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Not only did the hedge fund fee structure allow for billion-dollar payouts for successful schemes that attracted institutional investor dollars, but the unregulated field of hedge fund investing allowed for casino-like bets on various economic events using an ever-increasing array of derivatives and synthetic investments that amounted to little more than bets against another trader at an insurance company or bank backed by customer deposits and, ultimately, U.S. taxpayers.
The “heads I win, tails you lose” payout structure encouraged a level of risk-taking not seen since the late 1990’s tech bubble. The cult of invincibility led investors to invest first and ask questions later. The natural result was a man named Bernie Madoff and a ponzi scheme blustered past the “due diligence” net cast by his FINRA regulators, and numerous “fund of fund” front men, and hundreds of seemingly sophisticated wealthy investors. Even after whistleblowers alerted regulators and the media, Madoff’s commanding persona and sterling reputation sucked investors in.
How does an investor get past the media hype to make an objective analysis of a particular fund, fund manager, or portfolio management team?
First, learn a lesson from Ken Gregory, one of the nation's most experienced fund pickers. Start with the performance record, but then go beyond the track record to get the best results.
Investigate a fund's general investment philosophy to determine whether it makes sense, and whether it is appropriate to your individual investment objectives. And look at the fund's implementation history; has the fund manager invested assets consistently according to this philosophy?
Once this information is researched, dig a little deeper. Look at the fund's current portfolio characteristics. Are these securities that you would want to own today? Most investors give money to a money manager just as his strategy is peaking. He is probably sitting on a bunch of highly appreciated securities and he's starting to wonder what he'll do with the money next. A better approach is to find a great money manager whose portfolio is full of investments which are still attractively priced. Invest with these money managers before their stocks peak. To do this, the fund analyst has to look at the fund's current holdings and evaluate them relative to what is going on in the market.
Look into fund expense ratios, management stability, turnover, and various other factors. You will never find a perfect fund. No fund will score well in every area that you research. Your goal is to know the fund as well as you can, understand its strengths and weaknesses, and make an informed opinion on which risks are reasonable in light of the current market environment.
- Factor 1: Previous Performance Record (in context)
To do this, mutual fund analysts look for good long-term risk-adjusted track records versus an appropriate benchmark. Looking at a long-term period is essential. Even the small, Arkansas trust department where I once worked could string together a couple of months of solid outperformance. Fortunately, for that trust department, sometimes those random periods of outperformance happened to occur at the beginning of the year, meaning that the firm could report outstanding year-to-date performance versus the Standard & Poors 500 Index. But four consecutive months of investment outperformance isn’t noteworthy. Good short-term records can reverse themselves just as quickly. Unless the outperformance can be sustained, at least through one entire market cycle and preferably through a number of different market cycles, it doesn't mean much.
Soon after I arrived at that Arkansas bank-owned trust company, I was surprised by the perception that most employees had that the company's investment record was fairly solid, except for one gut-wrenching debacle involving a mutual fund that invested in mortgage-backed securities. In fact, the equity funds had lagged the S&P 500 Indexes by about 5% a year on an annualized basis. How did the previous investment management team manage to leave this erroneous impression? They got away with it because whenever short-term performance was good, they paraded those results for all that they were worth, even to the point of issuing news releases announcing that they had been listed as one of the nation's top money management firms, and cited their short-term record as an example.
But the rest of the time, when investment performance was in the tank, they kept quiet. Occasionally they would issue a formal excuse. "We didn't really underperform," they would tell clients, "we just took a lot less risk than the rest of the market took and - since everyone knows that risk and return go hand in hand - as a result we had slightly lower returns than everyone else. Using these two techniques, trumpeting short-term outperformance whenever it occurred and quietly excusing away the more typical period of lousy performance, this company managed to avoid criticism for a long-term track record which, at one point, put them absolutely at the bottom of the list of money managers. Yet most of the company's employees, and bank management, seemed surprised when I would mention that we had a "performance" problem.
It helped, of course, that this was in the late 1990’s, when the market itself was offering even poor investors handsome profits.
Look for good performance, not necessarily the "best" performance. The best track records will often be demonstrated by investment managers who currently have the "hot hand." They will sport fantastic short-term records, above average medium-term performance, and at least decent longer-term performance records. The fund with a "hot hand" may make an excellent investment so long as the current market environment is sustained. On the other hand, near a transition point these same managers may be loaded up with overheated (and overpriced) stocks which are ready to fall down to a more reasonable level. A good long-term record is mandatory. A “fantastic” record is not.
