seeking outperforming funds

Earlier this morning I ws reading a Wall Street Journal article on the Janus fund group.  What  especially caught my eye was the part on the performance of Janus bond funds.

Over the past one and three years, only 9% and 15% of Janus bond fund assets ranked in the top half of their Morningstar categories.  The corresponding figures from twelve months ago are 75% and 100%.

This home-run-or-strikeout approach to fund management is what I saw when I was competing against Janus equity products ten or twenty years ago.  The idea, which I think is never successful over long periods, is to run portfolios that are built for large deviations from their benchmark indices, in the hope of achieving eye-popping relative returns that will result in large asset inflows.

One problem with this approach is that it’s extremely hard to be very right in a big way on a consistent basis. A second is that, while the freedom to make big bets may be emotionally satisfying for portfolio managers, clients don’t necessarily want the resulting large relative ups and downs.  As one of my former bosses (often, as it turns out) put it, “The pain of underperformance lasts long after the warm glow of outperformance has disappeared.”

That is also, in a nutshell, the basic appeal of index funds:  while there are no sugar highs, there are no heart-attack lows that force the holder to periodically evaluate whether the fund manager knows what he’s doing.   Since there’s really no easy way of knowing, staying with an underperforming fund requires a leap of faith most investors are leery of making.  Better to avoid being put in this position in the first place.

 

This is probably also the gound-level reason Janus is selling itself to Henderson.  It will be interesting to see whether Janus changes its stripes under new ownership.  By the way, achieving such a cultural change is easier than one might think–just change the bonus structure to strongly emphasize batting average and defense instead of Dave Kingman-like power.

mutual fund and ETF fund flows

away from active management…

There’s a long-term movement by investors of all stripes away from actively managed mutual funds into index funds and ETFs.  As Morningstar has recently reported, such switching has reached 2008-era levels in recent months.  Surges like this have been the norm during periods of uncertainty.

The mantra of index proponents has long been that investors can’t control performance, but they can control costs.  Therefore, all other things being more or less equal, investors should look for, and buy, the lowest-cost alternative in each category they’re interested in.  That’s virtually always an index fund or an ETF.

Active managers haven’t helped themselves by generally underperforming index products before their (higher) fees.

…but net stock inflows

What I find interesting and encouraging is that stock products overall are receiving net inflows–meaning that the inflows to passive products are higher than the outflows from active ones.

why today is different

Having been an active manager and having generally outperformed, neither of these negative factors for active managers bothered me particularly during my investing career.  One thing has changed in the current environment, though, to the detriment of all active management.

It’s something no one is talking about that I’m aware of.  But it’s a crucial part of the argument in favor of passive investing, in my opinion.

what is an acceptable net return?

It’s the change in investor expectations about what constitutes an acceptable net return.

If we go back to early 2000, the 10-year Treasury bond yield was about 6.5%, and a one-year CD yielded 5.5%.  US stocks had just concluded a second decade of double-digit average annual returns.  So whether your annual net return from bonds was 5.5% or 5.0%, or whether your net return from stocks was 12% or 11%, may not have made that much difference to you.  So you wouldn’t look at costs so critically.

Today, however, the epic decline in interest rates/inflation that fueled a good portion of that strong investment performance is over.  The 10-year Treasury now yields 1.6%.  Expectations for annual stock market returns probably exceed 5%, but are certainly below 10%.  The actual returns on stocks over the past two years have totalled around 12%, or 6% each year.

rising focus on cost control

In the current environment, cost control is a much bigger deal.  If I could have gotten a net return of 6% on an S&P 500 ETF in 2014 and 2015, for example, but have a 4% net from an actively managed mutual fund (half the shortfall due to fees, half to underperformance) that’s a third of my potential return gone.

It seems to me that so long as inflation remains contained–and I can see no reason to think otherwise–we’ll be in the current situation.  Unless/until active managers reduce fees substantially, switching to passive products will likely continue unabated.  And in an environment of falling fees and shrinking assets under management making needed improvements in investment performance will be that much more difficult.

 

a professional portfolio manager performance check

I subscribe to the S&P Indexology blog.  Like most S&P communications efforts, I find this blog interesting, useful and reliable.

Anyway, two days ago Indexology published a check on the performance of equity managers who offer products to US customers.

In one respect, the findings were unsurprising.  For managers with US stock portfolio mandates, well over half underperformed their benchmarks over the one-year period ending in June.  Over five years, more than three-quarters failed to match or exceed the return of their index.

