Picking Funds Based On Past Performance Is Dangerous

During previous employment at my former brokerage firm, I was taught how to evaluate mutual fund managers. While the individual responsible for my instruction generally was a proponent of valuable criteria such as R-Squared (how close the manager sticks to their intended investment style) and peer group performance consistency, generally the decision to either hire or fire a fund manager came down to two things; did that manager under/over perform recently and how many free lunches, Colorado Avalanche hockey games (catered Box seats of course!), and seminar marketing dollars the mutual fund company was treating us to.

When we spoke to clients about dismissing one manager in order to hire a replacement, it helped to justify the switch by pointing our fingers at some new fund that had demonstrated superior performance. Wasn't outperformance what our clients were paying us for? Didn't showing clients "bad" managers followed by recommendations for "good" managers prove that we were on top of things? Perhaps we convinced the majority of our clients, but at the time (and still today) the criteria we used was adding zero value. The reality is we were just well dressed gamblers playing a loser's game at the client's expense. Convinced there must be a better way, I did my research then ultimately left the firm to pursue more evidence-based investment strategies for clients.

This blog post will examine how most professional and amateur investors select investment managers, why the typical selection methodology is crazy, and then we'll finish with a list of 10 sensible criteria to evaluate fund managers if forced to within an employer sponsored retirement plan like a 401(k).

Fund Managers Are Hired On Perception And Numbers

Selecting a manager involves qualitative analysis (subjective perception of expertise), quantitative analysis (objective review based on numbers), and usually both. Investors find new investment managers based on snazzy promotions. These attractive offers typcially contain some compelling message like a high Morningstar rating. If the investor considers buying, they're by default biased qualitatively before they even get to justifying the fund purchase with past performance. But, unless an investor has a time machine (these don't exist), they cannot buy outperformance.

Buying performance is flawed. Studies show a manager who has outperformed in the past is unlikely to do so in the future1. Unfortunately, many financial advisors get caught up in a manager selection merry-go-round looking something like this:

1. Fire managers that have underperformed.

2. Hire managers that have outperformed.

3. Repeat while reminding clients how smart their recommendations are.

Investors Buying Outperformance Rarely Receive Outperformance

The manager selection process I identified above meets Einstein's definition of insanity, as many investors do the same thing over and over again while expecting different results. This is an exercise in futility since:

- It generally takes a long track record for a manager's alpha to be statistically significant.

- Positive alphas, even statistically significant ones, may not be an indication of skill.

- By the time you are confident there is skill, it's probably too late to benefit.

- Past performance is (really) no indication of future performance.

A Graph To Illustrate Why Chasing Performance Is Silly

US News & World Report regularly revises their "Best Mutual Funds" report. The current version can be found HERE. At the time of this blog post, the #1 rated Short Term Bond Fund is the Metropolitan West Low Duration Bond Fund (MWLDX). Let's look at how this fund actually performed.

It's true that fund managers outperform their benchmarks, usually over a shorter time period, such as this fund did from the 2nd Quarter of 2012 through the end of the 4th Quarter, 2012. Whether or not the manager's performance was a function of luck or skill is further addressed HERE.

As I notate in the chart above, it's a common practice to promote a fund's outperformance to attract new investors. However, by the time that message is received and acted upon, the investor may not actually receive the very outperformance they assumed they were buying.

My Experience With Managers Promoting Their Wares

Recently I've been going back and forth with a fund manager, Jerry Miccolis, who manages the Giralda Risk-Managed Growth Fund and the Giralda Fund. Here is a P.S. he included in an email to me earlier this month:

The Giralda Fund, has just received a 5-Star Overall Morningstar RatingTM versus 154 funds in the Long/Short Equity Category for the three-year period ending February 28, 2015, based on risk-adjusted returns. The Giralda Fund is closed to new investors but its strategies are available through a similar fund, the Giralda Risk-Managed Growth Fund (GRGIX).

Sounds good! Well, maybe... Jerry's value proposition is his fund is designed to limit losses during market downturns. While I agree mathematically this downside hedging strategy is more advantageous than earning an assymetrical outperforming return (if actually achieved), his fund lacks a full market cycle track record to quantitatively measure results. But that's not my biggest hangup. The reason I won't invest client's money in his fund is because I don't share his same conviction that he'll be able to consistently predict market movements (and react prior to them) in advance. I want to believe he will, and I wish him success. As intelligent as he is and as astute as he is with his math, he's asking me to invest based on strategies untested in a live market environment. Not gonna happen!

Ok, I digress from the point of this blog. Let's wrap things up.

How To Shop For Mutual Funds

As many of you know, I don't use conventional mutual funds in my company's model portfolios. However, many times my clients are forced into selecting funds within their 401(k) plans. The following list of 10 criteria can be used by investors either forced into picking funds or for those investors most comfortable trying to identify fund managers that will outperform (I don't agree with the latter but that's my perogative):

1. Diversify by asset class rather than by fund manager, financial advisor, account type.

2. Buy into markets, not managers, and let capitalism be your buddy.

3. Focus on what you can control—costs, asset allocation, risk, and discipline.

4. Ignore what you cannot control—the media, prognosticators, market returns, and your gut.

5. Work with an advisor who understands these principles and can help you apply them.

6. No sales charges (front loads, contingent deferred sales loads, level loads).

7. A low expense ratio (shoot for below 1.00%).

8. Low turnover (trading frequency), no higher than 50% a year, and preferably closer to 20%.

9. Full investment policy. Cash reserves of nearly 0%.

10. Returns consistently in the top half compared to similar style funds.

Final Thought

Realize that fund manager's rarely deliver the performance they advertise. Try not to get caught up in the excitement of some shiny new investment strategy. Don't try to beat the market, hint: you are not smarter than collective wisdom of the other millions of investors out there (even you Jerry). Investing is a means to and end, ie., focus your financial concerns on if you are on track to meet your financial goals, not if you're on track to beat an investment benchmark.

Thanks for reading and have a great day!

1, Mark Carhardt, "On Persistence in Mutual Fund Performance," Journal of Finance 52, no. 1( March 1997). Garrett Quigley and Rex A. Sinquefield, "Performance of UK Equity Unit Trusts," Journal of Asset Management 1, 72-92. James L. Davis, "Mutual Fund Performance and Manager Style," Financial Analysts Journal 57, no. 1 (Jan/Feb 2001).