I remember being asked about which funds to buy, in early 2000. It was the height of the technology bubble, but the familiar challenge remained about how to pick a good fund. My advice was to avoid any stock that did well during 1999. Should an investor buy a Janus fund? Forget it. Just about the only way to outperform the market in 1999 was to own stocks that were overpriced and ripe for disaster. Flat out – a fantastic track record in that year was a sure sign of impending disaster. Off the top of my head, I can think of no funds that successfully navigated the top of the bubble and were able to protect investors after the market turned down.
Some funds, and many hedge fund managers, add risk by using financial leverage (borrowing money) to buy more securities than there is capital invested in the fund. Leverage magnifies both the losses and the gains. Still other funds may use illiquid (hard to market) issues to achieve outsized returns. When looking at fund performance, try to use "risk-adjusted" performance to enable what Ken Gregory calls an "apples to apples" comparison.
This is extremely important. If two cars look the same, feel the same, and cost the same, yet one of the cars has a tendency to roll over under certain conditions, which would you rather drive? Similarly, if two funds have demonstrated similar levels of outperformance, accomplish the same objective, and have similar expense ratios, yet one of the funds tends to fall twice as far in a bear market, isn't that something you'd want to incorporate into your fund analysis?
There are several ways to spot "riskiness" in a fund. Some people look at portfolio Beta (the fund's sensitivity to market moves up and down). Portfolio concentration is another key risk factor. A high Price/Earnings ratio on the underlying stocks in the portfolio may constitute portfolio risk, as well as concentrations in certain industries which are particularly vulnerable to the economic cycle. Financial leverage (borrowing against fund assets) boosts risk. Low cash levels may enhance fund risk, particularly if the management company does not have available lines of credit which could be drawn down in the event of a sudden surge in withdrawals from the fund.
Analysts look for good, long-term risk-adjusted performance records versus an appropriate benchmark. This benchmarking can be crucial. Another tactic that the small trust department with the dismal track record used to hide its underperformance was to play a game with rotating benchmarks. When I first arrived, they were using the NASDAQ small company Index as the benchmark for one of the portfolios. Intel and Microsoft make up a good portion of that Index, however, and when those two companies started doing well, the trust company switched to the Standard & Poors mid-cap Index. This index had been lagging, and made for better performance comparisons.
It is always easier to look good when in the company of "losers." The key to outperformance, then, is in finding the right universe with which to be compared. For the press release, the company managed to find a published universe of about 100 bank-managed pooled funds. This small, specialized group of generally mediocre funds, used during one of those rare instances of great short-term performance, made for a lovely comparison.
Know what index is most appropriate for the fund you are evaluating. If the fund manager keeps changing indexes, it might mean the manager is gaming the indexes, or that the fund's strategy or philosophy is changing. An ever changing strategy is often a bad sign, however. Moreover, don't let the fund's marketing department select the comparison period. Ask for several periods representing both short-term and long-term performance, based on calendar periods that you give them. It makes sense to request quarterly, year-to-date, 12-month, 3-year, 5-year and (if possible) 10-year trailing performance as of the most recent quarter-end. Be skeptical of other performance comparisons. They are almost certain to be biased.
If you are looking for an investment company to manage your portfolio for you, ask for composite returns presented in compliance with the standards set by the CFA Institute. These standards require the disclosure of actual net of fee performance for similar accounts. The CFA standards are designed to facilitate a full and fair presentation of the money manager's track record.
Select a benchmark appropriate for the fund being evaluated. It may be a representative index, such as the S&P 500 Index or the much broader Wilshire 5000 Index, or it may be a peer group of similar funds with the same stated objective. Track the performance regularly versus that index.
Professional analysts also look for consistent outperformance, rather than long-term outperformance which results from a few periods of incredible performance. In reviewing Martin Zweig's The Zweig Forecast newsletter, for instance, Mark Hulbert has noted that much of this newsletter's outperformance resulted from Zweig's adept handling of the market during the 1987 crash. Zweig had sold stocks prior to Black Monday and purchased an S&P 500 put option going into the crash, which soared in value when the market sold off. But if investors ignored that single incredible month's performance, and looked only at the rest of Zweig's record, the newsletter was no longer ahead of the market. Zweig's outperformance was all "bunched together" during that history making month in 1987.
Make no mistake about it, Martin Zweig still deserved credit for anticipating that crash. He is an excellent student of the market, and I would listen to his market timing advice long before most other advisors (market timing is really his strength). But when compared to another equally well performing advisor, Zweig's newsletter would be much less consistent in its ability to deliver above-average returns.
Another way to measure performance is whether the fund manager is adding to performance, or subtracting from performance, in the portfolio activity he initiates. For example, a sector fund may outperform the market because it is invested in a "hot" niche in the market, yet the fund manager may actually be making portfolio moves which have detracted from overall portfolio performance.
