“Ignorance more frequently begets confidence than does knowledge.” –Charles Darwin
In the last article, we looked at the first step in identifying All Star Fund Managers – getting rid of the bottom 90% of fund managers/investors. This article is about the final 3 steps in the process that take us from the top 10% to a team of All Star Fund Managers.
All the comments here are my personal opinion. There are many exceptions to most of them, but from our years of experience, we believe all of them to be generally true.
Step 2: Identify the Top 1-2%:
This step is focused on identifying the fund managers that use the most effective strategies and methods.
- High “Active Share” – A study by Yale researchers showed that the more different a fund manager’s holdings are from the index, the more likely they will beat it. Of the funds that had only 0-20% of their holdings in common with the index, the average fund beat the index.3
- Wisdom/Insight – Most top fund managers are in their 50s and 60s, since it usually takes many years of experience to learn to avoid the common investing mistakes, make the necessary contacts and gain the deep insights necessary to be a top fund manager. Being through a few market cycles can provide insight. We are looking for a fund manager to be disciplined, avoid getting caught up in fads or focusing on popular sectors, show wisdom to be cautious during the strong bull markets and confident after crashes, and generally have a deep insight into investing.
- More likely value investors – Fund Managers using a value style of investing are more likely to be All Star Fund Managers. They value companies as a business, not as a stock, and figure out a conservative “intrinsic” value to buy the company as a whole. Then they only invest if they can get a big discount (buying $1 for 50 cents), which they call a “margin of safety”. Warren Buffett recognized decades ago that, while there are many investment styles, “Graham and Dodd” value investors are a disproportionately large percentage of the top investors.1
- Stock pickers, not industry pickers – Bottom-up, not top-down. Many fund managers start by identifying the countries and sectors where they see the best opportunities and then choose the best stocks in those areas. The top fund managers find the companies that are the best opportunities and let that determine their allocation. They are usually stock pickers.
- Get rid of index-timers – Some fund managers try to market-time sectors either by actively switching between several ETFs or index holdings, or between key stocks in several sectors. In addition, “sector-rotators” switch between sectors based on the economic cycle. A Yale study3 confirmed our experience that these strategies generally don’t add value. This is another form of “top-down” investing. Top fund managers generally do not market time sectors or use ETFs. ETFs are generally for amateurs, market-timers and investors not skilled in stock picking. Top fund managers are stock pickers and will prefer the companies they know intimately to owning an entire sector.
- Look for focused portfolios – The average Canadian equity fund holds 99 stocks and the average global fund has 382. However, studies show you can get good diversification with 20-30 stocks. Fund managers cannot intimately know a lot of stocks. Is their 100th best choice really as good as owning more of the 30th best? Top fund managers tend to know their top companies intimately and have a lot of confidence in them, and therefore tend to have focused portfolios in fewer companies.
- Understand & measure risk – It is important to understand the risk level a fund manager is taking to achieve his return. This is much more than looking at the hundreds of risk statistics, since they will be much different in good and bad markets, and when the fund manager’s style is out of favour. Some fund managers beat their index just by being more aggressive than their index. Some fund managers believe in and are always loaded up with one sector and may look good when that sector is in favour. Some fund companies have risky funds in several sectors knowing at any time one or the other will probably do well. Risk is lower when you know what you are doing. Top fund managers always understand and measure the risks they are taking and have systems/disciplines to control risk without dragging down performance.
Step 3: Identify the All Star Fund Managers:
This step is focused on the fund manager himself and to identify the skilled stock-pickers.
- Look for the fund manager to have his own money in his fund – If the fund manager does not have his money in his fund, why should you? This is another issue with employee fund managers that often don’t invest in their own fund because of interference from their bosses.
- Know how they beat their index – Most top fund managers know why they beat the index over time. It is usually either superior stock-picking or a systematic inefficiency in the index that they can tell us about.
- Passion – The best investors are usually passionate about investing, work long hours, travel extensively, are voracious readers and know their investments intimately.
