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Who are the best stock pickers?[3 pages, 04/19/00] Introduction | Analysts | Mutual Fund Managers
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Mutual Fund Managers Current Level of Accountability: Due to SEC reporting requirements, there is already a significant level of accountability in the mutual fund industry. Funds are required to publish fairly detailed performance and expense information, and this information is available through a lot of offline and online sources as well as from the funds themselves. However, the numbers don't tell the full story. During an extended bull market such as the one we're currently in (or were in until a few weeks ago), a rising tide lifts all boats, and it's tough to tell whether it was the mutual fund manager's savvy or a few lucky picks that led to the fund's performance. Also, the performance alone doesn't tell an investor how much risk the manager took in chasing superior performance. One technique investors can use is to benchmark the fund's performance against the most relevant index, and while this is very useful, it still doesn't tell the investor whether a successful manager picked the right stock for the right reason or just got lucky. There are also rating services, the most well-known being Morningstar's, which factors in performance, risk, style, and expenses. All in all, such ratings provide a fairly accurate picture of the quality of a given mutual fund, and the fact that the highest-quality funds tend to subsequently get the largest inflow of cash from investors indicates that there is a fairly high degree of accountability in the mutual fund industry (assuming that investors aren't blindly following the rating systems). On the downside, mutual fund managers almost never explain the rationale behind their trades. To publicize their funds, they do sometimes throw sound bites at a camera, but a single-sentence explanation is never sufficient to establish the merits of a recommendation (and one can only hope that the manager's decision to buy or sell was based on a more thorough analysis). In an era of instant information, mutual fund shareholders are probably the only type of investor who are systematically denied knowledge of their holdings, having to wait up to six months to find out what their fund managers have been doing with their money. This is entirely legal, and there is some logic behind it. Mutual funds are all competing with each other, and their individual strategies are kept secret to prevent other funds from benefiting from them. Mutual funds also compete with individual investors... if you can pick winning stocks on your own, you're much less likely to enlist the aid of a mutual fund manager, who is charging you for the service. So some funds are probably reluctant to reveal their strategies for fear that you might learn from them. Unfortunately, another consequence of this secrecy is that individual investors aren't able to determine whether a successful fund manager was right for the right reasons or just happened to be right for the wrong reasons (in which case the fund's performance is not likely to be repeated). While funds don't have to completely tip their hands, they are required to publish their holdings at least once every six months. This can be instructive to investors who want to get an idea of what basic strategy the mutual fund is pursuing, but it makes portfolio allocation much more difficult, since the investor doesn't know how much he/she is holding in each sector at any point in time. Furthermore, the partial disclosure causes a conflict of interest. Mutual fund shareholders often judge a fund not just by its performance, but also by its holdings, and the fund managers know this. In order to paint the best possible picture of the fund, some funds sell underperformers and buy outperformers right before the semi-annual snapshots are taken. This activity is so prevalent that it has earned its own term, "window dressing". The effect is sufficiently pronounced that some investors believe that stocks which have been rising will rise even more in late December and June (and those that have been falling will fall even more), as mutual funds dump their losers and buy recent winners to make their portfolios temporarily look better. Of course, not every mutual fund succumbs to this conflict of interest, but due to insufficient disclosure it's virtually impossible to tell which do and which don't. Performance: The average actively managed equity mutual fund returns about 2% less per year to its shareholders than the stock market returns in general. In only four of the last 20 years did more than half of all general equity funds outperform the S&P 500. In recent years, their record has been even worse: about 80% percent of all general equity funds have failed to keep up with the S&P 500 in the past five years. In other words, a stock picking methodology based on throwing darts at a list of S&P 500 stocks could have been expected to outperform 80% of all equity mutual funds. (For more ugly numbers, check out http://www.fool.com/school/mutualfunds/performance/record.htm) I don't mean to imply that all mutual fund managers are poor stock pickers, since there are some who do a consistently great job (Peter Lynch, who used to manage Fidelity's Magellan Fund, immediately comes to mind). But as the above statistics imply, there are a lot who don't earn their keep. Explanation for Performance: Why aren't the professionals, as a group, able to do as well as a dart thrower? Just as with analysts, it's hard to blame it on a lack of intelligence, although that may be a partial explanation for some of them. The rest of the problem, as with analysts, is conflicts of interest. Since they are not compensated based on performance (as a hedge fund would be), for at least some of them the top priority is not to do as well as possible, but to avoid doing terribly at all costs. The easiest way to accomplish this is to overdiversify, and this is what many of them do. The average mutual fund has over 100 different stocks in its portfolio, and most have no more than 1% or 2% in any single holding, even their favorites. With that much diversification, there's very little chance that their performance will deviate more than a few