As most financial advisors know, the secret to successful investing is relatively simple: Figure out the value of something and then — pay a lot less. Unfortunately, as it turns out, it's really hard to figure out the value of a business. And finding good fund managers that can do the job for you — that can be just as difficult. There are several inherent reasons why this is so. Mutual fund managers have to do the things that private investors, such as me, can afford to do. We can own just a few stocks — say as few as 10 to 25 of our favorites — and we can choose stocks that are too small for big funds to buy and for Wall Street firms to follow. Also funds often get too big and charge too much to beat the market. Complicating things further, retail investors — even their financial advisors — are unwilling to hold a good manager when his style is, well, out of style.
Of course, a big impediment to beating the market that all managers must overcome is fees. Most actively managed mutual funds charge fees and expenses based on the size of the fund, usually 1 percent to 2 percent of the total assets under management. This means that the more assets a fund has, the more money the management company makes. As you might suspect, this incentive to gather more assets isn't necessarily good for investors.
To get big and take large positions, fund managers tend to go for big, well-known stocks. But, there can be big advantages to looking at smaller companies. These companies are often too small for large investment funds to buy and for Wall Street firms to spend money on doing research. Less competition from other buyers and less available Wall Street research often mean a greater opportunity to find bargain-priced stocks among these lesser-followed small-capitalization companies. Since there are thousands of companies with market capitalizations below $1 billion both in the United States and internationally, small-cap investors have a big advantage. Being able to choose from thousands of additional choices with less competition from large investors is a luxury that successful investors like Warren Buffett wish they still had. Yet the goal of most mutual funds is to gather as many assets as possible. Chances are that by the time you've heard of a successful mutual fund, it already has many hundreds of millions or billions under management and can no longer take advantage of some of these smaller investment opportunities.
Being the Market
The next problem is that most of these actively managed funds own between 50 and 200 stocks in their portfolio. It's difficult to do a good job analyzing the value of a business. Understanding a company and its industry well enough to project earnings, growth rates, and discount rates far into the future for even one company is a tough challenge. To have this kind of extraordinary insight into a handful of companies at any one time is probably more than any fund manager or management team can really ask for. One thing seems pretty clear: Once a fund gets to its twentieth or fiftieth favorite pick, it's not likely that very much extra value is being added to the portfolio. But there are a number of reasons why most funds still own so many stocks. Diversification is, of course, one reason, and there are some regulatory rules, too.
For funds that specialize in smaller-capitalization companies, and there are some, buying a portfolio with many stocks is almost a necessity. While these funds are designed to take advantage of the greater opportunities and choices among the thousands of smaller companies, they are also generally forced to buy many dozens or hundreds of small company stocks. Due to each company's smaller size, it's really not possible to invest a large amount of money in any particular stock. As a result, much of the advantage of being able to find a few great opportunities among smaller companies is lost by diluting a few excellent stock ideas with 50 or 100 other stock holdings that are not as attractive.
But the main reason most mutual funds choose to own dozens or hundreds of stocks is very simple: they don't like to lose. Most mutual funds are judged by whether they can beat the returns of a particular market index. One way to do this is to concentrate on a few of your favorite ideas. As we just discussed, funds specializing in smaller-capitalization stocks can't really do this due to the small size of each individual company. But funds that invest mostly in large- capitalization stocks can. Through hard work, industry expertise, and special insights (even though it's harder than with small-cap stocks), it's still possible for talented managers to find a handful of bargains among large-capitalization stocks and invest billions of dollars. But the few managers who do this are taking a big risk.
The returns from a portfolio of only 10 or 20 stocks can vary widely from the returns of a market index that contains a portfolio of 500 or 1,000 stocks. As you might expect (and, a portfolio of hundreds of large-capitalization stocks will usually do pretty average. A portfolio of 10 or 20 favorite picks has the chance to do well above average. But, unfortunately, it also has the chance to do well below average. Even a very talented manager who makes excellent stock picks over the long term can trail the market averages for years at a time. In fact, this is almost a certainty with a concentrated portfolio.
Yet the reality is that a manager who significantly underperforms the market averages for two or three years has a good chance of losing most of his or her investors. Most investors just can't figure out which managers fall behind the market averages because of bad luck or bad timing and which managers fall behind due to a poor investment process and a lack of talent. Most don't wait around to figure out which is which. They just turn and run! And no investors means no business! Over the long term, managing a concentrated portfolio may be a great way to beat the market averages, but over shorter time horizons it's also a great way to risk your business and your career. As a result, only a few brave souls choose this route in the mutual fund world. It's just much safer for most managers to buy a widely diversified portfolio of many stocks that are more likely to closely mirror the major market averages and much less likely to fall significantly behind. In other words, most mutual fund managers are effectively shut out from their best chances to beat the market. Most can't take advantage of the thousands of opportunities available in lesser analyzed, smaller-capitalization stocks. For practical and business reasons, most can't concentrate their portfolio on just their few best ideas. As for special situations, these are largely out of the picture, too. In short, most fund managers are stuck buying a portfolio of between 50 and 200 of the largest, most widely-followed stocks.
The result is predictable: Most don't beat the market. In fact, because of management fees, most don't even match the market averages. On average and over time, actively managed funds lose to passive index funds by approximately the amount of their higher management fees.
But for investors it gets even worse. Most investors have no idea why or how an active manager chooses the stocks in his portfolio. As we've seen, many estimates and assumptions go into each and every investment choice. What investors do know is how a particular fund has performed over the last few years. Has it beaten the market? Has it beaten other similar funds? Since the end result is pretty much all investors get to see, that's what they use to make their investment decisions.
