. It is
impossible for everyone to be above average, mathematically it just can’t
happen!! Half will fail because somebody always gets stuck holding the bad
stocks!
• The aggregate return of all investors in the market will be the market return,
(obviously), because all the investors own all the stocks. The market return is the
weighted average of passive returns plus active returns.
• If the index funds have the same pre-fee return as the market (which is what they
set out to do), then the other type of investor (active) will also have the same prefee return. If index funds bought, say, 30% of every stock issued, the remaining
70% left to the active investors would still have market index weightings.
• This is a zero sum game, the average return of all active investors before costs is
necessarily going to equal the average return of the market.
• Active investment is usually more expensive than passive investment so active
funds, as a group, will do worse than index funds after fees.
• No amount of trading or research will change that. Some will outperform, but as a
group they will underperform. Like a poker game, money is redistributed but not
created or destroyed by active management.
• Costs drag down the average performance of all investors. The average
performance of all investors will be the market average return, minus the average
expenses. To ensure that your net performance is above average, diversify
extensively and keep expenses well below average.
Whether the market is up or down, low cost diversified investors will still outperform the
majority of investors after costs, even if some investors still manage to outperform. Source: “The
Inefficient Market Argument For Passive Investing”, Professor Steven Thorley, the Marriot
School at BYU. Used with permission.
Figure 1a: Distribution of Simulated Portfolio Returns for 1996
Before Costs
1000
1000
Index Fund Return
900
900
800
800
700
700
Portfolio Count
Portfolio Count
Figure 2a: Distribution of Simulated Portfolio Returns for 1994
Before Cost
600
500
400
300
600
500
400
300
200
200
100
100
0
Index Fund Return
0
-20 -15 -10
-5
0
5
10
15
20
25
30
35
40
45
50
-20 -15 -10
-5
0
5
Percent Return
1000
900
800
800
700
700
Portfolio Count
Portfolio Count
20
25
30
35
40
45
50
40
45
50
Figure 2b: Distribution of Simulated Portfolio Returns for 1994
After Cost
Index Fund Return
900
15
Percent Return
Figure 1b: Distribution of Simulated Portfolio Returns for 1996
After Costs
1000
10
600
500
400
300
600
500
400
300
200
200
100
100
0
Index Fund Return
0
-20 -15 -10
-5
0
5
10
15
20
Percent Return
25
30
35
40
45
50
-20 -15 -10
-5
0
5
10
15
20
Percent Return
25
30
35
Percentage of Australian share funds
underperforming the ASX200 in the three years
to June 30 2002.
100%
80%
60%
40%
20%
0%
66%
56%
66%
1 year
2 years
3 years
Underperforming
Source: TD Waterhouse, data by ASSIRT
Outperforming
Survivorship bias
• Over longer time frames, “survivorship bias” affects the
data. If you close down or merge the underperforming
funds (and delete them from your database), replacing them
with new funds with better track records, you’ll bias the
sample average upwards, making active funds look better as
a group.
• In a previous slide “the arithmetic of active management” I
mentioned that somebody always gets stuck holding the bad
stocks. Survivorship bias is the mechanism for ensuring
that these people are ignored. The database will exclude a
number of below average performers, making the average
look a lot better.
• US researcher Burton Malkiel (author of A Random Walk
Down Wall Street) estimates that survivorship bias adds
1.4%pa to the return of the median fund manager. For small
company funds and sector funds, estimates exceed 2%pa.
Survivorship bias: amount median prices
are overstated per year
3 years 5 years 7 years
Australian shares
Global shares
Fixed interest
0.77%
0.79%
0.09%
0.25%
0.39%
0.20%
0.41%
0.66%
0.19%
Balanced pooled funds
0.52%
0.22%
0.20%
Source: Russel Investment Group, periods ending 30 June
2004, “Insights” IN107.
Another bias called “creation bias” is introduced
when fund managers create new funds. They give
seed capital to a lot of money managers, but the
ones that underperform during their trial period
are never opened to the public.
In this way, all new stock funds (that the public
hears about) come with a suitably high past
performance, further tainting the data.
It is of course nearly impossible to get accurate
figures to quantify the size of creation bias.
• Survivorship bias of course affects other
asset classes as well.
• This means that active funds do even worse
in international markets than they do in the
biased sample. (Scary thought!)
• Estimates made in the US show that barely
15% of active stock funds outperform the
S&P500 index over the long term once
survivorship bias has been corrected.
