May 2024
This article appeared in the Sunday Times on 5th May 2024
While the search for the next Apple or Nvidia often dominates discussion amongst investors, investment advisors typically emphasize asset allocation as key to investment performance.
However, asset allocation and stock selection are only part of the puzzle. For many, the decision of which fund managers to select can be as significant for investment returns.
Yet, investment theory offers little guidance on the topic of manager selection, perhaps because it transcends typical investment analysis, instead requiring a large amount of subjective analysis.
Investors and the financial media often like to draw analogies with sports when it comes to investing, particularly when selecting investment funds. A certain fund or manager many be in the portfolio for “defence” and another for “offence”. Just as in sports, the temptation is to bench a fund manager who is underperforming and replace them with a perceived "star player."
The problem is the sporting analogies are only partially valid and might actually be harmful. The flaw in these analogies stems from the role of of luck and randomness. While luck certainly plays a role in sports, the impact is far more pronounced in financial markets given the huge swings, often driven by random factors.
In a bull market, a naïve investor can outperform a savvy, sophisticated investor for months or years simply due to good luck. As Warren Buffett famously remarked, "it’s only when the tide goes out do you discover who has been swimming naked."
If you act on the sporting analogy and frequently change the team in response to performance you may end up removing an unlucky manager just before their fortunes improve or investing with a lucky manager just before they hit the inevitable tough period. That could be very costly for portfolio returns.
When assessing funds, investors typically zero in on the historical returns. It seems logical to infer a manager's prowess from past returns. After all, when we see Manchester City or Arsenal at the top of the league table, we assume they are the best teams—not merely lucky.
Investors and the financial media are often seduced by narratives. Stories provide colour and context, offering an explanation for market phenomena. When a fund manager is doing well there is typically a narrative around why his or her approach is superior.
Other biases tend to colour judgment aswell. It is human to weigh recent events more heavily – they tend to be fresher in our minds. The investment industry and financial media relentlessly focus on who is doing well this month, this quarter or at most this year.
However, when it comes to investing, the random element means past performance really is an imperfect guide to long-term returns. It’s never as simple as just selecting the investment manager who did best over the last few years.
For example, the legendary Bill Miller of Legg Mason outperformed the S&P 500 for 15 consecutive years before his hot streak abruptly ended. More recently Cathie Wood was the darling of the investment world as she rode the wave of emerging technology growth stocks until it came to a shudder in 2021.
How can an investor take a more pragmatic approach to manager selection?
For one, don’t overly fixate on performance. Yes, returns are relevant but keep in mind luck plays a part. If you are removing a fund because of disappointing returns, ask could performance be explained by luck? Professional investment fund allocators try and examine how the returns were generated. Did the manager take a lot of risk to generate the returns? Were the returns driven by a few concentrated bets that paid off?
Try and assess the fund manager’s investment process. If the returns have been stronger than peers ask why. Is there something about their approach that suggests they might be able to sustain stronger returns over time? Try and develop a healthy scepticism of narratives.
Keep in mind different strategies perform well in different market environments. Don’t expect an investment manager focused on say commodity markets to generate similar returns to equities, so a comparison with the S&P 500 is meaningless.
Also, remember why you selected that fund in the first place: it may have been for diversification. The fact that some parts of your portfolio don’t generate returns when the equity market is performing well may be a good thing - it may reflect that the portfolio is diversified.
When analysing the track record don’t overly weight the last few months or year. Regression to the mean is a strong force in investing. The manager at the top of the league table may be just as likely to be at the bottom the next year. Try and take a big picture view that incorporates as much performance data as possible.
In conclusion, selecting fund managers is more art than science. It requires a large amount of subjective assessment, along with standard quantitative analysis. By avoiding chasing performance, delving into the manager's process and keeping in mind that luck may play a role, investors may stand a better chance of navigating the challenge.
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