Hi Guys,
For those of us who seek excess returns, after the primary task of an asset allocation decision, the next most critical challenge is that of Finding Active Manager Expertise (FAME).
Given the sorry performance of most active mutual fund managers, this is not an insignificant task. The search harbors many false signals, and wealth depleting pitfalls and traps. As the old saw goes, “past performance is no guarantee of future performance.” Study after study reinforces this long standing truism. Even financial advisors, who spend all their time and resources attempting to identify superstar managers, often fail. The record is far from encouraging in terms of executing FAME.
David Snowball acknowledged this difficulty in his superb July Commentary. Here is a partial extract from his Dustbin of History section:
“In case you hadn’t noticed, Litman Gregory Masters Value Fund (MSVFX) was absorbed by Litman Gregory Masters Equity Fund (MSENX) in late June, 2013. Litman Gregory’s struggles should give us all pause. You have a firm whose only business is picking winning fund managers and assembling them into a coherent portfolio. Nonetheless, Value managed consistently disappointing returns and high volatility.”
David concluded by asking the question that is partially addressed in this post: “what’s the chance that professionals can assemble a team of consistently winning mutual fund managers?”
By way of full disclosure, I have owned multiple Litman Gregory mutual funds. I joined the original fund at nearly its inception in 1997. I liked the idea of a disciplined selection process designed to unearth superior managers coupled to the concept of a highly focused portfolio to augment the odds for excess returns. The dream remains, is somewhat tarnished, and is definitely elusive. Consequently, I have significantly shortened my positions with that firm.
For fairness, here is a Link to a Litman Gregory report that defines and defends their methodology:
http://www.litmangregory.com/research-articles/selecting-fund-managers.aspxThe Litman Gregory family of funds concept is not unique to them. The proper selection of an individual active fund manager can be easily morphed into a construction of a Fund of Funds strategy with the assembly of a group of actively managed funds. That’s precisely our goal in the actively managed sleeves of our private portfolios.
The Fund of Funds strategy has been under development since just after World War II. The Fund of Funds management has established a checkered history. Performance data is certainly available and is obviously better than anecdotal evidence.
Here is a Link to a performance summary of a Barclay Fund of Funds Index:
http://www.barclayhedge.com/research/indices/ghs/Fund_of_Funds_Index.htmlBe careful when accessing and interpreting these data. One potential pitfall is that many Fund of Funds proffer a mixed portfolio with substantial fixed income positions. So any legitimate comparative benchmark must be judiciously selected to match the fund’s asset allocation. When compared to a pure S&P 500 equity position, on average, the Fund of Funds excess rewards are simply not present in most instances.
Barclay also has a nice report that discusses the characteristics that they seek in choosing an active manager and fund firm. Here is the Link to their 2012 report:
https://www.barclayswealth.com/Images/Barclays_The_Science_and_Art_of_Manager_Selection_March_2012.pdfThe first one-third of the Barclay report documents the failures of most successful fund managers to deliver superior persistent performance over 3 and 5 year subsequent timeframes. The Barclay data reviews show probability distributions that resemble random rolls-of-the-dice statistics, with little demonstrated persistency skills. FAME is a fleeting commodity. But a few rare managers have the necessary skill set and the last two-thirds of the Barclay paper outlines their procedures to identify this exceptional talent.
Superior Fund of Funds do exist. The Vanguard Star fund (VGSTX), which assembles a bunch of its funds in a balanced fund mix, serves as a prime illustration. Over the long haul, this fine mix of Vanguard products has persistently done an excellent job at nearly duplicating and sometimes exceeding the returns of a pure equity holding. Like all Vanguard products, its one consistent advantage is its low cost. It does not pile extra fund management charges onto the portfolio as is often the case with Fund of Funds.
How do you go about the process of choosing a manager who guides an actively managed mutual fund to positive Alpha? What attributes do you include as part of your screening process? Here is my incomplete list.
Low costs seems to be a pervasive perennial factor. To avoid the trap that a manager is not a closet indexer, a high active share portfolio fraction is mandatory. Historical data supports the proposition that a small mutual fund is more agile and enhances the odds. Management with major skin in the game seems like a solid incentive to primarily work for the customer and not for the fund’s shareholders.
Additionally, low volatility relative to an appropriate benchmark increases geometric annual returns, adds to cumulative returns, and operates to mitigate the loss fear factor. Also, low Beta compared to a benchmark also reduces downside risk. Low maximum downside losses contrasted against some standard means that recovery demands are lessened.
Focused funds (with perhaps fewer than 50 holdings) should increase the likelihood of excess returns, albeit with an equal likelihood of underperforming with respect to an Index measure. Portfolio turnover rate is yet another factor since excessive trading frequency signals unstable investment decision making.