• Most funds will underperform, but how do
we identify the exceptional ones?
The top 25% of share funds in 1997: how
many of these gave top quartile
performance again in the next three
years?
25%
20%
15%
10%
5%
0%
25%
10%
1997
1998
Source: Frank Russell Australia, data by Morningstar
0%
1999
0%
2000
Number of funds
The top quartile Australian funds of 1999:
how did they perform in the year before
and the year after?
30
25
20
15
10
5
0
1998
Bottom
1999
Third
Source: Frank Russell Australia, data by Morningstar
2000
Second
Top
• If you are going to select active funds, you are best not going on recent past
performance (if anything, do the opposite, but I don’t recommend blind
contrarianism as a strategy). According to Morningstar, about 75% of investors
invest in last year’s top quartile funds, which explains DALBAR Inc.’s figures.
• While long term performance data seems to have some value, it is mainly
effective as a negative filter. Long term losing funds tend to be discontinued by
the fund manager, they rarely get better by themselves. Winners don’t reliably
repeat.
• I don’t take fund research house ratings very seriously. For example $1,000
invested in funds given a 5 star rating by Morningstar Australia between June
1998 and June 2000 would have produced $1,460 at the end of the two year
period. But $1,000 invested in a four star fund would have produced $1,588,
despite the funds’ lower rating.*
• Hulbert Financial Digest, an American investment newsletter, tracked the
performance of Morningstar US’ 5 star picks from 1991 to 1997 and found they
lagged the S&P500 on average by nearly 3%pa.
• Ok, so what does work then?
*Source: Frank Russell Australia, though Morningstar retorted with a similar
finding on Frank Russell’s recommendations, which have done little better.
Fama and French’s “Three factor” model
Your returns mostly come
down to asset allocation:
• The mix of stocks vs bonds
• The average company size
• The value characteristics of
the stocks - how “cheap”
stocks are compared to book
value.
Picture credit: Dimensional Fund Advisors
January 1980 to December 2003. Large
companies vs small companies vs value
companies
25%
20%
15%
10%
5%
0%
12.80%
13.94%
11.73%
16.04%
19.62%
17.78%
Aus large Global Aus small Global Aus value Global
large
small
value
Annual return
Source: Dimensional Fund Advisors
Annualised volatility
Value premium
• Academics who used to favour the random walk hypothesis and dart
throwing no longer debate whether there is a performance premium
for “value” stocks, they now debate why there is a performance
premium.
• Is the value premium because value stocks are underpriced
(inefficient market) or because they are more risky (efficient
market)? This is still hotly debated in academic circles and there is
evidence to support both arguments, so in reality it is probably a bit
of both.
• A value premium has been demonstrated in virtually every market
examined, including USA, Europe, Asia, Australia, UK and various
smaller markets.
• Dimensional Fund Advisors run two passive value funds that buy the
cheapest 30% of stocks on the market, the DFA Australian Value
Trust, and the DFA Global Value Trust.
Small company premium
• The small company premium is almost certainly due to the higher risk of
smaller companies, to that extent it seems to be consistent with the
efficient market hypothesis.
• The small company premium is certainly less reliable than the value
premium, outperformance seems to be restricted to rapid bursts, they are
quite volatile.
• Small cap performance seems to be correlated with rising inflation rates,
some researchers think this is because small companies can adjust their
prices more readily than large companies, but this is just one explanation,
there are many others.
• Probably best for conservative investors to avoid small caps and buy
value indexes if they want to beat the market with moderate risk.
• The small company premium has not been observed in every market,
including Australia. Small caps have underperformed the ASX100.
• Dimensional also has Australian and global small cap index funds, the
DFA Australian Small Companies Trust and the DFA Global Small
Companies Trust.
Value vs growth
The academic definitions of value and growth are polar opposites, they
usually define value stocks as being the stocks with the lowest price to
earnings ratios (PER) or price to book ratios (PBR). Growth is defined
as the stocks with the highest ratios.
Value and growth are practically irrelevant in large cap funds, there are
few deep value or extreme growth stocks in the top 100.
Thanks to their preoccupation with “tracking error”, many large cap
“value” and “growth” managers hold virtually identical portfolios. This
has lead to a myth that value and growth are just “investment styles” that
perform about the same in the long term.
In fact, “deep value”, really extreme value stocks as identified by PER or
PBR performs markedly better than high priced “growth” stocks.
Small cap value companies perform extremely well, but small cap
growth are a disaster in both risk and return - speculators beware!
