There can hardly be a football club chairman in the world who hasn’t at some point had the urge to sack the manager. Fans know the feeling too. The current incumbent offered such promise when he first arrived, but after two or three seasons of underperformance, thoughts turn to possible replacements. And everywhere you look there are up-and-coming managers who seem to be achieving miracles elsewhere.
It’s a similar problem facing investors using active money managers. Perhaps you were persuaded by the hype surrounding a particular fund a couple of years ago. But it hasn’t lived up to expectations and the weekend papers are full of stories about managers achieving higher returns. Why wouldn’t you want to ditch the laggard and hire a winner in their place?
The problem is that, while it might seem logical, hiring and firing fund managers, particularly on the strength of past performance, is counter-productive. Rather like those football club chairmen who end up ruing removing the last manager, investors who chop and change their funds often regret not leaving them exactly as they were.
The fired beat the hired
A well-known study by Amit Goyal and Sunil Wahal in 2008 of the hiring and firing of managers by large institutional investors in the US showed two things:
— The managers who were hired had, on average, produced higher returns in the recent past than those who were hired.
— The funds that were hired underperformed in subsequent years, while the funds that were jettisoned outperformed. In other words, the fired beat the hired.
If institutional investors and the expensive consultants they use are bad at hiring and firing, it shouldn’t come as a surprise that ordinary investors fare no better. Indeed, new research by Morningstar shows that to be true.
Researchers looked at more than 15,000 share classes of active US equity funds that existed between 1996 and 2018, and used funds’ organic growth rates as a proxy for hiring and firing decisions in the aggregate.
Like the institutions analysed in the 2008 study, Morningstar found that investors had a propensity to hire funds that had outperformed in the previous three-year period and fire those that underperformed. However, in subsequent years, in subsequent years, as with the institutional managers, the funds they fired outperformed the funds they hired.
Past performance tells us very little
So, what can investors learn from these two studies? First, past performance tells us next to nothing about how a fund will perform in the future. A track record of three, five or even ten years is nothing like long enough to show that a particular manager is genuinely skilled. If anything, a fund that has delivered strong recent returns is more likely to revert to the mean and underperform in the years ahead.
Secondly, tempted though you might be to ditch the losers in your portfolio, you should consider persevering with them. Again, one of the overriding laws of fund performance is mean reversion. A fund that has underperformed for a while often goes on to outperform.
But there’s a bigger issue here. As an investor, you actually don’t need to be hiring and firing fund managers at all.
Should Woodford investors stick or twist?
Investment adviser Stuart Fowler addressed this issue in a recent article about the UK fund manager Neil Woodford. For many years, Woodford was hailed as a “star” manager, but his performance in recent years has been abysmal.
Even some of his staunchest advocates in the industry are now advising Woodford investors to cut their losses and move their money elsewhere.
“Many investment ‘stars’ over the years have disappointed,” Stuart writes, “and left their followers with a massive problem. What to do has big consequences yet is really difficult to decide.
“It’s not a problem you can avoid by somehow making better selection of the managers. That’s to draw entirely the wrong conclusion.
“The insight you need is that the problem of living with your selection is a permanent and unavoidable feature of choosing active managers in preference to investing in low-cost index-tracking funds.
“It’s not a problem you need. You choose it or not.”
You may be tempted, if you’re a Woodford investor, to stick with him in light of the latest Morningstar study. His performance may well improve in the months and years ahead (it can hardly get any worse), but it will take several years of spectacular outperformance for investors to recover the money they would have made if they had indexed. And remember, he’s 59 and very wealthy. I suspect he may just choose to walk away.
A smarter choice
A much smarter choice, in my view, is not to hire active managers in the first place. Over the long term, only a tiny fraction of them will outperform a simple, low-cost index fund portfolio, on a risk- and cost-adjusted basis.
Do you really want to keep looking for those very few winners? Do you need the hassle of having to monitor the different funds in your portfolio? And do you want to be agonising over what to do with a fund that flops, and then, once you’ve sold it, see it outperform the fund you replaced it with.
I humbly suggest that you don’t, but the choice is yours.