A single good call won't cut it--it takes a succession of prescient decisions.
By Jeffrey Ptak, CFA | 01-02-16 | 06:00 AM | Email Article

A version of this article originally appeared in the December/January 2016 issue of Morningstar magazine

Jeffrey Ptak, CFA, is head of global manager research for Morningstar.

There's the saying, popularized by Warren Buffett, that if you've been in a poker game 30 minutes and don't know who the patsy is, you're the patsy. But what if we couldn't size up our opponents or estimate the odds and payoff of playing our hand? That's kind of what it can be like to choose active funds.

Consider, for example, that to succeed in choosing active strategies, investors need to make the right call repeatedly, not just once. Why? Because in most situations some circumstance will arise that forces us to reconsider our original choice and go a different direction. The manager leaves, for example, or performance tails off, the fund's style evolves, and so forth.

We tend to underestimate how often this happens because, frankly, we find the idea that we'll have to reconsider our decision unimaginable at the outset. We're typically overconfident and also have trouble grappling with errors we might have made in the past (often borne of overconfidence). Behavioral economists have had a field day documenting tics like these, which also includes our tendency to mistake noise for signal.

In the fund world, that "noise" is past performance--if a fund puts up good numbers, it's catnip to us as investors. We rush in, extrapolating past performance into the future. Trapped in that mindset, we can't fathom the idea that the fund we've chosen won't reward us as handsomely in the coming years as it has others in the recent past. Alas, past performance, especially short-term performance, seldom predicts the future. A mountain of evidence backs this up.

If It Can Happen at Third Avenue ...
But even investors who look beyond past performance to consider qualitative factors are prone to falling into this trap. Let's suppose we do our homework, according due attention to the prudence and repeatability of the fund's process; the talent and commitment of its management team; the shareholder-friendliness of its parent firm; and the competitiveness of its fees. Even then, it's usually not enough to avoid having to make a change in the future.

Consider Third Avenue Management. In many ways, Third Avenue had been the standard-bearer for active investing. The firm boasted a fiercely independent, research-intensive culture personified by its founder and longtime leader Martin Whitman; it was at the vanguard of shareholder-friendly practices, penning rich and insightful letters to shareholders, closing funds before asset bloat set in, keeping a lid on fees, and eschewing flashy marketing or gimmicky fund launches. For many years, the firm also boasted standout performance.

Not surprisingly, the firm became the apple of investors'--and yes, analysts'--eyes. By May 2007, the firm's mutual fund assets peaked at $20 billion, as it rode strong returns and abundant praise to join seemingly every investor's or gatekeeper's shortlist. (For the record, Morningstar analysts were among those recommending Third Avenue's funds at the time.) In that heyday, Third Avenue was often regarded as a can't-miss type of firm.

With the benefit of hindsight, we can now see that confidence was misplaced. Since the time this article was originally authored for Morningstar Magazine, Third Avenue's woes deepened due to the implosion of a high-yield bond strategy the firm offered. But even before this latest high-profile failure, the fund firm was under pressure. The returns of flagship  Third Avenue Value had fallen well shy of its benchmark and the majority of peers over the trailing decade ended Sept. 30. The firm has also been hit by a spate of portfolio manager changes in recent years, which marks a sharp break from the personnel stability of the past. Consequently, investors have pulled assets at an increasingly rapid clip.

...It Can Happen Anywhere
Third Avenue's struggles underscore just how perishable success can be in the active-investing business. And it should force active investors, including the most diligent and studious among us, to reconsider the durability of the choices we make. If it can happen at Third Avenue--a firm that had been very thoughtful in building a bench around Whitman to mitigate key-man and succession risks--don't we have to ask ourselves if it can happen anywhere, anytime, our conviction notwithstanding?

The short answer is, yes, we do. And only as we reckon with the implications--namely, that the path to active investing success isn't a single good call we make but rather a succession of prescient decisions--can we properly calibrate the odds we'll succeed. It's then we're in a position to identify the patsy at the table.

Moreover, when faced with a decision, we often do a subpar job, succumbing to impulse in acting rather than holding the line. Given that, it stands to reason that the more choices we have to make, and the more actions we take when faced with those decisions, the longer our odds of success become. The math is the math, and it's unforgiving.

Future Decisions
Accordingly, we should aim not just to make good decisions, but to make decisions in a way that forestalls or obviates the need to make choices (and, in too many instances, take bad actions) in the future. How can we do so? There are a few ways.

Have a Long Time Horizon
This can't be overstated--if we're going to successfully choose active funds, then we must stay focused on the long haul. Why? The more we emphasize short-term factors like performance, the greater the likelihood we make not just bad decisions, but frequent bad decisions. Put another way, if we shorten our time horizon, we're by definition going to be making more decisions using low-quality inputs (i.e., short-term returns, which are noise). That's likely to yield poor results.

Own Fewer Active Funds
We should pick our spots. Use active funds where they'll be most impactful, or in areas well within our analytical circle of competence, rather than everywhere. This alone is likely to reduce the incidence of future decisions and, in turn, the number of actions we ultimately take to our detriment. No, this is not a glass-half-full view of the world, but it better acknowledges the sobering reality of choosing active funds.

Favor Team-Oriented Cultures
True, there are examples aplenty of team-oriented cultures that have foundered on the shoals. However, firms like Wellington Management, T. Rowe Price, Dodge & Cox, Primecap Management, and Capital Research have shown that it's possible to sustain an investment culture across generations. That doesn't mean we can invest in one of these firms' funds and check back again in a few decades--it's not set-it-and-forget-it. But it can help to mitigate the risk of management turnover or mission creep and, with that, the likelihood of needing to make a change in the future.

Emphasize Lower-Turnover Managers
Decision-making isn't just a challenge for active-fund pickers. Portfolio managers themselves suffer from the same compulsions and impulsivity. To be sure, low turnover doesn't tell you anything about a manager's mental makeup, per se. But it can offer some reassurance that a certain amount of discipline suffuses the process, ensuring that the bar for new ideas is very high. The implication is that potential changes to the portfolio are heavily scrutinized, with only the most doggedly researched ideas surviving a vetting process that's geared to disproving and not acting, rather than confirming and taking action.

Stay Close to the Assets
In general, the more parties that stand between an investor and an active fund--consultants, gatekeepers, advisors, etc.--the more tinkering there's likely to be. Why? It's partly incentives and partly human nature, with each of these agents seeking to uphold the notion that they're adding value through hire-and-fire decisions. If we keep it simple, though, and stay close to the active funds concerned--which means doing our own work, not farming it out to others--then we can define "value" in a way that isn't a function of changes made.

For many of us, an honest accounting lays the truth bare--we're the patsy and should fold by abandoning active investing in favor of indexing. As for the rest of us, we need to reframe our thinking and consider that the odds of picking a successful active fund are less than chance would imply.

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Jeffrey Ptak, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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