Why Even Smart Investors Can't Pick Winning Managers — And What to Do Instead

Investing is a “wicked learning environment”. Something like chess is a kind learning environment. All the potential moves are defined. There are no exogenous events that could effect the game. The outcome is determined by the decisions of the players alone. The outcome is known right away. In investing, there are exogenous events constantly (weather, wars, recessions, for example). It may take years to find out if a decision was right or wrong. Sometimes a decision made for good reasons doesn’t work out, and sometimes a decision made for bad reasons works out because of luck.

On top of this, the sample size for decisions is relatively small. How many at bats are required before we know if a batter is skilled or not? Dozens? Hundreds? In investing, it is commonly held wisdom that less activity is better. More activity generally means more transactions costs and more taxes, but that also makes it hard to evaluate skill. If a fund only has 30 positions (which is common among actively managed funds, as concentration is also considered a key to beating the market), and has 20% turnover per year, that’s equivalent to 12 decisions per year (6 buys, 6 sells). Over a 30-year career that’s 360 decisions. If it takes a year or two to determine if those decisions were good or bad, that’s not a lot of data to determine skill.

Additionally, many of those decisions will not work out. Maybe 60% of those decisions will turn out well and 40% of those decisions will go poorly. These are not based on any specific manager or research, but just hypotheticals. The question then becomes, how much does the manager make when they are right, and how much do they lose when they are wrong? Being right but not making enough on your winners can be offset by losing big on your losers. In fact, some managers have only a few big wins in their career, without which their record would be mediocre. For example, Warren Buffett’s record would be very different without Apple, Geico, or American Express. He’d still be a great investor, but these are three of his biggest wins. Equally important is what the managers didn’t do that they should have done.

This measurement doesn’t appear anywhere, but it is hugely important: opportunity cost. What did you not earn by investing with one manager instead of another? Or the index? What did the manager gain or lose by not doing something they should have? This is impossible to measure but it means looking at what was reasonable at the time of a decision that, for whatever reason, didn’t happen. Every manager is not an expert in every company or industry, so you can’t expect them to find every winner. That said, did they cut one of their own winners too early? Did they not cut another winner early enough? Which losers should they have cut sooner? Which should they have held on longer? Did the manager outperform their benchmark? Was that benchmark the best option for investment? It might feel good to be the best performing value manager, but if value got trounced by growth stocks and by the S&P 500, is that much consolation to the investors? Looking at opportunity cost too closely though can lead to making decisions out of FOMO, fear of missing out.

Every manager will go through a period of underperformance. A good way to review manager performance is through rolling periods, 3 or 5 year periods are common. Looking at performance over periods such as “since inception” or “last five years” can be misleading if a sub-period within that time period happened to be really good or really bad. Say, for instance, a fund started right after the financial crisis. Perhaps returns look really good because the fund bought all of its positions at the bottom of the crisis and rode the recovery back up, but since then returns have been mediocre. Maybe over the last five years the first or last year was really good, but the other years were mediocre. Rolling periods help solve this by looking at manager performance over time, naturally removing exceptional periods, good or bad. Every manager will go through a long period of underperformance, like yearslong. At that time, you might start looking around at all the investments that did better. You think, “If I had just done X, I’d have $Y right now.” The question is, if you switch now, are you switching just before the tide turns? Morningstar research shows that investors tend to underperform the funds they invest in, because they tend to invest after a period of strong performance, and sell after a period of poor performance. I believe this comes down to lack of trust.

I’ve seen many times relatively conservative investors make a highly risky investment, because they are investing with someone they trust. It could be a family member or a close friend or business partner. Their risk tolerance changes because they trust the person they are investing with. Most investors, however, never meet the portfolio manager of a fund. They may or may not read the quarterly or annual letters that the manager sends, if they write one at all. Some fund managers go on TV to talk about their strategies, and have more celebrity status than others. But ultimately investors have an impersonal relationship with the manager, and thus, I believe, are less likely to stick with them through the hard times. There’s no awkwardness in simply moving your assets to another fund. That switching can itself dampen returns too.

