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Identifying All Star Fund Managers I – Cross off the Bottom 90%





“There seems to be some perverse human characteristic that likes to make easy things difficult.” – Warren Buffett

We don’t really think of ourselves as investors. We are evaluators of investors.

Our investment philosophy is to identify the world’s best investors that are available and invest our money and our clients’ money with them. We call them “All Star Fund Managers”.

Think of it like the general manager of Team Canada. We are not out there stick-handling and shooting.  We spend our time analyzing players to figure out who is the most talented and plays with the most heart, and then put them together in a line of All Stars that play well together.

Our process may be interesting to you for several reasons. If you are:

  1. Our client – Get an idea why we are so confident in our fund managers.
  2. Amateur investor – Learn about what types of strategies generally do and don’t work.
  3. Not very interested in investing – Think of this article as an overview of investing strategies. It can help you evaluate the quality of your investments or whether that guy at the party who bragged about his investments is really that good.

Most information about investing in the media or on the internet is very over-simplified. I hope this article can provide some thoughtful perspective on how well various strategies generally work.

Why bother searching for All Star Fund Managers?

Our purpose is to find the most effective investments. You may be wondering why I don’t try to pick investments myself, since I’ve been in the investment industry for 17 years and am also an accountant. I could do the research. What I have learned, however, is that there are many investment strategies and a lot of very smart people, including many that are better investors than me. Rather than try to be the most skilled investor of them all, I believe I am far better at identifying who is the most skilled.

Similarly, I’ve also realized that I am not going to make it as a professional hockey player, never mind make it onto the NHL All Star team. Never having learned to skate is part of it. I will never be the world’s most skilled hockey player, but I believe I can IDENTIFY the most skilled hockey players.

We have a better chance of winning if I have Sydney Crosby playing for me than if I am playing myself. Similarly, I’m busy working with our clients’ financial plans. How would I find that Malaysian mid-cap company with a 35% growth rate, a 5% dividend, selling at a P/E of 8 with passionate management that our fund manager found? How would I visit the plant and meet with management?

It is called the Dunning-Kruger effect. People that are not skilled tend to believe they are superior, while the most skilled understand the complexities and are better able to recognize skill in others.

Screening out the Obvious Non-All Stars

For some reason, many people believe that nobody can beat a market index. This is because the “average” fund manager does not beat the index. However, like any other field, some people are far more skilled than the average.

The surprising part is not THAT some beat the index, but by HOW MUCH. For example, in the last decade after all fees, our favourite Canadian equity fund manager beat the TSX by 10%/year (with less risk) and our favourite global fund manager beat the MSCI by more than 10%/year (Morningstar). That is a huge difference after a decade.

It is not nearly as simple as choosing “5-star funds”. Generally, they are high risk and underperform going forward. And you cannot find them just by comparing actual performance to the index. Fund managers may beat the index by luck or because their sector or style was in favour. Also, every top fund manager has periods when they underperform. They beat their index in the long run after fees, often by a wide margin, but most underperform about 1/3 of the time.

A classic example was Rick Guerin. He was a top fund manager from 1965-83, beating the S&P500 by 25.1%/year for his 19-year career! However, he underperformed 6 years, or about 1/3 of the time.¹

I should start by saying that all the comments here are my personal opinion. There are many exceptions to most of them and you can find very smart people that will disagree with each point. But from our years of experience, we believe all of them to be generally true. This is just an introduction to give you a general idea of what to look for.

There are 4 steps to identify an All Star Fund Manager:

Step Time (approx)
1.Cross off the bottom 90% one minute
2.Identify the top 1-2% day or two
3.Identify the All Stars months
4.Match the ones that work well together day or two

Step 1: Cross off the bottom 90%:

The first step in identifying All Star Fund Managers is to quickly screen out the vast majority, so we can focus on the top 10%.

When we meet a fund manager or amateur investor, we can usually tell almost instantly whether he is in the bottom 90% of investors by looking for the most obvious and common ineffective methods.

Here are the 10 most common ineffective strategies that generally identify the “Bottom 90%” of investors:

Get rid of performance chasers – Most investors, whether professional or amateur, tend to follow the herd. It always seems logical to most investors to buy investments that are “doing well”. The human mind tends to see trends and believe the same investments will continue to “do well”. However, studies consistently show that chasing performance by buying last year’s winners does not work. Chasing performance is the single most common error of amateur and professional investors. The most common investment mistake is to sell an investment you own that has not done well recently to buy one that has (sell low and buy high).

At any point in time, there are popular sectors or regions or strategies that have performed well recently. Popular sectors and regions tend to be fully valued or over-valued, so the best opportunities are usually elsewhere. We are looking for fund managers to find the best opportunities. If we find a fund manager is mainly invested in today’s popular sectors, we assume he is probably in the bottom 90%.

Get rid of marketers – In my opinion, most mutual funds are designed to be easy to market, instead of being the highest quality investment. Fund managers make more money if their fund grows, either because of good performance or because people invest in their fund. Many fund managers are mostly focused on having a fund that people will invest in. Fund managers that use popular buzz words, invest in popular stocks or sectors, emphasize the biggest & safest stocks, or generally seem to be too good at marketing may be more interested in attracting new investors than in investing. We want fund managers motivated by excellence in investing, not making money for the fund company.

