A Misconception About Choosing Fund Managers

Paul Winkler: Welcome. This is “The Investor Coaching Show,” and I’m Paul Winkler talking about money and investing. It has been quite a busy couple of weeks. I hope everyone had a great Thanksgiving.

Investment Managers

There was a study done years ago with five different investment managers. It went like this: every year, the two lowest performing investment managers were fired. The other ones were kept and a few more were hired. This was done consistently.

That system is not necessarily unusual. Typically, we look for people who have done good work in the past, and we hire them because it seems logical.

If they’ve done good work in the past, they’ll probably continue to do so in the future. The same logic is used with investing. People look at investment managers and ask who’s had good performance?

That’s one of the reasons I don’t talk a whole lot about performance. As I speak, there are areas of the portfolio which I typically advocate for that are up. But I don’t talk a whole lot about it. If you look at the area of the market that is actually most held by investment managers, which is large U.S. stocks predominantly, they’re down very significantly.

Past performance is not a reliable indicator of future results.

You’ve been hearing the news so it’s nothing new to you, but I don’t talk a lot about the performance. And you might look at it and think I am really good. And I’d say, no, it just happens to be an area of the market that I happen to hold because I knew it was part of a diversified portfolio.

And more about that in a second because I think that is a really key thing to understand. And that’s why I don’t go take credit for it because it’s something you just can’t know ahead of time. And it isn’t a skill thing as much as it is a knowledge thing in applying academic principles to investing.

What Makes Good Performance?

What happens is that you’ll have a fund manager that happens to choose the right companies in a particular period of time that just happen to do well, and they outperform their peers. To go and say, “Hey, now this is a really good manager, let’s put more money in their direction,” would be a bad conclusion to draw because it was random. They randomly happened to have good performance.

What happens when you fire the managers that had bad performance? You may be firing the person that would have had the greatest performance going forward.

And there was actually a study done on this. Basically what it looked like was two lines parallel to each other. The top line was the performance of a fund manager in a previous period of time. It represented the manager who had a good performance. The bottom line was the fund managers that had been the lower performers.

So you had the top line top performers, bottom line in these parallel lines going horizontally. And the bottom line was the underperformers. There was a line going vertically through those two lines. Okay, so they fired the bad performer, and then they hired the good performer that had had the great performance in the prior period.

And then what they did is the lines actually crossed each other, which was funny, so the horizontal lines ended up crossing each other. The one that was on the bottom went up, and the one on the top went down.

In other words, the one that had the bad performance in the past ended up having the better performance in the future, and the one that had the great performance had bad performance in the future.

Bad performance can lead to better performance and great performance can lead to poor performance. 

You find that happening all the time. It’d be like going, “Hey, you’re the guy that burnt down somebody’s house with the electrical. Yeah. Well, you’re hired.” That would be illogical in our world, right? It would make no sense.

Markets Are Random

That’s why it’s so hard for investors. It just seems silly to actually go and hire somebody that didn’t do well. But when you understand that markets are random, it starts to make more sense. Now, why? What’s going on here?

Something like 91% to 94% of your investment performance is due to asset mix, or asset allocation as it’s called. It’s how much money is invested in large companies, how much is in small companies, and those types of things.

Four percent of return differences were explained by stock selection, or which companies were held? So it did have an impact on performance, and that’s what I was talking about with randomness. You randomly happen to have a good company, and all of a sudden you’re a genius.

So if you’re investing, for example, in large U.S. stocks and that’s the only thing you’re investing in, just that one segment of the market, selection can make a small difference. Big U.S. companies would be Apple, Amazon, Microsoft, GE, Walmart, Target and so on..

If you’re investing in those companies and that group of maybe 500 companies is all you choose from, then someone may choose 20 of them that happen to be better out of the 500 than somebody else’s choices. So that can account for some performance.

But if you’re going and hiring the person that just had good performance and firing the person that had bad performance, you’re basically saying that that person had stock picking ability.

Well, if you look at the American Law Institute restatement of the law, which is basically the prudent investor rule, they actually talk about diversification there. They talk a little bit about stock selection as well.

Efficient Markets

What they say supports the theory of efficient markets. It reveals that in such markets, skilled professionals have rarely been able to identify under price securities, that is, outguess the market with respect to future return with any regularity.

Skilled professionals are rarely able to outguess the market with any regularity.

In fact, evidence shows that there’s little correlation between a fund manager’s earlier successes and their ability to produce above market returns at subsequent periods. So they’re basically saying it’s not what you think it is.

