Labor Day recognizes the value of human labor in our society. In this sense, I want to recognize the value provided in the labor of equity portfolio managers and the perhaps even more difficult labor of selecting them as investment managers for fiduciary accounts and laborers who are direct and indirect beneficiaries of mutual funds.
In a teratological sense it has to do with the search for good and great managers, as well as the differences between the two. The differences between the two are not primarily the difference in skill level, but a difference in the type of skills. As is often the case, the difference in skills is not a difference in intelligence or effort, but one of personality. I will discuss selecting great managers in a subsequent blog.
A good bit of my effort in managing fiduciary accounts is directed at the selection of mutual funds intended to be held for an extended period of time. These mutual funds are often held through multiple market cycles to meet the long-term payment needs of beneficiaries. The task is to effectively screen through the 8,391 US Diversified Equity Funds and 4,487 world equity funds. I generally exclude the 2,264 sector and 5,901 mixed asset funds. Sector funds are better used with a market-timing overlay once the core of a diversified fund portfolio is in place. Mixed asset funds generally do not combine top skill sets in selecting stocks, bonds, and allocations. I prefer to use separate funds for each of those tasks.
One of the reasons many analysts of investment performance look to mutual funds as a laboratory is not necessarily due to their skills, which aren't bad, but due to the longevity of the performance histories. Most funds have performance periods from inception to termination and every conceivable period in between. Furthermore, their portfolios are available periodically, with some delay. What makes the mutual fund laboratory even better is that there is a good sample of management companies (publicly traded), allowing for a better understanding of the economics of managing the fund and perhaps the incumbent motivations. This is the laboratory that I have devoted a lifetime to following. Thus, I use my more than fifty years of working with this data and knowing many of the key players in my search for good and great funds for investment.
Finding Good Funds
To set the stage, a good place to start is performance, particularly relative performance as absolute results are too variable for sound analysis. The study of most statistical universes suggests that they produce bell-shaped curves, with most of the participants gathered in the middle. For analytical purposes, the standard marketing approach of dividing performance into quartiles places inordinate importance on the 49th to 51st percentiles, which is why I much prefer to use quintiles. For any given time-period the relative rank of those in the middle quintile is not generally a good measure of skill, but of accidental or racing luck, which is not often repeated. In studying performance I see significant differences in the approach of the top and bottom quintile performers, which is worthy of further analysis.
In using relative rankings the length of the performance period is critical. Most often marketing needs focus on a single calendar year, five years, or even ten years. (The three-year period is often a trap, as the market frequently goes in a single direction during that time, often with no measure of performance in a down period.) In selecting funds for long-term investors we are mostly interested in long-term performance over different market cycles. For the most part, only commercially successful funds have very long-term records. We have developed a secondary analytical tool where we look at the frequency of quintile performance for each quarter, for five or ten-year periods. Episodic quintile placement for any given quarter, while an aid to understanding a fund, is not significant. What can be significant is both the frequency of placement and the trend in placements.
The Influence of Management Companies
Mutual funds are in the business of producing management fees for the owners of their management companies. This reality leads to the race for fund awards, particularly those awarded by the media. This often skews their views to the short term. The commercial needs of the management company owners avoid fifth quintile performance, if at all possible. With the cyclical nature of performance, the unspoken prohibition against poor performance in a quarter often has the effect of reducing the chances of top quintile performance, which frequently occurs in the period following a decline. Further, in many cases this reduces the chance that the fund will have a great long-term record. However, it could still be a good fund for its investors and a commercially successful fund for the owners of the management company, its distributors and other influencers. A wise management company, no matter what the market serves up, will attempt to have at least one fund that is currently doing well, taking some of the performance pressure off good funds currently doing poorly. Poorly performing funds might create good buying opportunities for a savvy fund investor and their advisor.
Selection Begins with Elimination
In the search for equity funds likely to result in low portfolio turnover, you must find funds that are likely to be in the portfolio in the future. We first create a universe of funds that has over the last ten years performed at least half the time in the second and third quintiles quarterly. (Those that performed better are candidates for the great funds category, which will be discussed in the future, as they have different characteristics than the steady-eddy good funds. Those with poorer quarterly ranks should be put aside as potential turnaround candidates for future study. Recognize that in utilizing the 40-quarter filter, we are looking for a fund that is in the second and third quintile at least half the time rather than beating its peers 40% of the time.) The ten-year period should begin with the fifth calendar quarter after the lead portfolio manager has assumed responsibility. The investment strategy should also have remained reasonably consistent in order to avoid both a start-up period, when the fund is not fully invested and has primarily cash on hand, and a replacement period where a new manager needs to change the old manager's portfolio. Performance is the initial attraction but is far from the only or even the main consideration in fund selection.
Most of the other preferred critical characteristics require one or more visits to the portfolio manager and others at the fund site, as well as understanding:
- The philosophy behind the investment strategy
- Management controls applied to the manager and portfolio
- Functions the manager is responsible for e.g. analysis, marketing, department and firm management
- The long-term psychic and financial rewards and risks influencing both the manager and the organization
- The level of manager involvement in the analysis of good and poor performers in the portfolio
The next set of criteria depends on the boards of the fund and management company.
- Are most of the board comprised of successful investors?
- Do some of the board have experience managing intellectual property producing individuals?
- How friendly are the directors with management?
- What are the firm's business prospects and how will that impact the fund?
- Is the group communicating effectively?
The Importance of Comfort
Dealing with humans and being a student of history, we know that everything won't go well. This is the exact point where comfort becomes critical. News events like a change in portfolio management, a significant change from external sources, or poor fund or market performance can shake one's confidence in the analysis and raise questions as to why the fund should be held. (Perhaps one should also be concerned with fund or market performance that is too good.) Additionally, many other people need to remain comfortable with the fund: the portfolio manager, the investment management of the group, the distribution channels, the regulators, and all members of the investment committee.