Get rid of “closet indexers” – A closet indexer is a fund that tries to be similar to an index, usually because this protects the fund manager’s job. The saying in the industry is that “It is better to fail conventionally, than to succeed unconventionally.” About 1/3 of mutual funds are closet indexers.The trend to closet indexing in the last 20 years is part of why so many funds don’t beat their index.² You can’t beat the index after your costs with holdings similar to the index. In addition, the best opportunities are usually in less-followed stocks – not stocks in the index that are widely followed. In our opinion, a closet indexer is the worst choice for a fund manager. They don’t even try to beat the index or be great investments. In general, if the top 10 holdings of a fund have more than 2 of the top 10 of the index, then the manager might be a closet indexer. Also, if the fund manager talks a lot about being “over-weight” or “underweight” various sectors compared to the index, he may be a closet indexer.

Get rid of over-sized funds – A fund that is too large cannot invest in smaller companies that often have the best opportunities and may take weeks to buy or sell one of their holdings. With Canadian funds, generally over $1 billion is probably too large. With global funds, generally over $10 billion is too large. Generally the smaller the fund the better.

Get rid of employees – Top fund managers are usually not employees of someone else’s company, such as a big bank or insurance company. They create their own investment firm and then get contracts from fund companies. A good employee fund manager may make $500,000-$1 million/year, while a good fund manager with his own firm may make $5-50 million/year. Fund managers that are employees have bosses that often want them to make their fund more saleable by having popular holdings or do “window dressing” (putting popular or “safe” companies in the top 10 at month-end so they appear on reports). Top fund managers usually own their own firm and have no bosses.

Get rid of economy followers – Most fund managers have a market view based on the economy, but following the economy is essentially useless for investing. Top fund managers are stock pickers and don’t waste their time on the economy.

Get rid of chartists – Many fund managers use charts of recent performance (“technical analysis”) either as a key part of their process or to help them decide when to buy and sell. Our belief is that the markets are too efficient for charts to be very useful. We consider technical analysis to be an over-simplified substitute for real research. In general, fund managers that don’t use charts are better investors than ones that use them. If a fund manager uses these charts, we assume he probably does little real research.

Get rid of internet data analyzers – There is a ton of public information available about stocks. Computers make it easy to analyze. Fund managers have software that can quickly screen all large companies by any combination of hundreds of factors and statistics. Our belief is that the markets are somewhat efficient, so this publicly-available information is mostly already built into the current price of a stock. The issue is that nearly everyone with a human brain runs similar screens and then ends up buying similar companies. We have seen extremely smart fund managers with unbelievably sophisticated computer models get average performance. Most fund managers may use this data to narrow down the 13,000 available companies to perhaps 500-1,000 to analyze in more depth. Top fund managers do their own research and will only invest in companies where they know something not publicly known or where they believe the public view is drastically wrong.

Get rid of home bias – In every country, investors focus on companies in their country, believing they are somehow “safer”. Investors in Iceland had 80% of their money invested in “safe” Iceland companies (can you name one?) just before the country went bankrupt. No country has more than a small portion of the best opportunities and companies in one country often face similar risks.

Most Canadian equity funds today are “Canadian-focused”, meaning they invest 10-50% outside of Canada. Fund managers investing mainly just in Canada are missing nearly all the opportunities.

Get rid of market-timers – Many studies have shown that, in general, the more investors trade, the worse they do. The old adage: “Your portfolio is like a bar of soap. The more you touch it, the smaller it gets.” – has a lot of truth. This is why studies consistently show that women are much better investors than men. Market timers with human brains generally get far lower returns than buy-and-hold, since most humans buy and sell at exactly the wrong times. There are a variety of different types of market-timing strategies, often based on economic conditions, charts, or the manager’s hunch. Too much trading may indicate the fund manager is a speculator, instead of an investor. A speculator buys an investment hoping it will go up, while an investor invests in a company in order to participate in the growth of the business. Very few of the top investors are market-timers. Top fund managers usually consider themselves to be investors in businesses and don’t time markets.

These steps can help us screen out the bottom 90% of fund managers/investors. The next article will outline what we actually look for in an All Star Fund Manager.

¹Classic article “The Superinvestors of Graham & Doddsville” – Warren Buffett (http://www.edrempel.com/pdfs/Active%20Share%20Study%20-%20How%20Active%20Is%20Your%20Fund%20Manager.pdf)

²Yale study “How active is your fund manager? A new measure that predicts performance.” – Martijn Kremers and Antti Petajisto (http://www.edrempel.com/pdfs/Active%20Share%20Study%20-%20How%20Active%20Is%20Your%20Fund%20Manager.pdf)

About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

Disclaimer: Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Opinions expressed are the personal opinion of Ed Rempel.





39 Comments, Comment or Ping

  1. I would narrow it down to choosing from the group of managers with concentrated portfolios (20-30 stocks) and/or sector weights different than the index. Basically, avoid the closet indexers. Not easy to do considering the number of closet-index funds in Canada. http://bit.ly/gVRSDI

  2. 2. cannon_fodder

    Ed

    Have there been studies done assessing the performance of buyIng a basket of the worse performing funds over the past X years? Especially if the recent performance is an aberration?

  3. 3. jesse

    You still have to take into account the survivorship bias. Call me skeptical.

  4. 4. dannycanuck

    Ed,

    “There seems to be some perverse human characteristic that likes to make easy things difficult.” – Warren Buffett

    This has me thinking: why not just invest your clients’ money in Berkshire Hathaway? Warren seems like the definition of all star to me…

  5. 5. DanP

    How come the internet hates mutual funds and shows so much love for ETFs? I think there is a place for both in a persons porfolio. And this nonsense about ETFs always beating mutual funds is crazy too. Just like any product, some mutaul funds are good,and some arent.