percentage points from the overall market. This strategy virtually assures mediocrity. Another conflict of interest is the "window dressing" effect I mentioned in the previous section. This compels some managers to dump stocks which have recently fallen in favor of stocks which are currently hot, even if it doesn't otherwise make sense to do so. In addition to these conflicts of interest, there are other factors that weigh on their performance, such as the funds' need to maintain enough cash to handle share redemptions. By and large, the mutual fund manager's goals are well-aligned with those of their shareholders: if the fund performs well, the fund will eventually grow larger, meaning the fund will be able to collect more in management fees. However, managers would have more of an incentive to maximize performance if their compensation was directly tied to performance, as hedge funds are. Also, one could argue that growing larger isn't necessarily good for a fund, since not all investment styles are ideally suited for 'bigness'; for example, small cap funds have considerable difficulty finding enough great small cap stocks to invest in as their assets balloon, which could have a negative impact on their performance. Sites Working to Improve Things: While twice a year is the minimum level of reporting required, some funds are reporting their holdings more often. Among the ten largest fund families, three (American Century, T. Rowe Price, and Franklin) report quarterly, and one (American Funds) reports monthly. In addition, most funds report their top ten holdings on a monthly basis, but without percentage breakdowns. Several mutual funds are going a step further. Montgomery Asset Management recently launched a new line of Stock Solutions funds, whose holdings will be posted after a two-week delay, along with running commentary from the funds' managers. Firsthand Funds, IPS Funds, Munder Funds, and Rydex Funds also update their holdings on their web sites at least monthly, with a time delay. Two upstart mutual funds are taking more radical steps to further increase accountability, in the hope that improved performance will result: MetaMarkets.com and StockJungle. MetaMarkets.com operates the OpenFund mutual fund, which publishes portfolio changes on its site, along with the rationale for the trades, as soon as they happen. It also asks for stock suggestions from site users (both account holders and anyone else who has an opinion). In fact, Don Luskin, OpenFund's portfolio manager, found out about one of his fund's better performers, New York venture capital firm Harris & Harris Group (HHGP), from a visitor to the site. Similarly, StockJungle also operates mutual funds that publish portfolio changes on the site, along with the rationale for the trades, as soon as they happen. And like MetaMarkets.com, StockJungle also solicits suggestions from site visitors. But one of StockJungle's funds, the Community Intelligence Fund, goes one step further, by compensating the best visitors for their picks. Its Hot Hands program pays cash to the top amateur stock pickers each day. StockJungle CEO Michael Witz says the fund's managers receive 20 to 200 stock picks a day. (The only requirements are that the stock be traded on NYSE, NASDAQ or AMEX and have a market cap of at least $100 million.) With each pick, the fund's managers can see the person's past record, which helps them separate the wheat from the chaff. Some critics have argued that the openness and community spirit of these funds are nothing more than gimmicks. They argue that openness is a mistake, as a mutual fund that revealed its holdings and portfolio changes in real-time might be at a competitive disadvantage, both to other mutual funds that might learn from the moves and to individual investors who might decide to invest directly in the companies rather than through the fund. This would be especially true of a large fund that tended to spread its purchases and sales over many trades spanning several days or more. In such cases, the initial trade might compel others to immediately hop on the bandwagon and drive the price up or down (called front-running), which would cost the fund money. But this could be worked around, for example by revealing multi-trade portfolio changes only after the trades were completed. I suspect that there are a lot of individual investors who would very much like to hand their money to a mutual fund manager who is willing to explain what he/she is doing with their money and why. Similarly, one could make the case that community stock picking is a mistake, and that the decisions should be left to the experts rather than to individual investors. I'll explore this further in next week's installment; for now, I'll just point out that (a) these community funds get suggestions and ideas from individual investors, but the managers themselves still do the research and make the final decisions; and (b) as I mentioned before, 80% of the professionals (equity mutual fund managers) haven't been keeping up with the indices, so it's entirely possible that certain individual investors could do a better job. One other issue critics raise is that if many mutual funds already resort to window dressing to impress investors twice a year, they would be even more inclined to cave in to popular opinion on a regular basis if their picks were public knowledge at all times. This is a very good point, and I suspect that some funds would succumb to this temptation if placed under the microscope. But I think that accountability will win in the end, as those funds that were willing to buck the trend when it made sense to do so would tend to outperform in the long run, and would be rewarded for sticking with their strategy. I don't expect all (or even most) mutual funds to begin reporting their trades and rationale in real time, and I'm certainly not suggesting that they should be required to. But I hope that the few that do will become sufficiently popular that those that don't will be at a competitive disadvantage in their efforts to persuade investors to hand over their money. I also expect most of them, even the giant fund families, to begin to report their holdings more than twice a year. back to top previous | page 2 of 3 | next Send feedback |
copyright 2002 Thomas Murcko. All Rights Reserved.