It has been well documented (by organizations like Dalbar as well as tons of academic research) that investors get lousy results over time.
One reason is that they try to do the investing themselves, but lack the knowledge, skill or temperament to invest successfully. Another reason is that they’re lousy at picking money managers. I can’t help with the first problem–it’s up to each person to be honest with themselves about their own abilities and results–but I can help with the second: picking money managers.
There are basically two ways to pick a money manager:
- Examine past results
- Examine a manager’s process to see if it is a good one
The benefit of examining past results is that it can be done quickly and seems objective. The problem is that separating random luck from real skill is extremely difficult.
Every money manager’s past record includes a component of randomness, or luck, and a component of skill. How do investors know whether they are seeing a record due to luck, or skill? They don’t.
Investing results are much more random than most investor recognize, especially over the short term. Looking at a record of less than 3 years is likely meaningless. Records of more than 3 years are more meaningful, but even outstanding money managers can under-perform for 5, and sometimes even 10 years! Correlatively, some managers have great records that don’t last because they were lucky, not skillful.
Most investors examine past records, but their ability to pick good managers by looking at investing results is terrible. Even professional consultants and investment committees filled with experts get this wrong much more often than right.
Examining past records has a dreadful track record of successfully picking managers.
The other option, examining a manager’s investment process, is much more time consuming, but has a much better chance of being done successfully.
Specifically, there are two measures that seem to be both reliable (persistent) and valid (actually lead to the desired result).
The first is called active share, which is a measure of how different a money manager’s portfolio looks from the general market. To beat the market, you have to be invested differently than the market. You want to find a manager whose portfolio looks different than the market, and therefore has high active share.
The second measure is called tracking error, which is a measure of how differently a manager’s portfolio moves relative to the market. If a manager is all in cash, his portfolio will not move up and down with the market at all, and that leads to high tracking error. A manager who owns the same stocks in the same proportions as the market will move in lock-step with the market, and that leads to low tracking error.
A manager with a good process tends to have moderate tracking error, which means his portfolio neither moves precisely with nor against the market. Such a manager doesn’t try to time market segments (all technology or all energy), nor does he try to pick “winning” asset classes (all cash or bonds to get in and out at the right times). A good manager picks investments that don’t mirror the market, but that do tend to move in the same general direction as the market over time.
Most investors use the wrong methodology to pick money managers and their results suffer. Instead of looking solely at past records and hoping they can guess whether that record reflects luck or skill, investors should look at a manager’s process.
If a manager picks investments different than the market (especially if those investments have been carefully analyzed), and doesn’t try to time segments or asset class exposures, you’re likely to have found a manager that will get good results in the future.
Examine a manager’s process, not just their record.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.