Fama & French Again On Active Investment Management

Last Thursday's Wall Street Journal featured an article reviewing a recent study by Eugene Fama and Ken French reprising their original work from the 1960s. In their update, they once again hold that active managers, as a group, do not outperform the equity markets.

The article states,

"The fact that some funds in the professors' study beat the simulations does suggest that by picking the right funds investors can consistently outperform the market. But there's just one problem, according to the professors: The "good funds are indistinguishable from the lucky bad funds that land in the top percentiles." "

Fair enough. Many of us have known for years of the parlor trick of beginning a game with, say, 64 investment advice letters predicting only an up or down market. If, in six sequential rounds, half are removed as wrong, and half go to the next round, a randomly selected investing approach appears to have had six straight years of skillful outperformance.

An apocryphal story has been around for years that Fidelity Investments actually selects its funds in this manner.

In any case, it's true that some investing ideas are luckier than smart, especially in monotonically favorable equity markets.

Mr. Mamudi's piece continues,

"That leaves picking the right fund a matter of guesswork. So even if investors stick with the top performers, they're running a risk because the manager's good results could be based on luck."

From my days in hedge fund management, I can add another risk. Back then, a friend would send me his copy of Cambridge Associates' published results of investment managers. What struck me was that roughly a quarter of public equity fund managers would beat the S&P in a given year, but it was a varying group.

Thus, an investor was faced with the difficult challenge of choosing an outperforming manager, in advance, from a constantly changing group each year. The number of managers who could outperform the S&P over more than four years were very few.

However, this isn't all that surprising. Equity investment management is a sort of cottage industry. Thousands of people are public fund managers, and, with so many, there are bound to be a lot of inept practitioners.

One might be better off beginning to sort public equity fund managers into groups simply by whether they'd outperformed the S&P by, say, less than 2 consecutive years, 3-5 consecutive years, and 5+ consecutive years.

I've been involved with equity investment management for over a decade. In that time, I've noted that it's far easier for a well-connected manager with mediocre results, or no track record whatsoever, to attract sizable investor funds than it is for a lesser-known or well-connected manager with a demonstrably better performance record. It is, I think, very much like the old conundrum of 1960s IT managers faced when choosing between IBM or another vendor.

The old saying went, 'nobody was ever fired for choosing IBM.'

And so it apparently goes with a large swath of investment managers. When a Vikram Pandit leaves Morgan Stanley and starts up what turned out to be an under-performing hedge fund, he attracted a large amount of investment capital. We constantly read about sticky investments in well-known but now lackluster public funds.

As Fama and French allow in their research conclusions, there are some consistently superior, skilled managers. But finding them is problematic because of some similar-looking performance records for brief periods of time by other managers who are, literally, luckier than smart.

Perhaps an apt perspective was provided by a one-time colleague and principal in a hedge fund with me. The colleague, an ex-Salomon partner, mused, to paraphrase him,

'Pity the average retail investor. The best options he has is a choice among actively managed mutual funds which, on average, can't even beat the index.'

Like so much of the finance sector, investment management, too, has seen a flight to private management of the best talent. Hedge funds have been, for at least two decades, the province of better managers who shun the added regulatory headaches and limelight of publicly-offered investment funds.