Great Investor, or Just Lucky?
Some fund managers perform well but then turn out to be duds. How can you spot them in advance?
During the pandemic we all learned about ‘false positives’, a concept previously confined to drug testing and statistics. The appearance of two little red lines, when there should have been one, caused all sorts of avoidable chaos.
False positives are rife in the investment world too: There are plenty of funds that look good, but aren’t. Being able to spot them is a useful skill because, in my experience, getting decent returns from a fund portfolio is more about avoiding disasters than finding the superstars.
So here are five signs of fund false positives that set my own alarm bells ringing:
1. The Hail Mary
When trying to eliminate a false positive, the first question to ask is ‘is this run of good performance repeatable?’
Here I look out for managers’ who’ve made hasty, outsize bets on single stocks or sectors. It’s usually luck whether such a call pays off or not. If it does, the manager will be lauded. But if it fails, they’ll be quietly removed.
The Hail Mary is often the last roll of the dice for a struggling manager. If they suspect time is about to be called on their career, that make-or-break bet suddenly makes sense.
I saw this first hand in the financial crisis. I held a US equity fund that had muddled through most of the crisis, but in February 2009, after another brutal run for US banking stocks, its manager decided to go ‘all in’ on banks, staking a huge part of his fund on their recovery.
Sadly, February was a month too early (see chart): He racked up some appalling losses as financials endured another calamitous plunge, and he was forced to close out the position, and with it his career. Days later the market hit its low, and banking stocks rebounded dramatically.
But that fund was a true negative; the false positive came a few months later. At a conference, I was presented with a European fund manager being hyped as the industry’s next big thing. His performance looked sensational, but after a little digging it became clear he’d taken the same all-in bank punt as my US manager — only he’d been lucky enough to place it a month later. So his fund had rocketed, not tanked.
All that separated them was luck, not skill. I avoided the fund and, sure enough, it failed to repeat its post-crisis performance. That sort of all-or-nothing call can’t be repeated indefinitely.
2. The top-down call
In a similar vein, I steer clear of managers using a ‘top-down’ process, which relies on macroeconomic or political forecasts to position their funds.
If they’re right, the performance can be sensational, as the whole portfolio rides the same macro wave. However, it’s been shown time and time again that economies can’t be accurately forecasted, and that, even if you could, it wouldn’t reliably help you to time markets.
This means that while a fund might pull this off once, or even twice, eventually they’ll get one wrong. And that will hurt. So, in my book, a great run for a macro fund is best dismissed as a likely false positive.
3. The false start
One time to be on your guard for false positives is the start of a fund’s life. Sometimes the initial cash arrives sporadically from disparate sources. This makes it hard to get the fund fully invested, and can mean it’s heavily concentrated in certain stocks or sectors for its first few days.
If those stocks happen to rally, it can boost performance far more than if the fund was fully invested (note that this is also a cause of false negatives).
And, like the hail Mary, managers also know that keeping their newborn fund in cash for a day or two in a falling market could give them an incredible head start over their benchmark. So it’s tempting to play that game (although it’s playing with fire, as it can just as easily go against them).
Clearly, none of this can be repeated once the fund is up and running, so we need to pay special attention to what happened in the fund’s first few days.
4. The red giant
If a fund has built up an incredible track record over a long period, you should pay extra attention to whether it’s become too popular, and therefore too large, to repeat that over the next 10 years.
It’s easier for a manager to run a small fund than a large one. There are a few reasons why, but chief among them is that they can no longer take large positions in small and mid-sized companies, which is often where the best opportunities are found. Tell-tale signs here include a growing weighting in large caps, a greater number of stocks, and having to own a bigger slice of a company than they might otherwise choose.
So, good as that manager may be, if the fund has become too large, then the last decade of great performance may just be one giant false positive. Time to consider a newer, smaller fund instead.
5. Style it out
Sometimes a false positive doesn’t indicate a bad fund, just that your expectations of that fund are out of whack with what it can realistically achieve.
The best equity funds often have a specific style. Over a decade they can give you tracker-trouncing returns. But that run will likely be made up of seven fantastic years, and three awful ones. So if you’re expecting a fund that has recently gone exponential to keep doing that forever, you’re in for an unwelcome shock when one of those three off-years rolls around.
We’ve seen this recently with growth funds. They had a long run in the sunshine, but the extent of their outperformance was, in most cases, a false positive: They were never going to keep that up forever. And 2022 proved an off-year for many (perfectly good) growth funds.
The answer is to be realistic about funds that have recently exponentially outperformed: if near-term returns matter to you, then putting all your capital in that one fund (or several funds with a similar process) may be more uncomfortable than you’re able to bear.
