Is picking funds an easy route to outperformance?
Purchasing a group of funds (be they active or passive) has many advantages. Investing in a fund is an easy way to gain exposure to a certain market or asset class. They are efficient in gaining access to markets that are more difficult to trade in and and can provide the investor with a more diversified exposure for smaller investment sums.
Buying funds also requires very little time investment and you utilise the combined expertise of the talented members of the fund management team.
I will argue however that it is possibly more difficult to pick and evaluate ‘winners’ in this space.
The usual starting place for determining the level of skill of the fund manager is to look at how they have historically performed. Whilst we are all aware that we ‘cannot buy past performance’ it is still often used as a guide for how talented the fund manager is.
However due to the nature of luck involved in investment returns, past performance is a poor proxy for determining manager skill. Using returns data standalone, you would need a very long time series of return observations to have enough data to deduce a statistically significant outcome about a fund manager’s level of skill.
A popular way to filter the universe of funds is to use the Morningstar star ratings. These ratings are based on past performance and rate each fund between 1 and 5 stars, where 1 is the worst and 5 is the best. Seeing many stars on a fund factsheet may be visually appealing, however in line with above, a 5 star rating has been shown to be a poor indicator of future returns. It’s interesting to compare the three year performance of funds before and after they gain a 5 star rating:
We can see that the successful past performance leads to a higher rating, but the persistency of this performance is shown to trail off. The importance of this is noted by Morningstar themselves, who state: “There are a couple of problems with using Morningstar's star rating for funds 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. Just as past performance and alpha can't indicate future success, neither can star ratings.”
As the popular financial disclaimer notes ‘past performance is no indicator of future results’. When evaluating fund manager performance it is important to not just know how they performed, but also what they did to achieve that performance.
The importance of process
For those of you who have attended Poker nights, the concepts of process and luck can become very apparent. Looking down at your pocket pair of Aces, you are feeling very comfortable looking at a flop of J, 8, 5. After your raise and reraise, only ‘Crazy Eddie’ is left in the hand. The turn is a 2. Another raise from you and a call from Eddie. The final river card is a 7. In the showdown, Eddie shows a 7-2 to take the mountain of chips in the middle, whilst you bemoan to your colleagues about what just happened.
In a fair world, all good processes would be justified with good performance and all bad processes would be punished with poor outcomes. Unfortunately like other pursuits involving chance, investing outcomes are not so neatly distributed, with bad processes occasionally resulting in good outcomes in the short term. Similarly, the past performance of the fund is a poor signal for investment skill as from this alone we do not have any insight into the process used to achieve it.
Take the relative performance of one famous fund manager in the late 90s:
It would have been very difficult for an investor to stomach a c20% underperformance over these two years. Taken alone we may also conclude the fund manager had ‘lost their touch’. However it does not consider the style employed by the manager or the market context. The late 90s was a period dominated by a momentum fueled market with many investors who adopted a value style approach suffering. In the case above, Anthony Bolton’s fund (and other value managers) held a structural underweight to momentum stocks in this period, so when the market environment was against them, this led to significant relative underperformance. When the style in favour changes, this can have a large impact on the outcome of the fund - Anthony Bolton went on to outperform the index for 7 consecutive years.
The importance of process is understood within institutions. When an institutional investor is looking to invest in a fund, they will typically send a ‘Request for Proposal’ (RFP) document to the fund groups in question. These fund groups then proceed to fill out this document, answering queries which touch upon all areas of the business. This document will provide detailed insights into the investment process that the fund adopts, including the manager’s perceived edge, the selling strategy and what market conditions the fund will perform best in. The structure and stability of the business will be considered, including how staff are compensated and incentivised. It will provide details in the size and level of oversight from Operational and Investment Risk teams, software systems that are used and how trading is controlled. The due diligence may be reviewed from investment, risk and operational perspective to determine suitability.
From this document and meeting with the fund manager and risk teams, the institutional investor can develop their expectations for the fund and better understand the conditions when it it is likely to underperform.
Given the importance of process in determining the underlying skill of the fund, the retail investor is (unfortunately) unable to gain the same level of insight into the underlying process of the fund. Descriptions provided in factsheets and investment brochures are typically vague, focusing on the end goal without going into specifics of the process as to how this will be achieved. This lack of information can make it harder to decipher whether the manager performance has been due to style reasons, structural reasons or luck.
Going deeper - further process considerations
Knowing the investment process inside out is still not sufficient to fully understand the environments that the fund is likely to perform well in as there is another element to consider.
Suppose for a moment you invested in a rules based, quant fund prior to 2008. They had explained the years of research, hundreds of backtests and you had a full understanding of the process and how it will behave in different market environments. Then the financial crisis happened. Suddenly the fund has started taking positions that are very different to your expectations.
This is not a unique experience. In an article by Jim O’Shaughnessy, he noted that over 60% of quants overrode their models during the financial crisis. Years of research and development to distill a model, only to be thrown in the bin when put in a stressed environment.
