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.