How to choose active fund manager

There are numerous articles written on how to choose active fund manager, and you may wonder which article is the best written. If you start comparing which articles are the best ones, you are also going through the process of comparing which fund managers are the best, and by the same logic, you might as well compare directly which stocks are the best to buy. If you want that formula to find the best articles or fund managers or stocks, just forget it. You will never get it. There is no shortcut to apply a single formula. All these need judgment.

Stock picking is a difficult job because stock price can fluctuate due to both business performance and speculation. In short term, you won’t know with high confidence which one is driving the stock price movement. Fund managers are often evaluated based on their short-term performance, and their performance are also subject to market movement by speculators (and by luck too). There are fund of funds (FOF) that help clients pick the best funds to invest in, but even they make a blunder and choose lousy funds. Investment performance appraisal is a topic in itself just like investment analysis is.

I won’t talk about all the points of choosing an active fund manager. I’ll just focus on three things:

Past Track Record

When you want to choose a fund to invest, for majority of people, the first thing is to look at past track record. If the average performance of the past 10 years is -3% or just +2%, forget it. Simple.

Now, if the past performance over 10 years for two funds are 10% and 12%, things become more interesting. You may go for the highest number, but it’s really not as simple as that. From the past performance, you can’t tell how much risk the fund manager had assumed, what kind of investment strategy/principle they employed, whether the strong performance was due to one or two big winners or many small winners, what industries they invested in, etc. It’s important to evaluate performance in relation to risk, but it’s difficult because risk is not measurable. Also, the old adage still applies: “past returns are not predictor of future performance”.

Just discussing this can make this post really long, and I want to avoid that. What I want to highlight is that when you look at the fund manager’s track record, see how he performed in good times and bad times.

In good times, when the market index is up 10% or 15% or 20%, see if the fund manager’s performance is on par. If his results are several points above or below the market index return, that’s ok. On average, you want his performance to be close to the market index return. Higher is certainly better, but not necessary to indicate his superior skills. Many people can beat the market index in goods times by using leverage or buying risky stocks.

More importantly, check the results in bad times. When the market index is down -10% or -15% or -20%, a good fund manager is likely to perform better because he has considered risks all along in the portfolio and built in a substantial margin of safety in the stock picking.

In fact, many top fund managers are contrarian in some ways and may achieve positive returns even when the market is down or negative returns when the market is up. Therefore, it’s not necessary that their performance track the market return in both good and bad years. Their performance’s up and down can deviate from the market cycle.

Essentially, this is looking at the fluctuation of this performance over the years. We don’t zoom in to look at weekly or monthly fluctuation because there are lots of noise from speculators in such short term fluctuation. Looking at yearly fluctuation over long term, such as 10-15 years, usually give a good picture of the manager’s skills.

If you see that the manager has built in risk protection in bad times while achieving satisfactory return in good times, you will want the overall average to still beat the market average after costs. Otherwise, we might as well invest in index fund.

What if the track record is quite short, such as only 3 years, and beat the market every year? It’s difficult to evaluate the performance for such short period because we can’t tell whether the result is due to skills or luck. The manager has also not demonstrated his competence to invest through the whole business cycle from bull market to recession and back to bull market. For such short track record, you may want to zoom in to look at the portfolio holdings. Is the higher return due to one or two lucky big winners or many small wins?

If you see two BIG wins (> 100% annual return) in a portfolio of 20 stocks, and omitting these two big wins will bring the average to below the market return, you want to be cautious. The two big wins could be due to luck or current market over-valuation  If you see 10-15 small wins (10-30% annual return) in a portfolio of 20 stocks, you have higher confidence that the manager has done many good stock picks (provided the losses are relatively small).

Of course, if you have a choice of another fund manager with long track record and similarly good performance, then you don’t have to force yourself to think hard to choose the manager with short track record. Why make tough decisions when the easier ones have the same effect?

You also want to check the starting point of the track record. If the managers started the funds in late 2008 or early 2009, then they started at the very bottom of market. They would have reported outstanding returns in 2009 as overall market bounced from the deep recession. Remember, whatever you bought in 2009, you were likely to make money. If someone lost money in 2009, he was really bad. The high return from that year 2009 could skew the average up by many percentage points. For funds starting in late 2008 or early 2009, you may want to do a quick exercise by removing its returns in 2009 to re-calculate the new average. I have seen one fund with 18% average yearly return for period 2009-2017, which looks really attractive to anyone. But when you remove the return in year 2009, the average drops to below 8%, which looks far less attractive.

Fees

In CFA curriculum, one topic discusses how to select fund manager and argues that the first thing to consider is fees. Funds that charge front-load 5% sales charge (such as unit trusts, mutual funds) are really quite costly. Many hedge funds charge 2/20 but end up underperforming the market. If you look at the stats, it’s arguable that funds with high fees, on average, underperform funds with low fees.

Of course, this generic observation does not apply to every case. Choosing fund manager is like choosing stock and is done case-by-case. There are outstanding fund managers that charge super high fees. SAC Capital, run by Steve Cohen, achieved 30% average annual return for 18 years after charging 3/30%!

The point is you want to compare the investment performance after fees. One fund with higher gross return than others might end up with lower after-fees returns. If you want to do comparison, make sure you use the right numbers that are relevant to yourself. It’s after-fees return that is relevant to you, not the before-fees return.

Personality of Fund Manager

If you can have access to the fund manager directly or watch/read his interview, observe what he says and also what he doesn’t say. From what he says and doesn’t say, you want to get a sense of whether he is candid about his own performance. Some manager share only his winners, how good he was at one or two stock picks. He is trying to convince you that he is good. He skips those negative stories, such as mistakes.

However, good manager will candidly talk about his mistakes. Why? because he knows mistakes are inevitable in stock investing, and he sees mistakes as learning points. Also, even after all these mistakes, his average return is still superior to others. He does not need to convince you that he is good.

For superior return, he will readily share with you not one or two big wins, but several big wins (a dozen or so or even more). Over investing career of more than 10 years, he would have bought at least 50-100 stocks. In order to have superior return (average around 12-20% annually), 10-20% of the stocks will likely achieve big wins (multi baggers). This tells you that skills are the primary factors of the superior return, not luck.

If, on the other hand, he shares many of his big returns (>100% return), but his average return is still around 8-10%, similar to market average, then those big returns probably have small weighting in the portfolio. Other possibilities: there are several big losses too or many stocks are just not performing (flat).

There are many factors that we can discuss, such as fund size, strategy, concentration, turnover, etc. As mentioned, these will drag it into a long post. I’ll let you google for the rest. Note: It goes into many pages.

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