In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John looks at why so many mutual fund managers fail to beat the market over the long haul — and how individual investors can succeed where they fail.
Excerpted from the Sept. 28, 2012 issue of the Validea Hot List newsletter
Why Fund Managers Fail — And How To Succeed
We are now nearly three-quarters of the way through the year, and, despite all the concerns about the U.S. fiscal cliff, European debt, and China’s slowdown, 2012 has thus far been a pretty strong year for the stock market. Unless things have turned around markedly in the third quarter, however, it has not been a good year for many mutual fund managers. According to a Bank of America Merrill Lynch report, about 70% of large-cap active fund managers underperformed the Russell 1000 benchmark during the first half of the year.
Unfortunately, that’s not that unusual. While I often highlight some top-performing mutual fund managers in this newsletter, whether it be gurus upon whom I base my strategies or top current managers like Donald Yacktman and Bruce Berkowitz, the reality is that most fund managers fail to meet their benchmarks. Consider this: In 2011, 81.3% of active large-cap funds failed to beat the S&P 500, according to Standard & Poor’s. Mid-cap managers fared better, but the results were still dismal — 67.4% of them failed to beat the S&P MidCap 400 benchmark. And small-cap managers fared worst of all: 85.8% of them failed to beat the S&P SmallCap 600 benchmark.
Those results were particularly bad. But over the longer term, the track record is still very weak. In the 10-year period ending in 2011, an average of 59.4% of actively managed large-cap funds failed to beat the S&P 500, according to S&P; an average of 63.5% of mid-cap managers failed to beat the S&P MidCap 400; and an average of 63.1% of small-cap managers failed to beat the S&P SmallCap 600. How about international fund managers? Well, over the past five years, according to S&P, about 83% of emerging markets fund managers have failed to beat the S&P/IFCI Composite, and about 78% of international funds have failed to beat the S&P 700. International small-cap fund managers are one of the few bright spots: Only about 26% of them underperformed the S&P World Ex-U.S. Small-Cap benchmark.
In theory, fund managers should have the expertise, experience, and resources to beat the market pretty consistently, right? So, why do so many fail to generate the returns you could get from simply investing in a passive index fund? Part of the reason is that fund managers are human, and, as I’ve often discussed, we humans are poorly wired for investing — it’s no different if you’re an individual investor managing a $10,000 portfolio, or if you’re a fund manager overseeing billions of dollars in assets. We’re prone to a number of behavioral biases that, if unchecked, can constantly eat away at returns. There’s Myopic Loss Aversion, which is when investors, not wanting to feel the pain of locking in losses, hold onto losing stocks well after they’re no longer attractive. And Anchoring, which is when one bases one’s expectations on facts or figures that are no longer relevant. (When a stock falls from, say, $100 a share to $50 a share, for example, many investors will “anchor” on that initial $100 price and assume the stock must be a bargain, without considering its fundamentals.) Then there’s Recency Bias, which is when investors extrapolate the recent past into the future. And don’t forget Hindsight Bias, which is more than just realizing how you could have made money (or not lost money) after the fact — it’s when we incorrectly think that what we should have done was obvious or easily predictable, and allow that misconception to color our future decisions.
All of these and other biases that are hardwired into our brains impact not only individual investors, but fund managers as well. But in addition, there are a couple other factors that negatively impact fund managers specifically, perhaps the most significant being “career risk”. Jeremy Grantham and his GMO colleagues have written pretty extensively on this topic, and here’s how Grantham explains career risk: “The central truth of the investment business is that investment behavior is driven by career risk,” he wrote in his first-quarter letter this year. “In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority ‘go with the flow,’ either completely or partially. This creates herding, or momentum …”
It’s understandable, really. In today’s world, many investors — who are continuously barraged by reports from a financial media that has the attention span of a gnat — have little tolerance for underperformance. They might give a fund manager six months, maybe a year, but quite often it isn’t long before they’ll jump ship if a fund is significantly underperforming its peers or the broader market. Of course, if you’re going to beat the market over the long term, you’re going to go through periods of significant underperformance — every one of the incredibly successful gurus I follow experienced that at some point. But many investors are too shortsighted to realize that, or they’ve been duped by crafty fund marketers into thinking that it’s possible to always beat the market.
