For better or worse (mostly, in my strong opinion, the latter) most mutual fund reporting makes investing seem like a horse race: Here’s who won over the past year or so, along with some analysis that attempts to explain those results. That’s not surprising, of course. Investing is a bottom-line business, and each manager’s success or failure is easily measured, day in and day out.
But the problem is that in the vast majority of the time there’s very little to be learned by examining short-term results.
A fine example came from last week’s Wall Street Journal. In an article entitled “Fund Analysts Steering the Ship,” we were told about the increasingly important role that investment analysts are playing a mutual fund firms like Fidelity, Putnam, and MFS. (For those unaware, analysts provide research for fund managers, suggesting that they consider buying one stock and selling another.)
The article tells us that these firms are entrusting their analysts with more responsibility, and in some cases, allowing them to manage funds. The verdict? “It’s working out better for investors,” according to one quoted expert.
In support of that assertion, we’re told that six of Putnam’s analyst-run funds have turned in fine returns over the past eight months (wow!), and that MFS’s stock funds have outperformed 68 percent of their peers over the past three years. That’s great, and while three years is at least more than four times more meaningful than eight months’ worth of performance, it barely moves the needle on the useful information scale.
Over the next three years, the odds that MFS’s funds will retain that ranking are no better than 50/50, and if they’ve slipped, we’ll be treated to a new article describing the current short-term winners, full of sound logic and expert opinion describing just how they did it, again with the underlying implication that this group of managers has stumbled upon a winning formula.
As evidence of the latter, consider what the article says about Fidelity’s new emphasis on the role of investment analysts. Rather than having analysts continually shuffle off to investment management roles, Fidelity now has “career analysts,” who spend long stretches studying various market sectors.
These analysts are entrusted with Fidelity’s ten “Select Portfolios,” which cover the market’s major industries and, according to a Fidelity spokesman, “generally reflect our best investment ideas generated by our research in those areas.” Presumably, then, some of their other funds are using something other than the analysts’ best investment ideas. And it seems that Fidelity is acknowledging that prior to this change their funds were using research that was second-rate.
As you can see, when you scratch the surface of attempts to spin developments like this as somehow revolutionary, you can see how silly they really are, and the fact that the logic behind them is so flimsy is a good indication of the shaky the entire premise of active management is.
If anyone thinks that a few months, or even a few years, of solid returns somehow validates a particular approach to investing, by all means, dive right in. But to think that the analysts at these firms can magically produce market-beating returns over the long-term by outworking or outsmarting the thousands of other investment professionals they’re competing with is a bit naïve. If outperforming the market was as simple as hiring a few extra analysts, or having them stay on the job for a few extra years, someone somewhere would have stumbled upon that formula years ago. And as soon as their success was publicized, they would have spawned scores of imitators, which, of course, would have eliminated the profits from that particular approach.
Another example of this horse-racing mentality cropped up last week in the form of Morningstar’s fund company performance rankings, in which Morningstar compiled asset-weighted outperformance records for the industry’s 25 largest firms over the three years ending August 2009, and compared those figures to the performance for those firms for the three years ending August 2006.
Again, of course, three years if far too short of a time period to tell us much of anything in terms of manager ability, but I admit that the vastly different market climates of the two periods might provide a bit of insight into a firm’s ability to weather different kinds of markets.
In examining their data, I was more interested in seeing just that — which firms were able to maintain strong performance in both periods. And there were a few that were able to turn in strong results in both: T. Rowe Price, Vanguard, and Janus, most notably.
But again, in discussing the data, Morningstar’s Russ Kinnel (who I feel does excellent work, by the way) spends a great deal of time focusing on firms that rose and fell the most in the two periods. The problem is that this information isn’t particularly useful. It likely tells us more about each firm’s exposure to various investment classes and styles than it does about the abilities of the folks running the funds.
The fact that PIMCO rose a great deal in the latest period, and that Dodge & Cox suffered a large decline is largely attributable to the composition of the assets these firms manage. PIMCO, of course, is a large bond manager, and their improvement is largely due to the simple fact that bonds fared much better than stocks over the past three years. Likewise, Dodge & Cox is a stock-heavy manager, and their largest funds made a big losing bet on financial stocks last year, which, combined with a relative lack of bond assets to buffer them, didn’t serve the firm (or their funds’ investors) very well.
Whether or not the current trajectory of these managers is something that will continue over the long-term is anyone’s guess, but making that guess on the basis of three years’ worth of returns doesn’t meaningfully increase the likelihood of getting it right.
An additional thing that struck me as I read the Morningstar piece is one of the main problems in choosing to use active funds. Both American Century and Janus fared very well in the most recent period, increasing their funds’ rankings by 25 and 11 percent, respectively.
Nicely done I suppose. The problem? Even if you make the leap and assume that three years’ worth of performance is sufficient to identify investment acumen, many of the managers who were responsible for that performance are no longer with the two firms. Perhaps the funds’ new managers will be able to step in and pick right up where their predecessors left off, buy maybe they won’t. If that’s the sort of bet that appeals to you, by all means pay your money and take your chances. As for me, I’ll be following the horse races from afar, taking comfort from the knowledge that my long-term performance depends not a whit on a manager’s ability or which styles or sectors are moving into or out of vogue over the short-term.
I sleep much better that way.
Image via Flickr user Rennett Stowe CC 2.0
