Many factors determine how well your investment returns do. The big ones are (1) how your holdings are allocated among asset classes, (2) whether you are an active or passive investor, and (3) your approach to risk management.
Today, I want to focus on active investors — meaning those of you who primarily employ mutual funds where equity managers select stocks for you. Let’s talk about active fund managers and, more specifically, which ones to avoid.
I’ve written before about knowing when you should fire your mutual fund manager. Today’s question is even more basic: What are the characteristics of the managers you shouldn’t hire in the first place?
As always, we begin with a caveat: If you are going the active route, you must accept that during some years, your fund manager — indeed, any manager — will not meet his benchmark. In any given year, a majority of active managers fall short of their target. Each year, Standard & Poor’s releases a study that tracks the performance of active fund managers vs. passive ETF holders. In 2011, most managers — 84 percent — missed their benchmarks. As S&P put it, “the only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.”
Of course, underperformance alone may not be the basis for replacing a manager. There are times when a manager underperforms for a good reason: Sometimes a manager’s sector or style falls temporarily out of favor. Value stocks or emerging markets may be strong one year, but out of favor the next. Those managers will perform poorly relative to the S&P 500 that year.
Also, there is good old-fashioned mean reversion. This simply means that all “hot hands” eventually go cold. Every style, sector, region that takes off eventually sees that momentum fade. After a few good years, managers mean revert and see their performance numbers (however temporary the reversion is) suffer.
So, how can you steer clear of those who are likely to underperform over the long term — for reasons beyond those mentioned above?
Manager types and funds to avoid:
Policy wonks: The policy wonk appears to be a deep thinker. He writes long missives about the Federal Reserve and the demise of the dollar. His specialty is esoteric history of some obscure corner of finance. They often wax eloquent in their monthly commentary to investors about the coming crisis in “____.”
The main problem with the policy wonk is that he imagines a theoretically possible scenario and then expresses your investment dollars toward that hypothetical. Unless his exact forecast comes true — and gets the timing right — the investment is likely to be a loser. That’s a problem for you, the home investor.