The fund management industry is fascinating. Over the decades “super star” managers have come and gone yet investors, both sophisticated and unsophisticated, chase the “super star” hoping they have a secret and can outperform. And some managers do …for a while.
- But do these managers have a secret?
- Why do investors feel the need to chase these managers?
- What’s driving these decisions?
- Why do they nearly always fail investors in the end?
Do they have a secret?
If you put a group of fund managers in a room, tell them they are the only managers in the market, and ask them who will outperform this year – they will all put up their hand.
Of course, they will.
Now if you frame the question and say, “c’mon team – you can’t all outperform, you are all good at maths right”. At least 50% of you will underperform – so let’s try the question again – but once again all the hands go up.
Why – that is their job – they must be optimistic.
If we extrapolate that to the broader market over decades and decades what we see is that less than 10% of active fund managers outperform.
This number reduced when you factor in survivor bias. There are realms of academic research on this and publicly available data.
To keep it simple, if we imagine the market as one circle and all fund managers make up the market then we have a few scenarios:
- The circle is the market return, so all the managers must get their return from the circle.
- A manager with a lower cost will get the circle return less their costs.
- A manager with a higher cost will get the circle return less their costs.
- There is a high probability that the lower cost manager will do better than the higher cost manager.
- A manager who trades more than another will most likely have higher costs and pay more taxes. Therefore, the higher trading funds are likely to also underperform and get less than the circle return.
- Funds that rely on a key person (like Magellan) are likely to underperform eventually. There have been a few star managers over time – but they don’t last the test of time. While the star manager may have amazing skill or be an amazing marketer eventually the circle catches up with them.
For each trade there is someone on the other side, that is how markets work.
So, the manager:
- Reverts to the mean.
- Has a bad quarter.
- Gets too big.
- Completely stuffs up.
There may be other reasons, as documented in the media “Magellan’s founder appears distracted by other matters and is now hoping the team can carry on”. The problem is the fund was sold on the fact that the founder was the key. Without that person, as an abettor you have an issue.
The data simply shows that for an active manger or outperformer the odds are against them.
Magellan is just another example, it’s not unusual. It’s actually very common you just don’t hear about the thousands that underperform each year. That is not exciting news!
Psychology and Investing
Daniel Kahneman who won a Nobel prize for his research in behavioural economics realised that as investors we are wired to make the wrong decisions. His research explains why investors chase these “hot” or star managers even though all the data points out that it’s a tough game and your chances of success as an investor are very slim – less than 10% chance. I don’t think that’s a bet worth taking with your money.
There is a smarter way to invest!