The mutual funds and managers to avoid

Washington Post, May 4 2012

 

 

 

 

How are your retirement investments doing these days?

For many people, that’s a loaded question. U.S. markets are up more than 100 percent from their 2009 lows, yet many investors are not thrilled by their returns. That’s quite telling and suggests that someone is doing something wrong.

Many factors determine how well your investment returns do. The big ones are (1) how your holdings are allocated among asset classes, (2) whether you are an active or passive investor, and (3) your approach to risk management.

Today, I want to focus on active investors — meaning those of you who primarily employ mutual funds where equity managers select stocks for you. Let’s talk about active fund managers and, more specifically, which ones to avoid.

I’ve written before about knowing when you should fire your mutual fund manager. Today’s question is even more basic: What are the characteristics of the managers you shouldn’t hire in the first place?

As always, we begin with a caveat: If you are going the active route, you must accept that during some years, your fund manager — indeed, any manager — will not meet his benchmark. In any given year, a majority of active managers fall short of their target. Each year, Standard & Poor’s releases a study that tracks the performance of active fund managers vs. passive ETF holders. In 2011, most managers — 84 percent — missed their benchmarks. As S&P put it, “the only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.”

Of course, underperformance alone may not be the basis for replacing a manager. There are times when a manager underperforms for a good reason: Sometimes a manager’s sector or style falls temporarily out of favor. Value stocks or emerging markets may be strong one year, but out of favor the next. Those managers will perform poorly relative to the S&P 500 that year.

Also, there is good old-fashioned mean reversion. This simply means that all “hot hands” eventually go cold. Every style, sector, region that takes off eventually sees that momentum fade. After a few good years, managers mean revert and see their performance numbers (however temporary the reversion is) suffer.

So, how can you steer clear of those who are likely to underperform over the long term — for reasons beyond those mentioned above?

Manager types and funds to avoid:

Policy wonks: The policy wonk appears to be a deep thinker. He writes long missives about the Federal Reserve and the demise of the dollar. His specialty is esoteric history of some obscure corner of finance. They often wax eloquent in their monthly commentary to investors about the coming crisis in “____.”

The main problem with the policy wonk is that he imagines a theoretically possible scenario and then expresses your investment dollars toward that hypothetical. Unless his exact forecast comes true — and gets the timing right — the investment is likely to be a loser. That’s a problem for you, the home investor.

The wonk may be brilliant and insightful, but he is utterly ill-suited to be managing other people’s money.

Closet indexers: The primary reason to buy an active fund — despite the higher costs than a passive index — is the stock-picking acumen of the manager. Generally speaking, if most of their major holdings outperform their benchmark’s average, the fund itself should do better as well.

Where this theory breaks down is when the manager has so many holdings that he might as well be an index. Let’s say your fund holds Apple, up about 50 percent over the past six months. If it is one of a hundred holdings in the portfolio, the impact is de minimis.

The investor is getting a closet index — all of the benefits of passive investing, only with all of the costs of active investing. No thanks. The investor would have been much better off with the Index ETF.

The “schtick” fund: I am not at all a fan of the funds that seem to be designed by the marketing department instead of the fund manager.

A few years ago, the “vice” funds did well — until they fell from favor. Then came the socially responsible funds, which outperformed for a while — until that stopped. In the late 1990s, there were a few “open funds” that ran money transparently — until they blew up, losing most of their investors’ money. And the latest gimmick seems to be appealing to people’s faith by marketing via biblical parables from the Gospel of Matthew. The Wall Street Journal reported that there’s even a registered investment fund called “Matthew 25.”

Investing is challenging enough, without having to adhere to some specific gimmick or schtick driving the stock selection. When the focus is on some gimmick, rather than returns, stay away.

The excess fees fund: The rise of Web sites such as Morningstar and Yahoo Finance have made it increasingly difficult to hide excess fees from the investing public. Yet, some fund families still are managing to charge hefty carrying costs for mutual funds.

There are A-Class shares with loads as high as 5.75 percent. Then there are the internal expense ratios — the actual costs of managing the funds — that can range from 50 basis points to more than 200. And don’t forget the 12b-1 fees. These are what the fund families charge for marketing the funds, as well as payments made to brokerage firms for steering you, dear investor, into these funds. Each year, investors pay about $10 billion in 12b-1 fees.

Studies have overwhelmingly proven that high fees are a drag on performance. Compound them over time, and they take a huge bite out of your retirement monies. Investors who manage to avoid these high fees guarantee themselves an extra percent or two per year, risk free.

Sports team/super yacht owner: Over the past few years, a string of managers have made some very high-profile purchases of “big boy toys.” Some have bought professional sports teams in the NBA, NFL or MLB. (You can still get a good deal on a soccer team in Britain). Others bought record-setting 170-foot yachts.

Now, I am all in favor of fund managers having outside interests. A broad knowledge base can only be helpful; all work and no play makes for a bored and error-prone asset manager. And it isn’t too bad for the economy for them to be engaging in all of this discretionary spending.

However, once most managers have acquired so much wealth as to allow them to broadly indulge themselves, one suspects their heart isn’t in it anymore. Their focus tends to wane, and their performance falters.

I am not suggesting managers need to live like Warren Buffett. One of the wealthiest men in the country, he still drives the same junker car he had 20 years go and lives in the same house he bought more than 30 years ago. Sure, he bought NetJets, a private jet company — but that was for Berkshire Hathaway.