What are the best indicators of future returns?
• The most reliable indicator of future performance is the fund fee: more
expensive funds underperform the most. This accounts for the majority of
variation between fund managers over the long term.
• The next indicator is asset allocation, which dominates short term returns
(quarterly data), but in the long term accounts for a significant but not dominant
difference. Obviously funds with a higher weighting to stocks instead of bonds
do better in the long term and deep value small company stocks are particularly
rewarding.
• Stock picking obviously has an impact on performance, but identifying skilled
stock pickers in advance is hard. By the time the manager’s skills are
recognised the fund may have become so large that keeping up this high
performance becomes extremely difficult. Headhunting is also rife, so you may
find that the manager you respect may well not be working there much longer.
• Tax efficiency has a major effect on post-tax returns. This goes beyond just
franking levels, you also need to look at capital gains distribution rates, the
amount of short term distributions (as opposed to “long term” discountable
capital gain distributions), and also unrealised capital gains on unsold stock. If
you must use a tax-inefficient fund, consider buying it in super, stick with tax
efficient funds for personal investments.
Source: Common Sense on Mutual Funds by John Bogle
Why buy an index fund?
•Chances of relatively high performance compared to active funds
are very good.
•Most index funds are extremely tax efficient (stocks anyway, not
bonds of course!), so their performance after tax compares even
more favourably.
•Index funds don’t change much. You can buy one and safely forget
about it, no need to change funds every year. Apart from anything
else this saves you the time and costs of having to closely monitor
your investments, or pay an advisor to do it.
•Index funds are usually less volatile than actively managed funds.
Active funds usually hold more concentrated portfolios, but index
funds only hold a couple of percent in their biggest investments.
Exposure to individual stocks is minimal.
•Indexing means never having to say you’re sorry.
Why buy an actively managed fund?
There are a few reasons to use active funds instead of, or
as well as index funds:
•despite the odds, perhaps you think a particular fund can
outperform
•there may not be an index fund available for an asset class
you wish to invest in, so you don’t have much choice
•if the active fund is different enough to the index, maybe
it will diversify the portfolio and potentially reduce overall
portfolio volatility (long/short managers are particularly
good for this).
Other things to look for in an actively managed fund:
The fund should be very different to an index fund. Active funds that try to
minimise “tracking error” inevitably fail to add value in the long term. To
outperform the index takes more than conservative tilts to 20% of your portfolio.
Top investors like Warren Buffett get beaten by the index 40% of the time. You
may remember the heady days of the tech boom of the late 1990s, pundits called
Buffett an obsolete dinosaur who had lost his touch, though in the end Buffett was
proven right, as usual. If you want to outperform in the long term you’ll have to be
prepared for periods of underperformance, and learn to ignore the pundits.
Index funds are cheap. You can buy the SSGA Streettracks ASX200 index fund for
an annual fee of only 0.286%pa, so how do you value active management?
An active fund that is 80% index + 20% active will not add value. If the index
hugging “active” fund is charging 1.5%pa, then they are charging a small fortune
for their little tilts: 80% x 0.286%pa + 20% x 6.356%pa = 1.5%pa
It would be more cost effective to combine a cheap index fund with a fire breathing
active stock picking fund if you want performance, rather than buy an index
hugging active fund. Don’t pay active MERs to index your money.
The marketing business vs the investment business
The priority of a fund manager keen to reduce tracking error is first and foremost to
avoid upsetting people. They want to minimise the risk of relative
underperformance, not maximise the probability of outperformance. If a fund
manager doesn’t like an index stock, he probably shouldn’t buy it. It seems rather
silly to load up on something just because it is a big company.
Many fund managers bought Newscorp at $30 not because they thought it was a
good stock (in fact the majority of fund managers hated NCP at that price), but
because they feared that the stock might go up further and they would temporarily
lag behind. They bought NCP just in case it didn’t fall!
Nobody was fired for losing money on Newscorp because all the rival funds lost the
same amount. Investors are less likely to pull their money out if the fund has been
average than below average. Thus, managers focus on relative quarterly
performance compared to peers, not long term absolute returns.
For business reasons unconnected with prudent investment strategy, fund managers
keen to avoid redemptions would rather buy major index stocks they don’t like than
take the risk of watching them go up while not holding them.
Tracking error is a good thing, it helps diversify your shares portfolio!
Portfolio turnover and market costs
• Buying and selling stocks is expensive. Brokerage is a
comparatively small expense compared to market impact
costs. According to a US researcher, the Plexus Group,
managed funds incur costs of around 0.8% on each side of
a transaction. It costs about 1.6% in total to buy and sell a
stock.
