The Toughest Investment Task

Steep Odds
All right, perhaps that is an exaggeration. There surely must be a more difficult investment task than finding an active U.S. stock fund manager who is likely to outperform the stock market indexes over the next decade, after expenses.

I don't happen to know what that is, however. Whether academic studies, industry research, or Morningstar's Fund Manager of the Year selections, all results point to the difficulty of identifying consistently successful U.S. stock managers. The academic findings have been pessimistic, industry studies have echoed that note, and, while Morningstar's International-Stock Fund Managers of the Year have mostly gone on to great things and Morningstar's Fixed-Income Fund Managers of the Year on to good things, Morningstar's Domestic-Stock Fund Managers of the Year have looked distinctly ordinary after the fact.

The news isn't improving. Three Oxford University professors have released a study on the performance of pension-fund consultants when selecting active U.S. stock fund managers. Their conclusion: "We find that consultants' recommendations of funds ... have a very significant effect on fund flows, but we find no evidence that these recommendations add value to plan sponsors."

This isn't a conclusive finding. It uses only 13 years' worth of data, and it makes assumptions in translating consultants' recommendations into buy/not buy signals. The database of consultants' recommendations is self-reported, meaning that it is subject to various biases. Also, the sample size is small. Although the study tracks the seemingly large number of 1,500 fund recommendations each year, these come from an average of only 29 consultants. (Then again, there aren't many pension-fund consultants in the first place. The authors state that the consultants in the study "had a 91% share of the consulting market"--a vague statement, but nonetheless a sign that the findings are reasonably representative of that marketplace.)

Within that context, though, the professors did a thorough job. They examined each fund's results in three ways: 1) against individual style benchmarks (for example, Russell 1000 Growth), 2) against the Fama-French three-factor model that takes under consideration market, size, and value/growth performance, and 3) against the Carhart four-factor model that adds a momentum factor to the Fama-French calculation. They conducted these calculations on both an equal-weighted basis, wherein all funds counted the same regardless of asset size, and on an asset-weighted basis (which they term "value-weighted"). They then compared the aggregate results of the recommended funds to the aggregate results of the nonrecommended funds.

The showing was dismal on the equal-weighted basis. No matter which of the three performance measures was used, the single-style benchmark, the three-factor Fama-French, or the four-factor Carhart, the recommended funds lagged the nonrecommended funds. This held true for all seven investment styles (large-cap growth, large-cap value, mid-cap growth, mid-cap value, small-cap growth, small-cap value, and core). The typical underperformance was from 50 to 100 basis points per year. Most of these results were not statistically significant--but the direction was always wrong.

On the asset-weighted basis, the consultants fared better but not well enough to celebrate. Their results were positive for five of the seven investment styles according to all three models and were statistically significant (at the 1% level) for the three- and four-factor models with mid-cap growth funds. However, aside from mid-cap growth and small-cap growth funds, the margin of victory when it existed was very small.

The asset-weighted basis seems to me the fairest way of viewing the matter. When asked to select among the larger, better-known U.S. stock fund managers, the pension-fund consultants didn't cause harm. Their selections weren't worse than throwing darts (and were better with the two growth styles). The consultants were less successful as measured by the equal-weighted method because they tended to recommend the bigger fund managers, who tended to lag their smaller, less-known competitors.

In essence, then, the pension-fund consultants erred by favoring the larger managers but neither erred nor shone when selecting among those larger managers.

Perhaps the consultants were too tied to the past in making their recommendations. Perhaps there is a straightforward way to improve selections by paying less attention to past performance and more to other factors. Unfortunately, write the professors, the consultants seem already to have taken that step. Per the professors, there wasn't a strong correlation between a fund's previous returns and its recommended status. The consultants, they write, appear to have been taking into consideration various "soft factors." Just not with much success.

Of course, hidden among the averages were better showings by some consultants (the professors didn't have access to the individual data, only to the aggregated recommendations) and worse by others. It's possible that those above-average consultants could continue to thrive. I suspect that their results were an accident of the time period, such that the winners would descend in the future and the losers ascend, but that remains to be tested. This study, as I wrote earlier, is not the final word. 

It's good enough for me, though. By now, the chain of skeptical evidence has grown pretty long.  Sequoia (SEQUX), various offerings from American Funds, and  Berkshire Hathaway (BRK.B) (which I think of these days as being a flavor of closed-end fund) are decent bets to outgain the Wilshire 5000 for the next 10 to 20 years. After that? Tough to say. I'm glad that I'm not on the team that assigns Morningstar Analyst Ratings to U.S. stock funds. Writing columns seems much the easier task.

The Revolution Starts Here
In response to my column on Ranking Smart Betas, fundamental-investing pioneer Rob Arnott writes, "I've long thought that the 'risk premium' is better thought of as a 'fear premium.' [Investors] should be rewarded for a willingness to accept discomfort, even fear. We should garner diminished rewards for an insistence on comfort."

Agreed. However, I think "dislike premium" is a better, broader term than "fear premium." As Arnott seconded that notion, that now makes two people campaigning to change the standard investment nomenclature from "risk premium" to "dislike premium." Do join us. We'd like the company. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.