    Here’s an example of one that does great! Ethical Special Equity. Over a 10 yr period and 15 yr period, it beat the index, and in the recession, it went down less than the index! Now, i knowthis is just one example, but there are tonnes out there. Mornign star rates it a 4, and globe advisor gives it a 2. Just shows those ratings are a joke.

    Having said that, i dont want anyone to think i agree with Ed’s commentary. While he usually brings up good points, these articles read like 5 page ads and are far too biased for my liking. Calling them an “all star fund manager” sounds far too sleezy for my liking.

  6. 6. DanP

    dannycanuck, a quick comment on that. It’d be a terrifble idea to invest all your money in berkshire, because the day Mr. Buffet passes away, you’d probably lose alot of money.

  7. 7. alexander45

    For some reason, many people believe that nobody can beat a market index

    I’d say that you set up a bit of a strawman here: what many people really believe is that few people can beat a market index consistently, and that it is near impossible to identify those people before the fact rather than after the fact.

    Using a single manager is, of course, risky because you can’t be sure you found one of the miniscule few until after the fact.

    Using more than one manager at a time helps spread the risk, but dilutes the potential returns because the chances of selecting at least one bad apple is greater, which brings down your overall return.

    I am still unconvinced that it is possible to identify consistently those few managers who can consistently beat an index or that the risk is worth it for most investors. Note that by “consistently” I don’t mean “every year”, but rather that over the long-term they come out much ahead. Do some managers do it — of course. But is it really possible to identify them ahead of time? Not consistently and not by many people.

    So — the question becomes: do I want to pay somebody to identify all-star managers for me.

    To me, the answer is no, for two reasons:

    1) Few managers have the ability to consistently beat the index, and
    2) Even fewer people out there have the ability to consistently identify those all-star managers ahead of time.

    The double uncertainty there makes it hard for me to think that I would ever be lucky enough to find the winning combination.

  8. 8. dannycanuck

    DanP: dannycanuck, a quick comment on that. It’d be a terrifble idea to invest all your money in berkshire, because the day Mr. Buffet passes away, you’d probably lose alot of money.

    dannycanuck: Okay, let me rephrase: “Ed, did you identify Warren Buffett as an all-star money manager and put your clients’ money in BH stock over the past 20 years? This seems like it would have been a fairly simple and lucrative identification of talent (albeit, sadly with no MER)” DanP: I guess it should be added that all star managers need to be young and/or immortal?

  9. 9. alexander45

    DanP

    The primary reason people like ETFs is because they have a much lower MER than Mutual Funds. So, given equivalent returns, the ETF wins every time because you are paying fewer fees.

    That said, this does not necessarily make them “better”. For example, Mutual Funds are far superior to ETFs for making small monthly purchases and/or frequent rebalancing. Such a strategy would kill you if you were using ETFs because of the transaction/brokerage fees for every purchase, rebalance, etc.

  10. 10. Ed Rempel

    Hi Larry,

    I agree completely. The #1 enemy of great performance is closet indexers.

    So many fund managers try to keep their job by owning stocks close to the index. Probably the worst choice among mutual funds is a fund that is similar to the index.

    Your article was interesting. I would put the portion of closet indexers in Canadian large cap even higher. In fact, in a Canadian large cap only fund, they are probably virtually all closet indexers. We don’t really even consider investing in a fund that is a Canadian large cap fund.

    Most Canadian equity funds today are “Canadian focused”, which means up to 50% can be outside of Canada. Also, many are really all-cap funds, so they can buy large, mid and small-cap stocks.

    They proportion of closet indexers is far lower in other areas, such as global and small cap.

    Ed

  11. 11. Ed Rempel

    Hi, Cannon,

    The most obvious study of last year’s losers is the success of the “Dogs of the DOW” strategy. There have been many studies that show that buying last year’s winners (which most investors do) is a losing strategy. Also, many studies show that value fund managers, who buy undervalued stocks (usually because they have not been “doing well”) generally outperform.

    Why are you asking?

    As a very general rule, buying last year’s losers is probably a better strategy than buying last year’s winners. However, great stock pickers are looking for far more than just how a stock has been performing lately.

    Ed

  12. 12. Ed Rempel

    Hi Dan,

    Good comments and a good example. There are lots of good examples.

    I agree that the fund rating systems are virtually useless in identifying top fund managers.

    I did not mean this to sound like an ad. It is meant to be a statement of what I believe. I invest personally with mutual funds or hedge funds that I believe are managed by All Star Fund Managers. I recommend this to clients because I believe this is the most effective investment strategy. Why would I write about and recommend anything other than what I invest in?

    Do you have a better name than “All Star Fund Managers”, Dan? I struggled with this name, but chose it because I like hockey. You understand what I am getting at. What should we call the best fund managers?

    Ed

  13. 13. Ed Rempel

    Hi Alexander,

    I think your issue is the word “consistently”. Why is it relevant at all? Anyone that uses the word “consistently” has read too much index propaganda.

    If a fund manager beats the index over the long term, who cares whether he beat it “consistently”? Of course “consistently” means “every year”. What else could it possibly mean?

    Look at Rick Guerin. He was a top fund manager from 1965-83, beating the S&P500 by 25.1%/year for his 19-year career! He did not beat the index “consistently”. He underperformed 6 years, or about 1/3 of the time.

    In fact, the index does not “consistently” beat almost any mutual fund (except closet indexers)! Almost everyone beats the index some of the time. The conservative funds lose less in down years. The focused funds beat it when their sector/style is in favour. Everyone gets lucky sometimes.