However you want to dole out the blame, the resulting situation is one that often isn’t good for investors over the long haul. Knowing that they will lose their clients — and perhaps eventually even their jobs — if they significantly lag their peers for more than few months, fund managers don’t deviate too far from their benchmarks. After all, it’s a lot easier to defend your performance — even if it’s a bad performance — if the broader market and many of your peers are in the same boat then it is if you’re alone.
Research shows that leads to a myriad of funds that are overdiversified and look extremely similar to their benchmarks. James Montier, Grantham’s colleague at GMO, pointed to one study in a 2010 letter to clients. He said that Jonathan Lewellen of Dartmouth College examined aggregate holdings of U.S. institutional investors over the period 1980 to 2007. “Quite simply,” Lewellen found, “institutions overall seem to do little more than hold the market portfolio … Their aggregate portfolio almost perfectly mimics the value-weighted index … Institutions overall take essentially no bet on any of the most important stock characteristics known to predict returns.”
What’s interesting is that there’s evidence showing that fund managers actually aren’t bad stock-pickers. In one paper, Montier noted, researchers Randy Cohen, Chris Polk, and Bernhard Silli looked at the “best ideas” of U.S. fund managers over the period 1991 to 2005. (“Best ideas”, Montier explained, were measured as those stocks with the biggest difference between the managers’ holdings and the weights of the benchmark index.) Their findings: The top 25% of best ideas from active managers generated an average return of over 19% annually vs. a market return of 12% annually. “The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability,” the authors said, “but rather to institutional factors that encourage them to over-diversify.”
Other factors can also stack the deck against mutual funds, including size. Managers who have success attract a lot of attention and new clients, which at a certain point limits the types of stocks you can invest in — if you’re running a multi-billion-dollar fund, you’re not going to be able to focus on smaller stocks, no matter how much you like them. Success can thus become self-defeating in some cases.
And, of course, fees are a huge issue. A percent or two off your returns might not sound like much, but over the long haul it can really add up.
To be sure, there are some great active fund managers, and I don’t mean to malign an entire industry. Lynch, Neff, Berkowitz, and Yacktman are among those who have had great success for lengthy periods of time. While there’s no specific formula for achieving that kind of success, I found that, generally, successful fund managers have the emotional fortitude to overcome the obstacles we’ve just examined. Often, they’ll hold more concentrated portfolios, with holdings that diverge significantly from their benchmark. They also focus on cold, hard facts and figures, and focus on the long-term — they aren’t swayed by popular opinion or short-term hype. Berkowitz, for example, took all sorts of criticism last year when a big investment in financials like much-maligned AIG dragged his fund down, putting it at the very bottom of his category in terms of 2011 returns. But he wasn’t swayed, and this year his fund has rebounded sharply, and is ranked in the top 1% of its class, according to Morningstar.
The majority of fund managers and most individual investors don’t have that kind of temperament, however. That’s why I created Validea. By using a system that is purely quantitative and focuses only on facts and figures, and by using a fixed rebalancing period that allows for buying and selling only at regular intervals, the Hot List and our other portfolios take emotion and behavioral biases out of the equation. That doesn’t mean the system will be right on every pick, or that it will beat the market every month, or even every year. But over the long haul, the system has proven that this sort of fundamental-focused, unemotional approach can generate impressive returns. Whatever the specifics of your own investment approach, I would urge you to make sure that you, or those who you trust to manage your money, are willing to follow a similar path — that is, act unemotionally, make decisions based on hard data and not hype, and always focus on the long-term.