Scratch & Sniff

Photo Courtesy of Jônatas Cunha

Photo Courtesy of Jônatas Cunha

A good first impression goes a long way. It can get you a good table at a popular boîte. It can give you an edge in landing a plum job. It might even get you a hotel or airline upgrade. Not surprisingly coming on like gangbusters pays off for portfolio managers too who the reap rewards for years to come—even when their performance lags.

A recent study published in Financial Analysts Journal, (eye glazing stuff to be sure), was covered this week in The Economist. After examining the performance of 1,824 managers of American mutual funds over a 12-year period it turns out that active managers do not outperform the market.

While this isn’t exactly news, it bears repeating because investors are prone to magical thinking for which they pay dearly. Most investors, even and maybe especially those who consider themselves sophisticated, desperately want to believe that paying a premium to a star fund manager is worth it. They are wrong.

For starters, the hotshot will not be able to maintain her performance record. The study showed that there is no relationship between a manager’s performance in the first five years and the subsequent five years. Now factor in the dilutive effects of the premium fees charged by active managers. Not a pretty picture.

To get a real sense of what long-term market returns will be take a glance at the risk-free rate. This is the rate of return you would get if you bought a government-secured T-bill, for example. Now look at corporate earnings. They are hovering around two or three-percent, right?

So you get the picture: Over the long haul, say, 10-15 years, it’s highly unlikely that you’ll do better than five or six-percent if you’re willing take on some risk.

Why twist yourself into a knot for five percent?

Instead, work with a low-cost portfolio manager, (or go the DIY-route if you have the time and inclination), and buy a bunch of  common shares of medium-to-large cap, dividend-paying companies in the U.S.A and Canada, and a low-cost bond index or mutual fund. Or, if you don’t want to hold individual securities, go for an all-fund portfolio of low-cost actively managed mutual funds and some ETFs. (An all ETF portfolio is suboptimal because managers must constantly trade to track an index. This herd mentality guarantees underperformance relative to the benchmark after fees.)

When I worked in the fashion biz, there was a rumour going around that certain firms would initially use high-quality ingredients for their new perfume creations. Once the punters were hooked, the formulas would be tweaked using lower-cost substitutes. The companies rightly figured that the halo effect from the initial product would keep customers coming back for more.

That’s not unlike the investment biz. Hotshot fund managers sure smell nice at first. However, the prudent investor should perform a scratch-and-sniff test a few years later. Is the aroma still so rosy?


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