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.
The wonk may be brilliant and insightful, but he is utterly ill-suited to be managing other people’s money.
Closet indexers: The primary reason to buy an active fund — despite the higher costs than a passive index — is the stock-picking acumen of the manager. Generally speaking, if most of their major holdings outperform their benchmark’s average, the fund itself should do better as well.
Where this theory breaks down is when the manager has so many holdings that he might as well be an index. Let’s say your fund holds Apple, up about 50 percent over the past six months. If it is one of a hundred holdings in the portfolio, the impact is de minimis.
The investor is getting a closet index — all of the benefits of passive investing, only with all of the costs of active investing. No thanks. The investor would have been much better off with the Index ETF.
The “schtick” fund: I am not at all a fan of the funds that seem to be designed by the marketing department instead of the fund manager.
A few years ago, the “vice” funds did well — until they fell from favor. Then came the socially responsible funds, which outperformed for a while — until that stopped. In the late 1990s, there were a few “open funds” that ran money transparently — until they blew up, losing most of their investors’ money. And the latest gimmick seems to be appealing to people’s faith by marketing via biblical parables from the Gospel of Matthew. The Wall Street Journal reported that there’s even a registered investment fund called “Matthew 25.”
Investing is challenging enough, without having to adhere to some specific gimmick or schtick driving the stock selection. When the focus is on some gimmick, rather than returns, stay away.
The excess fees fund: The rise of Web sites such as Morningstar and Yahoo Finance have made it increasingly difficult to hide excess fees from the investing public. Yet, some fund families still are managing to charge hefty carrying costs for mutual funds.
There are A-Class shares with loads as high as 5.75 percent. Then there are the internal expense ratios — the actual costs of managing the funds — that can range from 50 basis points to more than 200. And don’t forget the 12b-1 fees. These are what the fund families charge for marketing the funds, as well as payments made to brokerage firms for steering you, dear investor, into these funds. Each year, investors pay about $10 billion in 12b-1 fees.
Studies have overwhelmingly proven that high fees are a drag on performance. Compound them over time, and they take a huge bite out of your retirement monies. Investors who manage to avoid these high fees guarantee themselves an extra percent or two per year, risk free.
Sports team/super yacht owner: Over the past few years, a string of managers have made some very high-profile purchases of “big boy toys.” Some have bought professional sports teams in the NBA, NFL or MLB. (You can still get a good deal on a soccer team in Britain). Others bought record-setting 170-foot yachts.
Now, I am all in favor of fund managers having outside interests. A broad knowledge base can only be helpful; all work and no play makes for a bored and error-prone asset manager. And it isn’t too bad for the economy for them to be engaging in all of this discretionary spending.
However, once most managers have acquired so much wealth as to allow them to broadly indulge themselves, one suspects their heart isn’t in it anymore. Their focus tends to wane, and their performance falters.
I am not suggesting managers need to live like Warren Buffett. One of the wealthiest men in the country, he still drives the same junker car he had 20 years go and lives in the same house he bought more than 30 years ago. Sure, he bought NetJets, a private jet company — but that was for Berkshire Hathaway.
Buffett is on one end of the spectrum and the Master of the Universe/Yacht Captain/Ballclub Owner at the other. Do you want to guess which one is paying closer attention to your money?
Note: This tends to happen more often — but not exclusively — among hedge fund than mutual fund managers.
Investors considering going the active route should do their homework before putting their money at risk. Start with sites such as Morningstar, Yahoo Finance and MSN Money. There is an immense amount of easily accessible information out there on mutual funds.
There is no excuse for not knowing the fees and compositions of funds you want to invest in today, as there is a world of data and details about potential places for your cash.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. He owns a 7-year-old, 24 foot dinghy. You can follow him on Twitter: @Ritholtz