The Investment Contest You'll Never See

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.

Perhaps the most important part of this contest-that-will-never-happen would be its truly long-term nature. No results would be published quarterly or annually. So no one would feel pressure to pick up performance because he's lagging, or to avoid a troubled sector because it might hurt that year's ranking. Managers wouldn't be distracted by the content of competitors' portfolios, either, because they wouldn't see them. They would just make decisions based on their best judgment, and in 10 or 20 years we'd see the results.

Fund Managers Gone Wild?
You might think I'm saying, hey, let these gunslingers loose. Let them show us what they can do with the rapid trading and crazy allocation shifts that their staid bosses currently prohibit. But that's not the point at all.

A slice of managers would no doubt use the freedom from constraints to indulge their hedge-fund-superstar fantasies. Good for them. But others would almost certainly go in the opposite direction. Freed from close supervision and second-guessing, they might become less-active than they are now. For example, some managers might assemble a small portfolio of dominant companies and just sit on it for years. Others might raise a big cash cushion whenever a rally runs too far for their tastes. 

Meanwhile, if managers don't like stocks in a particular sector, they could avoid all of them, rather than thinking they need to own a few to avoid straying too far from the index weighting.

In the end, we would see which managers were the more talented long-term investors--a separate issue from whether or not a particular fund they happen to be running is an appealing choice.

The Point of Pretend
If you are as interested in investing as most of our readers are, the very idea of this contest will be intriguing. But since it won't happen, what's the point of bringing it up? Because putting things in this perspective highlights just how restricted many managers are--by their funds' mandates, by their supervisors, by the endless short-term performance scoreboards and the pressures those create.

It also helps illuminate a point not always recognized. When Morningstar fund analysts evaluate a fund, we evaluate the entire fund--its structure, its costs, its family, as well as its manager. With rare exceptions, we are not delivering a judgment purely on the manager's ability as a investor. We evaluate the fund as a whole package, for that's the choice available to the average investor.

Perhaps this exercise also will induce some of you to reconsider your commitment--if you have one--to funds with overly restrictive mandates. Yes, you might feel the need to exert a lot of control over your asset allocation. That's understandable. Even so, you could consider owning one or two managers with more leeway to follow their instincts. Not necessarily an extreme do-anything fund, either--just one that's not as hemmed in by restrictions as many are today. 

Canny, patient managers will use that freedom to their advantage. Stick with them for the long run and make it work to your advantage, as well.