• Funds that turn over 100% of the portfolio give away 1.6%
to market costs every year. If we assume that stock
markets are going to average 10%pa in the long term, there
goes 16% of the total annual returns, straight into the
pockets of brokers and market makers.
• There is little or no evidence to show that fund managers
are able to consistently time the market with any reliability
(and at any rate, they are only trading with one another), so
turnover drags down the performance of managed funds as
a group.
Turnover and gross returns
• In a review of 3,560 American stock funds, Morningstar
discovered that funds with low turnover ratios generate
superior long term returns to funds with a high turnover.
Over a ten year period, funds with an annual turnover
below 20% outperformed funds with an annual turnover
above 100% by a margin of 1.58%pa.*
• Other studies by Morningstar have shown that high
turnover is associated with poor performance in both rising
and falling markets, debunking a myth that being “more
active” helps preserve capital during bear markets.
• This is completely consistent with the Plexus figures
estimating how much 100% turnover costs and proves that
trading adds no value at all!
*Source: Carole Gould "The Price of Turnover”, New York Times, November 21,
1997
Turnover and tax efficiency
• Turnover also wrecks tax efficiency because it increases
the rate of capital distributions and often leads to
substantial short term (non discountable) capital gains
distributions, these are taxed at your full marginal tax rate.
• Looking around for low turnover managed funds places
major restrictions on your choices. There are less than a
dozen fund managers in Australia who adhere to a lowish
turnover strategy, only half a dozen adhere to a very low
turnover strategy.
• Very low turnover Australian fund managers include
Maple-Brown Abbott, Investors Mutual, Deutsche Alpha
Fund and virtually all index funds. These managers
typically keep fund turnover below 30%pa.
Turnover and tax efficiency cont’d
• I won’t name names, but most of the biggest funds have turnover between
50%pa and 200%pa. There are funds with turnover even higher, 400 or 500%
turnover is not unknown. So much for long term investment!
• On the other hand, turnover generated by tax-loss selling can actually improve
tax efficiency. Not every fund manager does this because tax efficiency is
usually ignored by investors, who rarely bother to calculate after tax
performance compared to an index fund. Fund managers will continue to ignore
tax efficiency for as long as their customers are willing to overlook it as well.
• I was shocked but not surprised recently when I asked a researcher from one of
Australia’s leading fund research groups how much consideration tax efficiency
was given in the selection of managers for their fund of funds products and
manager ratings, his reply, “you know Travis, that’s never come up before!” Tax
efficiency, so it turns out, wasn’t included in the rating system at all.
• Value funds tend to have lower portfolio turnover than growth funds because of
their longer time horizons and less reliance on “momentum” approaches.
Fund size
It is a well established fact that the bigger a fund becomes, the more difficult it is to
add value. (Though of course index funds don’t find size a handicap and in fact some
fund managers have used size to their advantage using methods like block trading.)
Billion dollar funds simply can’t invest in small and/or illiquid companies because
they impact prices too much and would take too long to buy or sell their holdings.
There is a direct conflict of interest between a fund manager’s marketing people that
would like the fund to become infinitely large, and the investment people that want to
keep it manageable.
There is no point researching small companies because the manager couldn’t possibly
invest a meaningful amount in them, so big funds are forced to deal in the more
“efficient” large cap sector of the market, where outperformance is largely a matter of
luck!
Buying a very large fund with high fees & high turnover is an almost guaranteed way
to underperform over the long term. Corollary: don’t buy funds that advertise on TV!
In the last few years, boutique fund managers have really come into their own,
managers like Investors Mutual, Hunter Hall, MMC, Platinum and PM Capital have
amazed investors with spectacular performance. There is little or no evidence that
these managers are any more risky than more familiar large funds.
Staff and stability
Nothing is more annoying than buying a managed fund because you are
impressed with the chief investment officer, only to have that manager
poached by a rival fund manager.
Managed funds have very high staff turnover, poaching is rife! Although
generally funds have succession plans in place and documented
investment strategies, stock picking skill is innate to individuals and can
not be branded. Staff turnover is one of the major reasons why past
performance is no guarantee of future results.
Classic examples include ING’s Smaller Companies Fund, a great
performer until BT poached the managers offering them seven figure
salaries, also BT used to be great until the managers now known as the
“BT Babies” left, and even Colonial First State have had several bad
years, which just happened to coincide with Greg Perry and a few others
leaving. This “musical chairs” goes on all the time in the funds industry.
