When Good Funds Go Bad

Mysterious Ways Tim Harford, a Financial Times columnist, wondered "Why Brilliant People Lose Their Touch." He maintains, at least for mutual funds, that the question cannot be answered. "Perhaps [the manager] has lost his touch, perhaps the world has changed, or perhaps he has simply been unlucky. It would be nice to know which, but in such matters the world does not always satisfy our curiosity."

Having looted Harford's topic, I will do likewise with his conclusion. He is mostly correct. The sample size of consistently successful mutual fund managers is too small, and the factors affecting their funds too large, to permit comfortable conclusions. However, I do think we can assess several commonly cited causes. In rising order of probability, they are:

Blood, Sweat, and Toil Back in the day, Fidelity Magellan's FMAGX Peter Lynch maintained that the difference between extraordinary and ordinary fund managers owed to work rate. He boasted of how he spent his Saturdays in the office, while his competitors played golf. (How ironic, then, that on Oct. 19, 1987--Black Monday--Magellan's frantic staffers tracked down Lynch on an Irish golf course.) By his telling, investment management rewards the virtuous. Extra hours lead to extra gains.

For Lynch, the homily might have held. He ran a huge, oft-traded portfolio that required extensive oversight. (When I visited his office, it appeared to have been struck by high winds, with hundreds of company reports strewn across his desk and multiple chairs.) When Lynch retired, he cited exhaustion as his main reason. But most investment strategies require far less effort than did Lynch's fund. His approach demanded high effort; but other potentially lucrative strategies did not.

The other reason besides exhaustion that work rate might slide is complacency. That would seem unlikely. After all, the same explanation is not generally applied to CEOs, who are usually wealthy before ever reaching their positions, and who--according to most corporate boards--perform better the more they are paid. Complacency also fails to predict professional athletes' results. For example, each of this year's NBA Most Valuable Player finalists has an annual salary that exceeds $20 million. The list contained no lean and hungry newcomers.

Thus, that a fund declines because its portfolio manager no longer works as hard is possible, but I think unlikely.

Youth's Rewards? Another possibility is that investment management is for the young. Some endeavors indisputably are. In chess, only one world champion since 1963 (male or female) has been over the age of 40. Mathematics operates similarly. (My mother once dated the head of a major university's math department, who gloomily told her that his research consisted of glosses on his Ph.D. dissertation.) In such fields, one would expect early victories to be followed by later defeats.

That pattern likely describes pockets of investment management--strategies that are highly quantitative and/or that require puzzle-solving abilities. In such cases, the mental ability associated with youth might trump the experience that accrues to age. Few mutual funds are so managed, however. The vast majority are headed by generalists, who conduct fundamental analyses by blending basic math with qualitative assessments. Such skills erode only slowly over time, if at all.

Successful day traders tend to be young, as well as the managers of some varieties of hedge funds. The age effect, however, looks to be minimal with registered mutual funds.

Battle of the Bulge A popular complaint is that successful funds become too big. Their strong returns attract a flood of assets--which, of course, was always the hope of the sponsoring fund company--that forces their portfolio managers to change their ways. They must hold more securities, and/or purchase those issued by larger entities, and/or trade less frequently. In all cases, the fund no longer follows its original investment strategy. It stands to reason, therefore, that its performance will fade.

I am less convinced by this argument than most. Too many giant mutual funds have prospered after skeptics bemoaned their bloat. For more than a decade, PIMCO Total Return PTTRX posted top relative returns while being the nation's largest bond fund. Similarly, for several years after being denounced for their size, Fidelity Low-Priced Stock FLPSX, several of American Funds' major equity funds, and (back in the day) Lynch's Fidelity Magellan continued to best the competition.

The claim is not without merit. There are times when funds become overly large, particularly if they invest in less-liquid securities, or if they trade aggressively. I do not dispute the size effect; it is no mirage. It does not, however, explain most instances in which a good fund goes bad--or even a large minority of such cases.

Moving On The great leveler, I believe, is time. The financial markets that greet the aspiring portfolio manager are not the same as those that hasten his demise. Along the way, something changed, thereby undermining the major reason for the fund's success. That something may be as simple as an industry's performance--from the mid-1980s though the mid-aughts, financial stocks powered most top-returning U.S. equity funds--or as complex as a proprietary valuation model.

Either way, the manager's initial competitive advantage disappeared. Perhaps that edge came from genuine insight. The rising investment manager saw something that escaped most of his elders and profited from the knowledge. Perhaps it owed solely to luck. How the manager chose to invest was well suited for the times, until it was not well suited. As Harford writes, it is very difficult to distinguish between the two cases from the outside.

Perhaps, though, that does not matter. Perhaps the central lesson is that most portfolio managers--Warren Buffett being an obvious exception--do not reinvent themselves. Over time, they adjust and tinker, but they do not alter their essential investment characteristics. They are who they will become.

If that is so--and I believe it is--then investors who hold actively managed funds that once prospered but now struggle should not wonder when management will "regain its touch." Instead, the question should be, "Will the markets soon revert to their previous ways, or will the current conditions persist?" Because ultimately, it is likelier that the markets will find the mutual fund manager, than the manager will find the markets.

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.