Increasing the Odds

Written By Pratyush Rastogi

77% year-to-date[1]. That’s what one of the hedge funds we invested in (both personal and client money) has returned to us. This is in a year where markets tanked by dozens of percentage points just in a few weeks, where viruses ravaged the world, and most economies ground to a standstill. During this time, the S&P 500 has dropped ~7.0% and the MSCI All World index is down 9%, which implies the fund has outperformed by 84% and 86% respectively. Most people would see a return like that and instantly jump in, and those already invested would pat themselves on the back for having the genius and foresight for investing in such a fund. While we’re happy about the returns so far, we have tempered expectations about the future.

Why? Because we know that past performance is no guarantee of future results.

Does that statement sound familiar to you? It should, you’ve probably heard it dozens of times as it’s often printed on fund documentation, emails sent to you by your banker, and it’s just general parlance when talking about asset returns. However, we’ve found that when it comes to funds, people completely ignore this statement, and the first thing they look at is how the fund performed most recently. If that performance is extremely positive, investors quickly flip the statement on its head and think “past performance is a guarantee of future results” and will find themselves wrong 96% of the time[2].

Now one might ask why are we even bothering writing this? After all, don’t 92% of funds fail to outperform the benchmark anyway[3]? While this is true, especially for the last decade, we do think the future will look quite different from the past. And while the odds could still be poor we do think the ‘stock pickers’ market of the 2000’s (when the market was generally flat for the decade) could return in a post-corona world where there will be clear winners and losers. So while we’re going to write more about passive versus active funds going forward, suffice it to say we do recommend our clients have some active funds as part of their portfolio.

But we digress. Circling back, if past performance is no way to pick a fund – you may ask instead what should you look for? Well, to answer that question you need to ask yourself why would one invest in a fund in the first place? The answer is simple - because you think the fund will give you better returns than you can generate yourself or that the market can generate for you (via an index ETF). So then the next question becomes: How do you pick an outperforming fund?

The answer to this question is not as simple . There is no easy way to do this. In fact, you really don’t know if you’ve invested in an outperforming fund until you’ve spent several years in it. The reason for this is because a fund is only deemed an ‘outperformer’ after it has outperformed for several years (so you can’t know beforehand that it is an ‘outperformer’) and outperforming funds may not continue to outperform as time goes on (see the paragraph above). So really what discerning investors need to do, and really the only thing to do, is increase their odds of investing in an outperforming fund.

Below, we’ll give you a few tips that you can use to identify such a fund, but do note that all this will do is increase your odds of finding an outperforming fund, there is no guarantee that the fund will outperform. To caveat there are outperforming funds that may not fit all/any of the below criteria and the above criteria doesn’t really apply for quant funds (which operate quite differently than human-managed funds).

1)      Understand and Believe in the Strategy

The first part of this is obvious. You need to clearly understand the fund’s strategy and be able to explain that strategy to a 5 year old (if you can’t you don’t understand it – and are at risk of getting Madoff-ed). If it’s a long only – how will they react during market downturns? If its long/short – what makes them go long an asset and what makes them short an asset. If they make use of derivatives, how do they stop permanent capital loss or worse, catastrophic loss? Now the purpose of understanding is twofold: 1) Do you think they will make money? And 2) Do you notice style drift. This is where strategies change due to pressure from the market/investors. Style drift is very dangerous to outperformance, as it causes fund managers to move toward the most ‘acceptable’ investments, and this is a great recipe for mediocrity. A fund manager who picks based on pressure from the market or investors might save their job, (as the old saying goes, “No one gets fired for buying IBM”), but they won’t save you from underperformance. (Hint: to notice style drift, read everything the manager has ever written).

Understanding a strategy is not enough however. You must also believe in it. If you don’t believe that the strategy will work, or you lose that faith, you will never stick with the fund during the bad times. And rest assured, bad times will come. In fact in a study done of money managers from 2000 to 2010, for the managers with top quartile performance over this ten-year period, 97% spent at least three years in the bottom half of performance[4]. The lack of faith in the strategy is what causes investors to move in/out of funds at precisely the wrong times.

2)      Know the Fund Manager

It’s important – whenever possible, to speak to the fund manager, and get a sense of who they are and what makes them tick. Typically we do this over many months and multiple conversations. Frankly, good fund managers will also want to speak to you. They’ll want to know what your experience is and if you are a fit for their style, if not, it’s going to be uncomfortable when things do not go as expected. Even if you can’t meet the fund manager, there is a lot of research you can do on the internet or by talking to other investors in the fund.

It’s also important to understand what the fund manager’s motivations are. There are tell-tale signs for this. If they drive around in the latest Ferrari and own many apartments, and when you meet them take you to fancy dinners, this might be an indication that money is more important to them than the pursuit of investing excellence. Further if they spend more time marketing the fund than working on their investment theses and fundamental research, then it might be a sign that they’re focused on gathering AUMs. Lastly, if they don’t have a bulk of their personal net worth invested alongside the investors, alarm bells should ring. 

