Quiz Time
You read about a fund manager who runs a fund that has beaten its benchmark for 14 consecutive years. You might conclude:
a) He’s the genuine article. That wasn’t luck.
b) He’s probably the genuine article. The odds are against the feat being mere chance.
c) He might be the genuine article. Probably not, but 14 years is worth a look.
d) He’s not the genuine article. The stock market is efficient.
Miller’s Tale
The question above is real in the United States, where investors enjoy the option of investing in a mutual fund, Legg Mason Value Trust, which has outperformed the benchmark U.S. stock index (S&P 500) for 14 straight years. The Legg Mason Value trust has been managed during this time by a team led by William Miller.
As far as most are concerned, it’s not a difficult question. They’ve bought and bought and bought. Miller and his team now manage a whopping £20 billion sterling in assets. If you assume an average of 0.50% annually in management fees on that £20 billion (a conservative estimate, as the fee is higher for Value Trust and probably about at that level for his institutional accounts) that means that Mr. Miller’s stock selections are worth a cool £100 million in annual revenue.
But what should you believe? You, the discerning reader of The Rekenthaler Report?
Pros
My answer: Be excited, but not 100% convinced. That is, I choose “b”.
The excitement owes to the length of Miller’s winning streak. Many funds and fund managers have modest-sized streaks of 5, 6, or 7 years, on rare occasions even as long as 10 years. Those strings don’t impress me much – although they do usually mean a flood of incoming monies, and a fund manager who will die with a large bank account. However, 14 years is a different matter altogether. If you flip a coin 14 times, and have the patience to repeat the experiment for 100,000 measurements, the odds are that the coin will land on the same side for all 14 flips on only 6 of the 100,000 tries. That is, once on 17,000 occasions.
To which, the discerning critic might say, “Wait a moment, aren’t there loads of mutual funds in the U.S.? Enough such that we might expect to put all the monkeys in the world in front of a typewriter and have one such fortunate monkey to come up with a Shakespearean verse?” Good question. It would be directly on target, if asked now – the U.S. does have loads of funds, in excess of 18,000 at last count. So over the next 14 years, we could expect that by pure chance one of these monkeys will outperform a benchmark each and every year, thereby becoming a very cheerful primate indeed.
However, as there were only roughly 2,000 U.S. stock funds that existed 15 years ago, this argument withers. It looks highly likely that Miller was more than lucky.
Cons
There are counterarguments to be made. First, there’s a difference between likely and proven. If 2,000 funds existed 15 years ago and this event occurs once every 17,000 times, then there is a non-significant probability that the event was mere chance.
Second, there are further questions to be asked. Namely, is the benchmark a fair comparison? And, can we fairly assume that Miller’s past results will be predictive of his future results?
The first question stems from a common problem in fund analysis: Examining results over time periods that have consistent performance characteristics, for example large companies beating smaller companies. In such a case, a fund that tends to own larger companies than the benchmark against which it is compared will usually look consistently good on a relative basis – and a fund that owns smaller companies will tend to look consistently poor. You would be shocked to know how many highly paid consultants overlook this level of analysis when preparing expensive, elaborate proposals for their clients to buy a fund.
Fortunately, a consistent benchmark has not been the case in this instance. During Miller’s tenure, the S&P 500 has experienced every conceivable climate. Years that favor big companies, small companies, technology companies, health care companies, manufacturers. Even years that favor no companies (e.g., 2002). You name the weather, the fund has been dressed appropriately.
However, it remains to be seen whether the fund can maintain its flexibility. When it started its streak in 1991, it was only 3% of its current size – and Miller didn’t run all those institutional assets, either. Now as a giant, the fund is necessarily less limber. Miller should still be able to maneuver between different kinds of large companies, as he has so often done. But when the broad market surges, he will be at a major disadvantage.
The moral of the story?
The jury’s still out even where a manager has delivered a winning streak of 14 years. Therefore, so-called “superstar” managers who’ve delivered for three or four years may just be lucky monkeys!
Quiz Answers
a) False. What’s 14 years? Wait until we’re both dead, and your proof will be in hand.
b) Correct. But go ahead, read the article anyway! It’s always fun to confirm you’re a genius.
c) Mostly false. I’m a sceptic by nature, too, but here I think you’re being a bit harsh.
d) False. Don’t be such an efficient-market hardliner; that’s no longer in fashion.
John Rekenthaler is Morningstar's Vice President of Research. He views his job as "helping investors to avoid common mistakes." In his 18 years at Morningstar, John has worked as a fund analyst, editorial director, and research director; in addition, he has earned an Masters in Business Administration from the University of Chicago and has become a Chartered Financial Analyst. Says John, "Investment science is useful when regarded as a tool, not an answer. The best investors are not those who master high-level math, but rather those who master their emotions and make sound decisions when others are losing their bearings." John can be reached at john.rekenthaler@morningstar.com.
