Above Index Returns – How to Beat the Index

I went to a Leafs game with my annoying friend, Andrew. I think the Leafs are finally building a proper team of the future with talented rookies and a great coach.

Andrew doesn’t believe it. He doesn’t believe anybody is above average. I said: “Really? You don’t think Auston Matthews is above average? It’s been more than 10 years since a rookie was near the top of the NHL scoring leaders.” He said, “No. Nobody has superior skill. Just lucky.”

Andrew is a math guy. He thinks math alone tells him everything about the world. He doesn’t believe there is a human side.

“What about Sidney Crosby who is one of the youngest to ever reach 1,000 points. He is all over the record books and won a few championships.” Andrew says, “Nope. There are lots of players and by luck, someone will end up with more points. That’s the player everyone talks about.”

I asked, “What about hard work? Crosby apparently works harder than anyone else.” Andrew doesn’t believe that either.

I tried to find examples in other fields. He doesn’t believe Warren Buffett is an above average investor, or Einstein was an above average physicist. Tom Brady did not impress him in the SuperBowl. He doesn’t believe Denzel Washinton or Meryl Streep are above average actors. He went on to say no coach, doctor, lawyer, or salesperson is above average.

Then he hit my personal pet peave – no financial planner is above average. What!

Skilled Fund Managers?

I told a few friends about my annoying evening. Everyone agrees with me. Everyone could name some exceptionally skilled people in various fields. The only exception is that a few people told me the one exception is fund managers. “Every field has exceptionally skilled people, except no fund managers are above average.”

When I asked why they think that, they were quick to point out that the average fund manager does not beat the index. I said, “Of course the average fund manager is not above average. I’m not talking about the average fund manager. I’m talking about the elite All Star Fund Managers.”

“Do you believe there are top investors with superior skill?”, I asked. Most said, “Yes”, right away.

However, I did get 2 objections.

Two guys told me: “No fund manager can beat the index with skill. But I can.”

“ReallY? But you are an amateur with no investment education or connections.”

They both had their reason, though. One just thinks he has a gift for identifying great stocks and quotes me one that is up a lot.

The other says he uses a superior style. “I pick dividend stocks and they always outperform.” I countered, “Lots of professional investors focus on dividends.” The answer came back, “Professionals have fees and can’t beat the index. I can.”

I have to admit I find this funny. I get a kick out of the Dunning-Kruger Effect. People that know the least are the most likely to believe they are superior.

Identifying skill

The other objection is more interesting. A couple guys said, “Some fund managers have superior skill, but nobody can identify them ahead of time.”

Interesting. How do you identify skill?

The reason most people cannot find a skilled fund manager is because they don’t look for one. They pick a fund by looking at recent returns, looking at various ratings or statistics, trying to predict what sectors or regions will perform well, or going with a type or style that is popular.

In fields like sports and sales, the stats tell you a lot about skill, but not everything. The best might be on a weak team or have a difficult product to sell.

For actors and doctors, it is much more subjective. You need intimate industry knowledge. You almost have to be an actor or a doctor to know which are truly the most skilled.

For fund managers, it is inbetween. There are tons of stats, but they are only a start. Analyzing all the stats tends to just point to whoever did well recenlty. Investing is complex and the markets go through cycles. Nothing works all the time.

Even the recognized best of all time, such as Warren Buffett’s “Super-Investors of Graham-and-Doddsville”, who trounced their indexes over their career, lagged for signficant periods.

To identify top fund managers, you have to study the fund manager, not the fund. Intimate industry & investing knowledge is very helpful.

Outperforming the index(es) most appropriate for them based on the type of investments and risk level over the long term is just one of many critieria.

Most have a few characteristics, though. They are usually not “closet indexers”, performance chasers, great marketers, technical analysts (chartists), or stuck on “home country bias”. Fund company marketing departments often create “concept funds” designed to sell, as opposed to funds managed by the best fund managers.

Skilled fund managers usually have an effective style (e.g. value investing), high “Active Share”, focused portfolios, lots of experience, and have their own money in their own fund – “skin in the game”.

High “Active Share” means investing very different from the index. Returns are sometimes far above or below the index. Low Active Share means a “closet indexer” who is not really trying to beat the index. High Active Share indicates trying to out-perform. it is usually a critical part of out-performing over the long term.

I wrote 2 articles on identifying All Star Fund Managers a few years ago:

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

Identifying All Star Fund Managers II – Finding the All Stars

Ed’s All Star Fund Managers

I don’t have any special skill in identifying what sectors, countries or stocks will out-perform, or in making short-term or medium-term predictions. (Although long-term predictions are obvious.)