Case study: the “BT Babies”
• Following the careers of the “BT Babies” is interesting. This is the
nickname given to three of BT’s top former fund managers who left the
firm to open their own boutique fund management firms.
• Kerr Neilson left BT to start Platinum in 1994, Paul Moore left to start PM
Capital in 1998 and Mike Crivelli started Perennial Investment Partners in
1999.
• Each of these individuals were extremely successful managers for BT for
many years and the BT funds they ran all beat their benchmarks by a handy
margin. When they left to start their own firms they did even better.
• With the loss of their top managers BT never really recovered, they’re now
little more than a shadow of their former self. There are lessons here for
other leading fund managers, you can create a brand but no institution can
make a team outperform. (BT has since reinvented itself and has an
entirely new team of investors.)
• My own investigations show that past performance is more reliable when
you track the performance of an individual investor rather than a firm. The
short duration of many investors’ terms with a particular fund is, in my
opinion, one of the reasons why past performance is such an unreliable
measure of future potential when you base your analysis on funds. I follow
the person, not the institution.
Nobody works harder than an owner
• A very encouraging signal that a manager is not going
to be seduced by a better offer is that the manager
owns significant equity in the business.
• Platinum, Investors Mutual, Hunter Hall, PM Capital,
Maple-Brown Abbott are all fund managers where the
man managing the money owns significant equity in
the firm and/or is paid according to performance.
• The manager will retire one day, and there is no
guarantee the successor will perform well, but at least
poaching is probably out of the question. It is hard to
poach the founder of a firm, much easier to target an
employee.
Eating their own cooking
• Another good sign is when managers have a significant amount
of their own money invested in their own funds, including their
superannuation and their family’s personal investments.
• One has to worry when a fund manager has their personal money
invested very differently to the construction of their managed
fund, but this is not uncommon among very large funds where
committees run the show and risk managers tell the fund to load
up on major index stocks purely to reduce “tracking error”.
• You rarely see money managers for the really large institutional
funds given equity in their product or even investing their own
money in the funds they run. What you more often see is the
manager running their own in-house funds, quite different to the
products they sell the public, usually for their own money they
ignore tracking error and omit, rather than underweight, index
stocks they don’t like.
Questions to ask your fund manager
• Break down your performance figures into “income” and
“growth”? Growth is more tax efficient for most
investors.
• Break up the income component into realised capital
gains and dividends / interest / rent? If the income figure
is more than, say, 4 or 5%, much of it is probably trading
profits and indicates that the manager is probably
churning the portfolio.
• Break up the realised capital gains into discountable
(long term) CG vs non-discountable short term CG?
Personal investors and super funds pay a much lower rate
of tax on long term capital gains.
• What is your normal expected portfolio turnover, and
what has it been in each of the last three years? Anything
more than 30 or 40% is high churn.
• What is your franking level?
Efficient market hypothesis
You’ll note that so far in this presentation I have not made the claim that the market is
completely efficient and that exceptional investors are the product of pure luck, as
many academics do.
I didn’t make that claim because I don’t believe it. Warren Buffett was not “lucky” to
have earned nearly 30%pa from 1956 to the present day, and I don’t doubt that
Colonial First State’s Greg Perry was a first rate stock picker and “his” Imputation
Fund was a real winner – up until the point when he quit!
The trouble lies in identifying such individuals in advance, before their funds get too
large and before the manager retires or gets poached. This isn’t much easier than
outperforming the market yourself because it usually takes a superior investor to
recognise a superior investment approach. Track records are fickle things in this
business, by the time you have established a good one the factors that enabled you to
outperform (including small portfolio size and the attendant flexibility this brings)
may be gone.
Index approaches work because of low costs and tax efficiency, not because
outperformance is impossible. Index funds would beat active funds regardless of how
efficient the market is, in small caps, emerging markets, overseas or anywhere else.
You can believe in inefficient markets and still embrace indexing. (I do!)
If everyone indexed, would the market cease to be
efficient? Would there be a bubble in index stocks?
The critics of indexing have made this claim since indexing first
started gaining momentum in the 70s, but it lacks credibility.
Studies have found that index funds account for only a small
percentage of monthly transactions in stocks, typically under 5%.
To claim that 5% of trades by passive investors doing no analysis
set the prices for the other 95% of trades by active investors defies
common sense.
