What to Look For in an Active Investment Manager

AppId is over the quota
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Yet investors regularly ask for a mutual fund’s track record over one, three, five years or more before putting their money in. Sure, the fund may keep going up, and the past performance is an indicator. But what happens if the fund starts to drop? Should the investor sell, or hang on because the fund did well in the past?

A report released this week from Barclays Wealth and Investment Management, “The Science and Art of Manager Selection,” aims to lay out the risks of trying to read past performance into future returns when selecting active managers — as opposed to passive management of your money through index and exchange-traded funds.

Investors are asking the wrong question when they argue whether active or index funds are better, said Aaron Gurwitz, chief investment officer at Barclays and one of the authors of the report. “The question is, Can you identify managers who are going to perform well in the future?” he said. “If you can’t, you should be in an index fund. If you can, then you should select managers the way we do.”

The report highlights a basic problem in investing — that the obsession with recent returns hurts long-term performance. Psychologists and behavioral economists call the phenomenon the recency bias, and it is not confined to investing.

“We’re like pattern-finding machines,” said Terrance Odean, professor of finance at the Haas School of Business at the University of California, Berkeley. “If lightning strikes and something falls off the table, we think the lightning caused it. Or worse, the book falls and lightning strikes and you think the book caused it.”

But searching for patterns does not add up to a good investing policy. “The investor who is in the market and is constantly seeing patterns better have a good day job,” Mr. Odean said.

In a paper in 2008, “All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors,” Mr. Odean and a co-author, Brad M. Barber, a finance professor at the Graduate School of Management at the University of California, Davis, found that individual investors were more likely to buy a stock if they saw something about it in the news or if it had a high one-day return. The two professors attributed this to how difficult it was to do detailed analysis on thousands of stocks before buying one.

But how can investors be broken of their habit? The Barclays paper advocates a mix of what its authors call the art and science of picking active managers.

The art refers to the idea that the ability of most mutual fund and hedge fund managers to outperform their indexes peaks and then declines as more money comes into the funds. (Private equity managers have better luck because they are essentially repeating the same strategy with different companies.)

David Romhilt, the head of manager research and selection at Barclays and the lead author of the report, said active managers went through four phases: start-up, growth, maturity and decline. He sought to identify those managers in the second phase, growth, because that is when they have had enough success with their strategy but not so much success that money has poured in and changed how they invest.

One example of this life cycle is Bill Miller, the chairman and chief investment officer of Legg Mason Capital Management. He outperformed the Standard & Poor’s 500-stock index from 1991 to 2005 with his Value Trust fund. Then, for five of the next six years he either underperformed or significantly underperformed the benchmark.

The Barclays report does not address individual managers, but its authors say the decline should not be shocking. As assets grow, managers have to take enormous stakes in single companies or diversify into too many different securities. The fund loses the nimbleness it once had.

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