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Five Lies About Fund Manager Talent

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Former Oakmark Fund OAKMX manager Bob Sanborn. Yackman Fund's YACKX Don Yacktman. Former Internet Fund WWWFX manager Ryan Jacob. These once-revered fund managers have fallen to earth.

That begs the question, How talented were they in the first place?
There's no easy way to figure out whether a fund manager is a gifted stock-picker who can keep it up or merely a lucky one who was in the right place at the right time. But that doesn't stop fund investors from trying. Here are the ways we "prove" how brilliant our fund managers are--and why our efforts fall short.

1. "She Has Beaten Her Peers during the Past X Years."
We think that because our managers have done well in the past, they'll continue to do well in the future, even if what we're drawing on amounts to just a couple of years. But a manager may have been riding a trend, such as Internet mania. Is that investment skill or dumb luck? Returns can't tell the difference.

"What about looking at a five- or 10-year period?" you counter." If a manager outperforms for that long, won't he continue to outperform?"

Maybe, maybe not.

Oakmark Fund's returns landed in the top third of the mutual fund universe every year between 1992 and 1997. That seemed like a reasonable stretch of good returns; surely it would continue. It didn't. In 1998 and 1999, the fund's performance sank to the fund industry's lower depths. The fund's year-to-date returns through June fall in the bottom 10% of all funds.

Further, statisticians will tell you that you need 20 years' worth of data--that's right, two full decades--to draw statistically meaningful conclusions. Anything less, they say, and you have little to hang your hat on. But here's the problem for fund investors: After 20 successful years of managing a mutual fund, most managers are ready to retire. In fact, only 22 U.S. stock funds have had the same manager on board for at least two decades--and I wouldn't call all the managers in that bunch skilled.

2. "Just Look at the Size of His Alpha!"
Alpha is probably the most popular and most misunderstood statistical measure that investors use to gauge a manager's skill. Alpha is the difference between a fund's expected returns, based on the amount of risk it's taking on, and its actual returns. It's often referred to as the value added by management. (For the nitty-gritty on alpha, including how it's calculated and used, visit the Morningstar.com Interactive Classroom, Funds 205: "Gauging Risk and Return Together, Part 1".)

But alpha isn't an airtight measure of skill, for a couple of reasons. It depends on two other variables--beta and R-squared--which are themselves shaky. Alpha only means something if beta is meaningful, and beta is only meaningful if a fund's R-squared (a measure of correlation) versus the comparable index tops 80. (Confused? Learn more about beta and R-squared in Funds 203: "Looking at Historical Risk, Part 1".) Perhaps more important, a high alpha could come from plain old luck. There's no way to tell.

3. "Morningstar Gives Her 5 Stars."
Ouch--pull out the Morningstar rating and use it against me!

There are a couple of problems with using the Morningstar rating as an indicator of manager skill. For starters, though we've found that the star rating has some predictive abilities, all it really tells you is how well a fund has performed in the past, given the risks it has taken on. (For more about how we calculate the star rating and how to use it, read "Secrets of the Star Rating".) Just as past performance and alpha can't indicate future success, neither can star ratings.

Moreover, we don't rate fund managers--we rate funds. There's a big difference. When Garrett Van Wagoner left Govett Smaller Companies GSCQX to start his own funds, for example, he didn't take his 5-star rating with him; it remained with the fund. Likewise, when Bill Nygren took control of Oakmark Fund earlier this year, he inherited the fund's sickly single star. We didn't replace it with the 3-star rating of Nygren's other charge, Oakmark Select OAKLX.

4. "I've Heard Her Speak, and She Knows Her Stocks Inside and Out!"
This is one I fall for all the time: confusing well-spoken managers with talented ones.

Let's take a noninvestment example here: baseball players. Some sluggers can't explain how they hit home runs. But does that have anything to do with a hitter's ability to recognize a pitch and whack it out of the park? Of course not. Just because a hitter can detail exactly how he hits a home run doesn't make him Mark McGwire.

It's the same thing with fund managers: Some are good talkers; others aren't. The talkers aren't necessarily better investors than the reticent types. And many of the managers who rarely speak, such as the teams at American Funds and Sequoia SEQUX, are actually brilliant investors.

5. "He's So Different from Everyone Else."
Departing from the norm certainly can lead to greatness. Berkshire Hathaway's BRK.A Warren Buffett didn't make himself an investing legend by following the conventional wisdom of spreading out his bets; instead, he focused on a few companies. Third Avenue Value's TAVFX Marty Whitman didn't earn his place in the fund-manager pantheon by following the crowd, either. He made a name for himself by profiting from out-of-favor securities.

Yet going against the grain doesn't always pay. Just look at investors, such as former FPA Paramount FPRAX manager Bill Sams, who have been waiting years for gold's rebound.

Plenty of concentrators eventually suffer, too. Take Don Yacktman. He generally keeps at least half of Yacktman Fund's assets in its top 10 holdings. That strategy worked wonderfully--until top holdings Philip Morris MO and Department 56 DFS each shed nearly half their values in 1999. The fund lost 17% that year, placing it in the bottom 1% of all mid-cap blend funds.

So What Should We Be Looking For?
This doesn't mean that you should ignore performance, ratings, iconoclasts, and managers who can string together complete sentences. Nor does it mean that skilled managers don't exist. Most would agree that Tom Marsico, Legg Mason's Bill Miller, and Janus' Helen Young Hayes are, in fact, skilled. What it does mean is that skilled managers are tough to spot and even tougher to quantify and that historical information is an inadequate indicator of future performance.

So rather than obsessing about finding the most skilled manager out there, do the following:

  • Discover how your managers invest and think about how their styles will fare in different climates. No style will thrive at all times, and understanding when a manager's style will excel and suffer will help you keep performance in context.

  • Figure out if too many assets will adversely affect performance. Great managers can become mediocre ones if they have too much money to invest. Just take a look at the guys at Kaufmann Fund KAUFX.

  • Examine expenses. The higher a fund's expense ratio, the higher the hurdle the fund manager must overcome year in and year out.

 

Susan Dziubinski is University editor with Morningstar.com..© Copyright Morningstar

Susan Dziubinski does not own shares in any of the stocks mentioned above.