Identifying All Star Fund Managers I – Cross off the Bottom 90%

“There seems to be some perverse human characteristic that likes to make easy things difficult.”  – Warren Buffett

We don’t really think of ourselves as investors. We are evaluators of investors.

Our investment philosophy is to identify the world’s best investors that are available and invest our money and our clients’ money with them. We call them “All Star Fund Managers”.

Think of it like the general manager of Team Canada. We are not out there stick-handling and shooting. We spend our time analyzing players to figure out who is the most talented and plays with the most heart, and then put them together in a line of All Stars that play well together.

Our process may be interesting to you for several reasons. If you are:

1. Our client – Get an idea why we are so confident in our fund managers.
2. Amateur investor – Learn about what types of strategies generally do and don’t work.
3. Not very interested in investing – Think of this article as an overview of investing strategies. It can help you evaluate the quality of your investments or whether that guy at the party who bragged about his investments is really that good.

Most information about investing in the media or on the internet is very over-simplified. I hope this article can provide some thoughtful perspective on how well various strategies generally work.

Why  bother searching for All Star Fund Managers?

Our purpose is to find the most effective investments. You may be wondering why I don’t try to pick investments myself, since I’ve been in the investment industry for 17 years and am also an accountant. I could do the research. What I have learned, however, is that there are many investment strategies and a lot of very smart people, including many that are better investors than me. Rather than try to be the most skilled investor of them all, I believe I am far better at identifying who is the most skilled.

Similarly, I’ve also realized that I am not going to make it as a professional hockey player, never mind make it onto the NHL All Star team. Never having learned to skate is part of it.  I will never be the world’s most skilled hockey player, but I believe I can IDENTIFY the most skilled hockey players.

We have a better chance of winning if I have Sydney Crosby playing for me than if I am playing myself. Similarly, I’m busy working with our clients’ financial plans. How would I find that Malaysian mid-cap company with a 35% growth rate, a 5% dividend, selling at a P/E of 8 with passionate management that our fund manager found? How would I visit the plant and meet with management?

It is called the Dunning-Kruger effect. People that are not skilled tend to believe they are superior, while the most skilled understand the complexities and are better able to recognize skill in others. (http://youarenotsosmart.com/2010/05/11/the-dunning-kruger-effect/ ).

Screening out the Obvious Non-All Stars

For some reason, many people believe that nobody can beat a market index. This is because the “average” fund manager does not beat the index. However, like any other field, some people are far more skilled than the average.

The surprising part is not THAT some beat the index, but by HOW MUCH. For example, in the last decade after all fees, our favourite Canadian equity fund manager beat the TSX by 10%/year (with less risk) and our favourite global fund manager beat the MSCI by more than 10%/year (Morningstar). That is a huge difference after a decade.

It is not nearly as simple as choosing “5-star funds”. Generally, they are high risk and underperform going forward. And you cannot find them just by comparing actual performance to the index. Fund managers may beat the index by luck or because their sector or style was in favour. Also, every top fund manager has periods when they underperform. They beat their index in the long run after fees, often by a wide margin, but most underperform about 1/3 of the time.

A classic example was Rick Guerin. He was a top fund manager from 1965-83, beating the S&P500 by 25.1%/year for his 19-year career! However, he underperformed 6 years, or about 1/3 of the time.¹

I should start by saying that all the comments here are my personal opinion. There are many exceptions to most of them and you can find very smart people that will disagree with each point. But from our years of experience, we believe all of them to be generally true. This is just an introduction to give you a general idea of what to look for.

There are 4 steps to identify an All Star Fund Manager:

Step                                                                 Time (approximate)

1. Cross off the bottom 90%                         1 minute
2. Identify the top 1-2%                                Day or 2
3. Identify the All Stars                                 Months
4. Match the ones that work well together   Day or 2

Step 1: Cross off the bottom 90%:

The first step in identifying All Star Fund Managers is to quickly screen out the vast majority, so we can focus on the top 10%.

When we meet a fund manager or amateur investor, we can usually tell almost instantly whether he is in the bottom 90% of investors by looking for the most obvious and common ineffective methods.

Here are the 10 most common ineffective strategies that generally identify the “Bottom 90%” of investors:

