Clients,
critics, and financial media consumers want to understand how other professional
investment managers and I select the securities that are found in their
portfolios. For me, the starting points are the financial and emotional needs
of the account. I believe that one size does not fit every individual account.
Using those elements as a base plus an understanding of critical time horizons
colored by views as to the current market opportunities, I decide on one or
more selection processes for the funds that will be resident in the account.
The purpose of this post is to examine two opposite selection processes, (1) Picking winners and (2) Avoiding losers; as well as to discuss the provability of these or any selection processes before-hand.
Picking only winners
A number of selectors of mutual fund portfolios and some newsletter writers look to near-term performance. In at least one popular case the published pundits select funds with the best available one year performance regardless of investment objective. Under their ministrations the subscriber or account holder will continue to own the fund for a year. At the end of the year the underperforming funds will be replaced with the current year's best performers. This is a momentum approach adapted from the individual stock world to the portfolios of tax-paying mutual fund holders. Early in a long cycle the momentum approach can produce good returns. Often it has the benefit of producing spectacular results near the top of a highly speculative market. The descent from the peak however can be very painful in the first year of a decline.
Avoiding big losers
While desirous of gains, many of the clients that have chosen me to manage their investment fund oriented accounts are relatively risk adverse. With that as a filter I turn to the databank now known as Lipper for Investment Management. (I no longer have any direct connection with my old firm, the producers of the data.) I particularly search for down quarters. Because the majority of the money I manage is in large institutional accounts or on behalf of very wealthy families, I restrict my search to funds with current assets of over $100 million. My accounts are expense-oriented, thus I seek to have total expense ratios below 1.26%.
The purpose of this post is to examine two opposite selection processes, (1) Picking winners and (2) Avoiding losers; as well as to discuss the provability of these or any selection processes before-hand.
Picking only winners
A number of selectors of mutual fund portfolios and some newsletter writers look to near-term performance. In at least one popular case the published pundits select funds with the best available one year performance regardless of investment objective. Under their ministrations the subscriber or account holder will continue to own the fund for a year. At the end of the year the underperforming funds will be replaced with the current year's best performers. This is a momentum approach adapted from the individual stock world to the portfolios of tax-paying mutual fund holders. Early in a long cycle the momentum approach can produce good returns. Often it has the benefit of producing spectacular results near the top of a highly speculative market. The descent from the peak however can be very painful in the first year of a decline.
Avoiding big losers
While desirous of gains, many of the clients that have chosen me to manage their investment fund oriented accounts are relatively risk adverse. With that as a filter I turn to the databank now known as Lipper for Investment Management. (I no longer have any direct connection with my old firm, the producers of the data.) I particularly search for down quarters. Because the majority of the money I manage is in large institutional accounts or on behalf of very wealthy families, I restrict my search to funds with current assets of over $100 million. My accounts are expense-oriented, thus I seek to have total expense ratios below 1.26%.
In
this example I focused on three particularly bad quarters since December of
1999 and I was interested only in those funds that declined measurably less
than the average in their peer universe. Because of the needs of a particular
account I looked at only small capitalization funds. My original sort started with
some 400 funds. The resulting roster of funds that passed through my filters
was a grand total of five. Three of these were closed to new accounts. I may
have to be less stringent in my screens in order to surface a suitable number
of funds to examine with current upside potential. Time will tell whether I can
come up with winners, but history is on my side. What I am confident in is that
when the periodic down markets occur
these kinds of selections will perform better than the momentum driven
suggestions from the first approach.
Can you prove it?
I have been recently asked “What do you believe about investing, but know that you could never prove?" Before addressing whether I can prove that my approach of avoiding large losers rather than the approach that is momentum driven, I want to share some of my thoughts as to "proof" of investment decisions.
From my exposure being a Caltech Trustee and my vague memory of my physics classes at both Columbia University and the Staunton Military Academy, the discipline of the "scientific method" makes me question whether anything can be proven about investments before the final trade is tabulated. The basis of the scientific method is that anyone following the same procedures will get the same result. In physics there is no attention to the emotions of the experimenter or the fact that all conditions surrounding the experiment are known. As we don't know why anyone buys or sells a security, we don't know the critical motivation to the trade.
Can you prove it?
I have been recently asked “What do you believe about investing, but know that you could never prove?" Before addressing whether I can prove that my approach of avoiding large losers rather than the approach that is momentum driven, I want to share some of my thoughts as to "proof" of investment decisions.
From my exposure being a Caltech Trustee and my vague memory of my physics classes at both Columbia University and the Staunton Military Academy, the discipline of the "scientific method" makes me question whether anything can be proven about investments before the final trade is tabulated. The basis of the scientific method is that anyone following the same procedures will get the same result. In physics there is no attention to the emotions of the experimenter or the fact that all conditions surrounding the experiment are known. As we don't know why anyone buys or sells a security, we don't know the critical motivation to the trade.
Is
the seller making an investment judgment as to the value of a security
absolutely or relative to some other security? Are they putting their portfolio in the
desired order or are they meeting a funding need? The buyer may find this
particular security attractive in and of itself or may want to increase the
portfolio's exposure to the market or sector. The buyer may need to be in a
more fully invested position by a report date. Both the buyer and seller may be
reacting to competitive pressures from within their organization or beyond.
Given the same general economic, political, and announced corporate results but
a change in any of the other factors listed above, a different set of results
are possible. As Mark Twain said, “History does not repeat itself but it does
rhyme.” A good example of this is when Ruth and I go to many of the wonderful
concerts of the New Jersey Symphony Orchestra; the program informs us as to
what is going to be played, but not how it may sound to us. Guest conductors and
soloists as well as different musicians on stage let alone different concert
venues and weather can produce startling different levels of appreciation.
Instead of utilizing my academic exposures in getting comfortable with expectations of future results, I fall back on my two real sources of thinking: the racetrack and the US Marine Corps.
Instead of utilizing my academic exposures in getting comfortable with expectations of future results, I fall back on my two real sources of thinking: the racetrack and the US Marine Corps.
What
I try to do is guess what the odds are on a result. I use past experience
adjusting for current conditions as well as the persistency of trend. (The
longer the trend the less likely it will be continued.) Like many who are always focused on survival,
I accept that my bias for quality will reduce some of my upside potential.
Nevertheless I echo “The Long View”
column by John Authers in Saturday’s Financial
Times, “Numbers add strength to Buffett's law of selection not only for
Warren Buffett's focus on quality, but his price discipline.” That discipline
can be summed up by "It is better to buy an excellent company at a decent
price than a fair company at an excellent price." I believe the same concepts can be used in
selecting fund mangers.
You can have it both ways
One of the nice elements of a portfolio of funds is, when appropriate, one can assemble a portfolio following a number of different approaches. This multi-approach portfolio could make sense for a portfolio that has different time horizons.
Which approach do you use?
You can have it both ways
One of the nice elements of a portfolio of funds is, when appropriate, one can assemble a portfolio following a number of different approaches. This multi-approach portfolio could make sense for a portfolio that has different time horizons.
Which approach do you use?
Traveling and learning
September will find Ruth and me in London and Budapest. I would be happy to meet with any members of this blog community to share views, particularly from those who will help me learn.
September will find Ruth and me in London and Budapest. I would be happy to meet with any members of this blog community to share views, particularly from those who will help me learn.
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© 2008 - 2013 A. Michael Lipper, C.F.A.,
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