Morningstar and Yelp are not the same
Yelp takes in user reviews to tell potential users how fresh they should expect sushi to be. Morningstar tries to do the same thing, not realizing that in finance, past returns tell us little about the most important (and difficult to see) characteristic of a fund, which is alpha.
Average and realized returns tell you some aggregation of beta-risk, luck, and alpha, but the salespeople will try to convince you to ignore the first two. According to theory, in efficient markets investors are compensated for non-diversifiable risks taken on. This does not include wide variance within a security’s expectation, only when that variance tends to move in relation to everything else. That is to say that if there is no alpha, the realized returns being pitched are simply measures of the beta-risk taken on with a delta for luck in each period. Since you can easily and cheaply alter the risk you take on by changing the composition and weighting of your portfolio, and you can’t (reasonably) invest in luck, the only element you actually want to find is alpha, or return that is not compensation for risk taken on. Since alpha is zero sum (mispricings are value transfer between idiots and Warren Buffet), and we know that the industry at large pays itself unimaginable aggregated fees, we know that the average “alpha” is negative, unless retail investors are so egregiously bad that they are able to fund both these fees and then some by buying and selling at just the wrong time, which is possible although it strikes me as marketing for mutual funds more than reality. This leaves us with the hypothesis that most funds are probably bad decisions.
Beyond that though, the data that Morningstar is able to take in is limited.
- Survivorship bias distorts data sets significant. This is where bad luck shuts down, and good luck claims it deserves (and often gets) more capital.
- Managers don’t live forever, and even 20 years of data would be sparse to determine whether or not a manager seems to have achieved alpha. Even if the stats told you that alpha had likely been achieved it does not tell you if this will persist in market environments of the future. The “alpha” identified may also be the product of lumpy risks that just didn’t realize in the holding period. This kind of behavior is highly incentivized for managers that can increase their assets under management many times over for when lumpy risks go their way, and simply have to start over and blame an “unforeseeable black swan” when things do not go their way. While you can lose your entire investment, they can change business cards and keep chugging along.
- Determining the appropriate benchmark can be hard. While funds are happy to tell you which benchmarks they use, they are highly incentivized to construct portfolios with slightly higher betas than the benchmarks, as this will lead to great results in good times and bad results in the states where they might be dead anyway. This optionality is at your expense.
So, why have active managers anyway?
It’s improbable that you know much about the funds you are giving capital to, and given the significant fees being charged which are functional negative alpha, the only ways I can think of to justify these fees are that they
- correct your own misbehavior with respect to under diversification,
- solve your “investing” addiction, and those pesky trading fees,
- manage assets with 0 beta exposure along arbitrage alpha theses — from my experience with recruiting, these funds tend to seem fraudulent to me, but the legitimate ones seem to be phenomenal, albeit not necessarily accessible to the people who read some random undergrad’s Medium articles. Funds that take on beta exposure are asking you to pay them for buying the SPY for you.
So, how do you pick a manager?
First, I would personally recommend rejecting any managers that invest in beta. You are starting off negative after fees and as stated above, you are paying them to buy the SPY for you. At this point, few funds make the cut, and since they probably don’t want your capital, I would suggest going with the lowest fees possible via a platform like Wealthfront, where I happen to keep my meager savings.
If you insist on investing with managers that invest in beta, you may be able to spot return profiles that indicate that more risk is being taken on on your behalf than you are actually suited for. This happened to my parents (both in their 60’s) when they had a 43% return in a year that no index reached half of that. While for many this might seem like good news, the most probable explanation was that grossly inappropriate amounts of risk were being taken (the second most probable was fraud, the third luck, and the fourth alpha.) Since the fund was not Baupost or peers, I struggled to buy the thesis that this was alpha generation. I urged them not to continue with a manager who took on sufficient risk for a soon to retire couple to achieve that kind of result, and thankfully (I think?) they listened. This goes beyond a question of alpha, and into boundary conditions, which get tighter as the half life on your career shortens or your obligations expand. Even if the 43% did not rely on wipe out investment decisions, it is hard to believe that such a positive outcome was not part of a distribution of possibilities that included unacceptable outcomes.
On the other hand, excessive micro management of funds actually leads to underperformance, and if you’re going to invest with a manager it may be best to go big or go home with respect to trust. Fund managers are aware of the tendency of investors to react to performance within short time frames (virtually no one is willing to forgive more than a few quarters, let alone a few years) which means that they are not often able to take on strategies that may need to be held for longer than you can stomach in order to be realized. This creates forms of arbitrage for the managers who are able to hold onto underperforming (and undervalued) positions for years and years, and by creating a relationship with a good manager which allows them the freedom to take on ugly positions, you are both creating opportunity for alpha and also behaving in accordance with your implicit claim that they know better than you when it comes to investing.
Honestly, I’m not sure if you can spot most of the bad managers, since I think we have to hypothesize that even the most clueless “professional investors” learn how to pose convincingly enough to keep their jobs. I’ve found that understanding probability, value, and focusing on intellectual humility have been prevalent with the most successful investors I’ve spoken to, and that’s about all I can say on that.