Why Fund Investing Is Not Like American Idol
When a star manager hits a dry spell, don't treat him as though he's some off-key wannabe
(Money Magazine) -- If there's a Sinatra of mutual fund managers, it's Bill Miller of Legg Mason Value Trust (LGVTX (Charts), whose string of hits is unsurpassed. He's beaten the S&P 500 for 15 years running.
But this year Miller is way behind. So what are his fans doing? Giving him the boot as though he were an also-ran on America's favorite talent show.
It's not just Miller's shareholders. A surprising number of top managers, including Bill Nygren of Oakmark Select (OAKLX (Charts) and Ron Muhlenkamp of the Muhlenkamp Fund (MUHLX (Charts), a MONEY 65 selection, are in the midst of steep performance slumps, and impatient investors in recent months have been yanking out cash and roasting their heroes.
One Simon Cowell imitator sniped - incorrectly - in an online forum, "Bill Miller has evaporated more money than any other fund manager this year."
Whoa. It's just flat-out dumb to expect a fund manager to outperform every year. Even the best make mistakes; Miller and Nygren, for example, avoided energy stocks in recent years. Muhlenkamp owns them but didn't anticipate the recent slide in oil prices. And all three managers have loaded up on beaten-down big growth stocks, which have long trailed shares of smaller companies.
That kind of contrarian thinking is why a star investor is likely to underperform more often - and for much longer - than you would expect. Consider a study by researchers at investment firm Litman/Gregory, who reviewed the performance of actively managed large- and small-cap funds that beat their benchmark indexes over the 10 years through 2005.
The data showed that more than 90 percent of these elite funds lagged their benchmarks by an annualized two percentage points or more for at least one three-year period. Nearly 30 percent trailed by more than 10 points.
Says Litman/Gregory co-chief investment officer Jeremy DeGroot: "It's clear no manager's strategy works all the time."
But if you bail out when it's not working, you'll likely sing the blues later. For example, the managers of Longleaf Partners (LLPFX (Charts), who buy bargain-priced stocks, lagged badly between 1995 and 1999, when high-flying techs were the rage. But for the next four years, the fund topped the charts, and over the past 10, Longleaf ranks in the top 3 percent of its peers.
Miller, Nygren and Muhlenkamp aren't down for the count either. Sure, there's no guarantee that a slumping manager will rebound to the top of the charts. And sometimes it makes sense to dump a star. But don't base your decision on his most recent record.
Instead, look for these warning signs.
A new investment strategy Sell if the manager starts chasing whatever's hot. In the late '90s, the managers of Vanguard U.S. Growth, who had avoided tech, finally succumbed - just in time for the tech bubble to burst. Miller, Nygren and Muhlenkamp show no signs of changing their iconoclastic stripes.
A flood of assets When so much cash flows in that the manager has to buy stocks he's only lukewarm about, you'll suffer. Ask the shareholders of Fidelity Magellan, which topped $90 billion in assets only to post years of subpar returns.
Excuses, excuses A good manager cops to his mistakes. Miller, for example, has admitted he bought back into homebuilding stocks too early. But he's also confident about the prospects for Yahoo and other Net stocks he owns that are down of late. You want such conviction. Otherwise, why stick around?