Another useful measurement would be the specific trading record of the manager. This statistic requires much more work to collect. It would be generated by comparing the performance of discarded stocks against replacement stock performance. It addresses the question if the individual trades increase or decrease rewards from a timing perspective.
Perspective and context are always important. There’s the old story of a man who moved from Boston to San Francisco. When asked about the relocation he replied that it was okay except that he was now too far from the ocean. Indeed it all depends on perspective.
How do you select a solid active fund manager? Please add to my incomplete list. We can all have fun with this topic.
I welcome all addition or subtraction recommendations.
Best Regards.
Comments
Thanks for this posting. I noticed it only because you alluded to the poor reception it received in your most recent posting.
About that poor reception...
Note that: 1) you posted on what was for many of us a holiday weekend 2) the MJG "brand" says to veterans of the board "long detailed post requiring time and effort". So: I know that some of us were taking the weekend off from MFO, and infer that others were on holiday from reading long postings.
One more point: you "buried the lead". If you want to stir the pot with a provocative question such as "How do you select a solid active fund manager? -- add to or correct my list" -- lead with the question -- then provide your additional exposition, links etc. I only suggest this because I recall you mentioning that you compose off-line and then paste into the board software -- a much less hasty process than most of use, I wager.
And to answer your question...
In addition to your criteria I look for:
- managers who explain themselves well in letters to investors, in a way I find plausible (e.g. Steve Romick, FPACX, but not John Hussman, who explains himself well, but not plausibly, by my lights)
- team management (e.g. Manning & Napier, Dodge & Cox)
- funds with consistent management history, including successful transitions (e.g. Vanguard funds managed by Wellington Management, such as VWIAX, VWELX)
- (more so now than in past) managers with flexible mandates
- (less so than in the past) managers with a value bias
- a past track record of success in the same fund or a similar one
I also give a low weighting to the "skin in the game" criterion. I find it mildly concerning when a manager has no investment in the fund he/she manages, but I do not let that stop me from investing in a fund that otherwise meets my criteria, particularly in the case of niche funds. I could also make an argument that a manager's judgment could be negatively impaired by having too much skin in the game as a proportion of the manager's total wealth (information generally not made available to fund investors).Finally, I would like to triple underline and boldface the point that you are interested in active managers for the active management sleeves of your portfolio, but that you also maintain a passive management sleeve.
I find I originally went from a heavy bias toward deep value investing, which resulted in certain sameness in my fund manager selections, toward a deep conviction that I want to diversify my selections among several successful investment strategies.
Cheers.
gfb
Hi Greg,
Thank you for your thoughtful and thought-provoking contribution. Based on our many past interactions I would expect nothing less. I was not disappointed.
I do prepare my MFO postings using Microsoft’s Word.
For me that tool is a necessity given that I have either the gift, or perhaps the curse, of being a prolific writer once motivated. MFO members who interpret my postings as overly lengthy and rambling might be shocked to learn that I usually severely edit my work and submit about half of the original.
Admittedly, I do not verify all of my factoids, but I do check a major fraction of my reported data and references. Once I complete that task, I verify spelling and immediately submit the work. The minor delay is part of my quality control effort to improve overall accuracy. This procedure is a residual from my previous life which included an endless number of very competitive and highly technical contract proposals.
Many thanks for expanding the active mutual fund management selection criteria list. Your recommendations added several dimensions to the list that had escaped me. It surely makes the list far more comprehensive.
We do have a minor parting-of-the-ways with regard to the significance of a fund manager’s ownership commitment to the fund he controls. I suspect our disagreement most likely centers on the magnitude of that ownership, not just that he should participate.
From my perspective, I really don’t care about the absolute dollars involved; I measure the managements commitment by the fraction (percentage) of his long-term investment holdings that he has dedicated to the particular product under consideration. A 1 % allocation (even if it is millions of dollars) is trivial in a relative sense. It is really not meaningful skin-in-the-game. A 5 % or more allotment presents an entirely different story. I recognize these data are typically not available. That’s too bad.
It’s always informative and fun exchanging investment candidates and concepts with you. I learn a lot each and every time.
Best Wishes.
Hi Maurice,
Really good stuff. In general, I concur with your assessment, but I especially liked your baseball analogy. I love stories that serve to illustrate a primary theme; you hit a home run.
Fortunately, in the construction of a diversified portfolio, it is rarely a mandatory either/or active/passive fund decision. For many institutional and private investors alike some investment policy split is considered and exercised. Given MFO’s purpose, I would be shocked to find a pure passive Index investor as a regular participant on this board.
Statistically the Investment Company Institute’s 2013 Fact Book reports that about one-third of mutual fund holders own one or more Index funds. In the equity fund arena, individual investors commit 17.6 % of their equity positions to Index products. Institutional agencies hold about 30 % of their equity resources in equity Index funds.
