The market has hopefully put in a bottom. One can never know for sure, but the last several days have been encouraging. Still, it has been a very tough year thus far, and that brings up a topic that is worth discussing: How should one judge the quality of an active mutual fund manager?
The obvious answer is to look at the results. How has the fund performed? It seems like a simple question, but unfortunately the answer is not simple. There are countless ways to measure investment results, so this leads to a problem. We have all heard it before: figures lie and liars figure. A mutual fund’s marketing department can almost always come up with some measurement that will make it look good. What is real and what isn’t?
The usual measure of investment results is the trailing return numbers. We look at a period ending, typically at the end of a calendar quarter or at least a month-end, and look back over time; specifically, we look at the one-, three-, five-, and 10-year periods (if the fund has not existed for 10 years, then we look at since inception). Most have probably not given those time frames much thought, but if one is a geek like me, she may ask, “What is so magic about the one-, three-, five-, and 10-year periods? Why not six-year periods?”
The truth is there is no magic in these time periods, but in 1940 when Congress decided to regulate investment managers, the Securities and Exchange Commission (SEC) had to come up with something. They decided that managers of mutual funds needed to show a consistent measure that could be compared so an investor could make a wise decision. A mutual fund could show more information if they wished to, but they had to show one-, three-, five-, and 10-year results. Further, they had to be calculated using a time-weighted methodology versus a money-weighted methodology, but that may be too much math for one day. Suffice it to say that all the different mutual funds have to do it the same way.
Since that is what the SEC requires, that has become the default method of looking at mutual fund managers and judging their performance. But should it be? There is a problem with using trailing return periods to judge the quality of a manager. Knowing what the return has been for the one-, three-, five-, and 10-year periods that just ended doesn’t tell an investor how the manager got there.
Judging an investment manager is very much like judging a coach. We could use any sport as an example, but the NBA Playoffs are going on so let’s use basketball. An NBA game lasts for 48 minutes. Knowing who won the game doesn’t mean you know how the game went. In these playoffs there have been games where a team got off to an early lead and never looked back, while the losing team was losing for all 48 minutes. There have also been games when one team got off to a hot start and the other team slowly but surely came back, not taking the lead until the very end. The losing team in that game was actually winning for most of the game. The end result is the same, but how they got there was much different.
Why does that difference matter? It matters because there is going to be a next game, and a team that is close to winning but just didn’t finish is a different thing than a team that is being dominated. Trailing results – even the “long-term” 10-year results – are just one time period, like one game. A manager can be winning that game for nine years, have one bad year and lose that particular 10-year game. Conversely, a manager could be losing for nine long years, have one fantastic year, and end up a winner for that one 10-year game. The future prospects of those two managers are very different. When one year sticks out (for the good or the bad), then that year is a fluke. Odds are that both of those managers will go back to being themselves – one who consistently does well and one who consistently doesn’t. However, if all one considers is that one 10-year period, then how would she know which manager is which?
This is why so many people say that it is impossible to select a manager who will outperform in the future: They keep judging them based on just one game. We don’t judge coaches on the basis of one game, and we shouldn’t judge them on the basis of just one season, although fans are guilty of such. Great coaches are identified based on many games, over many seasons in their careers. Likewise, this is how we should judge the mutual fund manager. Iron Capital uses rolling time periods; In other words, we do not look at just one trailing period of time, regardless of how long, but instead look at every trailing period of time. Each month there is a brand new one-, three-, five-, and 10-year period, and it is two months different than the last one. One month has been added and the oldest month has been removed. It can be surprising what a difference two months can make. For those who look quarterly, the difference is six months and that can be meaningful.
Because time periods can be so different, it is important to look at them all. We primarily focus on the manager’s three-year results rolling forward every month; we then average those periods to see how the manager has done on average. It resembles looking at a coach’s career versus focusing on one game, and it is far more valuable. It tells us with a fairly high degree of certainty whether this manager is good, or if has he just been lucky lately.
It is also important to note what it doesn’t tell us: It does not tell us that this manager will outperform in the next game. Nothing can do that, and there are many in our field who mistake that fact with not being able to judge talent. What our process tells us is that this manager is a quality manager and therefore our odds of doing well over time are good. Rolling time periods is only the beginning for us, but it is an important beginning. It identifies consistency. It also helps us know when we should be patient with a manager who just had a bad game. Everyone has those from time to time, it cannot be avoided, but quality managers bounce back.
With the market down so dramatically, we will see managers who stumbled, and we will see some who did well, at least relatively. It is easy to judge them after just one period, but that is no way to make prudent decisions. At times like this we need to know that the people managing the mutual funds in which we are invested are actually talented, that they are good at what they do. Trailing returns, no matter how long, can’t tell us that; we have to dig deeper.
Figures lie and liars figure. It isn’t enough to consider only a trailing return number and then think we can judge a manager. We need to understand the how and why, and one cannot get that from simple trailing returns. That is an important lesson anytime, but extremely important in this environment.
Warm regards,
Chuck Osborne, CFA
Managing Director
