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The Investment Contest You'll Never See

How good is that manager, really?

Gregg Wolper, 08/18/2009

This is a column about an idea that will never happen.

First, some background. Two weeks ago, I examined why one of the Longleaf Partners funds is lagging this year while its siblings are flying high. Naturally, last year--when the flagship fund, Longleaf Partners LLPFX, had an abysmal showing--also came up for discussion.

One potential explanation never entered the picture: Restrictions on the managers imposed by the funds' mandates, or by the managers' bosses. Unusually in the mutual fund world, those funds have very few limitations. For better or worse--and usually it's for the better--the Longleaf managers can do whatever they want with their portfolios. They must comply with the legal guidelines of a very broad prospectus, but other than that, the funds's returns reflect the managers' decisions, pure and simple. (Along with, of course, the funds' expenses.)

That's quite a contrast with most mutual funds. Large fund conglomerates, in particular, impose a number of restrictions on their managers, mainly because so many of their funds are devoted to a specific style. Straying from that mandate would put the fund in competition with a different fund from the same company. Moreover, such funds are sold on the premise that they won't stray, and shareholders who like that sort of thing might rebel if their managers get too adventurous.

As a result, in most cases it can be very difficult to determine just how skilled a manager truly is. We can measure the manager's capacity to meet a specifically defined goal such as beating a certain index or similarly constrained peers, but a sense of his or her overall investment ability remains elusive. If the manager of such a fund underperforms, it often can be excused by the fact that he didn't have the choice to own small caps, or foreign stocks, or corporate bonds. Perhaps if he did, the fund might have performed far better. Unfortunately, we'll never know.

The Contest
The restrictions faced by most managers can seriously narrow their choices. Few foreign-stock funds can buy companies based in the United States. Maybe one or two such stocks at most. Even world-stock funds (also called global funds) often have set targets for their U.S. and foreign weightings; they don't simply let the manager invest wherever he finds the best opportunities at a particular time. In addition, many foreign and global funds can invest only a small amount of their assets in emerging markets.

Meanwhile, many domestic-stock funds do invest a decent amount of assets in foreign stocks. But they face other restrictions. Market-cap limitations are common. (Part of that limitation comes from SEC rules.) Most domestic-stock managers are also instructed to stay fully invested; no cash piles allowed. And unless a fund is specifically identified as being "focused," many managers would run into strong resistance from their superiors if they decided to have just 20 stocks in their portfolios.

All these factors explain why it's often not clear how much blame--or credit--can be laid at the feet of the manager. In order to learn the answer, I propose a contest. I'd like to see all equity managers have a separate pile of money to run, privately, with very few restrictions. (Maybe they must be long-only, just to keep things close to a regular mutual fund. But that's about it for the rules.) No need to invest everything if they don't want to. No reason they can't add some bonds to the mix.

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