• Get rid of performance chasers – Most investors, whether professional or amateur, tend to follow the herd. It always seems logical to most investors to buy investments that are “doing well”. The human mind tends to see trends and believe the same investments will continue to “do well”. However, studies consistently show that chasing performance by buying last year’s winners does not work. Chasing performance is the single most common error of amateur and professional investors. The most common investment mistake is to sell an investment you own that has not done well recently to buy one that has (sell low and buy high).
• At any point in time, there are popular sectors or regions or strategies that have performed well recently. Popular sectors and regions tend to be fully valued or over-valued, so the best opportunities are usually elsewhere. We are looking for fund managers to find the best opportunities. If we find a fund manager is mainly invested in today’s popular sectors, we assume he is probably in the bottom 90%.
• Get rid of marketers – In my opinion, most mutual funds are designed to be easy to market, instead of being the highest quality investment. Fund managers make more money if their fund grows, either because of good performance or because people invest in their fund. Many fund managers are mostly focused on having a fund that people will invest in. Fund managers that use popular buzz words, invest in popular stocks or sectors, emphasize the biggest & safest stocks, or generally seem to be too good at marketing may be more interested in attracting new investors than in investing. We want fund managers motivated by excellence in investing, not making money for the fund company.
• Get rid of “closet indexers” – A closet indexer is a fund that tries to be similar to an index, usually because this protects the fund manager’s job. The saying in the industry is that “It is better to fail conventionally, than to succeed unconventionally.” About 1/3 of mutual funds are closet indexers.The trend to closet indexing in the last 20 years is part of why so many funds don’t beat their index.³ You can’t beat the index after your costs with holdings similar to the index. In addition, the best opportunities are usually in less-followed stocks – not stocks in the index that are widely followed. In our opinion, a closet indexer is the worst choice for a fund manager. They don’t even try to beat the index or be great investments. In general, if the top 10 holdings of a fund have more than 2 of the top 10 of the index, then the manager might be a closet indexer. Also, if the fund manager talks a lot about being “over-weight” or “underweight” various sectors compared to the index, he may be a closet indexer.
• Get rid of over-sized funds – A fund that is too large cannot invest in smaller companies that often have the best opportunities and may take weeks to buy or sell one of their holdings. With Canadian funds, generally over $1 billion is probably too large. With global funds, generally over $10 billion is too large. Generally the smaller the fund the better.
• Get rid of employees – Top fund managers are usually not employees of someone else’s company, such as a big bank or insurance company. They create their own investment firm and then get contracts from fund companies. A good employee fund manager may make $500,000-$1 million/year, while a good fund manager with his own firm may make $5-50 million/year. Fund managers that are employees have bosses that often want them to make their fund more saleable by having popular holdings or do “window dressing” (putting popular or “safe” companies in the top 10 at month-end so they appear on reports). Top fund managers usually own their own firm and have no bosses.
• Get rid of economy followers – Most fund managers have a market view based on the economy, but following the economy is essentially useless for investing.² Top fund managers are stock pickers and don’t waste their time on the economy.
• Get rid of chartists – Many fund managers use charts of recent performance (“technical analysis”) either as a key part of their process or to help them decide when to buy and sell. Our belief is that the markets are too efficient for charts to be very useful. We consider technical analysis to be an over-simplified substitute for real research. In general, fund managers that don’t use charts are better investors than ones that use them. If a fund manager uses these charts, we assume he probably does little real research.
• Get rid of internet data analyzers – There is a ton of public information available about stocks. Computers make it easy to analyze. Fund managers have software that can quickly screen all large companies by any combination of hundreds of factors and statistics. Our belief is that the markets are somewhat efficient, so this publicly-available information is mostly already built into the current price of a stock. The issue is that nearly everyone with a human brain runs similar screens and then ends up buying similar companies. We have seen extremely smart fund managers with unbelievably sophisticated computer models get average performance. Most fund managers may use this data to narrow down the 13,000 available companies to perhaps 500-1,000 to analyze in more depth. Top fund managers do their own research and will only invest in companies where they know something not publicly known or where they believe the public view is drastically wrong.
• Get rid of home bias – In every country, investors focus on companies in their country, believing they are somehow “safer”. Investors in Iceland had 80% of their money invested in “safe” Iceland companies (can you name one?) just before the country went bankrupt. No country has more than a small portion of the best opportunities and companies in one country often face similar risks. Most Canadian equity funds today are “Canadian-focused”, meaning they invest 10-50% outside of Canada. Fund managers investing mainly just in Canada are missing nearly all the opportunities.
• Get rid of market-timers – Many studies have shown that, in general, the more investors trade, the worse they do. The old adage: “Your portfolio is like a bar of soap. The more you touch it, the smaller it gets.” – has a lot of truth. This is why studies consistently show that women are much better investors than men. Market timers with human brains generally get far lower returns than buy-and-hold, since most humans buy and sell at exactly the wrong times. There are a variety of different types of market-timing strategies, often based on economic conditions, charts, or the manager’s hunch. Too much trading may indicate the fund manager is a speculator, instead of an investor. A speculator buys an investment hoping it will go up, while an investor invests in a company in order to participate in the growth of the business. Very few of the top investors are market-timers. Top fund managers usually consider themselves to be investors in businesses and don’t time markets.

These steps can help us screen out the bottom 90% of fund managers/investors. The next article will outline what we actually look for in an All Star Fund Manager.

Ed

¹ Classic article “The Superinvestors of Graham & Doddsville” – Warren Buffett (“The Superinvestors of Graham & Doddsville” )

² Article “Why the Economy is Not Relevant to Investing” – Ed Rempel (Why the Economy is Not Relevant to Investing )

3 Yale study “How active is your fund manager? A new measure that predicts performance.” – Martijn Kremers and Antti Petajisto (Closet Indexers vs. Stock Pickers – Truly Active Managers Outperform )