Manager of Managers

‘Punch or May Day’ by Benjamin Robert Hayden, 1829

Can a financial advisor manage a portfolio of active funds and consistently select outperforming managers for her clients in advance?

It’s definitely possible, but highly unlikely. Trillions of dollars have come out of actively managed funds and shifted into systematic strategies, rules based strategies and index strategies. Cost is part of the story, but so is persistence.

Persistence doesn’t exist. Financial advisors are periodically asked to defend their asset allocation choices to the clients who’ve entrusted their money to them. Financial advisors used to put themselves into the position of selecting active fund managers and then either defending the underperforming ones or making a big show out of firing them, demonstrating their value-add to the client by making manager changes.

It doesn’t work, and not because active managers can’t beat the market or their peers. Every year there are outperforming managers. Every year there are funds that absolutely crush their benchmarks and their peers.

That’s not the problem. This is:

In 2010, five US stock fund managers were nominated for fund manager of the decade. Know how many outperformed this decade?

Zero.

Average underperformance of the five nominees was 5 percentage points per year.

And the winner? 8 percentage points underperformance per year.

— Meb Faber (@MebFaber) October 29, 2019

You can’t use previous track records to identify the winning or losing managers for the next period of time. There aren’t any performance-related data points that will help you do this as a financial advisor. Morningstar can’t do it. Lipper can’t do it.

We would all love to believe that a fund that has just trounced its peers for five straight years has a higher probability of doing so over the next five years, but statistically it’s just not true.

Ten years ago Morningstar said, based on a review of its entire database, that the fund attribute most likely to predict future fund performance vs it’s peers is having a lower cost. Past performance, brand, pedigree, staff size, etc were not significant drivers of outperformance – so an advisor doing due diligence on these qualitative aspects of a fund was certainly doing her job, but it wasn’t actually helping clients beat the market on a go-forward basis.

Even worse, financial advisors came to learn that the fund selection game was asymmetrical for them – if they picked a great manager who went on to outperform, they didn’t get much credit for it, because this was expected by the client. “Wow, you did your job.” However, if they picked an underperforming manager, and then had to mount a defense of that choice, they got a lot more blame than credit for all of their other good choices. Advisors began to question the wisdom of making these guesses and putting their own necks into this noose. Then they stopped doing it.

A decade ago, there were many financial advisors at big banks and brokerage firms telling their clients that they served as “the manager of managers” – vetting the funds for them and monitoring them each year. There are less financial advisors presenting themselves to clients this way now, as the facts I’ve stated above have become more widely understood and the economic incentives of the advisory business model have changed.

I spend a lot of time thinking about what might suddenly change and make things go back to the way they were – higher interest rates? A crash? A bear market? A new fund incentive structure? A regulatory shift? A wave of young, rock star celebrity managers coming along?

After considering these possibilities and what they might do to influence advisor or client behavior, I just don’t think the current trend will reverse.

This reality doesn’t get advisors completely off the hook for explaining their portfolio choices, however. The scrutiny of asset allocation decisions has instead shifted more toward geographic or sector weightings, tactical moves and / or rebalancing timing, the total cost of fund expenses, the commission cost of trades, the tax impact of any moves being made and even the social, environmental and governance aspects of the underlying holdings. And that’s before they have to defend whether or not a portfolio is still appropriate for each specific household’s personal plan and situation.

Advisors are still answering to clients for fund choices every day, week, month, quarter and year – this will never change. But they’re trying to answer for things that are more within their own control. Managing managers – essentially predicting the success or failure of someone else – has been increasingly cut out of the whole endeavor.