Accidental Portfolio Managers

A hidden migration of money managers is underway, a countless number entering the ranks of hedge funds and pensions and mutual funds. Many of these newly minted portfolio managers have no formal training and don't spend more than a few hours a week researching and implementing new ideas. Who are these brave souls? Why, none other than do-it-yourselfers who attempt to time and trade their way to superior risk-adjusted returns, often with the help of exchange-traded funds.

ETFs can be used effectively by investors to achieve a good long-term result, but those who trade too often and venture into asset classes they know little about or obtained insufficient research on are setting themselves up for disappointment. The frequent traders are not capitalizing on the low costs or tax-efficient traits of the funds. In fact, they are likely getting a worse result than most actively managed mutual funds could provide, and they are almost certainly going to underperform a more passive strategy over time.

The criticism of ETFs I hear most frequently from mutual fund boosters is that ETF investing leads to bad behavior. But just because ETFs trade intraday does not mean you should make it a daily or even weekly habit. My suggestion is to use ETFs in nearly the same way you would use a mutual fund. ETFs have not revolutionized investing concepts; they are merely changing the way in which you can gain access to asset classes.

All too often, investors who actively time their ETF trades to exploit valuation or technical views don't realize how tough it is to consistently generate excess returns. Investors who have thought about the skill hurdle involved may reason that because the top third of mutual funds beat their benchmarks over five years, all they have to do is be in the top third skillwise relative to mutual fund managers to generate excess returns (no mean feat!). However, much like poker, it's hard to tell whether an investor is good or just plain lucky with just a few trials. In fact, the markets are even more luck-driven than poker, so even fairly long performance records don't give investors a foolproof litmus test of skill.

Skill or Luck?
Several studies have attempted to grapple with the way luck confounds our attempts to divine true investing skill. Their results are not reassuring for the active do-it-yourselfers. Depending on which study you look at, estimates for the percentage of skilled managers, after controlling for their market, size, value and momentum exposures, range from less than 1% (Fama and French) to 10% (Kosowski) of all funds. That is a pretty harsh assessment. While I believe there are a few more good managers than that, these figures are sobering. Regardless of the actual percentage, the consensus among academics is that truly skilled managers are in the minority in the industry, and the skill hurdle has risen over time.

Even if we accept the high estimates of the percentage of skilled portfolio managers, do-it-yourself investors trying to gauge the skill hurdle they need to surpass must account for several biases that make money managers more likely to be skilled than average. Aside from the fact that portfolio managers tend to come from the best schools and tout advanced certifications, the fund industry picks its best analysts to become money managers and relentlessly culls underperformers from the business. Managers also have access to scarce data, such as the expertise of lawyers versed in arcane securities laws or on-the-ground analysts.

Individuals do have some advantages over portfolio managers. They don't have to worry about marketimpact costs, which allow them to pursue small opportunities. They are also free to deviate from the benchmark and underperform it for years if valuations or their strategy warrant it; an active manager pursuing the same strategy would likely be fired. Notice these advantages still require a decent amount of skill and fortitude to exploit.

Despite the high skill hurdle investors must surpass to be confident of generating alpha, many ETF investors still choose to implement a high-turnover, and often expensive, investment strategy. The problem is behavioral. People tend to overestimate their positive qualities, thinking they're smarter, better-looking, and more skilled than they really are, a phenomenon called illusory superiority. This cognitive bias traps most investors in an epistemological pit, where their self-assessments don't reflect reality. One way to avoid falling prey to illusory superiority is to anchor skill assessments to an objective measure, such as outperformance against the benchmark. But because the market is extremely noisy, it's impractical for most investors to obtain a statistically significant measure of their own skill. Even if the measured period is long enough, choosing the right benchmark� a science unto itself�compounds the difficulties of the retail investor.

The high skill hurdle for active management to pay off and the cognitive biases that trap most investors suggest that investors should take a margin-of-safety approach to active management. For us, all of our tactical decisions are done in tandem with data compiled by our equity analysts, helping us measure when our margin of safety has been reached. Make only the wagers you have the most confidence in, and don't buy nondiversified funds on a whim. And when you are sticking to the broader index ETFs, keep your own costs as low as possible, in case one's active management is useless or even harmful. Also, be extremely picky about exotic investments that venture beyond low-cost, well-diversified funds that derive their returns from fundamental cash flows, such as stocks and bonds.

So many investors feel the need to get into a fund, wait for some small gains, and move on to the next idea. This is a horrible waste of time and will likely cost you money in the long run. Conversely, if you are using the margin-of-safety approach, you will only be purchasing your best ideas at the time they present themselves. Perhaps that means you'll go a year or two without making a single trade, but when you do make a decision, you can do so with enough conviction to make it count.

Some indexing diehards have argued that investment research is useless. I think quite the opposite is true; it is more important than ever if you are going to do your own active management using indexed ETFs. The catch is that you should not be afraid to index when you don't have any ideas with a big enough margin of safety.

Even retail investors still have scope to improve their risk-adjusted returns by employing sound strategies and diversification, which both require considerable effort and understanding to implement properly. Strategies that stand a chance of earning better risk-adjusted returns include value and size tilting, along with momentum investing. Investors can also improve their portfolios by diversifying into more asset classes, such as international bonds, emergingmarkets stocks, and even alternative betas.

We investors should pay attention to the extensive literature documenting the slim odds of generating alpha. We should treat the market with respect, something not easily conquerable, and acknowledge the potential amount of luck that determines our investment results. To do otherwise is foolhardy.

This article first appeared in the May issue of Morningstar ETFInvestor.

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