Actively managed funds are not following typewriters, pagers and landline phones into obscurity, despite the claims of index fund supporters. In certain segments of the market, actively managed funds may provide a superior blend of risk and return than index funds. Unfortunately, investors often achieve sub-optimal results by choosing active managers solely on the basis of past performance. Investors who look beyond past performance are more likely to make successful choices.
The answers to three questions are helpful in judging the outlook for an actively managed fund:
What is the fund manager’s competitive edge? Ariel Investments portfolio manager Rupal Bhansali makes the important point that the markets “reward correct, non-consensus views, but there are harsh penalties for wrong answers.” Fund managers that don’t have an identifiable competitive edge aren’t likely to outperform relative to competing funds and benchmark indexes.
Is the fund manager’s competitive edge sustainable? Success breeds competition, so today’s competitive edge may not last. The Michael Lewis book “Moneyball” (later a movie starring Brad Pitt) told the story of baseball’s Billy Beane, who led the Oakland Athletics to consistent success despite having a smaller budget than other teams. Beane’s competitive edge was the use of sophisticated data analytics that identified players who were undervalued by other teams. Beane’s competitive edge and the Athletics run of success ended when other teams imitated Beane’s approach to evaluating talent. In the fiercely competitive investment industry, as in baseball, it is hard to maintain a competitive edge.
How will the fund perform in different investment environments? “Being in the right place at the right time” often plays a significant role is explaining investment success. Consequently, distinguishing between skill and fortunate timing can be challenging. Many fund managers rode the rising tide for technology, media and telecommunication (“TMT”) stocks during the 1990s. The 1990s were tough on value-oriented managers, as value stocks trailed badly during the TMT boom. TMT-focused investors looked like geniuses, while value-oriented managers faced tough questions from disgruntled shareholders. When the TMT boom turned into the dot-com bust, many of the big winners from the boom failed to survive. Value stocks, however, rebounded strongly, and the best-managed value funds started a long stretch of strong performance.
Manager research professionals assess competitive edge and performance expectations by examining the fund manager’s philosophy, people, process and performance, known as the Four P’s:
Most investors have fundamental investment beliefs that guide their approach to managing money. From value investor Dodge and Cox: “From the earliest days, Dodge & Cox’s investment approach has stressed evaluation of risk relative to opportunity. A strict price discipline — steering clear of popular choices that come at a price premium we would rather not pay — is critical to achieving our investment objectives.”
Dimensional Fund Advisors is renowned for their application of academic research to investing, so their philosophy is noticeably different from Dodge and Cox: “Letting markets do what they do best — drive information into prices — frees us to spend time where we believe we have an advantage, namely in how we interpret the research, how we design and manage portfolios, and how we service our clients. It means we take a less subjective, more systematic approach to investing — an approach we can implement consistently and investors can understand and stick with, even in challenging market environments.”
No single investment philosophy is a guarantee of success (or failure), but managers with a logical and consistently applied investment philosophy have a higher likelihood of success than managers who modify their philosophy to chase the latest investment fad.
Manager research professionals evaluate the investment team to develop insight into the primary contributors to the investment process and how the investment team works together. It is helpful to understand how investment professionals are compensated, the degree to which compensation is aligned with shareholder interests. Fund managers should be willing to share insights into the decision-making process, providing examples of the thought process behind both winning and losing investments. Particular insight may often be gained from discussion of losing investments or periods of adversity, as learning from mistakes is a key part to being an investor. Fund managers who deflect inquiries about unsuccessful investments or refuse to provide meaningful insight into their investment process may not be worth investing with.
Successful investors have a competitive edge supported by a well-designed, repeatable investment process.
Harding Loevner, an international equity investment firm, identifies potential portfolio holdings through fundamental security research that determines a company’s competitive advantage, prospects for sustainable growth, financial strength and management quality. An evaluation of Harding Loevner investment process would include a discussion with the investment team about the fundamental analysis behind stocks included in their fund, inquiry into stocks that were considered for inclusion but weren’t purchased, and a portfolio-level review of portfolio characteristics, risk profile and turnover. Harding Loevner’s process is organized around people — portfolio managers and analysts — who evaluate companies, industries, and countries in a fundamentally driven investment process.
Fund managers such as Dimensional Fund Advisors (DFA) and AQR Capital Management have a different approach, investing through the use of systematic, computer-driven techniques that have their roots in academic theory. Fund managers who employ systematic, computer-driven approaches of those managers should explain the academic theory behind their investment process, the intuitive reason for the academic theory to work and the approach taken to apply the theory in capital markets. Investors should be wary of fund managers who hide behind academic jargon, a “black box” computer program, or simulated historical performance.
Many fund managers appear to be winners on the surface, benefiting from periods of performance that were more luck than skill. Identifying the “false positives” — funds that look good on the surface but may not have a sustainable edge — is critically important.
One fund manager had considerable success during a market downturn, claiming to be a disciple following Warren Buffett’s approach to investing. The fund manager encouraged a narrative about his ability to identify the highest quality companies and avoid the most excessively valued companies. The fund manager’s narrative was contradicted by a thorough review of his investment process, people and performance. Performance attribution highlighted the importance of a period of time in which the fund had held a very high cash position, and also highlighted mediocre stock selection results net of the cash position. Meetings with the fund manager’s investment team created doubts about whether he had the research depth to develop Buffett-like insight into portfolio holdings, doubts that were confirmed after a stock by stock review of the portfolio revealed the fund manager’s lack of insight into most of the fund’s holdings.
Performance results should be consistent with expectations formed through an understanding of philosophy, people and process. A disconnect between performance and the other P’s should be a signal that more investigation is required.
A sustainable competitive edge is typically a function of a durable philosophy, outstanding people and a repeatable process. Investors develop deeper insight into the Four P’s are more likely to avoid the fate of investors who chase past performance.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.