Researching Equity Managers and Mutual Funds: The JPH Advisory Approach
By and large, both investors and fund professionals rely heavily on past performance in their fund selection process. The problem is that past performance is of little use in identifying funds or managers who will deliver superior future performance relative to their peer group. Numerous studies have failed to unearth a significant positive correlation between past relative performance and future relative performance. The only correlation found has been the consistency of managers with very bad returns to continue to be bad. These results are true even if looking at performance of managers within their respective peer groups. So why do investors insist on basing important decisions on data that does not increase their chances for success? There are several reasons:
- Many investors either do not realize that track records lack predictive value or simply don’t want to believe it.
- The industry, including fund companies, mutual fund rating agencies (with their ranking systems based on past performance), the financial media and many advisors all tout past performance, and in doing so, support that fantasy that it can be used as the basis for making successful investment decisions.
- Investors don’t know what else to look for. Numbers are easy to get and easy to understand. Research that goes beyond numbers is a labor-intensive process that is time consuming, demands experience and knowledge of what to look for, and requires access to fund management firms that most investors and advisors don’t have.
All of this begs the question, “Why aren’t track records predictive?” Shouldn’t we expect some subset of the best performing managers to be among the most skilled and therefore, as a group, shouldn’t funds with better historical records continue to outperform? Our experience evaluating active managers leaves us less than surprised by the inability of winners to consistently repeat. There are a variety of reasons why maintaining a competitive edge is difficult:
- Success leads to asset growth and that may lead to declining flexibility, especially for smaller cap managers. Even larger-cap oriented managers occasionally buy stocks of middle and smaller sized companies if they are extremely compelling. Asset growth may reduce the stock pickers flexibility and result in a smaller universe of investable stocks.
- Success often leads to stardom and the temptation to leverage the marketability of the portfolio management team by launching other products. This may force the management team to manage other types of portfolios reducing their focus on the original fund. Focus is critically important to winning the investment game.
- Stardom also leads to turnover as some successful investors move on to other firms or start their own.
- As successful managers become spread too thin because of new product and marketing
responsibilities (along with the challenge of running more money) they often expand their team. While this may be a positive it can also be a negative if responsibility is delegated from key individuals with proven, special skills to less skilled or untested team members.
- Success often leads to overconfidence that can result in sloppiness or the downplaying of the risks that result from the success traps discussed above.
The fact that track records are not useful in predicting future relative performance is the basis on which index fund proponents conclude that low cost index funds are the better choice. We disagree with the underlying premise. The fact that track records are not predictive is not tantamount to concluding that superior future performers can’t be identified. It simply means that the track record does not provide sufficient information to do so. (Does anyone really expect that investment success should be as simple as projecting the past into the future?) Our approach to fund research recognizes that past performance is useful only as a tool for screening funds to identify those that may be worthy of further research. Value added comes not from evaluating performance but from identifying why a fund performed well, determining if the portfolio management team has an identifiable edge and assessing whether the edge is sustainable.
The JPH Advisory Fund Research Process
Step One: Performance Screens are the starting point in our research process. We consider funds that have outperformed their peer group and benchmarks over a reasonably long period of time. Generally we require a minimum of five years of performance. However, occasionally we will consider funds with a shorter record. We are also willing to take into account a manager’s separate account record prior to the fund’s inception, if we believe it is representative of how the existing fund would have performed over the same time period.
In addition to absolute performance we take into account:
- Performance consistency relative to the fund’s peer group and benchmarks
- Special factors that impacted performance that may not be repeatable
- The level of assets on which the record was based
Step Two: We routinely hire a third party research firm to perform complete due diligence on the money manager, which may include:
- Detailed Questionnaire
- Portfolio Manager Interview
- In most cases, a site visit to talk to the management team face to face to see if they do
what they tell us.
Step Three: We review all the research and then decide whether or not they go on our buy list.
What Makes a Stock-Picking Guru?
What are we looking for in this time-consuming and labor-intensive process? Simply stated, we are looking for managers with an identifiable edge that we are highly confident can be maintained. Specifically this translates into the following:
- The stock picker must have an investment process that is disciplined. Though there are some highly intuitive investors who are successful, we believe a disciplined process helps to avoid decision errors that result in sloppy, incomplete analysis. We simply have less confidence that highly intuitive stock pickers will be able to maintain their success.
- The investment process must give us a reason for believing the manager has an edge.
Sometimes the edge is the level of passion that results in an obsession with knowing companies so well that there is an information edge. Other times the process results in a unique way of looking at companies that can lead to better insights. Some stock pickers gain their edge from a combination of factors such as an incredibly high level of discipline that allows them to minimize decision errors and an obsession to know their companies better than their competition.
- We require that the stock-picking team be highly focused with few business or marketing
distractions. They must not be running too many different investment products that may pull them in too many directions.
- We must be confident that the team will be fairly stable and that business growth won’t be at the expense of returns to existing shareholders. We don’t care for empire-builders.
The Importance of Our Discipline
Going through all these steps doesn’t guarantee success. Critically important to mitigating mistakes is our acceptance that not many managers will make the cut. This doesn’t bother us because we don’t need to identify many good managers. We only need a few. And the reality is there are only a few that have an identifiable edge who we believe will also maintain their focus, team stability and grow their business with shareholders in mind (as opposed to maximizing their own bottom line).
The benefits of all this work go beyond significantly increasing our batting average when it comes to fund/manager selection. In addition, it allows us to be patient with managers who go through a slump, as they all do eventually. Because our recommendation of a manager is based on such exhaustive research, we have the confidence to ride through a slump as long as something has not occurred that causes us to reassess the factors that led to the recommendation.
Investors want quick answers. Projecting a track record forward without any additional thought generates some quick answers. For those who realize the flaws in this approach, buying the whole market at the lowest possible cost (indexing) provides another quick answer. Performing high quality due diligence on stock pickers and fund companies requires a disciplined, exhaustively thorough effort—it is not a quick answer. It is highly labor intensive. But we believe that in doing the hard work that no one else wants to do, we can continue to add value by finding managers who will be able to beat market benchmarks. And as is true throughout investing, a small edge adds up to big rewards over time. This is the payoff from doing the difficult work.
“Only when the tide goes out do you discover who has been swimming naked.”
– Warren Buffet