Mutual funds and ETFs (exchange-traded funds) pool assets from thousands of investors to be managed together. These funds often have daily liquidity, meaning investors can sell the fund or withdraw their money each day. When many new investors are coming into the fund, the manager has more funds to invest. When many investors are withdrawing funds, the manager may have to sell investments to meet withdrawals (also called redemptions). If investor behavior follows Morningstar’s research, then it follows that more investors are coming in after the assets in the fund have already gone up in value. The fund manager may be buying more of already expensive assets. Alternatively, investors will leave after a period of poor performance, meaning that the manager has to sell assets that are cheap and would potentially be good investments. To add to the misery, mutual funds have to distribute their capital gains to their investors. If the manager decides to sell investments that have gone up in value, which might be prudent if those are the already-successful and fairly priced assets, then the fundholders who actually stayed will get hit with a tax bill! The fundholders that left will have their own tax bill if their own shares increased in value, but they will miss the year-end distribution. ETFs are more complicated and out of the scope of this article. The bottom line is that not only can an investor’s behavior hurt their own returns, it could detriment other investors as well in pooled investment vehicles. This has made it more attractive for managers to go to hedge funds, the largest of which these days are Citadel, Point 72, and Millenium.

Hedge funds, such as Citadel, Point 72, and Millennium, typically work with institutional investors, such as endowments and pension funds. There are several benefits to working with these investors, one is that they have long time horizons and don’t mind, generally, agreeing to locking up their capital for longer periods. This means the hedge fund doesn’t have to worry about assets leaving at the wrong time, and the fund can even stop accepting new money when they have fewer investment opportunities. Additionally, these investors are non-taxable, so hedge funds do not have to worry about taxes as they trade. As such, these hedge funds often encourage their portfolio managers to make more decisions, more trades, which gives the fund more data to find which are the skilled managers. These hedge funds pride themselves on having consistent returns (which are often surprisingly low on their own, but magnified by leverage), and low drawdowns. Portfolio managers are fired for even minor losses, and risk is managed tightly at all times. For talented portfolio managers, the high compensation and freedom from managing liquidity and taxes can be attractive, and lure them away from managing mutual funds or ETFs. It’s impossible to quantify the impact of this, but I believe it is a factor making it more difficult to find good portfolio managers in the mutual fund space. On the other end, though, is the paradox of skill, that the weaker managers are the first to drop out, and only the best remain.

The paradox of skill states that over time, when the poor performers are eliminated and the remaining pool is more skilled, the survivors will have to work harder and harder to outperform each other by even a little bit. The general trend today is that more and more investors are choosing passively managed funds over actively managed funds. Passively managed funds attempt to track an index, such as the S&P 500, rather than try to outperform the index. Both actively managed funds and passively managed funds generally earn revenue by charging a fee on assets under management, meaning the more assets they manage the more revenue they receive. As assets have shifted from actively managed to passively managed funds, revenue to actively managed firms has decreased in many cases. As revenue drops, fund companies likely have to cut costs. The most likely targets are probably underperforming funds with the fewest assets. As these funds are closed, only the better funds remain. Thus, the managers that remain might be the better managers, but they are less likely to significantly outperform or underperform the average.

What does all of this waves at the ~1,600 words above mean for you? Choosing the best portfolio managers in advance is really hard. Research shows year after year that the odds are against choosing the best funds in advance. The good news is that you probably don’t have to to meet your goals.

Thanks to the widespread availability of passive investments, you can simply accept the average of all those managers battling to outsmart each other. Getting the market return over time might be all you need to reach your goals, so why go through the headache and heartburn of trying to find the next best manager, waiting through their inevitable rough patch, and hoping that in the end they outperform the market or at least don’t underperform by too much?

Active managers are important. Someone has to set the prices in the market, otherwise passive investing does not work. But that someone doesn’t have to use your money to do it. The important thing is to know thyself and know your goals, and find the investing strategy that you can stick with for the long term and that helps you achieve your goals.

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This content is for educational purposes only and does not constitute personalized investment advice. Past performance is not indicative of future results.