If sheer weight of “dumb” indexed money was what drove index
stock prices then it is hard to understand how individual stocks
move so differently. There are always stocks moving against the
trend, indicating that those 5% of trades are not as influential in
price setting as critics claim they are.
Studies have failed to find any evidence of “index bubbles”.
If you are going to invest in actively managed funds…
•Remember that the odds are against you, you should only invest in an active
managed fund if you have a very high level of confidence in the manager. If you
aren’t willing to do a significant amount of homework you should stick to index
funds. Few active funds have come anywhere near the long term performance of
value indexes, which have in turn beaten large company indexes like the All
Ordinaries and MSCI World index and you have to remember that the value index
funds are highly tax efficient as well, magnifying their relative outperformance.
•It should not be a surprise that the characteristics of an ideal fund manager resemble
those that any good investor should strive for: long term discipline, a willingness to
ignore the crowd and take unpopular positions, an ability to isolate facts from
opinions and a willingness to take a long term view.
•Read up on Warren Buffett and the great masters. There are common threads that
may help you recognise a good investor when you see one.
•Such fund managers are actually very rare. The majority of funds are really just
“product” produced by financial institutions. Their concerns are the same as any
product manufacturer: maximising profit margins, increasing volume and market
share, building a brand and getting their logo printed on everything! These concerns
are usually directly opposing the interests of investors.
A perfect active fund manager:
• small to medium sized fund
• no index hugging, active managers need to be willing to stick their necks out.
• low fees, but performance based fees are ok
• managers are given strong incentive to perform well because they have their
own money invested in the funds
• key staff are less likely to accept a generous offer from another manager if they
are equity partners in the business. It is hard to persuade a business owner to
go work for the competition!
• low portfolio turnover is better than high turnover
• the manager considers tax efficiency of the fund to be a vital concern and
management of distributions is a high priority activity by the manager.
• good long term performance is a bonus but not necessarily indicative of future
performance
• short term performance usually is a better contrary indicator
• good “value” funds outnumber good “growth” funds
Summary
• Active funds as a group do not beat index funds. If you want a low stress high
probability investment strategy, forget “beating the market” and buy and hold
index funds.
• “Value” strategies outperform “growth” over the long term, though not
necessarily every single year. Value has beaten growth in every decade since
the 1930s, and has done so in many international markets.
• There is also a slight performance premium for smaller companies,
particularly small value companies.
• Small “growth” companies, usually the favourites of speculators and stock
brokers are historically the most risky and worst performing class of stock.
• Costs matter a lot. If you want to improve performance you are more likely to
get better results by focusing on tax efficiency, brokerage, reducing turnover
and minimising fees. There simply is no more reliable way to increase returns.
• Fees will probably matter more in the next ten years than the last, because
average returns are probably not going to be as high.
Recommended reading
•Common Sense on Mutual Funds by John Bogle
•The Intelligent Asset Allocator by William Bernstein
•A Random Walk Down Wall Street by Burton G. Malkiel
•The Intelligent Investor by Benjamin Graham
•Common Stocks and Uncommon Profits by Phil Fisher
•One up on Wall Street by Peter Lynch
•Beating the Street by Peter Lynch
•How to Pick Stocks Like Warren Buffett by Timothy Vick
•Contrarian Investment Strategies: The Next Generation by David Dreman
•John Neff on Investing by John Neff
•Money Masters of Our Time by John Train
•Masters of the Market by Anthony Hughes, Geoff Wilson and Matthew Kidman
Web sites of interest
http://www.stanford.edu/~wfsharpe/art/active/active.htm
http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm
http://marriottschool.byu.edu/emp/srt/passive.html
http://www.diehards.org/
http://www.investorsolutions.com/ArticleShow.cfm?Link=art_It_Dont_Get_Much_
Worse_Than_This.cfm
http://www.investorhome.com/cherry.htm
http://library.dfaus.com/faqs/
http://library.dfaus.com/articles/dimensions_stock_returns_2002/
http://www.indexfunds.com/
http://faculty.haas.berkeley.edu/odean/
http://www.efficientfrontier.com/
http://www.tweedy.com/library_docs/papers.html
http://www.travismorien.com
Disclaimer:
This article contains the opinions of the author but does not represent a
personal recommendation of any particular security, strategy or
investment product. The author's opinions are subject to change
without notice.
Information contained herein has been obtained from sources believed
to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be
considered investment advice or an offer of any security for sale.
Investors should seek the advice of their own qualified advisor before
investing in any securities.