A blog post by Michael Schmidt published on June 8 on Investopedia represents pretty much everything that is wrong with financial journalism. The post is titled: "Choose A Fund With A Winning Manager". The author assumes trying to pick an outperforming fund manager is a worthy endeavor. His premise is fatally flawed, as illustrated by the "guidance" he sets forth for accomplishing this elusive goal.
Once you buy into the concept of finding a fund manager who can "beat the markets," you are already on the road to financial perdition. Let's put the task of trying to pick a "winning fund manager" in perspective. In a study by investment management firm First Quadrant, the authors found the average actively managed fund underperformed its benchmark by a whopping 4.17 percent after taxes over the 10-year period studied. Only 9 percent of the funds studied over the period outperformed their benchmark after taxes. The benchmark was the Vanguard 500 Index Fund.
Assuming you were somehow successful in identifying the small pool of "winners," how big is your payoff? The same study found the winners "won" by an average of only 1.79 percent. It's far more likely you would have picked a "loser," in which case your returns would have suffered a big hit. The many "losers" lost by an average of 4.79 percent.
If you are an investor and not a speculator, presumably you are concerned with the overall performance of your portfolio, and not just the returns of a particular fund. For you, the relevant inquiry is how likely it is your portfolio of actively managed funds will outperform a portfolio of comparable index funds. We don't have to guess at the odds. My colleague Larry Swedroe noted in a blog post that the odds of a portfolio of 10 equally weighted actively managed funds, rebalanced annually, successfully generating outperformance (or "alpha") over a 10-year period is a minuscule 0.055 percent. When you consider taxes and longer time periods, the odds are even lower.
If these overwhelming odds don't discourage you, you will find little comfort in the suggestions offered by Schmidt for finding the "winners" needle in the "losers" haystack. He advises looking at the qualifications of the fund manager, examining the fund for consistency, definability, soundness, relative versus absolute performance, peer performance, performance over cycles and personal investment.
Absent from these broad and vague terms are any metrics that would permit you to screen for these traits, assuming you have the tools that would permit you to do so. Without finite metrics, these observations are simply blather. They provide no assistance to anyone engaged in the ill-advised quest for alpha. Notably missing from Schmidt's musings is reference to a study (or to any other data) illustrating how someone using his methodology was able to identify "winning" fund managers prospectively.
There is a reason why those who write about picking "winning" mutual funds are long on rhetoric and short on data. There is no credible evidence anyone has the ability to engage in this exercise successfully.
Here's the bottom line: The game of trying to pick outperforming fund managers is not worthy of your time or effort. You are unlikely to succeed. Instead, you should focus on your asset allocation, invest in a globally diversified portfolio of low management fee index funds and focus on factors you can control, such as diversification, fees, costs and taxes.
Schmidt could provide more value to investors by showing them how to capture market returns, rather than holding out the false hope of "beating the markets."
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.
The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information, and content on this blog is for information purposes only and should not be construed as an offer of advisory services.
- Michael Schmidt