- Integrity – It is surprising how important integrity is. A passionate fund manager without integrity may be focused on making money for himself, instead of for us. Integrity means they believe in what they do, they stick to their style even when it is out of favour (no “style drift”), invest their own money in their fund, and are focused on long term returns and not on making their fund easy to market. They are clearly part of the profession or investing, not the business of investing.
- Confident, but not over-confident – The most brilliant fund managers often have an understated confidence about them that may make them easy to overlook at first. “Hubris”, or arrogant overconfidence, can happen to a fund manager after a lucky streak or if he starts believing his own press. Hubris is sometimes called the “pride that blinds”. We avoided one disaster by not investing with one fund manager who had an awesome track record but was just too arrogant. Top fund managers are focused on their investments – not on themselves.
- Study hundreds of stats – Stats can identify issues and differences between different fund managers that can help understand them. The problem with analyzing stats is that they are all focused on recent data. Therefore, no matter how much you analyze statistics, you tend to come up with whoever did better recently. Since we are looking for superior skill, we need to filter out recent performance, being over-weight in recently hot areas, and currency effects to try to identify stock-picking skill. We also need to study risk and return stats in different market conditions.
- Meet the fund manager – It is critical to know what kind of person a fund manager is. I like to have my wife, a personal coach, meet fund managers to provide more insight. We are looking for intelligence (above-average is all that is necessary), ethical (this is critical), hard-working, experienced (generally at least 10 years, and 20-30 or more is better), a well-defined process, deep market wisdom/insight and usually a kind of under-stated, humble confidence. The most dangerous combination is smart and hard-working, but not ethical. Warren Buffett says an IQ up to 125 (a bit above average) is helpful, but there is no evidence of any advantage beyond that. Wisdom and insight provide a vital long term focus. We can’t be truly confident in a fund manager without meeting him.
Step 4: Match the ones that work well together:
- Correlation & similarity – Each fund must invest differently from the others – different countries or sectors, different size companies or different investing styles. They should perform best in different market conditions. If two are similar, you only need one of them. The theory is that, if you have 2 fund managers that both make 10%/year over time but have their good and bad years at different times, then you will make the 10%/year with less ups and downs than either of the funds.
- Create teams of All Stars for different clients – We must combine several All Star Fund Managers into a portfolio suitable for different clients, depending on their risk tolerance, portfolio size and goals.
I realize that some of these are controversial, but we have found all of these to be very helpful and generally true in identifying All Star Fund Managers. Most are also useful to evaluate various investing strategies and to know whether the guy at the party is really a good investor.
While it is true that the average fund manager usually makes less than the index, we believe the solution is investing with fund managers that are exceptional stock pickers. Many investors look for the lowest-cost investments by picking their own stocks or ETFs. However, studies show that amateur investors on average make far less than the “average” fund manager, mainly because they make many of the mistakes listed in this article. For example, the Dalbar study 4 shows that the average investor makes only about 1/3 of the gains of the average mutual fund.
In short, the average fund manager makes less than the index, but we believe the solution to “average” is not “amateur”. The solution to “average” is “All Star”.
From experience, we have found that having confidence in your investments is probably the single biggest factor in successful investing, mostly because it leads to effective behaviours. Whatever investment process you choose, you need to have the confidence to remain invested through the inevitable bear markets.
Investing with All Star Fund Managers gives us a lot of confidence. This confidence allows us to have a higher proportion in equities (often 100% equities), invest larger amounts of money, and most importantly, stay invested in down and difficult markets with confidence.
Just like the confidence a solid financial plan brings to the likelihood of reaching your long term goals, the confidence inspired from our rigorous ‘All Star Fund Manager’ selection process also increases the confidence with which we (and our clients) can ride out the inevitable spells of turbulence and remain focused on their financial plans. After all, if you have done your research well, the time to change a fund manager is definitely NOT simply due to recent events in the news. You should be able to confidently remain invested with the fund manager unless the key underlying attributes that first attracted you to a manager have changed.
1 Classic article “The Superinvestors of Graham & Doddsville” – Warren Buffett (The Super Investors 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 )
4 Dalbar study: Quantitative Analysis of Investor Behaviour (QAIB) Dalbar – QAIB Study