My special skill is identifying skilled All Star Fund Managers. It’s essentially all I focus on related to investments.

I have identified roughly 50 fund managers with superior skill over the years. All have beaten their index over long periods of time and I am confident it is skill. Not nearly every year, but over the long term.

Most are on my “Watch List”. I only own a handful of them.

I have always resisted posting any stats on my personal investments. I am a more confident and aggressive investor than most people. Just because I own an investment does not mean it is suitable for anybody else.

However, as evidence that it is possible to identify All Star Fund Managers ahead of time, below is the performance of all my personal long-term (5+ years) fund managers (other than 2 hedge funds), including how long I have owned them.

I didn’t pick and choose – this is all of my long term managers.

All 5 have outperformed their index over the long term. The charts below are after fees.¹

Before, you ask, I am not necessarily recommending any of these fund managers and will not reveal or confirm their identities.

I am globally focused and have really only had one Canadian fund mananger. I don’t market time. Once I  am confident a fund manager is the Sidney Crosby of fund managers, I will hold long-term regardless of what happens in the markets.

Are they more risky? Two are less volatile and 3 are more volatile than their index.

I’m not perfect. I’ve replaced a few and one fell off the rails. However, a couple of my best are more recent and not included below.

This is not a scientific study or conclusive proof. However, it is evidence that some fund managers are above average and that it is possible to identify them ahead of time.

Here are since-inception charts for all my long term fund managers and when I first invested:

Ed’s Canadian Equity Fund vs. TSX 60 Total Return (Since 2003 – 2 funds)²

Ed’s Global Equity Fund #1 vs. MSCI World $C (Since 2002 – 3 funds)²

Ed’s Global Equity Fund #2 vs. MSCI World $C (Since 2006)

Ed’s Global Equity Fund #3 vs. MSCI World $C (Since 2005 – 2 funds)²

Ed’s Global Equity Fund #4 vs. MSCI World $C (Since 2003)

Why I will never own an ETF or index fund

I will never own an ETF or index fund. I’m not happy with below index returns.

I choose investments entirely based on the fund manager. I want to invest with the Michael Jordan or Albert Einstein of investors – the very best. I try to invest with the next Warren Buffett. There are some amazingly smart, disciplined, experienced, connected and insightful fund managers.

ETFs and index funds do not have a fund manager, so I have no interest.

The goal of investing is the highest long-term return after fees. A skilled fund manager pays for himself and more.

Above Index Returns

To try for above index returns, there are 2 main options:

1. All Star Fund Managers that have beaten their index over the long term and I am confident it is skill.
2. Portfolio manager paid by performance fee (and little or no base fee). If he doesn’t beat the index, fees are similar to ETFs. If he does, the performance fee pays for itself.

Charging only a performance fee motivates the manager specifically to beat his index. He puts his money where his mouth is.

If “nobody can beat the index”, why would a manager base his income on a performance fee?

Some investors have wished for Warren Buffett’s original compensation method. He started by managing a fund where he charged no base fee, but took 50% of gains above 4%. Performance fees today are much less than 50%, but are usually on top of a high base fee.

Performance fee models with a very low base fee give you the low fee advantage of an ETF or index fund – plus B good chance of above index returns.

Let me be clear. I am not recommending this for everyone. Identifying skill is not easy and takes effort. “Know-nothing investors” (as Warren Buffett calls them) and people who won’t get advice may be fine with ETFs and below index returns.

Trying for above index returns does not guarantee better results. But you are trying.

Getting above index returns is about finding skill.

Summary

I will never own an ETF or index fund. I’m not happy with below index returns.

There are people with above average skills in every type of career. Fund managers are not an exception.

Identifying them starts with researching the fund manager, not the fund. It is partly stats (like identifying top athletes), and partly experience and knowledge (like identifying top actors).

I choose investments entirely based on the fund manager. I try to invest with the next Warren Buffett. There are some amazingly smart, disciplined, experienced, connected and insightful fund managers.

To try to get above index returns, you can either find skilled All Star Fund Managers or a portfolio manager that puts his money where his mouth is with a performance fee (and little or no base fee).

The goal is the highest long-term return after fees. A skilled fund manager pays for himself and more.

Getting above index returns is about finding skill.

Ed

¹ Graphs from Globe&Mail.com. To measure the fund managers’ skills, graphs show since-inception returns for F-class funds, which are after the fund managers’ and admin fees, but exclude the financial planner’s fee. Names hidden & minor details changed to protect the innocent.

² Graphs show one fund, but I owned the same fund manager in 2 or 3 nearly identical funds.