If computers are "hot," then a technology sector fund's outperformance ought to be expected. But if you look more closely, you will see whether the stocks sold from the portfolio really began to underperform the portfolio after being removed from the portfolio. If not, then the act of selling them created a drag on portfolio performance. Similarly, did the stocks purchased into the portfolio actually outperform the portfolio? If not, once again the activity subtracted from total returns. When the unmanaged portfolio does better than the managed portfolio, it simply means that the stocks in the portfolio at the beginning of the period, left untouched, performed better than the portfolio actually performed. The high priced portfolio manager actually reduced returns through management of his day-to-day trading activities.
At the end of 1995, that small trust department I had joined sponsored a pooled fund with one of the worst 5-year performance histories in the nation. That year had been particularly embarrassing. During a year in which the market soared 35%, that fund managed only a 21% gain. The stocks in it were so out of favor that when the new year began, and investors stopped selling them to generate tax losses, they automatically popped up when the selling pressure stopped.
At the beginning of 1996, just before these stocks started to bounce back, the fund manager sold them. Tired of their performance the previous year, he sold them in favor of buying some other stocks which were not so depressed. In spite of these sales, the fund still managed to appreciate about 6% during the month of January. For the quarter, the fund appreciated 8.4%, putting it well within the top 20% of all funds.
What would have happened had the portfolio changes not been initiated? The unmanaged portfolio would have appreciated 11.9%, instead. The portfolio moves actually cost the fund over $700,000! The unmanaged portfolio would have placed in the top 2% of all funds during that quarter. While the portfolio manager trumpeted the "abrupt about-face" he'd engineered after the previous year's "essentially abysmal" performance, his characterization of this turnaround as "not coincidentally" the result of "quality improvements made to the fund" during the quarter was completely erroneous. But only by examining the "managed" versus "unmanaged" portfolio performance could this error be known.
Another factor to consider when evaluating performance is whether or not it makes sense to invest into an "out of favor" investment philosophy or style. What has happened for years, decades in fact (and probably for centuries) is that money flows to the hot hand, just at the time when it should probably be going the other direction. Pension consultants know that the best time to fire a money manager is when they have outperformed for a significant period of time. But clients never want to fire money managers at that point. Clients are in love with the money manager that has helped them beat the market.
Clients do want to fire all of the money managers which are underperforming the market, even the good ones. Instead, experienced pension consultants know that hiring a good manager when his performance is less than stellar is often the wise move. Investment cycles change. Favored investment styles change. These changes most often hurt the manager with the hot hand, and help boost the good money manager who is currently in a slump.
Picking a fund manager requires the same larger vision. Even great money managers experience slumps, during which time their long-term records falls toward the mediocre category. All managers who are at the top of their form eventually rotate out of the favored seat and into a less advantageous position. I am less likely now to be "reflexively contrarian" than I would have been fifteen years ago. With mutual fund money flows heavily favoring whoever has the best short-term record, sometimes the hot hand can stay hot for an extended period of time. Marty Zweig often reminds us that "you can't fight the tape." Getting in the way of a trend is usually about as satisfying as getting in the way of a freight train.
Finally, when evaluating a fund's previous track record, the reasons for the performance need to make sense. Did the fund outperform for reasons which could reasonably be repeated in the future? Did a fund underperform for reasons that are temporary in nature and likely to reverse direction in the near future?
It is difficult to evaluate where the performance came from, and what it means to you, without having a broad understanding of what's going on in the market, and a well defined objective for each fund incorporated into your asset allocation model.
Examining the basis for the fund's performance makes sense for many different reasons. The portfolio manager who sold his underperforming stocks at just the wrong time did not outperform for the reasons he cited. This calls into question not only the manager's ability to understand his own fund performance, but also his credibility in communicating fund philosophy and future progress updates. There is a difference between putting a good face on a bad situation, and misrepresenting the situation. When that line is crossed, investors should look elsewhere for their money management expertise.
Examining previous performance, in context, is just the first step. Investors should also look at a fund's general investment philosophy, which helps investors know whether the fund is suitable for their own unique investment objective. Even great funds are not great for everyone. A finely crafted Mercedes Benz may be the perfect (albeit expensive) car for many people, but it may be a lousy choice for the weekend boater looking for a vehicle to pull his boat through scrub oak with a camper on top. Similarly, funds must be matched to investor objectives. Without knowing an investor's objective, no professional should be recommending particular funds. Finding good funds is only half the battle. Matching them to the appropriate investor need is the other half.
Next post: Factor 2: General Investments Philosophy (Not yet posted.)
To start at the beginning of the Investment Heresies eBook, click here
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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