    The index industry uses the word “consistently” to try to set a ridiculously high bar in order to promote sales of index products. Nothing in investing is consistent. I don’t believe anyone can be a successful investor looking if they look for something that is “consistent”.

    Nobody can even “consistently” beat the Leafs!

    I would suggest you remove this word from your investment vocabulary completely, and start looking for “excellence” or “skill” or “integrity”.

    Ed

  14. 14. alexander45

    Oh man, are you serious Ed?

    I explicitly defined “consistently” to mean exactly what you want it to mean — outperforming the index over the long term. I did this specifically so that I could not be charged with setting a “ridiculously high bar” of meaning “beating the index every year”. And yet you still charge me with this.

    My point was, and remains:

    1) There are very, very few managers who outperform the market over the long-term;
    2) There are even fewer people out there who can reliably identify these managers at the start rather than through hindsight.

  15. 15. Colin

    This is sad. I read financial blogs because the authors are (usually) informed enough to know that Active Management is a great way to enrich financial planners and portfolio managers at the expense of the customer. Why is this artice here?

  16. 16. Ed Rempel

    Hi Danny,

    I wish I had thought of it. I wasted my 20s, 30s and early 40s with all kinds of other investment ideas. Only slowly over the last decade did I figure out that I should be looking for people smarter than myself.

    Warren Buffett’s outperformance is well documented, but recently he has outperformed by much less than he did earlier in his career. He was amazing from 1957-69 when he made nearly 10 times the return of the DOW!

    Being young is almost always a disadvantage.Of the managers we consider All Stars, none are in their 20s, the odd one in their 30s, a few in their 40s, more in their 50s and some older.

    Experience is a huge factor and it is hard to be exceptional without a lot of market experience. Learning the wisdom required for successful investing, making the right contacts and getting the knowledge takes a long time.

    It is also difficult for us to identify an All Star from a short track record. Everyone is lucky sometimes or has their style in favour. An amazing 5-year record for a 20-something investor tells us nothing really.

    We need to know the fund manager has a discipline to stick with his strategy when it is out of favour, not make common mistakes (like changing horses when he is underwater), and the skill to give us confidence he will outperform over time.

    Young is a disadvantage – but immortal would be helpful!

    Ed

  17. 17. cannon_fodder

    Ed

    I was just musing that would the average Joe be better served chasing the losers rather than the winners. Eg screen mutual funds in the bottom quartile of their peers and pick out the ones which have underperformed their track record the most and review to see if they have kept their “all star fund manager”.

  18. 18. Ed Rempel

    Hi Alexander,

    If returns are about equal, a mutual fund should clearly be a better choice than an ETF.

    This is because a mutual fund also pays your financial advisor. You should be able to find a planning-focused advisor to help you create a financial plan to help you make smart decisions with all areas of your financial life without charging you, if you buy your investments there. If your returns are similar, then this advice does not cost you anything.

    The focus in the mutual fund/ETF comparison is usually about returns and fees, but seems to miss out that the mutual funds include advice, while ETFs require you to pay extra for advice.

    I realize you were referring to similar returns before fees, while I am referring to similar returns after fees, but I think the 3rd factor of advice in the mutual fund?ETF comparison is actually the most important of the 3.

    Ed

  19. 19. Ed Rempel

    Hi Cannon,

    Good musing. I agree that most investor are better off chasing the losers than the winners – most of the time.

    The issue is that there are so many closet indexers, that many of the losers are there for a good reason.

    The best case scenario may be an All Star Fund Manager with a great long term track record that shows his skill, but that has underperfromed recently.

    You may find the ratings interesting for your musings. One study showed that the average 2-star fund beat the average 5-star fund going forward. General observations I have had over the years are that the top 10-year funds are often the top 1-year funds, but often just because of their recent performance.

    However, the top 15-20 year funds often where not the top performers in almost any year. Instead, they often were somewhat above average (3 or 4 star) most of the time. The 1-star and 5-star are usually the non-diversified funds and often bounce between 1-star and 5-star.

    There are all kinds of generalities, many of which are not intuitive, but looking for skill is different than looking for winners or losers.

    Ed

  20. 20. alexander45

    Huh? You don’t need to use an advisor to buy either a mutual fund or an ETF, and you can use an advisor to buy either.

    I don’t see that as having any bearing whatsoever.

    Frankly, I’d much rather have a fee-only advisor rather than one who works on commission via mutal-fund recommendations.

  21. 21. Jungle

    Thanks for the article Ed.

    When I read Peter Lynch’s book, One up on Wall Street, he provided examples of leading Fadelity investments with an impressive track record.

    His advice, look for 10 up and coming companies around you, that Wall Street has not noticed that are selling product, then buy all ten.

    More then likely, most will be duds and some may have a negative return. But what he found was there was usually one that turned 10 banger, raising above and pulling the portfolio to above benchmark return levels.

  22. 22. Jungle

    The problem with buying Warren’s company is that the stock price was too high (recently) for the average joe investor to buy enough and be properly diversified with everything else. It was more suited for institutional buys. They did introduce BRK-B in 1996, but before then, you had to pay out quite a lot for those shares.

    I can consolidate our net worth and probably buy 2 shares of BRK-A. lol

  23. 23. Nick

    Hi Ed – Thanks for taking the time to provide us with a thought provoking article.

