Manager Picking

Why Manager Picking is an Exercise in Futility

Manager Picking

An old investment proverb observes that “markets make managers.” This means that if the market favors a money manager’s particular investment style anyone can achieve outstanding performance.

Markets can make a money manager look good or bad — a factor that’s independent of their “skillful” stock picking or market-timing abilities. An active money manager that an investor selects will usually turn out to be a winning or a losing manager because of the behavior of the market itself, rather than the manager’s skill at picking stocks or timing markets. Active money managers play a game that’s almost entirely random in conferring long-term investment success among them.

There are at least three other problems associated with manager picking. For one thing, investors are seldom aware that active funds or separate portfolios that have good performance histories are often riskier than the indexes they outperform. According to Modern Portfolio Theory, any portfolio of investments that holds fewer stocks than the index in which it is invested must be, by definition, under diversified relative to that index portfolio. It follows then that any mutual fund or separate portfolio that has turned in a market-beating performance achieved it by holding investments that somehow were different in kind or amount from those of the relevant index. Any mutual fund or separate portfolio that boasts a superior performance history may have achieved it from concentration risk, which could cause underperformance in subsequent time periods.

A mutual fund manager with recent performance success has bet money and concentrated it in specific stocks or bonds. The bet may pay off, but people are too blinded by the “brilliant investment insight” to understand that the bet was too risky in the first place. Peter Lynch, the legendary manager of Fidelity’s Magellan mutual fund, concentrated about 25% of the fund’s holdings in foreign stocks in the 1980s. These stocks turned out to be top performers, and Magellan widely outpaced the S&P 500. The irony is that these stocks weren’t even represented in the S&P 500.

Lynch’s performance was not measured against an appropriate benchmark comprised of a proportionately weighted mix of U.S. and foreign stocks. It was measured against the wrong benchmark, the S&P 500. Using an appropriate benchmark would have reduced, perhaps even eliminated, his successful performance during this period. Lynch’s bet was nevertheless deemed a winner by popular acclaim, and he was widely hailed as the leading investment guru of the decade.

Had Lynch’s bet turned out wrong and Magellan underperformed, Lynch would have been widely criticized as a fool for making such a risky bet. Right or wrong, it was still a risky bet because Magellan had a greater amount of diversifiable risk than was represented in the benchmark by which it was measured.
There are two lessons to be learned from this. First, any active investment strategy is inherently risky, but is not considered risky in hindsight if it turns out to be a winner. Second, a mutual fund’s outstanding performance history is nothing more than the market’s reward for exposure to excessive investment risk. Due to the unpredictable nature of the market, the same excessive risk that produces outstanding performance today can turn and produce miserable performance in the future. Once the market begins to favor sectors other than those a manager is invested in, his or her luck has run out.

Yet another problem with manager picking is that outstanding performance histories can be surprisingly fragile. Few investors realize that the most important factor separating a winning performance history from a losing one is the choice of starting and ending dates. Fidelity’s Magellan beat the S&P 500 for the decade ending in mid-1995. Lengthening the ending date by one year to mid-1996 would have painted a very different picture. Fidelity’s Magellan underperformed the S&P 500 for that 11-year period.

Lastly, outstanding performance histories don’t always reflect taxes or commission loads. Published mutual fund ratings are often pre-tax returns that disguise their true after-tax performance in taxable accounts. Fidelity’s Magellan generated an average annual pre-tax return of 18.3% over the 10-year period from mid-1985 to mid-1995. Once the taxes and commission loads were factored in, the net return dropped to 12.7%. At first glance, this fund appeared to widely outperform the market. A closer look reveals that Fidelity’s Magellan came very close to underperforming it. However, an investor may never know this because mutual fund advertisements often feature only pre-tax and/or pre-commission load returns. Tax-adjusted returns are now available from Morningstar on the Internet at Morningstar’s tax-adjusted returns only account for federal income taxes, but not state income taxes. Investors should also consider that state income taxes need to be deducted in order to see a complete picture of how all taxes impact investment performance, especially relative to a tax-efficient index fund.

The inception date for the Magellan fund was May 1, 1963. For a 47 year, 11 month comparison of the Fidelity Magellan Fund to the IFA Indexes and Index Portfolios, see here.

Indexes such as the S&P 500 or Wilshire 5000 are often used to evaluate the performances of active money managers. Given the Fama and French findings, the use of such benchmarks is often misleading. Because these indexes are weighted heavily towards large company stocks and high priced stocks, the performances of managers investing more heavily in small company stocks or low priced stocks won’t be accurately measured by them. Instead, customized benchmarks are needed to provide accurate measurements of the contributions to performances made by active money managers.

The Fama and French Three Factor Model is a superior way to evaluate the performances of active money managers. It shows whether a manager achieves returns in excess of index returns. After all, an active manager shouldn't be rewarded just for buying value stocks—that’s something that can be done inexpensively with an indexing strategy.

The place where a portfolio is positioned or structured on the cross hair map in the figure below determines the vast majority of its return. The cross hair map doesn't plot the market risk factor since all stock portfolios take similar market risk and are plotted relative to the stock market. So, there’s no need for a separate axis; instead, the stock market sits right at the cross hairs of the map. The cross hair map has two dimensions. The size dimension is plotted along the vertical axis, and the value (BtM) dimension is plotted along the horizontal axis. The axes represent exposure to these two risk factors. Portfolios that take on a lot of size risk appear higher along the size axis, and portfolios that take on a lot of value risk appear further along to the right on the growth/value axis.