William J. Bernstein
The Grand Infatuation
Troll the latest reincarnation of the office water-coolerinvestor internet chat rooms and discussion boardsand you'll find abundant evidence of romantic disaster in the making. No, I'm not suggesting that these forums are hotbeds of amorous intrigue, but rather are incubators of heartbreak of the financial sort.
Without putting too fine a point on it, fund investors have an alarming tendency to fall in love with their fund managers. There is an ever-growing body of data which suggests that superior fund manager performance simply does not persist. And, having paid the price myself, I speak from sad experience. Increasingly I find myself in the role of a maiden aunt observing the romantic follies of my nephews and nieces, knowing full well the heartache they will soon find.
First some data. I'll say it loud, and I'll say it clear. Human beings cannot pick stocks. Period. Yes, over any given time period some funds will perform better than others. But on the average, superior performance does not persist. There are now dozens of academic studies that all pretty much show the same thing. Namely, that if you take the top tier of money managers over a given period, they may or may not best their peers by a dozen or two basis points going forward, but they still underperform the market by 100-200 basis points. Remember that these managers had as a group outperformed their peers by several hundred basis points looking back, but only a tiny sliver of that superior performance translates forward. It's as if Babe Ruth were to hit only 7 home runs the season after he hit 60.
These studies do show one area of strong persistence, howeverthe worst performing managerswhose inferior performmace shows a remarkable tendency to continue.
Probably the best study of mutual fund performance persistency was done by Micropal. Their worldwide fund database extends back 3 decades, and provides a panoramic view of fund returns. Starting with 1970, they looked at the top 30 domestic diversified funds for a given 5 years and followed their performance out to June 1998. Here are the results:
Top 30 Funds 1970-74
Top 30 Funds 1975-79
Top 30 Funds 1980-84
Top 30 Funds 1985-89
Top 30 Funds 1990-94
In each example the top funds for the first period underperformed the S&P 500 in the subsequent period, and in 2 of the above 5 examples actually underperformed their peers as well.
Does this look like the performance of highly skilled money managers? No. We are looking at the proverbial bunch of chimpanzees throwing darts at the stock page. Their "success" or "failure" is a purely random affair. The most successful chimps (who are all very well dressed, it seems) wind up being interviewed in Money, The New York Times, and by Uncle Lou. Their assets under management balloon, and their shareholders' admiration is vindicated by all of the media attention.
However, time passes, and the laws of chance eventually catch up with these folks. Hundreds of thousands of investors find that the handsome prince managing their funds turned out to be just another hairy simian. In fact, with the particularly perverse logic of fund flows, very few investors actually obtain the spectacular early returns of the "top" funds. These early high returns inevitably attract large numbers of later investors, who wind up with merely average performance, if they are lucky.
The Efficient Frontier Mutual Fund Acid Test
Just about every fund investor I come across thinks that they're the exception to this rule. Sure, everybody else's funds eventually go kerplunk, but my managers have a unique long-term investment outlook and discipline that will endure and flourish. Very well then, I suggest a simple exercise. Trek down to your basement, get out your old fund statements, and take a look at which funds you were invested in 10 years ago. I can guarantee you that the list will be for the most part an embarrassment. (Mine is so bad that I'm too ashamed to mention most of the names in print.) You say you weren't investing in funds 10 years ago? Oh. Then wait a few years, and join the crowd.
From Alpha Man to Ape Man
If you're not convinced with dry data or personal confessions, I'll provide a particularly powerful story, which is just now playing out in the financial press, pointed out by friend and colleague Steve Dunn. Robert Sanborn, who runs Oakmark Fund, is an undisputed superstar manager. Since inception in 1991 to year-end 1998 its annualized return has been 24.91%, versus 19.56% for the S&P 500. In 1992 it beat the benchmark by an astonishing 41.28%. However, a different story emerges when we examine its performance and fund assets by individual year. The first row tracks the performance of Oakmark Fund relative to the S&P 500:
What we see, then, is the all too familiar pattern of fund investors chasing performance, with more and more investors getting lower and lower returns. Lest the sharpies among you point out that S&P 500 tracking error is not a fair measure over the past few years for a value manager, I also did a formal Fama/French 3-factor regression for 3 different periods for the fund. The annualized "alphas" were +22.4% per year for the first 29 months, -0.2% for the second 29 months, and -7.3% for the last 30 months.
I'm not above using the odd buzz word, and "alpha" is a good one. This refers to the excess return added by a manager after taking into account such factors as market exposure, median company size, and value orientation. Unfortunately, in most cases it is a negative number. Oakmark's alpha for the first 29 months is truly spectacular, and quite statistically significant, with a p value of 0.0004. For those of you unfamiliar with the statistical measurement of fund performance, these numbers are exceptional, and are unlikely to be due to chance.
My interpretation of the above data is that Mr. Sanborn is modestly skilled. "Modestly skilled" is not at all derogatory in this context, since 99% of fund managers demonstrate no evidence of skill whatsoever. However, unfortunately even these skills were overwhelmed by the impact-cost drag of managing billions of dollars of new assets, chasing up stock prices and lowering ultimate returns.
Asset managers have been know to proudly refer to their shops as "alpha factories," and more than a few have been known to belt an off-key rendition of "I'm an Alpha Man" into the karaoke machine after downing a few too many.
But bewareAlpha Men usually turn into Ape Men. Remember, too, the iron law of manager performance:
Alpha always absconds.
copyright (c) 1999, William J. Bernstein