    On the topic of Index/ETF vs. Mutual Funds, for most it seems to come down to the inherent trade-off of MERs vs. the value the investor places on active mgt (& possibly active advice, too) and as was also alluded to by others here.

    In my experience, there is an army of PF “gurus” & “pundits” who have well established the mantra that paying attention to fees is one of the most important things you can do on the way to becoming a successful investor. I certainly find that intuitive. But, am intrigued by the idea that not necessarily all fees are wasted $. Again, it is a question of value.

    If it is reasonably possible to identify, before the fact, some elusive “All Stars” who will improve my chances of coming out ahead of the pertinent indexes over the long term (& after fees), then I do/will not begrudge them their >2% MERs. Once again though from my experience, the challenge is usually staying with your plan during the down periods, removing the emotion of investing, being capable of analyzing whether your original investment thesis has changed and how, or is it a momentary blip, etc. For instance, it is quite possible to be sitting in what you believe to be an “All Star” managed fund that is currently negative since inception (maybe it was started in the past 5-8 yrs). It would be quite natural to question your original analysis and also to be resenting those rather high MERs right now. However, I also know that most investors do not even realize the published returns of the investment vehicles in their own portfolios due to poor timing, etc.

    To me, much of the value of active mgt & advice then is support & assistance with managing this “stay or go” problem (assuming that I have found an advisor that I genuinely trust).

    So, my rather long-winded question(s) was essentially, you probably face this challenge with your clients and if so, how do you manage it? Are there some tips for investors around this? And, why is it so commonly held in PF circles that DIY is such a valid alternative? I pay my mechanic because I can not hope to have his knowledge, tools etc. and certainly do not wish to devote my precious non-working hours to an effort at approximating it!

  24. 24. Eric

    Nobody can even “consistently” beat the Leafs!

    Love it

  25. 25. alexander45

    Nobody can even “consistently” beat the Leafs!

    Of course “consistently” means “every year”. What else could it possibly mean?

    Absurd statements. Consistently is a synonym of reliably, not a synonym of invariably.

  26. You always seem to have a lot of haters Ed!

    My father is an investment advisor, and a very honest and good one at that, and his investment philosophy is almost exactly the same as what you describe here.

    I’ve actually taken a turn at trying to manage my own investments and jumped on the bandwagon promoted by people at RedFlagDeals and other personal finance blogs and forums that low MER ETFs are the best way to invest because mutual funds almost always under perform the index.

    I do still think that ETF index investing is a good thing and is probably better for a lot of people than the crappy mutual funds they already have – but picking the right mutual fund can possibly be much better, less risky, and fairly easy to do as you have described here.

    The trick is to make sure you are buying a mutual fund with a good manager that actively invests and trades based on their excellent knowledge of investing and isn’t restricted too much about what they can invest in by the definition of the fund itself.

    Paying a 2.5% MER for a fund like that is much different than paying a 2.5% MER for a bank balanced fund or bank index fund.

  27. 27. Echo

    Mutual funds get a bad reputation, but mostly due to advisors selling their institutions’ own funds rather than looking for what you describe as the “all-stars”. If you are going to go this route, it’s important to have an advisor who will do this work for you and who will look out for your best interests.

    In my opinion, a DIY investor might as well research their own individual stocks, since the methods you describe in choosing the right fund sound just as onerous as selecting stocks would be.

  28. 28. Ed Rempel

    Hi Alexander,

    You may well have meant “long term” when you said “consistently”. However, the word “consistently” gets misunderstood easily and people may think you mean “every year”.

    I may have over-reacted a bit, but the word “consistently” is one of my pet peeves. It is hugely misused to baffle people in the mutual fund vs. index discussion. Virtually nothing in investing beats anything else “every year”.

    I would suggest you use “long term” when you mean “long term”.

    The other point is that there may be a lot more than the “very,very few” fund managers that beat the index in the long term.

    The core holding in equity portfolios should normally be global equities. In the last 10 years, 47 funds equaled or beat the MSCI World index and 49 made less, so 49% of mutual funds beat the index.

    In Canada, there are very, very few large cap stocks at all, so nearly all large cap funds are closet indexers. However, if you look at all the categories of domestic equity, 116 funds tied or beat the S&P TSX 60 over the last 10 years vs. 109 that made less. So, 52% beat the index.

    This is not at all scientific, because there is some survivor bias, quite a few funds move between classes as their portfolio holdings change, quite a few funds have multiple versions, etc.

    However, the fact remains that a lot of fund managers beat the indexes over the long term.

    Ed

  29. 29. alexander45

    You may well have meant “long term” when you said “consistently”. However, the word “consistently” gets misunderstood easily and people may think you mean “every year”.

    Yeah, except that I explicitly said that I did not mean every year. It is like you decided to completely ignore my comments, in order to simply harp on something.

    The other point is that there may be a lot more than the “very,very few” fund managers that beat the index in the long term.

    Every academic study I’ve ever seen suggests that there are very, very few. If you can provide me with some evidence that this is incorrect, I’m all ears.

    The evidence that you do provide is meaningless, because there is no indication that it is the same funds that are beating the index. All your numbers show is that, on average, half of the funds beat the index over a given timespan, and half the funds are below the index over a given timespan. This is exactly what we would expect in a random sample. Now if it were the same funds beating the index over and over again, then that’s something quite different. And, as I said, academic research suggests that very, very few funds do this.

  30. 30. Ed Rempel

    Hi Alexander,

    If I can put a little perspective on the fee-only vs. commission planner comparison.

    I can understand that you may think a commission planner will be biased to in-house investments or really be just an investment salesperson, since these would describe most commission planners.