What you really want to figure out is if it’s more important for the fund manager to be a great investor or to be a rich investor, and no, they are not explicitly linked. A great investor should over time become a rich investor, but there is no telling if a rich investor was also a great investor.

3)      Expenses and Fees

Expenses are quite straightforward: the lower, the better. Fees are a little more complex, obviously the lower the better, but it’s also important to understand how they are structured. Often we find funds which have a performance fee but no high-watermark (which implies that even though you, the investor, could be losing money, the fund will still take its performance fee). Or even if there is a watermark, there is no hurdle rate, which implies that even if the fund woefully underperforms the benchmark, the manager still gets to capture a performance fee.

What you’re looking for here is alignment. No one is against fund managers making money, as long as they do an outperforming job. And no matter what, most of the profits should go to the investor, not to the fund manager.

4)      Concentration/Conviction

While we are data-ignorant (i.e. we haven’t seen data to prove this one way or the other) on the number of positions a fund should have, we do strongly believe that there should be evidence of conviction. Typically conviction is shown by having at least a few stocks that are greater than 4-5% of the portfolio (concentrated positions). People used to joke that Peter Lynch “never found a stock he didn’t like,” and he used to have hundreds of stocks in his portfolio, but when he thought he had a multi-bagger on his hands he would add to the position so it became significantly larger than the average position in the portfolio.

Without conviction we don’t really see the point of giving our money to an active fund manager. If we wanted diversification we would simply invest in a broad-index ETF[5]. Further data does show that concentrated funds (where the top 10 positions make up more than 40% of the portfolio) outperform[6]. Now, we do get into arguments here about ‘risk management’, ‘allocation limits’ etc. However we believe that these concepts are overemphasized in modern finance, and are really focused on keeping losses low (i.e. portfolio managers keeping their job) rather than making outsized returns. Let’s put it this way, if you invested in a fund and didn’t look at it again for 10 years, you really wouldn’t care about its volatility if as long as it gave you above-benchmark returns during that time (which is precisely why private equity/venture capital is so popular!). If you believe volatility is more of an opportunity than a risk like we do, then you won’t worry too much about modern risk-management. In any case, if we find a fund manager who doesn’t use leverage and doesn’t invest in companies that are leveraged, then most of the risk management is naturally taken care of. 

5)      Size

While there are plenty of multi-billion dollar funds that put up good returns, data does show that returns and fund size tend to be negatively correlated[7]. We don’t even have to look at the data to see why this is true. Let’s take a fund that is $10 billion in size. If it has say 25 positions, each position would roughly be $400 million. Now let’s say the fund does not want to hold more than 10% of any one company because of accounting/compliance/regulation, then the minimum size of a company they can invest in is $4 billion. This essentially makes the small-cap space (where growth rates tend to be higher) un-investable for the fund.

Now one might argue that the fund could simply invest in more positions than the 25, but then we get into the concentration issue we mentioned above. A real world example of this is Berkshire Hathaway (not really a fund, but you get the point). Investors have very moderate expectations of Berkshire’s returns, not because of Warren Buffet’s skill (although that has been questioned lately), but because Berkshire is just too large to be able to be as nimble as it was in the past.

Thus, typically we like to focus on funds smaller than $1 billion, but we have invested in funds with as much as $6-8 billion where concentration and conviction has been strong.

6)      Past Returns

Wait, what? You just said don’t focus on past returns!! Yes we did, but what we mean is that you shouldn’t solely focus on it nor should it be the first thing you look at it. But certainly, past performance should be incorporated as part of your analysis. Ideally, you want to see if a fund has or is going to have the ability to outperform the benchmark by at least 5.00% annualized (an idea pushed by Benjamin Graham), otherwise it may not really be worth your time/effort/emotions.

What we said is true, just because the fund has not outperformed in the past, doesn’t mean it won’t and fund’s that have cannot guarantee that they will continue to do so. So knowing this, we try to take a look at the returns, splice the data, and ask ourselves a couple key questions; Were there 1 or 2 years that drove the out/underperformance? If they have been outperforming in aggregate, is the fund continuing to do so or is most of the outperformance in the past? If they have been marginally underperforming, is there something about the strategy that’s going to cause the fund to outperform going forward? Extremes are also important. If a fund has been underperforming severely for several years, perhaps it’s an indication that their strategy is really not working.

Just to drive this point home: The fund we mentioned in the introduction of this article was actually marginally underperforming the S&P 500 when we invested, and our clients questioned us on this. However, by really breaking down the returns, we saw the underperformance was driven by a 3-4 month period where an exogenous shock occurred, and that the market had more or less priced that in going forward.

In Conclusion:

While there are no guarantees of investing in an outperforming fund, we do think there are ways of increasing your odds of doing so. We hope the above helps you think through which funds to invest in and which ones to leave alone. We wish you all the best. Happy Investing!

Pratyush Rastogi
Previous

Buyer Beware
Next

Tackling Hot Topics