Investing by Accident

Apples, Oranges, and Kumquats It is only a slight exaggeration to state that the history of fund analysis is the history of misinterpreting fund managers' contributions. Technically, such errors are called confusing beta for alpha. That means making the mistake of crediting (or blaming) investment managers for decisions that they did not make.

Simple examples would be praising funds that always invest in small-company stocks for outgaining the S&P when secondary stocks lead the way, or crediting funds that favor lower-quality bonds for beating high-grade funds during an economic expansion. Clearly, those funds' managers did nothing to warrant such praise. They held what they were going to hold, no matter what the market conditions, and were buoyed by favorable winds.

Investment analysts quickly learned to avoid that sort of miscalculation. They found specialized indexes--or combinations of such indexes--to use as benchmarks for funds that invested outside the mainstream. If a small-value fund outperformed a small-value index, then that represented true achievement. The comparison became apples to apples, as opposed to the apple of a small-value fund, the orange of a broad small-company index, and the kumquat of the S&P 500.

Not so Simple, Simon That additional step, however, did not suffice. Almost all fund managers have investment habits: perpetual traits, regardless of market conditions. Consider the small-value manager who, year after year, favors beaten-down tech stocks, who holds about 10% of fund assets into foreign securities, and who dislikes banks. That manager's relative fortunes will vary with the performances of those three areas. If all three break in his favor, his fund will almost surely beat the index. If they break the other way, the fund will trail.

And that is a simplified example. In reality, managers will have more than three ongoing differences with their benchmarks. In addition, the numbers will not be fixed but instead will fluctuate within a range: That 10% position in foreign stocks might be as high as 15% at some times or as low as 6%. Thus, adjusting the benchmark to make it reflect a manager's "true" universe, so that the resulting comparison gives the manager's "true" alpha, is no simple matter. It requires much more data and, ideally, extended conversations with that manager to understand which preferences might change and which are fixed.

The difficulty of conducting such work, on a mass scale, spurred GMO's Jeremy Grantham to state, "90% of what passes for brilliance or incompetence in investing is the ebb and flow of investment style." That is, most manager selection consists of investing by accident.

Cause and Effect This leads to tail-chasing, as investors pursue funds that have had strong recent relative performances. The relevant factors blow to a fund's advantage. The fund climbs the performance rankings, gains additional stars in its Morningstar Rating, makes the consultants' buy lists, and attracts new assets. The marketplace seems to be rational, with the better funds receiving their just rewards.

But then the winds change. Perhaps their effect is neutral, so that the fund's returns become average. Observers comment that management has become distracted by the fund's newfound success or that it is having difficulty investing the larger asset pool. Or, perhaps, the effect is negative and the fund's performance really suffers. In that case, it may be said that the manager suffers from a cover jinx or that he "lost his discipline."

Such explanations are personifications. For the most part, the investment weather drives the performance decline, not the investment people.

Of course, even this portrait is a simplification. Investment managers do make decisions that are not fixed--decisions that lead to true contributions. Yes, most funds tend to have stable risk exposures over time, with their asset allocations, geographical mixes, and sector weightings generally being predictable. But not always. When such moves do occur, for time-specific reasons, the results come from investment intentions, as, of course, do security-level selections.

Set Up to Disappoint Such is the state of today's investment art. Most people realize that the strongest arguments for portfolio-manager efficiency are overstated. (Warren Buffett: "Ships will sail around the world, but the Flat Earth Society will flourish.") Every fund manager makes meaningful choices, and some are better at doing so than others; thus, some managers are superior. Identifying those "A" students, however, has proven trickier than expected.

This, as the Financial Times' Stephen Foley noted while attending Morningstar's Investment Conference, has severely damaged active managers' reputations. The average actively managed fund is decently run. Add its expense ratio back to its reported total returns, and the result roughly matches that of the fund's benchmark. Adding trading costs, which are not contained within the official expense ratio, puts the typical active fund slightly ahead of the index. So, there has been no surprise in aggregate with active managements' results.

The surprise comes from the particulars--when an apparent star fund, run by an apparent star manager, reverses course. Such behavior does more than tarnish one manager's name. It besmirches the entire field of active investment management, by suggesting that that success is a mirage. When this happens once or twice, or even a few times, investors can shrug off the experience and maintain their faith. Eventually, though, they stop believing. In Foley's words, "harsh reality" intrudes upon active management's "warm cocoon."

(Foley takes Morningstar's star ratings to task for being part of the problem of misidentifying skilled managers. Setting aside Morningstar's disclaimers that the star rating measures past performance and does not incorporate predictions, Foley's argument is fair. The stars, too, have trouble distinguishing between alphas and betas. However, Foley errs in linking star ratings to performance-chasing. Most performance-chasing occurs when investors sell one asset class to purchase another; the star ratings do not address that issue. They carry no information at all about asset classes.)

My intent is not to point fingers. There is more that Morningstar can do to separate alphas from betas so that investors are not surprised by how their new funds perform. There is also more that investment consultants can do, more than financial advisors can do, more that the media can do. If blame is required, there is plenty to be passed around. This article is instead intended to serve notice. The problem with active management is not active management. It is instead management's overly high costs (covered in several previous columns) and the incorrect expectations that are established when people invest by accident.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.