    We considered these options, but decided being commission-based actually would be more effective for providing real advice. There are 2 main reasons:

    1. Fee-only plans tend to be one-time or short term plans, instead of the long term planning relationship we think most people need.
    2. Fee-only relationships create issues for providing more creative or aggressive strategies.

    People tend to hesitate to maintain a long term relationship with a planner or even call with questions if they know they are “on the clock” and will be billed for it. Some people would pay for a first written plan, but few would go back regularly for reviews or call to discuss financial issues that come up.

    We found that fee-only planners tend to provide accountant-type standard advice, but a commission-based relationship provided motivation to develop creative and more aggressive strategies.

    For example, we do a lot with various versions of the Smith Manoeuvre to help clients save for retirement when they may not have enough cash to invest (or for aggressive-growth clients). We find many people who don’t have a plan invest too conservatively to have any chance of having the retirement they want, so we often take the time to explain the real risks of equities and what it takes to hold higher portions of it. Now in RRSP season we are doing full plan reviews and projecting tax refunds so we can use “RRSP top-up” strategies, RRSP loans or various financing methods to help clients find the money to make their RRSP contributions needed to make their goals.

    Constantly searching for creative ways to do things have helped us invent some strategies, such as 2 versions of the Smith Manoeuvre, and a cool RRSP/tax strategy to help seniors qualify for government benefits.

    In a fee-only relationship, there would not be motivation to brainstorm creative ways for clients to achieve their goals, take the time to recommend more aggressive financial or portfolio strategies, or invest new methods.

    In fact, taking the time to come up with them would be hard to bill clients for. More importantly, more aggressive strategies require an on-going relationship to avoid clients abandoning the strategy at the worst possible time. It would generally not be appropriate for a fee-only planner to recommend a more aggressive strategy knowing that there is a good chance the client will not maintain the relationship for the long term.

    Have you actually ever paid for a fee-only planner, Alexander? We find most of the people that say they would rather pay for a fee-only planner would not actually pay for it. Canadians tend to be very fee-sensitive and most are not like you in preferring to write a cheque to pay for advice.

    Ed

  31. 31. Ed Rempel

    Hi Jungle,

    I agree, Peter Lynch’s strategy is interesting. Having concentrated portfolios works most of the time, but not usually with small cap growth stocks that he bought.

    I read some studies that showed that small cap growth (Peter Lynch’s focus had far lower returns long term than small cap value, large cap growth or large cap value. This is because many of these companies are fast-growing, so expectations are too optimistic or the stocks may be over-hyped. Small cap growth tends to have a higher proportion of companies go bankrupt.

    This means there is a different formula for success, as you pointed out with the “buy all 10″.

    For small cap value or large cap stocks, having a focused portfolio of few well-researched stocks usually produces better returns. However, with small cap growth, the most effective strategy is often to hold a huge number of stocks – perhaps 300-500, like Peter Lynch.

    The theory is that a stock cannot lose more than 100%, but they can go up over 1,000%. One “10-bagger” means you make good money even if several went bankrupt.

    It’s a math puzzle. Even though the average return of small cap growth is lower, owning a large number of stocks allowed him to beat his index because a small number of those stocks compounded large returns into massive returns.

    I find it interesting finding the different strategies that work with different types of investments. Often, what works and what doesn’t is counter-intuitive.

    Ed

  32. 32. Ed Rempel

    Hi Alexander,

    If you want to see the funds that beat the index, just look them up on line. Here is one link that sorts all global equity funds by 10-year return: http://globefunddb.theglobeandmail.com/gishome/plsql/gis.fund_report?rep_type=LT&order_by=14&direction=DESC&start_row=1&pi_report_tab=161&iaction=fundFilter&pi_portfolio_id= .

    The MSCI World index lost 1.2%/year for the last 10 years. I chose 10 years because it is a reasonably long period of time with quite a few funds having been around the entire time.

    There are 50 funds per page, so if you scroll down, you will see that all but 2 on the first page made more than the index over the last 10 years.

    If you hit “Next”, you will see 48 funds on page 2 that made less than the index, for a total of 50 that made less.

    In short, 48 funds made more and 50 made less.

    My software is far more in-depth and includes a few more funds, which is why my figures are slightly different.

    However, nearly half beat the index. This is not a proper study at all, but it is just meant to show you that lots of fund managers beat the index.
    ——

    I am mystified by your comment that it should be the SAME funds beating the index every year? Why is that relevant? You DO mean “every year” don’t you???

    Are you referring to beating the index over time or beating the index every year, Alexander? “Over time” is relevant – “every year” is irrelevant.

    I checked. Looking at calendar returns only, zero funds beat the index every year and the index beat only one fund every year. Everybody beats the index sometimes! (The only fund that made less than the index all 10 years was CIBC Global Equity.) Even GICs beat stock market indexes sometimes.

    I don’t believe any academic study has ever been done on the SAME funds vs. the index the index, or funds vs. the index every year. That is a ridiculous comparison. Companies offering indexes promote their products with ridiculous comparisons like that, but I don’t believe any academic study has ever been done. This is because a 5-minute analysis will show that every fund beats the index sometimes and makes less sometimes (except CIBC’s fund).

    The 48 funds beat the index over 10 years. Period.

    Ed

  33. 33. alexander45

    Oh Ed.

    Once again you misrepresent my comments. It is you that is obsessed with the “every year” thing, not me.

