If you are an investor who puts some or all your money into active mutual funds, you should know about a critical tension that exists in the industry. It’s a tension that also affects many fund managers.
The subject is explored by Michael Mauboussin in chapter two of "More Than You Know: Finding Financial Wisdom in Unconventional Places."
But first, active investing results are now measured against index investing, and Mauboussin began chapter two by providing a “Scouting Report” on indexing, which has become the competition for active investment.
For example, if you want exposure to large-cap stocks, you have a choice between an active fund with that mandate and an index made up of stocks in the S&P 500. And, the author wrote, “Accordingly, we can consider an appropriate index’s return to be a measure of an investor’s opportunity cost—the cost of capital—and that beating the benchmark over time should be an active manager’s measure of success.”
Put another way, the gap between the returns of an index fund and an active fund should be the measure of success (or failure) of an active manager. If the active manager beats the index over time, then the manager is successful. On the other hand, generating returns of less than the index fund would be a failure.
A discerning investor would want to know, then, the odds of beating the index with an active manager. According to Mauboussin, the odds are poor. He cited one (undated) study that found indexes outperformed more than 40% of active managers, and that more than half of the active funds failed to keep up with the benchmark index fund over 10 years.
That still leaves, however, a significant number of active managers who did beat the benchmark and were able to do so over longer terms. That begs the question, “What did these active managers do to achieve their success?” Mauboussin credited their success to these four attributes:
- Low portfolio turnover. While all equity funds average turnover of 89%, the successful funds had a turnover rate of about 35% (turnover in the S&P 500 index fund was just 7%). In a related measure, the successful funds had an average holding period of about three years, compared with a roughly one-year holding period for the average funds.
- Concentration in their portfolios was another attribute of successful active fund managers. On average, 35% of their assets were in their top 10 holdings, compared with 20% for the index fund.
- Investment style was also a factor, with the “vast majority” taking an intrinsic value approach; in other words, they look for stocks that have market prices below their intrinsic values.
- Geographic location was a surprise to me, with Mauboussin reporting that the high-performing funds were not in New York or Boston. Instead, they were to be found in cities such as Chicago, Memphis, Baltimore and, not surprisingly, Omaha.
In winding up this section, he noted:
“Further, it is worth underscoring that the success of these investors is not the result of their portfolio structure but more likely reflects the quality of their investment processes. I once overheard an investor remark to one of these superior performers, 'You can have low turnover because your performance is so good.' At once, the manager shot back, 'No, our performance is good because we have low turnover.' It would be futile to try to replicate the portfolio attributes (i.e., low turnover, relatively high concentration) without an appropriate process.”
And, the author was left with this question: “Why is the profile of an average fund so different from these superinvestors?”
With that, he turned to the issue of profession versus business. Specifically, the investment profession refers to managing portfolios with the goal of maximizing long-term returns. The investment business refers to generating earnings for a mutual fund (Mauboussin pointed out those are often short-term earnings the managers are pursuing). I would put the situation in these blunt terms: Is the manager focused on his client’s success or on his firm's success.
Granted, the author noted that a firm has to produce good earnings to attract and keep top investing talent, “But a focus on the business at the expense of the profession is a problem.”
To further explore the tension between the profession and the business, he cited Charley Ellis, the founder of Greenwich Associates. Ellis observed that this tension arises because the profession and business operate at different rhythms:
- The profession has long time horizons, low fees and practices contrarian investing.
- The business requires short time horizons, higher fees and selling what’s in demand.
So what should fund managers do, how should they manage the trade-offs? Mauboussin once again cited Ellis: “The optimal balance between the investment profession and the investment business needs always to favor the profession, because only in devotion to the disciplines of the profession can an organization have those shared values and cultures that attracts unusually talented individual professionals.”
That citation did not mean Mauboussin was without an opinion; he wound up the chapter with these words: “I would argue that many of the performance challenges in the business stem from an unhealthy balance between the profession and the business. Many of the investment managers that do beat the market seem to have the profession at the core.”
Conclusion
Fund investors will find it difficult to know what the balance between the profession and the business is for any given active fund. However, they can reverse engineer, in a sense.
In screening funds, investors can seek out funds with a value approach, with low portfolio turnover, concentration in the top 10 holdings and perhaps being based in a city beyond Boston and New York.
A fund with such characteristics seems likely to put its clients front and center.
Read more here:
- More Than You Know: Be the Casino, Not the Gambler
- More Than You Know: Building on Charlie Munger’s Intellectual Legacy
- Just One Thing: Attempting to Beat Time
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