Investing Caffeine

Performance Beauty in Eye of Beholder

January 30, 2011 at 11:31 pm 4 comments

The average person may be a good judge in picking the winner of a beauty contest, but unfortunately your average investor is ill-equipped to sift through the thousands of mutual funds and hedge funds and thoughtfully discern the relevant performance metrics for investment purposes.

Investment firms however, are well-equipped with smoke, mirrors, and a tool-chest filled with numerous tricks. Here are a few of the investment firms’ gimmicks:

• Cherry Picking: Fund firms are notorious with cutting out the bad performance numbers and cherry picking the good periods. As investment guru Charles Ellis reminds us, the wow factor results of “investment performance become quite ordinary by simply adding or subtracting one or two years at the start or the end of the period shown. Investors should always get the whole record – not just selected excerpts.”
• Limited Time Period: Often the period highlighted by investment firms is insufficient to make a proper conclusion regarding a manager’s outperformance capabilities. Ellis acknowledges that  gathering enough yearly performance information can be practically challenging:

“By the time you had gathered enough data to determine whether your fund manager really was skillful or just lucky, at least one of you would probably have died of old age.”

• Fee Disclosure: Some managers’ performance figures look stupendous until one realizes once hefty fees are subtracted from the reported figures, what previously looked top-notch is now average or below-average. It is important to read the small print or ask tough questions of the broker peddling a fund.
• Audited Figures: Legitimacy of performance is key, and there are different levels of audited figures. Global Investment Performance Standards (GIPS) compliance is an industry accepted standard. For pooled investment vehicles, audited results from regional or national accounting firms can be important too. 
• Misused Rating Systems: Morningstar is the 800 pound gorilla in the mutual fund world and provides some useful data. Unfortunately, most Morningstar investors use the data incorrectly. A 2000 study by the Journal of Financial and Quantitative Analysis discovered, “There is little statistical evidence that Morningstar’s highest-rated funds outperform the medium-rated funds.” On this subject, Charles Ellis points out the following:

“While Morningstar candidly admits that its star ratings have little or no predictive power, 100 percent of net new investment money going into mutual funds goes to funds that were recently awarded five stars and four stars…Indeed, in the months after the ratings are handed out each year, the five-star funds generally earn less than half as much as the broad market index!…Morningstar ratings are misleading investors into buying high and selling low.”

Investors need to be careful in how they use the ratings – simply buying 4-5 star funds and selling star-losing funds can be a heartburning recipe for bad results. Buying high and selling low usually doesn’t turn out very well.

Find Winners…Then What?

Even if you are successful in identifying the winning funds, those same funds tend to underperform in subsequent periods. Ellis, a believer in passive index investing, noticed only 10% of active managers outperformed over 25 years, and the odds of sustaining outperformance in subsequent periods diminished even further.

Charles Ellis also noticed a fat-tail syndrome of losers versus winners. For example, Ellis found 2% of active managers outperformed over a set time period, but a whopping 16% underperformed the market over a similar timeframe. Consistent with these findings, Ellis stresses that past performance does not predict future results, with one exception: “The worst losers do tend to keep losing. If you do decide to select active investment managers, promise yourself you will stay with your chosen manager for many years…changing managers is not only expensive, but it usually doesn’t work.”

Professionals to the Rescue

Well, if individuals are not in a position to pick future winning fund managers, then thank heavens the professional consultants can help out…not exactly. Ellis was blunt about the capabilities of those professionals selecting active investment managers:

“Pension executives and investment consultants who specialize in selecting the best managers have, as a group, been unsuccessful at selecting managers who can beat the market.”

Ellis uses a respected firm as an example to prove his point:

“Cambridge Associates reports candidly, ‘There is no sound basis for hiring or firing managers solely on the basis of recent performance.’”

At the end of the day, finding current winners is not a problem, but sifting through the massive quantity of funds and selecting future winners is very challenging for individuals and professionals alike. The financial industry would like you to believe picking the future performance beauty winner is a simple task – the data seems to indicate otherwise. Rather than wasting your money attempting to pick the beauty winner, perhaps your money would be better spent on purchasing a tiara for yourself.

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in MORN, Cambridge Associates, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Education, Mutual Funds. Tags: active managers, Cambridge Associates, Charles Ellis, consultants, fees, GIPS, investment performance, Morningstar, star rating system, stars.