Why do mutual fund managers fail?

It’s hard to be a fund manager.

Sorry the second post of the week is coming a bit late. One of the benefits of committing to a pretty light publishing schedule is that I’m really only going to write when I’m inspired by something. No filler posts. No rants. That’s my motto.

Anyway, Standard & Poor’s recently released a study of how well past mutual fund performance predicts future performance. In other words, if you picked a fund that did really well last year, how well could you expect it to do this year or next year?

The answer? Past performance doesn’t predict future performance very well at all. In fact, S&P said that only 4.27% of large-cap stock funds managed to be better than average for five consecutive years. If mutual fund performance was totally random, you’d expect a little over 6% of funds to perform that well. Not looking good for active managers.

Of course, S&P, among other organizations, regularly reports the tendency of active managers to underperform after factoring fees in. Statistically, that’s not all that surprising. So much money is run by funds, that added up all together, they should perform exactly as the market does. Throw in an expense ratio, and managers as a whole don’t have a prayer.

But lately, I’ve wondered if we’re being too harsh on active managers. After all, isn’t the whole idea of investing that we do well in the “long run” even if that means losing money in any given year? When you listen to some economists talk about the market, they speak in terms of decades.

Yale economist Robert Shiller, for example, publishes data that values the S&P 500 based not on this year’s, next year’s, or last year’s earnings, but on the average of the last ten years’ earnings. And often, investors use that as a benchmark to predict how the market will perform over the next ten years. Not in the next year.

In contrast, take a look at the plight of the active manager. He knows that if he significantly underperforms the market in a year, lots of investors will get up and leave for somebody who does better. If enough investors do that, his company won’t let him keep managing money for long. So you’d think that a lot of managers are investing money hoping that they’ll outperform right now even if in the back of their minds, they’d rather invest for the long run.

So who does do well?

Take Tom Forester, for example. Now, Forester was the best performing domestic stock manager in 2008. In fact, he was the only manager to not lose money. How did he do in 2009? Not great, actually. His fund made 18.3%, but that was almost 6 percentage points worse than his peers. If you look at the last 10 years, Forester has only been better than half his peers three times. In 2003 and 2006, he was in the 100th percentile—about as bad as you can do.

Does that make Forester a bad manager? Not by a long shot. Because he’s performed so well in other years, Forester’s 10-year annualized return is 5.24%, which is in the top 10% of his peers.

Forester’s lucky. Whenever you see a guy’s last name in the name of a fund, it probably means he’s the boss or the boss’s son. So after his poor performance in 2003, Forester wasn’t about to fire himself.

Other managers aren’t so lucky. David Dreman, a pretty darn good value investor in his own right, got fired from one of his funds in April 2009, right as the market was turning around. How good was he? Well, he managed to stay on top of that fund for 20 years, until a bad bet on the financial sector made him lose 47% all at once. And that was that.

The point is this: Mutual fund managers want to invest well. But unfortunately, to keep their jobs they need to do well every year. That leads them to do silly things, like “closet indexing”—that is, investing to mirror the index so that you never underperform. Or in the late 90s, they loaded up on tech stocks so they wouldn’t be left behind.

In 1998, Warren Buffett famously said he wasn’t going to invest in tech stocks, and his company didn’t look so hot for a while. That is, of course, until he was vindicated. What if Berkshire’s shareholders fired Buffett for a new chairman during the tech bubble? That’s what thousands of investors do in spirit when they leave a mutual fund after one bad year.

And what should you do?

What does that mean for you? If you’re choosing active managers, sorry bud, but I can’t help you. If you asked me ten years ago, I’d say, “Pick a manager who’s outperformed the market over the last three and five years.” Ok, that doesn’t work. If you asked me a couple years ago, I’d say, “Stick with value managers who’ve had their jobs for at least five years.” But—with hats off to Dreman—that’s probably too rare to build a portfolio out of.

So today, I say “I don’t know.” And I minimize my trading costs with low-fee funds. Kind of boring. But I feel pretty good about that answer, actually.

Tagged as: Investing, mutual funds