    I have never — not a single time — claimed that funds need to beat the index every single year. And, in fact, I have explicitly and repeatedly said that this is not what I am arguing. And yet you continue to put those words in my mouth. Why? Why can’t you address the points I’m actually making, instead of the points you wish I were making.

    No matter what time span you pick — be it 1 year, or 5 years, or 10 years or 25 years — you will find that roughly half the funds beat the index and about half the funds are lower than the index. That’s the way it works.

    But:

    (1) It is difficult or impossible to identify those funds ahead of time
    (2) The vast majority of funds don’t even last over the long-term — especially with the same manager, which makes it hard to actually maintain.
    (3) Many, if not most. of those that beat the index do so for reasons of luck, rather than skilled management (see the link below)
    (4) The list that beats the index over 10 years, will not be identical to the one that beats it over 7 years or over 12 years. This means that, despite what is often argued, you do need to time the market for when you think each fund has hit its ceiling on how much over the index you can expect it to go. Wait a couple of years, and chances are it will revert to the mean and you have lost your advantage. Cash in too early, and you missed the big earning years and you have lost your advantage.
    (5) Most importantly, those returns are before fees. Once you take out trading and management expenses, many of the ones that beat the index actually don’t when it comes to how much money actually goes to the investor.

    I know that you are aware of the research, but are choosing not to share it.

    Even the most positive academic research, (e.g., http://www.hammondassociates.com/pressroom/articles/MutalFund.pdf) suggests that mutual funds with skilled managers are hard to find and are becoming even harder to find. And that paper I linked to is, as I said, among the more positive academic research. I could have, as you know, linked to dozens showing that the % of skilled managers as opposed to lucky is miniscule.

  34. 34. Ed Rempel

    Hi Nick,

    The “stay or go” question with an investment. That is a critical question and is where most investors go wrong.

    Many studies show most investors get it wrong by buying and selling at the wrong times. The Dalbar study shows the average mutual fund investor makes about 1/3 of the investments they own. John Bogle in his study “Investors are getting killed in ETFs” showed the average ETF investor makes 4.5%/year less than the average index mutual fund investor. In both cases, it is entirely because of bad market timing.

    The #1 mistake investors make in investing is to sell investments after they are down to buy something that has been performing well recently. This is the mistake that leads to the poor long term return statistics.

    From experience, I can say that avoiding this common mistake is more difficult than you would think. Even with lots of experience, my brain and my gut are very creative at coming up with all kinds of reasons to buy something that has done well recently or sell something that has not. You have to be constantly aware of not making this mistake.

    Regardless of how you choose to invest, the “stay or go” decision is critical. However, it is different with different types of investments.

    In general, this decision is much easier to get right if you are investing, instead of speculating:

    Speculating – Buying an investment you think will go up.
    Investing – Investing in a business or investment where you want to participate in the profits (or growth of profits).

    If you are speculating, then you will probably get the “stay or go” question wrong. Normally, the best decision is the OPPOSITE of what your gut tells you.

    If you are investing, then the decision is easier. In general, you should only sell if the reasons for owning it have changed.

    If you own shares of a great business where you want to participate in its profit growth, but it hasn’t been doing anything, if nothing has fundamentally changed you should probably keep it.

    With our strategy of investing with All Star Fund Managers, we want to participate in the stock-picking skill of a fund manager. The “stay or go” decision is based on whether we believe anything has changed with his stock-picking skill.

    Of course these decisions are anything but exact and there are many factors. Whether or not a fund manager is still an All Star is far more involved than just looking at his recent performance.

    My best advice here: Make a note each time you sell investment A to buy investment B. Compare them 1 year, 3 years and 5 years later. If you are normal, probably 80% of the time the investment you sold will have outperformed the one you bought. You can use each case as a learning experience.
    —————–
    The biggest benefit of working with a financial planner should be having a written plan so you know you are doing all the right things to achieve your life goals. However, helping you make the “stay or go” decision correctly is also a major part of it.

    Why is it so commonly held in PF circles that DIY is such a valid alternative?

    Interesting question. I think it comes down to TRUST.

    It does look easy, doesn’t it? I tried it when I was younger. I went through a lot of the common stages:

    - I tried picking my own investments based on recent performance.
    - I tried working with a broker doing lots of trades.
    - I tried choosing investments based on short-term momentum.
    - I tried investing heavily in the sectors that were performing very well.
    - I developed a market-timing algorithm based on tracking a group of investments and a group of economic stats, based on a calculation of the optimum size move in each sector that should indicate a change in momentum.

    Eventually, I realized that there must be smarter people out there than me, so I started searching for them to see what they do. That led to my philosophy of investing with All Star Fund Managers, when I realized that most of what the top investors do cannot be easily replicated.

    The investment industry is a big part of the problem. It is not primarily about giving good investment advice – it is about selling investments. At any time, there is a lot of marketing effort to encourage investors to invest in whatever has been performing well recently. Most investment advisors are usually recommending the same thing. It is much easier to sell a popular investment than to give real investment advice.

    All this marketing effort seems to make it easy for DIYers to know what to buy. In general, whatever investment companies are marketing, may well be the wrong place to invest.

    The other big factor is that many DIYers tried working with an advisor and were disappointed.

    This could be for the wrong reason – the market and their investments went down.

    Or it could be for the right reason – they felt they were being “sold” and were not getting real financial advice. On average, investment advisors normally make the same mistakes that DIYers do and so performance is often disappointing over time.

    Most news pundits like to comment on fees, since it is objective and easy – far easier than to recommend good investments. Recommending any investment could be wrong and could cause problems with advertisers.

