How Not to Report to Fund Shareholders

Faking It, Hollywood Style Hollywood's moguls belong to a club that we wish to join, but never can. Is that because they have special abilities? No, said screenwriter William Goldman, who was a full-fledged club member himself, having collected two Academy Awards for his work on Butch Cassidy and the Sundance Kid and All the President's Men. The moguls certainly are convincing. They look the part, dress the part, and act the part. But, in truth, "nobody knows anything."

Goldman had his tongue partly in cheek--but only partly. Hollywood is indeed a place where impressions can suffice, because it’s a land of small sample sizes and hard-to-explain results. A director works on six films, two of which become surprise hits. Why did those two films sell? What, if anything, would have changed with their fortunes had somebody else directed? The first question is difficult to answer, and the second is impossible. Without other knowledge, the director’s version of the truth takes hold. He becomes the talk of the town.

If this isn’t beginning to sound familiar, it should. As measured by calendar years--the normal way of evaluating investments--portfolio managers are also judged on small sample sizes ... also with outcomes that are difficult to evaluate. The former needs no explanation; in the mutual fund business, a manager who has collected five data points is fairly well proven, and one with two hands’ worth of evidence is a grizzled veteran. As for the latter, it’s an easy task to measure performance and to test whether a fund succeeded or failed, but it is difficult indeed to determine why.

Well, sometimes we do. It would have been easy to score a fund that swapped banks for defensive stocks in summer 2008 because its manager believed that the financial crisis would deepen. (Unfortunately, there weren’t many such funds; predicting the economy ahead of time is simple enough in hindsight, but not in real time.) So, too, would have been a fund that retreated to cash in early 2009 because its manager feared a second straight bear market.

But most of the time, the underlying causes are difficult to decipher, which leaves the portfolio manager in charge of the explanation. If the fund performed well, it was because he correctly anticipated events. If the fund lagged, the reason was unforeseen circumstances. Quantitative easing caused stocks to move in tandem, thereby reducing the opportunities for active management. Index funds disrupted market valuations. The fund manager got it right--but the rest of the marketplace got it wrong.

Faking It, Investment Style AQR chief Cliff Asness has heard quite enough. In "Hedge Funds Search for Their Real Killers," Asness emulates Goldman in confessing about his industry's ignorance. According to Asness, too many rival investment managers "blame others for their problems" by claiming that the financial markets are broken. Such claims are false, writes Asness, because those managers are only guessing about a reality that they do not know:

In no particular order, many hedge fund managers have publicly blamed quants, indexing, algorithmic trading, ETFs, high frequency, and sometimes “risk parity” for their travails. This casting of blame is almost always bereft of specific logical (or god forbid numeric) explanation linking how these [items] … have kept hedge fund geniuses down for so long. I’d sooner take on proving hedgies aren’t suffering the ill effects of the Town of Greenwich Connecticut adding more fluoride to its water … than fight such random non-specific (but strongly worded and serious!) accusations.

I concur, fully. Unfortunately for those who wish to make such cases, the financial marketplace is not a controlled experiment. One can’t hold all things constant, change a single variable, and then measure the difference. In real life, many major trends occurred at once. Stock market indexes grew as strategic-beta funds attracted assets, as foreign investors increased their position in U.S. securities, and as the Federal Reserve conducted quantitative easing. Those effects (and many more) cannot be separated. Guesses about which factors had what effect on U.S. stocks are just that--guesses.

It’s understandable that we take fund managers at their word when they write about broad investment topics. They live the part; we do not. Also, their discussions address important subjects that others do not touch (for example, the potential market distortions caused by today’s very low short-term interest rates). However, as with Goldman’s Hollywood executives, when they assume such tasks, investment managers overstate their abilities. They do not, and cannot, know.

You needn't take my word (or Asness') about this. Consider the proof by contradiction. Let's assume that the effects of broad financial-market trends can be understood. Bright professional investors who have the right connections can figure out how algorithmic investors are pushing stock prices or how they can profit from index funds' trades. So ... where are these people? Where are the winning funds? We know that they are not mutual fund managers. Per Asness, neither are they hedge fund managers. I would submit--they are nobody. They are a myth.

Just the Facts, Ma'am This column isn't to disparage all investment-manager explanations for a fund's underperformance. Quite the contrary. Although outside parties such as Morningstar can learn a great deal by comparing a fund's holdings against those of its benchmark and noting its winners and losers, they can't get inside management's head. They can't know why the decisions were made. Such information is critical for understanding a fund's performance.

For example, consider a fund loaded with value stocks lagging during a market when growth-style companies shone. Did that positioning occur because the manager made a so-called “style bet,” seeking to hold value stocks because, in the manager’s view, that style would soon shine? Or did that style bet occur accidentally, as a byproduct of trades that were made for other reasons? The answers are eminently knowable, and they are also instructive.

Fund-manager communications are best suited for the middle road. Portfolio managers can and should run conventional attribution analysis, to determine the factors behind a fund’s results. Also, if they have learned something from the recent period that might alter how they manage the fund in the future, that information is worth sharing. However, that is as far as things should go. Hollywood magnates are paid to deceive; investment managers are not.

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.