Unfortunately, it turns out that relying on recent good or bad performance to make investment decisions isn't such a smart way to go. Even professional allocators of capital seem to chase recent good performance and run from underperforming managers. Several research studies tracked the investments of these large, “professionally” managed fund allocators (such as foundations, endowments, and pension plans) and analyzed their decisions to hire and fire investment managers. The results weren't pretty. [For more, see Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” Journal of Finance, Vol. 63, No. 4, August 2008 (this study followed more than 3,400 professionals); see also Stewart, Neuman, Knittel, and Heisler, “Absence of Value: An Analysis of Investment Allocation by Institutional Plan Sponsors,” Financial Analysts Journal, November/December 2009.]
Most managers were hired due to good recent performance. Most managers that were fired had recently underperformed the market averages. In short, these “professional” fund allocators would have been better off staying home! In the years following hire and fire decisions, the recently fired managers significantly outperformed the market while the recently hired didn't show any outperformance at all.
And that's how the “professionals” did at picking managers. Individual investors make even worse decisions. The best-performing stock mutual fund of the last decade earned more than 18 percent annually (by the way, this fund runs a concentrated portfolio of fewer than 25 large-cap stocks). This is particularly impressive since the market as measured by the S&P 500 was actually down close to 1 percent per year between 2000 and 2009. Yet the average investor in this same fund managed to lose 11 percent per year over those 10 years. How? Pretty much after every period in which the fund did well, investors piled in. After every period in which the fund did poorly, investors ran for the exits. So the average investor managed to lose money in the best-performing fund purely by buying and selling the fund at just the wrong times! While this is an extreme example, individual investors follow the same pattern as professionals. They pull money out after the market or a manager does poorly. They put money in only after the market is already up or a manager has outperformed.
On average, because of poor timing decisions (with regard to both market moves and manager selection) and the drag of management fees, investors can't even match the market averages. You might intuitively think that when you combine everyone's returns, the end result would have to be average. But over the last two decades ending in 2009, the S&P 500 averaged returns of 8.2 percent, yet mutual fund investors earned much less — approximately two-thirds of that amount, according to one study, and less than half that amount, according to another. The rest went to management fees and bad market timing decisions. Over two decades those lost returns (even using the two-thirds estimate) actually translate into half as much in profits.
So bad market timing aside, it's pretty clear that professionals and amateurs have a hard time figuring out which active managers to invest with. Even Morningstar, the most influential company in the mutual fund rating business, has generously admitted that ranking funds based solely on low expenses would have done a more consistent job of predicting future good performance than their proprietary star rating system. Yet even with all this bad news, each decade approximately 30 percent of active funds do manage to outperform the S&P 500. Isn't there some way to find those guys ahead of time?
Well, it might be possible, but there are some major roadblocks that need to be overcome. Looking at just the top quartile (best-performing 25 percent) of managers over a recent decade, almost all of these top-performing managers (96 percent) spent at least one three-year period during that decade in the bottom half of the performance rankings. Even more telling, 79 percent spent at least three years in the bottom quartile (bottom 25 percent of managers) and a staggering 47 percent spent at least three years in the bottom 10 percent. In other words, even the best-performing managers go through long periods of significant underperformance.
Unfortunately, this makes perfect sense, since to beat the market (as represented by the S&P 500 in this case), you must invest differently than the market. At a minimum, you can't invest in exactly the same stocks in exactly the same proportion as a market index and still beat it. Even if a manager has talent and his strategy is sensible, stocks fluctuate at different times and in different ways, so long-term outperformance due to a strategy that differs from the index is almost always accompanied by lengthy periods of underperformance. Since almost all investors chase recent good performance and run from recent poor performance, it's no wonder they have a hard time sticking with even those managers who eventually end up with the best long- term records.
There's one final problem before we beat this horse to death. As we've just discussed, mutual fund managers who have been successful in the recent past attract lots of investors. (After all, it's hard to throw money at managers who have been unsuccessful or only average.)
The problem is that it's generally more difficult to manage larger sums of capital. When a fund is smaller, it can take advantage of some smaller opportunities. A larger universe of stocks to select from gives a manager more chances to find bargains. Smaller situations can still have a major impact on a small fund's portfolio. In addition, a manager generally can concentrate more in his favorite situations when he can choose to own both larger and smaller stocks. Having the ability to invest in smaller situations also generally means a manager is not forced to spread his investments over a larger number of stocks and so may not have to move as far down a list of favorites.
But once hundreds of millions or billions come in the door, things have to change. Many times the smaller situations and opportunities that helped make a manager successful and attracted all that money in the first place are now too small to have a major impact or, because of their small size, are off the table completely. As Warren Buffett said to BusinessWeek in 1999, “It's a huge structural advantage not to have a lot of money. I think I could make 50 percent a year on a million; no, I know I could. I guarantee that.” Of course, all of us would rather have billions and make less than 50 percent, but you get the basic idea.
Investing with the managers who have performed the best and attracted all the money is probably a great way to win the last war, just not a great strategy for beating the market going forward.
Joel Greenblatt is the founder of Gotham Capital, an investment partnership founded in 1985. Greenblatt, an adjunct professor at Columbia, has launched four no-load mutual funds under the Formula Investing brand and has recently published another book, The Big Secret for the Small Investor (Crown Business), from which this article was adapted.