    Recommending lower fees and assuming all advice is worthless is easy – and there is quite a bit of truth to it.

    There are valid reasons for being a DIYer. For example, you may be very knowledgeable & experienced, or you may really love spending time researching investments.

    In the end, for many DIYers it comes down to TRUST, though.

    - It is difficult to know who to trust.
    - It is easy to believe that you can’t trust anyone.
    - It is difficult to know whether anyone’s advice is worth it or better than what you can do yourself.
    - It is difficult to admit that you might need help with investing or financial planning.

    Anyway, that’s my view on it.

    Ed

  35. 35. Ed Rempel

    Hi Saving Mentor,

    Excellent comment. I agree completely.

    Ed

  36. 36. Ed Rempel

    Hi Echo,

    You have a point that identifying an All Star Fund Manager is as much work as identifying a good stock to invest in – assuming you are doing the proper research.

    There are some critical differences though:

    - You only need 3 or 4 fund managers to have well-diversified portfolio, but you would need at least 20-30 stocks to be properly diversified.
    - Once identified, a skilled fund manager is more likely to maintain his skill. Therefore, you may be able to stick with the fund manager for 20 years.
    - If a skilled fund manager fades, he normally becomes merely above average. A good stock can easily become a bad stock for many reasons.

    The more important difference is that the fund manager can make the allocation decision, instead of me. He is a far better investor than I.

    For example, I may try to figure out what allocation to resources I want to have. Studies show that making a top-down sector allocation decision is an underperforming strategy on it’s own. The effective way to make the decision is bottom-up by picking the best stocks and letting that determine the allocation.

    If I invest with an All Star Fund Manager with a somewhat broader mandate, such as a Canadian small cap fund, that manager will choose the best stocks, which will determine how much I end up having in resources.

    Having that decision made by the fund manager and by picking the stocks (instead of the sectors) are 2 critical success factors.

    It would be difficult for a retail investor to replicate this. Most do no research other than looking at some internet info that is probably already built into the price of the stock. In general, publicly-available information is or little use in stock-picking.

    Retail investors probably know only 1% of the info that a good fund manager will know about the company they invest in. They rarely analyze the financial statements, rarely visit the company, don’t meet with management, don’t talk to the competitors, may not understand the technology or critical success factors for the company, and may not even know the history of the CEO.

    These are just basic, introductory facts any investor should know before buying a stock. Any good fund manager would know all this and far more.

    Ed

  37. 37. Ed Rempel

    Hi Alexander,

    Perhaps I have misunderstood you. I think I understand what you are saying now. When you said that fund managers don’t “consistently” beat the index or that it is not the “same funds” that beat it, you are referring to the last 7 years vs. the last 10 years vs. the last 12 years. Is that right, Alexander?

    So, it is not “every year”, but over different mid to long term periods of time?

    Sorry if I have misunderstood your point. Yes, I’ll admit the “every year” thing is my pet peeve. I’ve heard it many times as a ridiculous way to try to support index investing. In most cases, people that say mutual funds don’t “consistently” beat the index have just read the index propaganda and don’t understand the issues.

    All your comments about the difficulties of identifying the best mutual funds make sense. However, consider:

    1. We are evaluating the fund manager, not the fund. If a fund manager managed 3 different funds for 5 years each, I have a 1-year track record – not just the 5-year track record of the fund.
    2. We don’t need to prove anything about mutual funds vs. indexes in general. We are just looking for a few fund managers that we believe are the most skilled fund managers.
    3. If a fund manager is in the top funds in the last 10 years but not in the last 7 years, that does not mean you need to market time his fund. Market timing strategies nearly always reduce returns. Every fund manager has periods of time when they underperform. Sidney Crosby does not score every game. If you are confident that a fund manager has skill, when he underperforms is the best time to invest more – not switch out.
    4. All the returns for mutual funds shown are AFTER fees. Any public returns shown in the paper, on the internet, or on services like Morningstar are all AFTER fees.

    The study you linked to is interesting. It showed that if you exclude the clearly unskilled fund managers, then the average of the rest beat the index Interesting.

    The writers wondered whether the skill of the average fund manager is lower than it was 20 years ago. They thought it might be because skilled mutual fund managers switched to manage hedge funds instead.

    I believe that the average fund manager is definitely less skilled than 20 years ago. The reason, however, is the rise of “closet indexers”. Twenty years ago, almost all funds had holdings completely different from the index. Today, about 1/3 of mutual funds try to just keep their holdings and/or allocation similar to the index, mainly to protect the fund manager’s job. Closet indexers obviously underperform and are probably the worst funds to invest in.

    We believe that the rise of closet indexers is the reason studies show the average fund manager is much less skilled today.

    Ed

  38. Hi Ed:
    Would you consider Wilfred Hahn an All Star Fund Manager? I’ve been looking at their offerings with some interest. http://www.hahninvest.com/
    I’d be interested in your thoughts.
    Sandy

  39. 39. Ed Rempel

    Hi Sandy,

    We prefer not to comment on specific fund managers. However, as a general comment, his strategy is an ETF allocation strategy. It is very difficult to outperform with this type of strategy.

    This is a type of “top down” strategy, where the fund manager would start by deciding on how much to allocate to each sector or country/region, and then choose the best stocks based on that. There are quite a few different top down strategies, but based on the Yale study, it seems that top down fund managers on average get about the same returns as the average fund manager.

    In general, stock pickers that find the best stocks and let that determine the allocation tend to outperform those with “top down” strategies.

    Ed

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