By ROBIN POWELL
We often see fund managers compared in the media to sports stars like Lionel Messi or Usain Bolt, but the analogy is totally misleading. In my latest article for The Financial Suitability Forum, I explain why.
There’s plenty of focus in the UK media just now on so-called “star” fund managers, and understandably so. Neil Woodford was the brightest star of all, and his fall from grace has been more spectacular than any of us could have imagined.
Attention now has turned to other “stars” like Woodford’s protégé at Invesco Mark Barnett and Nick Train at Lindsell Train, both of whose performance has of late been poor. Suddenly people are asking whether famous managers are worth bothering with. Worse still, are they worth the risk, especially if investors start heading en masse for the exits when performance plummets?
Terry Smith, manager of the £18.8 billion Fundsmith Equity Fund, waded into this debate the other day in his annual letter to investors, and he made some interesting comments.
Admiration for index funds
I should say at this point that, as active managers go, I do like Terry Smith. Throughout his career he has made constructive criticisms of the fund industry, the lack of transparency around fees and charges and the poor value for money that many firms provide. He has also expressed his admiration for Jack Bogle and his championing of index funds.
Yes, I’d rather he paid his taxes in the UK, where the vast bulk of his wealth is earned, rather than in Mauritius. But if you can overlook that, and the disappointing performance of his Emerging Equities Trust, it’s hard not to be impressed by him. Smith is a genuine, high-conviction active manager. His Equity Fund invests for the long term, keeps its trading to a minimum and, thus far, has delivered the goods.
But I don’t agree with his latest remarks on star managers.
A media obsession
Smith is right on one thing: the media is obsessed with them. Journalists (of which I’m one) need stories, and we love personalities; active management provides a ready supply of both. There is always someone, at any one time, who looks like a genius. Even before Woodford investors learned the extent of their losses, there was a steady stream of articles about big-name managers they should look to next.
But Smith goes on to say that investors should not be deterred from investing with star managers. “It makes no more sense,” he says, “to avoid funds run by star fund managers than it does to avoid supporting sporting teams because they have star players.”
I’ve seen this analogy used many times. There’s a well-known adviser who clearly shares my interest in football and is always writing about his “dream team” of fund managers. Often during major sporting events, financial publications opine on who the Messis and Ronaldos, or the Stokeses and Kohlis, of the fund world are.
It is, however, a meaningless comparison. Fund management doesn’t conform to the rules of sport. It just doesn’t.
Take the English Premier League, for example. Yes, there are notable “black swan” events — Leicester City winning the league in 2016 being the most recent example — but you can normally predict at the start of each season at least three or four of the teams that will finish in the top six.
Fund performance bears no resemblance to that at all. As the Persistence Scorecard produced by S&P Dow Jones Indices illustrates time and again, returns appear to be completely random.
The March 2019 scorecard, for example, showed that, of the 498 US-domiciled funds that finished in the top quartile over the five-year period ending March 2014, only 16.1% managed to repeat that performance over the five-year period ending March 2019. We would expect 25% to do so from random chance alone. On the other hand, 31.5% of the top-quartile funds fell into the fourth quartile — more than would be randomly expected to do so.
The equivalent, in football parlance, is Manchester City winning the title one year, then finishing 16th, 7th, 14th and 3rd in the following four seasons, and then getting relegated.
There are several possible explanations for why outperforming fund managers tend to fizzle out. One is that, as they become more popular and attract more clients, the size of the fund grows. They consequently have to broaden their range of stocks, thereby diluting their best ideas. A second explanation is that a “style” of investing that helps a particular manager to outperform for a period of time simply stops working.
But surely the most plausible explanation is that it’s extremely difficult, if not impossible, to distinguish luck from skill in active money management. When you watch a top football team action, their natural ability is plain for all to see. Yes, luck will always play a part — strange refereeing decisions, for example, or injuries to key players. But, over the course of a season, it’s easy to see why a team like Liverpool will finish higher than a team like my own (let’s not go there, all we?)
Contrast that with active management. Was Neil Woodford lucky of skilful at Invesco? Has he been unlucky since setting up on his own? Or did he just pick the wrong stocks? My hunch is that, in both cases, it was a combination of the two, but the answer is that we just don’t know.
The paradox of skill
In case you’re thinking I’m writing off fund managers as incompetent, I’m not. As Charley Ellis, author of that landmark book Winning the Loser’s Game has often explained, the asset management industry has ballooned in size over the last 40 years. The problem is not that there’s a lack of skill, but rather there’s too much of it.
With so many professional investors competing for a finite amount of alpha — all with the same information, the same processes and the same technology at their disposal — it should be no surprise that so few of them are able to outperform consistently after costs. Aggregate skill, in other words, has never been higher; relative skill is harder to demonstrate that it has ever been.
A tennis analogy
The scale of the task fund managers face is brilliantly explained by Larry Swedroe in his book, The Incredible Shrinking Alpha, by way of a tennis analogy.
At the height of his powers, says Swedroe, Roger Federer was the greatest tennis player of his era. That was despite Andy Roddick having a better serve, Andy Murray a better backhand, Rafael Nadal a better baseline game and so on.
Yet while Federer’s opponents were other tennis players, fund managers are attempting to outwit a far more formidable opponent, namely the collective wisdom of the entire market. Wherever they turn, they’re constantly competing with fellow managers who are very good at whatever it is they specialise in.
As Swedroe says, it’s as if each time Federer stepped on court he faced an opponent with Roddick’s serve, Murray’s backhand and Nadal’s skill at the baseline. If that had been the case he may not have won a single tournament.
Again, I have a great deal of time for Terry Smith. Will his Equity Fund beat the market in the future? Will he struggle to shine as brightly as he did as it grows in size? Or will he simply run out of luck? I just don’t know.
What I do know is that Smith is wrong on star managers. And despite his superstar salary, he’s certainly no Messi or Ronaldo himself.
About the Financial Suitability Forum
In the words of its convenor Paul Resnik, the FSF is “a gathering place for members of the financial services community who want to build advice businesses, provide services, and offer investments and other financial products around a suitability standard”.
As well as providing content for financial advice firms on issues around suitability, the Forum also runs occasional adviser workshops. You can find out more by visiting the website.
Picture: Nigel Tadyaneh via Unsplash