After submitting this post, I checked my present position on this matter. In the equity sleeve of my portfolio, I currently commit 35 % of my holdings to passively managed mutual funds.
Relative to Index benchmarks, my actively managed funds are a mixed bag of performance results with an overall slight positive edge to actively managed holdings. This current finding is consistent with my historical performance data. The lesson here is that an investor must choose wisely and monitor diligently.
Maurice, thank you for your wisdom on this controversial topic.
Best Wishes.
You need to commit to active manager on a long term basis but you risk picking the wrong horse and lagging behind on a long term basis as well. That manager risk is the reason why index funds are suggested. Yes, you can employ various filters to determine manager expertise you cannot truly eliminate that future will not play out as you expect.
Frankly, the only benefit I think managers can offer is making a majority of correct timing calls on the "market" as a whole. This becomes difficult unless they are a "go anywhere" fund. (That's why I held Fairholme, and I had already lost too much to give up). Otherwise, YOU are deciding which market segment will rise; and then, of course, you have to make the correct sell decision. (I am very poor at that.) You have to subtract their fees from their returns and compare them to the return on ETFs or broader market indices to decide if they have justified their costs. Few do.
I looked at my (many) funds today, and they were almost all up, of course; but few of them were up more than the S&P. Some of the stocks (but a disappointing percentage) were up over 1.5%, but at least I'm not paying any percentage of their value to someone else.
I love MFO (and will buy through their Amazon link), and will continue to pursue recommended funds (not those elevator guys; that's like throwing a dart - notice how none of them warn about risks?), but I think it's all about fees in the end and trying to make some broad market decisions. I hoped I was buying that from the managers, but I have been disappointed too often.
As to the "persistence" issue raised above, I think most of us are looking at the 5 or 10 year performance (when it exists) and finding it lagging the benchmark. When new funds are listed here, I look for past performance elsewhere (Cinnamond, as a prime example). I don't expect yearly outperformance, but you have to earn your fees at some point and I think a three year window is reasonable. By that time you should have realized the market is against you and have made some adjustments.
If it's all about "buy and hold", you should be indexing; and if it is about rotation, you should have a "go anywhere" manager with a record, who preferably is much younger than you. If it is about individual stock selection, you might buy Morningstar premium and look at their 5 star choices (but I'm STILL negative on Western Union, and gave up on Exelon).
Sorry, let my cynicism/pessimism take over.
Hi STB65,
Perhaps inadvertently, perhaps intentionally, you are making a pervasive case for passive investing. Many investors, fewer MFO members, share your frustrations with active mutual fund management. In terms of performance, and to lesser degree to risk mitigation, active fund management promises much more than it practically delivers.
Even professionally populated institutional entities recognize the performance gap, and, consequently, allocate 30 % of their resources to a variety of passively managed products. That’s a huge concession to reality. Excess return opportunities are not easily identified.
Not surprisingly, professor Burton Malkiel has addressed this issue for decades and echoes many of your concerns. Here is a Link to a very recent article by him published in the WSJ:
http://exactcpa.blogspot.com/2013/05/burton-g-malkiel-youre-paying-too-much.html
Several of his observations are especially relevant to your submittal. Here are a pair of short but succinct quotes from his article.
“Passive portfolios that held all the stocks in a broad-based market index have substantially outperformed the average active manager since 1980. Therefore, the increase in fees likely represents a deadweight loss for investors.”
“The one-third that may outperform the passive index in one period are generally not the same as in the next period.”
Many MFO members use a mix of passive and active products. I do, but I have been recently increasing my percentage of passive holdings.
Cost is a dominant factor in the equation. All the accumulated data supports that conclusion. Not unexpectantly, Malkiel takes the same position. He said: “You can't control what markets can do, but you can control the costs you pay. The less you pay to the purveyors of investment services, the more there will be for you.”
Both costs and persistency impose challenging burdens that active management struggles to overcome. Only a few succeed. For a diminishing portion of my portfolio, I optimistically continue the search for active management success stories. Admittedly my optimism is on the wane.
Thank you for providing yet another investor perspective. It adds to provide a more complete picture of the active/passive debate.
Best Wishes.
"Old too soon, wise too late." (Benj. Franklin or Oscar Wilde - one of them said almost all the good stuff)
I hate to burden the innovators on this site, but it would be interesting to compare the 3 year records as they become available of the various MFO profiled funds against passive comparators. While I'd like longer records, that would yield fewer funds. They almost all have beaten some benchmark when recommended, so this would identify those regressing to the mean. If the concept that smaller and more nimble funds run by experienced managers outperform is valid, the selections should have proven this. (If this already exists in some table, I apologize for not having paid more attention.)
On the other hand I would probably not buy the Gabelli fund today since 1 I think the fees are too high and 2. The mortality risks similar to owning Berkshire.I do of course hope Mario lives a long time for both selfish and unselfish reasons .