Buffett is on one end of the spectrum and the Master of the Universe/Yacht Captain/Ballclub Owner at the other. Do you want to guess which one is paying closer attention to your money?

Note: This tends to happen more often — but not exclusively — among hedge fund than mutual fund managers.

Investors considering going the active route should do their homework before putting their money at risk. Start with sites such as Morningstar, Yahoo Finance and MSN Money. There is an immense amount of easily accessible information out there on mutual funds.

There is no excuse for not knowing the fees and compositions of funds you want to invest in today, as there is a world of data and details about potential places for your cash.

 

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Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. He owns a 7-year-old, 24 foot dinghy. You can follow him on Twitter: @Ritholtz

 

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Category: Apprenticed Investor, Mutual Funds

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

10 Responses to “Mutual Funds and Managers to Avoid”

  1. Russ says:

    BR, not directly related but of possible interest for you re cognitive errors, slippery slopes, bad choices, and error.
    A summary of some emerging (though not conclusive) studies on fraud and decision making, esp with reference to framing the issue. (The case study is about Toby Groves, a decent enough guy who committed loan fraud–and all the support people who willingly helped him.)

    http://www.npr.org/2012/05/01/151764534/psychology-of-fraud-why-good-people-do-bad-things

    I don’t think this content much explains Bernie Madoff, but it may pertain to JP Morgan this week and some of the dynamics of the runaway mortgage misrepresentation a few years ago. And it may describe if not fully explain the policy wonk fund manager who insists on being right rather than effective.

  2. mad97123 says:

    All we hear is “the Markets are up 100% since the 2009 lows”, rather than the the Markets are still down 15% from their 2007 or 2000 highs, based in dollars that are losing value.

    “Yet many investors are not thrilled by their returns. That’s quite telling and suggests that someone is doing something wrong.” The “something” that they have done wrong is buy overvalued stocks in the first place.

    All we’ve heard about for the last six months is “the monster rally off the October lows”, yet stocks are now below their 2011 highs. The Wallstreet hype machine always spins the rallies, as if the smart money is selling at the top and buying at the bottom. If only you had someone so smart managing your money….

    The investment manager “career risk” that Grantham always rails against virtually ensures most fund managers will run with the herd, even if that means off a cliff. Then they can tout their 100% gain off the bottom, which is really a 15% loss off the top.

  3. theexpertisin says:

    Two others come to mind:

    1. The musical chairs mutual fund manager system, where funds yank folks in and out way too often to establish any fund consistency.
    2. The college punk-managed mutual fund manager. who has acedemic pedigree but is totally lacking in practical experience.

  4. atswimtwobirds says:

    You probably won’t say but would John Hussman be a policy wonk?
    Your remark about British soccer teams was not insightful. No salary cap and shortterm contracts means most of the revenues go in buying players, their salaries or their agents fees. Secondly you’re competing against the bottomless resources of Abou Diabi who own a team and a Russian billionaire who owns another. Both treat their teams as vanity projects.
    Thirdly is the unrealistic expectations of your supporters who expect you to spend at least as much on your team as the sheiks or the Russian. The supporters of Liverpool and Arsenal and Manchester united hate their American owners for their lack of spending.
    Finally there’s always the possibility of relegation. If you finish in the bottom three you move to a lower division.
    A workmate is from Blackburn who’s epl team is being relegated this season. They’re owned by Indian businessmen in the chicken business. The fans have been releasing chickens on to the field in protest.
    As my acquaintance said”The next owner needs to be at least a billionaire”

    ~~~

    BR: The issue with pro teams isn’t an investment question, its the time commitment and evidence of lack of interest in running money. Or at least, a new found interest in what the fund manager’s wealth can do for them (not you)

  5. Pantmaker says:

    Mom and Pop are generally better off with regular interval buying of a decent mix of very low cost index funds over time….keep the expense money. In this current market the fund manager litmus test is an easy one: Any manager net long equities here doesn’t know their ass from two dollars.

  6. gasman says:

    hasn’t Hussman handily outperformed the market over full cycles?

  7. ricecake says:

    So right!

    The reason why put money in Money Saving Fund only is because that just can’t like the look of the baskets of the stock mutual fund listed in the retirment program. Almost in every basket there some (many) losers that are almost guarantee the end result of no gain but possible pains and sleepless nights. So why bother I ask you?

  8. subscriptionblocker says:

    The biggest disaster to ever befall “pension funds” were 401Ks. Most 401Ks force contributions into “managed” mutual funds where “professionals” use all manner of skimming efforts to separate savers from their money.

    Buy the underlying securities instead – you run the gauntlet once.

    Then you are subject only to company managements and their off balance sheet thievery :)

  9. kenny powers says:

    Brilliant. One other category: The Story Manager. The “specialist” that focuses on a single niche of the market guaranteed to underperform right after you invest. The Generic China is a Miracle Fund for example. Or Oil will go to 300 dollars fund. Stories are easier to market and investors chew a salient story right up instead of thinking about the constraints and inherent risk of such a strategy.

    I think it pays to be a generalist in a changing world. But that’s just me…

  10. mcknz says:

    @gasman I would argue yes (I’m in a couple of funds), but it might be time to fire him. From his latest letters, he’s more interested in what the market should be, rather than what it is.