This is business as usual.  Why this is so isn’t 100% clear to me.

One of my mentors used to say that ” the pain of underperformance lasts long after the glow of outperformance has faded.”   I think that’s right.  In other words, clients will punish a PM severely for underperformance, but reward him/her by a much smaller amount for outperformance.  In a world where risks and rewards aren’t symmetrical, it’s probably better not to take the buck-the-crowd positions necessary to outperform.  Instead, it’s better to accept mild underperformance, keep close to the pack of rival managers and spend a lot of time marketing your like-me/trust-me attributes.

(To be clear, this isn’t a strategy I wholeheartedly embraced.  I generally achieved significant outperformance in up markets, endeavored not to lose my shirt in down markets.  My long-term US results were a lot better than the index, but at the cost of short-term volatility that was greater than the market’s.  Pension consultants, heavily reliant on academic theories of finance, tended to demand a smoother ride, even if that meant consistently less money in the pockets of their clients.  Yes, a constant problem for me.  But it illustrates the systematic pressure put on managers to conform, to look like everyone else.)

 

The surprising news in the blog post comes in international markets.   Generally speaking, the markets overseas are simpler in structure, information flows much more slowly than in the US, and PMs tend to be ill-trained and poorly paid.  Rather than being the culmination of a long a successful career, being a PM abroad is often only an early stepstone to something better.  So pencil in outperformance.

On a one-year view, however, Indexology reports that the vast majority of managers of global, international and emerging markets portfolios all underperformed their benchmarks.  This is the first time this has happened since S&P has been checking!!

I don’t watch this arena closely enough to have a worthwhile opinion on how this happened.  The fact of underperformance itself is surprising–the fact that more than 75% of managers of international funds underperformed is stunning.  My guess is that no one saw the deceleration of Continential European economies coming.

For anyone with international equity exposure, which is probably just about everyone, current manager performance is well worth monitoring closely.

 

the FT, Vanguard and Morningstar: active vs. passive investing

Saturday’s edition of the Financial Times opens with a screaming front-page headline, ” $3.5 billion pulled out of Fidelity funds.”  

 …must have been a slow news day.  

The article goes on to explain that net inflows of individual investor cash into the stock market–both in the EU and the US–over the first half of 2014 have been going to index products, not to active managers. 

I can see several good reasons why this is so:

1.  Indexing is like cruise control.  You know you’re going to get more or less the return on the index against which a given index fund/ETF is benchmarked.  So you only have two variables to consider:  how closely the fund/ETF is able to track the benchmark, and what its expense ratio is.  There’s no fretting about an active manager’s style and strategy, or whether he/she is still running the portfolio whose historical record you’re examining

2. Fidelity doesn’t necessarily want mutual fund customers.  I’ve had a Fidelity brokerage account for decades.  Fidelity has never approached me, ever, to buy a mutual fund product of any type.  I presume it’s because the company makes more money from having me trade individual stocks.

3.  Picking active managers takes some effort.  It requires having some understanding of the stock market and an ability to deduce strategy from the lists of holdings that managers report each quarter to the SEC.  

True, there is Morningstar, a service which has been providing its famous “star” rankings of mutual funds for about a quarter century.  Although Morningstar, disingenuously, warns buyers of its star information not to use it as the reason for picking a given mutual fund, people do pay for the rankings.  So they must have a reason.  Investment management companies take out full-page adds to tout their high star-ness.  Inflows seek high-star funds and shun low-star ones.

Over at least the past several years, however, Vanguard points out that following Morningstar rankings hasn’t been a good idea.  The index fund giant is publicizing a study it did of Morningstar fund rankings from 2011 – 2013.  Over the three years, Vanguard says there was a strong correlation between Morningstar star ranking and fund performance, but it was the opposite of what the rankings suggested.  One-star funds performed the best vs. their peers, two-star funds the next best   …and so on, in order, with five-star funds performing the worst.  Whoops!

Personally, I’ve never been a fan of Morningstar’s use of short-term volatility as a measure of the riskiness of a portfolio.  My guess is that the relative stability of a fund’s NAV ends up being the most important factor in getting a high star rating.  So that rating has little to do with future return potential.  But I have no real idea how Morningstar could have gone as badly astray as Vanguard says.

Anyway, to sum up, if there’s any news in the FT article, it’s the (understandable) extent to which individual investors are embracing psssive investing, not the fact that they’re doing so.