I have wonderful news for you.
Thanks to an exhaustive study by Amit Goyal and Sunil Wahal entitled The Selection and Termination of Investment Managers by Plan Sponsors, I can reveal how real experts pick fund managers.
Imagine how useful this information is. You pick a fund manager when you invest in an actively managed fund. Maybe you rely on the much touted Morningstar star system. More likely, your "investment professional" makes a recommendation and you follow it.
What if you knew the secret criteria used to select the fund managers for over $737 billion in assets?
This study looked at more than 9,000 decisions by 3,591 plan sponsors (retirement plans, unions, endowments and foundations) between 1994 and 2003. Sometimes the decisions were made by plan sponsors themselves, but in most cases they had the benefit of consultants to assist them. I assume they hired the most expensive consultants available.
The study looked not only at who was hired but also at who was fired. More than 900 managers got the boot during the period studied. These terminated managers were responsible for investing over $117 billion in assets.
There was nothing mystical about the way these sophisticated plan sponsors and their elite consultants hired managers. They looked at past performance, just like your "investment professional" does. If a manager had a good track record, she was far more likely to be hired.
The average pre-hire "excess return" (return over benchmark) of the more than 8700 managers hired was 2.91%. Sounds pretty good. These managers must really know what they are doing!
However, when the returns of these managers were measured in each of three years after they were hired, they underperformed their benchmark in each year. The promising "excess returns" disappeared. The assets they managed would have yielded greater returns if they were simply indexed to the benchmark.
What about the performance of the fired managers? These hapless souls had great track records pre-hiring, but significantly underperformed their benchmark post-hiring. It is not surprising that they were fired.
In an interesting twist, the study tracked the performance of these managers post termination.
The terminated managers generally beat their benchmarks and added excess returns.
It gets worse. The post firing performance of these managers was generally better than the performance of the managers hired to replace them!
Here's the bottom line:
Some of the most sophisticated investors in the U.S. (and their consultants) couldn't hire managers who could deliver returns in excess of their benchmark. Whatever criteria they used to fire managers and hire replacements boomeranged. They would have been better offer keeping the terminated managers in place.
Every day "investment professionals" tell you to look at track records as a basis for picking an actively managed mutual fund. When that fund underperforms, they often advise switching to another fund.
I view it as a form of three card Monte.
You are unlikely to find the money card -- or the money fund -- trying to pick fund managers who can "beat the markets."
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