It’s not like other industries where skill is such a big deal. So yes, the 4% difference does make a difference, but what they find is because of the expense of actually engaging that activity, it actually hurts returns more than helps them necessarily.

Then you have market timing, and that’d be very much akin to stock picking. When do you get in, when do you get out, it’d be the same type of thing. Asset allocation is 91% to 94% of the performance. So that’s a big deal.

If we look at that and say, okay, now let’s take this to the next level. We have large U.S. stocks, and we have small U.S. stocks. Now small U.S. value stocks are up for the year. I don’t know what they’re going to do next week or the week after that. You don’t know either.

I just want to use this as an illustration more than anything to get you focused on that area of the market. But if you look at that and see large U.S. stocks are down pretty significantly, well, that’s a pretty big difference. Now if you had an investment manager that diversified across asset categories but had a little bit more small value than another manager, and the other manager had more large U.S., if large U.S did great, you’d likely look at the first manager and think they were an idiot and fire them.

Come to the Right Conclusions

Well, what if going forward the next six months the large U.S. does better than the small value? All of a sudden you’ve just shot yourself in the foot by going and sticking all your money with the fund manager that happened to have more small value than the other person.

So again, you’ve come to the wrong conclusion. And that is a tactical asset allocation conclusion that somehow you have this ability to figure out which market segments are going to do better in the future.

So basically, hiring somebody with great performance has done you no good because it’s random. And that is a point that people miss.

So if we look at these market segments for a longer length of time, when I’m talking longer, I’m talking way longer. I’m going out, not even just 10 years because you might have a 10-year period with zero return. Go back 50 or 60 years and isn’t it interesting that large U.S. and large international have very similar returns?

I mean really very, very close. Small international had a slightly higher return versus small U.S., but both of them were similar in their same ballpark. If we look at large value and international value, they had similar long term returns.

Now we’ll have differences in returns even within categories. For example, large and small companies, we look at that and see that small has the edge. Why? There’s more risk. More risk equals higher expected return.

But what happens is that we lose track or lose sight of the idea that you could have things randomly happen that affect some groups of companies in different ways than others. Then all of a sudden, you come to the wrong conclusion and you fire a manager.

It wasn’t their fault that they underperformed. They just happened to be in an area that happened to have under performance because news came out that happened to affect them more negatively. Like interest rates going up, like Russia going into the Ukraine, or gas prices going up, or food shortages, or technology regulation maybe was changed, or whatever.

You don’t know ahead of time when those changes will take place, and all of a sudden investors are sunk. It isn’t the end though.

The Norms of the Investment Industry

Now I would love to tell you that this is the rarity in the investing industry that people invest in this particular manner, but it is the norm. It is not a rarity.

In the investing industry, the norm is to invest based on this idea, this criteria.

Average investors jump from investment style to investment style, which helps them none. 

Style drift is through the roof.

Now what is the investment manager’s job? Well, their job is to make sure you’re capturing asset class returns. A lot of people think their job is indexing. Indexing works well with large U.S. stocks and large international, but it doesn’t work with other asset categories.

So if you’ve never heard the show before, and this is news to you, the reason that indexing doesn’t work terribly well is because of the fact that typically the index is going to be weighted based on the size of the company, the vast majority.

So what you’re doing is overweighting the area that has lower expected return, and you can actually end up decreasing returns. Vanguard’s target-date funds use index funds, and then they overweight those big companies with lower expected return.

You end up with, as we look through history, lower expected returns, and you can end up with more volatility because of the fact that you’re concentrating more on those big companies. The bigger they are, the harder they can fall.

Indexes vs. Stock Picking and Market Timing

Now, if we look and say, well, what else happens? Well, you see investment managers use indexes all the time, which is better than stock picking and market timing.

It’s better than stock picking. SPIVA actually compares the indexes versus the professional managers, and it’s laughable how bad the professional managers do. It is better than stock picking, but it’s not the best overall.

What they do is they market time with the index funds, which the whole idea of stock picking is the idea that you don’t know where there are mispricings. I mean, twenty something years ago when I started this radio show, I was a little bit afraid to start the radio show because I thought people would start to figure this stuff out and then all of a sudden the investment managers and big investment firms would change their ways.

A friend of mine said, “No, Paul. They have too much invested to change their ways. Go ahead, start your radio show.” And he was right. He was so right. It’s actually gotten worse. It has not gotten better.

That’s why I’m still here.

If you fail to understand the basic concepts of investing, I believe you’re going to be forever disappointed in the results you get.

You’re always going to be anxious about your investments because you’re always going to be wondering, am I missing out on something?

Want to talk with us directly?

Schedule a call here.

*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.