The Cult of the Portfolio Manager

The Stars Arise The cult of the mutual fund portfolio manager began during the 1960s, to ill effect. "Performance managers" who owned the "glamor stocks" of "go-go companies" thrashed the major stock indexes, attracted large inflows and glowing press reports, and then smacked into a six-year wall. Happily, after encountering that wall, their funds would not pay capital gains taxes for many years to come. Unhappily, that was because those funds had realized massive net losses and there weren't many remaining shareholders to deplete their tax benefits.

The cult behaved better upon its return, during the bull market of the 1980s. This next generation of mutual fund heroes, by and large, invested more soberly than its predecessors. Vanguard's John Neff was conservative by any standard, favoring the cheapest of blue chips. But even the growth-stock stars, such as Fidelity's Peter Lynch or Acorn's Ralph Wanger, knew how to survive bear markets. Unlike the go-go managers, the 1980s' breed of mutual fund superstar retained most shareholders during the downturns.

With apologies to Jack Bogle, I can even be persuaded that the 1980s cult was a positive thing. Star managers attracted some investors who otherwise would not have purchased stock funds (back then, as opposed to now, famous managers inevitably held equities). Good timing, given that stocks rose almost uninterruptedly for two decades. For those who switched from holding stocks directly to receiving professional management, that decision worked out well, too. In most cases, the leading funds outperformed the portfolios of do-it-yourself stock investors.

So, there wasn't much to dislike. To be sure, the publicity machine was distasteful, particularly to the portfolio managers themselves. (Rare is the skilled investment professional who enjoys giving a marketing spiel.) But the ends justified the means. Would mutual funds have attracted as many assets had the cult never developed? Perhaps. We can't know the answer to that counterfactual question, but we do know the benefits that accrued from what actually occurred.

(Unlike with the 1960s, the major damage inflicted by mutual funds on shareholders during the 1980s came not from the personality-laden funds but from the faceless long government bond portfolios. Almost instantly upon their creation, such funds commanded billions of dollars, contributed by investors who were attracted to the funds' high yields and apparent government guarantees. Those shareholders quickly learned about interest-rate risk.)

Unlike today, the biggest actively run stock funds of the 1980s and early 1990s often beat the S&P 500. The stock market was less efficient back then, because investment professionals accounted for a smaller percentage of the trades. Also, compliance regulations were less strict, thereby permitting portfolio managers to receive "guidance" from corporate managers that retail investors did not hear. Better training and better information--it would have been a surprise had the top professionals not excelled.

It's a New Day Then things changed, as professional investment managers gradually lost much of their competitive advantage. Although they still possess training that few can match, and the support of their research departments, fund managers now must compete against others who are similarly armed. Taking candy from the individual-investor baby was one task; removing it from the clutches of another professional manager is quite another. With corporate guidance being severely curtailed, it's difficult for even the brightest of fund managers to triumph routinely.

In addition, the needs of the mutual fund shareholder have evolved.

Thirty years ago, people mostly purchased their mutual funds from financial advisors, who were paid to monitor those investments, or they bought the funds directly rather than purchasing individual stocks, in which case the investor was already prepared to do some work. It's easier to track the results of a single fund manager than to oversee a portfolio of stocks. Thus, even with the task of keeping abreast of the star manager, idiosyncratically managed funds were easier to own than many alternatives. They met the needs of 1980s' investors.

The Long View New Millennium shareholders face a somewhat different situation. Increasingly, mutual fund monies reside in 401(k) plans, hosted by plan sponsors who are quite aware of their legal liabilities. Dozens of lawsuits have already been filed against companies for allegedly failing in their fiduciary duties, and dozens more are being contemplated. With 401(k)s, there is no such things as a pleasant surprise. Nor, really, should there be. The 401(k) investor commits for decades. That shareholder is best served by a fund that can be bought and then ignored.

The same largely holds true for IRA accounts. Because of their relatively small size, most IRAs are either completely self-directed or only lightly advised. At the date of retirement, the IRA account might be rolled over into an advisory account, in which case the task of tracking star managers becomes acceptable. But until that point, the characteristics of the ideal IRA fund will closely match those of 401(k) funds: cheap, diversified, and utterly without eccentricity.

Vanilla Is the New Black Which leads to the House That Jack Built. Whether through its better-known index funds, or through its still-substantial actively managed coterie, Vanguard is the place where personalities go to die. The index funds, naturally, were built to be maintained rather than steered. But a similar mindset underlies the active funds. They generally have multiple managers, owning hundreds of positions, and don't stray far from their benchmarks. They, too, are made to file and forget.

The rest of the major fund companies, from exchange-traded fund providers BlackRock and State Street to the mutual fund behemoths Fidelity, T. Rowe Price, and American Funds, have long since followed the same path. (Indeed, American Funds was there before anybody.) Individuality is out, and conformity is in. Today's fund industry, to use my colleague Don Phillips' words, is a "processing" business. (Don pilfered that term from somebody else, whose name I will withhold to protect the guilty.)

No complaints from me. Thirty years ago, I fervently believed that informed investors were best served by buying funds run by star portfolio managers rather than their effective but bland competitors. Today, I would counsel the opposite. To be sure, there are exceptions to that general rule, particularly for those investors (or their advisors) who enjoy the thrill of the chase, but there's no doubt the game has changed. The times are different. The conditions are different. Thus, the outcome is different.

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.