Equity Mutual Fund Selection – Process vs Outcome

One of the world’s best investors – Mr Warren Buffet..

If I asked you to name the world’s best investor, most of you would answer Warren Buffet without the blink of an eye.

He is currently the world’s 3 rd richest man with around USD 60.8 bn  net worth, thanks to his long term investment track record.

Source: http://www.longboardfunds.com/

But here is something you didn’t know about his performance

According to the research done by Eric Crittenden, the Chief Investment Officer of Longboard Asset Management,

“If you look at Berkshire Hathaway on a daily, weekly, monthly, quarterly, or six-month basis over its entire history, an investor in Berkshire Hathaway would have underperformed the S&P 500 more than half the time. But despite that, an investor in Berkshire Hathaway would have made tremendously more money than an investor in the S&P 500.”

If interested you can listen to the entire interview here – Meb Faber Podcast

Even Buffet was not spared from the curse of short term under performance..

In fact, during the tech bubble Warren Buffet was massively underperforming the S&P 500 and many began to doubt his investment process.

But, instead of abandoning his strategy he stuck with it, and the rest is history as Berkshire Hathaway returned 53% compared to a loss of 25% for the S&P 500 over the next three years.

As mere-mortal investors, this makes one thing clear

Even the best of investors inevitably go through temporary periods of under performance!

But why does this happen?

This doesn’t seem to happen in other fields such as running, chess etc where the consistency in performance is reasonably high and past performance is a good indicator of future performance.

Why is investing different?

Let’s take the help of the brilliant investment strategist, Mr Michael Mauboussin who discusses this issue in his book “The Success Equation”.

The Role of “Skill” and “Luck”

The outcome from many activities such as sports, business, investing etc are the combination of Skill and Luck.

However, the degree of contribution of skill and luck vary across different activities.

But how do we determine the level of skill in a given activity:

Here is an interesting way. Just answer the question –

Can you lose on purpose?

If yes, then there is some degree of skill involved.

A good way to think about business, investing, sports etc is in the form of a continuum of activities with pure luck and no skill on one end to pure skill and no luck on the other end.

For example, the outcomes for activities including chess and running races are close to pure skill, while games of chance, such as the slot machines and lottery are close to pure luck.

Generally, most activities fall somewhere in between these extremities and combine both skill and luck.

Investment returns – combination of luck and skill

Now coming to our most important question,

Where do we place investing?

Now while it is definitely difficult to build a portfolio which outperforms the benchmark, what makes it interesting is that it is equally difficult to intentionally do a lot worse than the benchmark over a short period of time.

This tells us that investing is slightly tilted towards the luck side of the continuum.

This also means that we have a problem!

Unlike activities where skill dominate (eg a top tennis player, where outcomes are almost a pure indicator of skill), in investing we can’t focus only on the outcomes (read as short term returns) to judge skill.

What this means is that, good investment returns from your mutual funds over a short period (say 3 years) may be because of your fund manager’s skill or that he just got lucky. He may have been just riding a trend, such as Internet mania. Is that investment skill or dumb luck? Returns can’t tell the difference.

Similarly, bad performance from a fund manager in the short run, maybe because he got unlucky or that he truly lacks the skill. Returns yet again can’t tell the difference!

But unfortunately, more often than not, most of  us select funds only based on their recent returns.

Luck is mean reverting..

Any activity where there is luck , there is reversion to the mean.

Reversion to the mean simply says that for outcomes that are far from the average, the expected value of the next outcome is something closer to the average.

That doesn’t mean that it is going to go all the way back, but it indicates that it should move closer to the average.

Now, this is exactly the problem – when we pick equity mutual funds purely on the basis of their recent performance. We have no clue if it is led by skill or luck. And if it is driven by luck then it means it will mean revert and we are looking at lower returns in the future (which is exactly what matters to us)

So, how do we evaluate if our fund manager has the skill?

“If you compete in a field where luck plays a role, you should focus more on the process of how you make decisions and rely less on the short-term outcomes. The reason is that luck breaks the direct link between skill and results—you can be skillful and have a poor outcome and unskillful and have a good outcome.” – Michael Mauboussin

In search of skill

Thus the key here is to focus on process instead of short term returns.

But therein lies a problem.

There is no precise objective method to evaluate the investment process of a fund manager. It is a lot more subjective. And unfortunately not all of us have access to fund managers. Add to it the fact that Indian fund managers hardly communicate, our job becomes even more difficult.

So how do we solve this problem?

When skill determines an outcome, a relatively small sample of outcome is enough to identify skill. However we need a large sample of outcomes when luck plays a large role in an outcome.The reason is that we have to evaluate large enough outcomes to ensure that luck has averaged out and that only skill is revealed.

Thus while evaluating equity mutual fund managers for skill, we need a sufficiently long time frame to evaluate their performance. Obviously, the longer the time frame the better. But for starters, we would at least need a 7 year track record (in the Indian context a 7 year time frame generally captures an up and down cycle) to evaluate skill and investment process.

Now there is no denying that the fund manager may sometimes end up getting lucky even for 7 years. This is where diversification comes into play. If we select 4-6 fund managers who have consistent long term track records, then we can afford to go wrong with 1 or 2 of them and still come out reasonably ok in the long run.

Parting thoughts

1. Short term investment returns are not the best indicator of future returns as they maybe driven by skill or luck
2. Over the long term, a good process (driven by skill) provides the best chance for desirable returns as luck averages out
3. Hence, evaluate fund manager returns over long time frames (at least 7 years or a period covering a bull and bear market) to judge skill & investment process
4. Track fund manager interviews to evaluate the investment process
5. Diversify across fund managers

But,

1. How exactly do we evaluate equity fund performance over long periods?
2. How do we evaluate fund manager investment process from interviews?

Hang on. We will explore the answers in the coming weeks.