Posted by on Dec 10, 2012 in Articles & Advice, Blog, Books, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig | Dec. 7, 2012  7:48 p.m. ET

Have investors finally learned that past performance doesn’t guarantee future results?

You might think so. Investors are dumping mutual funds run by fallible stock pickers and replacing them with index and exchange-traded funds—”passive” portfolios that mimic the market rather than trying to beat it. Over the past 12 months, according to Morningstar, investors have pulled $132 billion out of actively managed stock funds and added $57 billion to passive funds.

But you would be foolish to conclude that investors no longer believe they can identify tomorrow’s best money managers today. And, unless you turn traditional thinking upside-down, you would be even more foolish to share that belief with them.

Just look at what is going on in bond funds. Since the beginning of 2009, investors have added $1 trillion more to bond funds than they have withdrawn. Of that, says Morningstar analyst Michael Rawson, $751 billion—fully three-quarters—went into actively managed funds.

But interest rates are at record lows and bonds of all stripes pay similar yields. And most managers are boxed into specific areas of the bond market, limiting their ability to outperform. As a result, most active bond funds don’t stand a snowball’s chance in Hades of outperforming an index fund that costs one-tenth as much.

So investors haven’t learned that it is hard to pick funds that will beat the market. They have merely learned that it is hard to pick stock funds that will beat the market.

When it comes to selecting bond funds, hedge funds, the short-term trading firms called “tactical asset allocators” and many other approaches, people remain as convinced as ever that past performance predicts future success.

Michael Mauboussin, chief investment strategist at Legg Mason Capital Management and author of The Success Equation: Untangling Skill and Luck in Business, Sports and Investing, published last month, has some answers to this puzzle.

Precisely because most professional investors are so skillful, he says, their results end up being differentiated largely by luck, much the way contests between equally matched great athletes are often decided by a bad bounce of a ball. Just as athletes rarely admit that luck turned the tide, investors attribute differences in performance to skill alone.

In one classic experiment, people guessed the outcome of a coin toss. When told they got the first four tosses correct, they concluded on average that they would be able to guess 54 of the next 100 coin flips. “When you observe a good outcome,” Mr. Mauboussin says, “your mind concludes that there must be a good process going on.”

So when a fund puts up good numbers, you will naturally be inclined to think it has a sustainable edge.

If one manager beats the market by 10 percentage points by sheer guesswork, that number alone will make him seem like a genius, preventing many people from questioning whether he was just lucky. Another manager who outperforms by 0.2 percentage point with a sensible strategy over a longer period might never attract your notice at all, even though he is likely more skillful.

Outcomes don’t just grab your attention more than process does; they are much easier to measure. So most investors look for top performance first. Only then (if ever) do they ask how it was earned.

Instead, Mr. Mauboussin suggests, investors should turn that thinking upside-down. Start by studying a fund’s process, which has three components: analysis, or how the manager assembles the portfolio; behavior, or how the manager responds to the emotional extremes in the market; and organization, or how the business is structured to ensure that investors’ interests come first.

You can size up a manager’s analytical process by seeing how the portfolio differs from average. If the names and size of the top holdings are essentially indistinguishable from those of an index fund in the same market, you aren’t looking at a future superstar.

A manager with a good behavioral process makes decisions based on policies and procedures, not intuitions—and doesn’t credit good returns to his own brilliance while blaming bad results on irrational markets, financial crises or bad weather. The manager’s letters to investors will give you an intuitive—but imprecise—feel for this.

Finally, is the firm owned by a giant conglomerate that cares only about maximizing its own profits? Did the fund launch when its investments were so popular they were overpriced? Has the manager closed funds to new investors when too much money came in to manage prudently?

Only after a fund or other investment strategy passes these tests should you look at its performance. That is at least as true for bond funds as for stock funds.

And if you aren’t willing to spend the time ruling out luck as an explanation for performance, exercise a simple skill of your own: Buy an index fund instead.

Source: The Wall Street Journal