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Mutual Funds and Management Risk

The Fairholme fund is an actively managed mutual fund run by a fellow named Bruce Berkowitz. Since the fund’s inception in 1999, Berkowitz has had an impressive run. According to Morningstar, the Fairholme fund is in the top 1% of funds in its category (large-cap value funds) for both 5-year and 10-year annualized returns. That’s quite an achievement!

However, as esteemed investment author Taylor Larimore recently pointed out, the fund’s performance has been rather lacking over the last year. In fact, it’s been pretty bad. For the twelve months ending 4/29/2011, Fairholme is in the bottom 1% of funds in its category. Yikes.

So what does that mean for investors in that fund? Is Berkowitz’s hot streak over? Or is this just a short-term hiccup in what will turn out to be another decade of superstar performance?

I have no idea.

And that’s the point.

Actively Manged Funds: You Can Never Be Sure.

When you own an actively managed fund, there will be periods during which your fund underperforms its benchmark and its peers–sometimes dramatically. When that happens, you have to decide whether or not you want to continue holding the fund, which means trying to determine whether:

  1. The poor performance is just a fluke and your actively managed fund’s performance will soon pick back up,
  2. The fund manager has “lost his touch.” (For example, he had previously succeeded by exploiting a particular market inefficiency, but that inefficiency has now become public knowledge, rendering it ineffective and leaving your manager scrambling to find a new trick.),
  3. The fund has grown so large that the fund manager can no longer handle it effectively, or
  4. The fund manager was never anything but lucky in the first place, and his luck has now run out.

Years later, with the benefit of hindsight, you may be able to tell which of those scenarios was actually the case. But while it’s actually happening, all you can know with certainty is that your fund is losing money and falling behind its peers.

Yet Another Reason I Like Index Funds

When you invest in index funds, the overwhelming majority of your funds’ performance will be explained by two things:

  1. The performance of the underlying indexes, and
  2. The funds’ costs. (Lower costs = better returns.)

As a result, you don’t have to spend time researching fund managers. You don’t have to spend time trying to determine whether a particular manager is skillful rather than just lucky. And you don’t have to spend time worrying about whether your fund’s manager has “lost his touch.”

Truth be told, I don’t even know the names of the people who run the funds I own. It’s not that I don’t appreciate their work. It’s just that the information isn’t particularly relevant to what I do with my portfolio.

If you’re an index fund investor, management risk–the risk that your fund’s performance will be harmed by the manager’s poor decisions–is one thing you don’t have to worry about.

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  1. Indeed. I always find it interesting how slow mainstream media, mainstream financial advice, and most investors have been to pick up on the indexing idea.*

    William Sharpe’s Arithmetic of Active Management–in which he proved in just ~1400 words and using very simple math that most actively managed dollars will underperform indexed dollars–was published twenty years ago. And Malkiel’s A Random Walk Down Wall Street was published 18 years before that. Yet people only recently seem to have been catching on in very large numbers.

    *This includes me. As recently as 5 years ago, I sold actively managed funds for a living and sincerely believed I was acting in my clients’ best interests.

  2. From the article Larry linked ,

    Brian Reid, the Investment Company Institute’s chief economist, says,
    “I don’t believe that most people today believe in true passive management,” he said. “They want active management, just active management of index funds. That is an important shift.”

    Iam not quite convinced if I get the above statement. Why would an investor prefer an active management of index funds? Am I missing something here? I understand there might be a few investors but most people!?

  3. Well, I’m sure that’s the case for some investors. As to “most people,” I have no idea of course.

    In general, I tend to be very skeptical of anything the ICI says–aside from statements of hard facts (though they’re very helpful for that). As the trade organization of fund companies, they seem to be (not surprisingly) reluctant to fully support the indexing idea.

  4. IndexInvestor says

    I believe the concept of indexing have only caught on recently due to the proliferation of the internet. I am thankful that I am growing up in an age where you can get unbiased opinion. If I was 20 years older, I would have just invested in whatever the bank is willing to sell me. There’s no marketing for index investing since little money is to be made compared to high fee active mutual funds.

  5. I used to play the active management game. I have been gradually switching over to index funds over the last 3 years, particularly in the taxable side. Putting on my actively managed hat, several things jump out at me:

    – The funds bipolar percent rank. Top 6% or better in 2002, 2004, 2008, and 2010. Bottom 10% or worse in 2003 and ytd. Three instances where the % rank is either 1% or 99%. It is my anecdotal observation that when a fund is near either extreme in the percent rank, than it is really not in the right category. Not to suggest that the fund has a proper category. Just suggesting that the current category is imperfect and comparisons to it should be taking with a grain of salt.

    – In 2006, the fund had $3.7 billion in assets. In 2008, fund had $6.7 billion in assets. Fund now has $17.8 billion in assets. Most of its stellar returns were when the fund was mid cap. Now its much larger and less nimble.

    – In 2010, the Fairholme added two funds to their lineup, all managed by Berkowitz, giving them three total. One trick pony adding two more tricks to the lineup.

    – Lastly, Berkowitz has been getting a lot of press recently. This isn’t a codifiable rule, but I have found that “Giganticus Egotus” is almost as burdensome as high costs.

    This is not the fund it used to be. I would consider selling if I owned it.

    I realize that isn’t the point of your post. Just giving a perspective from the other side.

  6. How about a core index fund holding with some actively managed funds sprinkled in. Makes it more interesting. As far as index funds are concerned I think equal weight index funds/etfs are an interesting idea.

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