After a recent column about manager Bill Miller and his recent hot streak with Legg Mason Opportunity Fund LMOPX +0.21% , Stanton wondered whether the problem with expecting money managers to beat a stock market index is that we expect them to do it always and forever.
Rich Stanton from Richmond, Va., wants to know what is wrong with wishing on a star.
Why do investors take risks?
Miller made his reputation by recording one of the longest “winning streaks” in mutual-fund history. Between 1991 and 2005, Miller’s Legg Mason Value Trust LMVTX -0.07% beat the S&P 500 on a total-return basis for 15 consecutive years. When the streak ended, however, it seemed mostly like Miller could do no right; the Opportunity fund was crushed during the 2008 financial crisis, had a good year in 2009, but quickly returned to the cellar the following two years.
But Opportunity knocked again in 2012 and has been hot thus far this year.
Stanton, therefore, wanted to know what’s wrong with using active managers to beat the market over the short term.
“All I read is how managers lose out to the S&P 500 if you give them enough time, so why not take a hot manager like Miller and just give him a little time,” Stanton asked. “He has shown an ability to beat the market, so now that he is on a roll, why not hold him and just make it that the first quarter or six months where he loses to the market, that’s when you’re out?”
It’s a good question for anyone who likes the idea of active management — which essentially provides the promise of beating the market — but who believes that index investing is the long-term solution.
But trying to hold the hot hand is a way to get burned.
Plenty of newsletters appeal to momentum investors using a strategy that is at least partially based on the idea Stanton was espousing here. Indeed, in the my first column on Miller, I noted that Stephen McKee of the No-Load Mutual Fund Selections & Timing Newsletter currently gives Legg Mason Opportunity four “comets,” on his five-point ranking system, making the fund worthy of consideration as a buy.
The problem for most investors is that they have a tough time recognizing when a manager like Miller or Kenneth Heebner of the CGM Funds — another famous manager with a feast-or-famine record — is heating up, and only recognize it after the feed has started.
Heebner’s CGM Focus CGMFX -0.33% , for example, has the best record in the business among large-cap blend funds over the last decade, according to Morningstar Inc., with an annualized average gain of 10.75%. Over the last half of that decade, however, the fund is dead last in the category, with an annualized loss of 5.45%.
In short, it started the last decade hot, then fell off sharply.
Over the last year, however, Heebner has been back on top, gaining nearly 50% over the last 12 months.
The problem is that someone trying to time a Heebner hot streak would have had a tough time seeing it coming after such a run of misery — the three- and five-year records are so bad that they’re still at the bottom of the group despite the 46% gain of the last 12 months.
Anyone acting one they saw the outperformance might be too late to catch the feast.
In short, deciding to buy a traditional, actively managed fund when it’s hot amps up the timing risk, the possibility that the problem is less the manager’s ups and downs but your lousy timing in trading the fund.
Besides, many of the best long-term fund managers are the ones who thrive on consistency more than short, great runs. Don Yacktman of the Yacktman Fund YACKX 0.00% , for example, has a superior long-term track record, but typically has avoided being at the top or bottom of the heap; to get the best of his record, you have to be willing to ride out the good and bad.
Furthermore, anyone playing the momentum game like Stanton is using funds for something they’re not intended for. Funds were built to provide professional management and diversification at a reasonable price, in order to deliver returns of the representative asset class over time.
Trying to use them to instead play the hot hand is like trying to win a horse race by starting out by riding the front-runner, then switching midstream to the horse that catches up, then switching down the stretch to the one challenging from behind. It might work, but if any of those changes is botched, the race is lost and the fall is hard.
The moral of the story is simple: Plenty of people have tried to play this game with funds and star managers, but with the exception of a few newsletters, most have wound up being less satisfied and successful than if they had stuck with a simple buy-and-hold with a solid active manager or in an index fund instead.