“I know that as a systematic, rules-based quantitative investor, I can negate my entire track record by just once emotionally overriding my investment models, as many sadly did during the financial crisis.” - Jim O’Shaughnessy
Not only do you need to know the fund’s process, but also how the fund manager will behave in the periods when that process will inevitably underperform. Will the portfolio manager stick to their process given the career risk (that term again) or will they override their process to gain a relief from the pressure being applied to them? Choosing a fund is now not only a game of choosing a fund with a good process, but also choosing a manager who will be talented enough to know when to stick to the process (even under high pressure) and when to update the process to the constantly evolving marketplace. Had Anthony Bolton caved under pressure in 1999 to mirror the index, his subsequent performance would have been -5.9%, -13.3% and -22.7% from 2000-2003. His actual performance? +25.8%, +3.8% and -10.7%.
The next challenge
Suppose that you have overcome the previous challenges and have been able to identify a fund with a fantastic process and a manager that will consistently adopt this process. Subsequently the fund has had excellent performance. Financial press starts to celebrate the performance of the fund. The fund manager starts appearing on the covers of investment literature. Suddenly your hidden gem of a fund has become incredibly popular and the assets under management have ballooned from a couple million to billions. The fund now has a new challenge. Previously the manager had built a process around being able to dynamically enter and exit positions but this is now not possible due to the new liquidity challenges (as discussed in a previous article) from the increased fund size.
The negative impacts of increased fund size have been documented in investment literature, with some papers concluding that the larger fund size does result in relative underperformance due to the additional liquidity constraints reducing the size of the investment universe, resulting in diseconomies of scale.- The impact of this effect is likely to be related to the market cap of the stocks that the manager is targeting. A fund that invests in small caps is most likely to be affected by size constraints and as such may lose the nimbleness in their approach.
An insight into investor success
Perhaps one of the insights into how difficult it is to choose and hold funds is demonstrated through the returns that investors have received. One of the most successful funds in the 10 year period from July 1999 to July 2009 was the CGM Focus fund, which earned an annualised 17.8% total return, outperforming the S&P 500 by 640% over the period. The average annualised return of investors that bought this fund over this period? -16.8%.
Re-read that.
That’s right - the average investor who owned this fund actually lost money. Despite investing in a fund that was subsequently described as the ‘fund of the decade’ by the Wall Street Journal, the timing of investor flows meant that the money weighted return was negative.
Investors underperforming their underlying funds is unfortunately a recurring theme in the Dalbar’s Annual Quantitative Analysis of Investor Behavior and in investment literature, with Frieson finding “Investors in both actively managed funds and index funds exhibit poor investment timing”.
Note that this is not limited to retail investors. In the “The Selection and Termination of Investment Management Firms by Plan Sponsors”, Goyal and Wahal noted how on average funds that have been fired by institutions have subsequently gone on to outperform their hired counterparts.
We can understand some of the key elements at play here. Holding an underperforming fund can be hard, no matter whether related to style or luck. There is always a shiny new fund that is shooting the lights out and it is easy to justify the switch to the oversight committee (Yes, those who choose funds suffer career risk also).
As you can see there are several factors at play when choosing funds to invest. With thousands of available alternatives, buying a fund is very easy. Evaluating a fund on an ongoing basis however is considerably more difficult.
So reverting back to where we began. . .
Can I achieve similar results leaving it to the pros?
Without knowing an investors results (or desired results), it is of course impossible to say whether one could achieve similar results in a fund. For an investor performing in line with a passive fund after fees then the obvious answer is yes; if you are outperforming the index the answer is also yes - I just don’t know which fund will match your desired performance in advance.
Irrespective of the fund chosen, an investor should consider the impact of fees. When you invest in a fund, the fee applied is typically a variable fee (for example 1% on AUM). This means that as the size of your portfolio grows you pay more in absolute terms. If however you were to adopt a consistent trading approach of purchasing a fixed number of stocks at the start of the year, then no matter how the size of your portfolio grows, the commission fees are broadly fixed as they are based number of trades, not monetary amount (with exception to share levy of £1 for a £10,000 trade).
To provide a concrete example, assume that both you and the fund have consistent gross (pre-fee) return of 10%. For the fund, fees are based on start of the year value and charged at 1% AUM. For the investor, they have a generous fixed fee of equal to 1% of the starting value; as a result the charges after the first period are the same. (Note that in this simplified example I am ignoring Stamp Duty as it borne both by fund and investor).
From the chart we can see that we can build a larger portfolio value over time, without generating any additional return in comparison to our fund. This is because as our portfolio grows our relative costs decline, whereas our relative costs are constant for the fund. Cost savings compounding over time offer huge benefits. As John Bogle of Vanguard notes: “Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy.”
Conclusion
With thousands of funds to choose from and an asset management industry managing assets equivalent to 373% of UK’s GDP, investors are spoilt for choice when it comes to available options. The large number of alternatives have enabled investors to gain exposure to any niche they wish, however the sheer volume has possibly made it harder to identify and analyse funds.
Given the large sample there are likely to be winning funds that generate excess performance but we should not be deceived into believing that picking funds is an easy route. Similar to stock selection, capital allocation is a competitive business in itself, with trillions of pension assets seeking the best funds.
If one does choose to allocate investment capital to funds then we should ensure we know why we hold each fund and where it fits in our overall portfolio.