Beware the star-manager trap

I still remember when my sister broke the news that there was no such thing as Santa Claus. It wasn't malicious, at least not entirely. She knew that she'd be able to let me down easier than if I heard it from a random know-it-all classmate. And truth be told, I already had my doubts. As the youngest of six kids, my "Santa" was getting a little sloppy with the details now and then. I'd occasionally spot presents in my parents' room that later showed up under the tree on Christmas morning, and Santa's handwriting did look suspiciously like my mother's. When you're picking up on details like that, it's probably time to cross over into the nonbeliever camp.

So fund investors, I'll do my best to break it to you gently, but I am here to say essentially the same thing: There is no Santa Claus. By that I mean that there's no one fund manager for all seasons, who can deliver unassailably good results in all market environments. And the sooner you recognise that, and manage your portfolio to avoid falling into the "star-manager" trap, the better your portfolio results will be.

Bernie Madoff is the most stark example of how investors can be lulled into believing that an investor can achieve the impossible. Even sophisticated investors shovelled money his way, refusing to question that the investment returns he purported to achieve defied reality.

The fund world has never seen a calamity on that scale, but that's not to say that fund investors don't make a similar type of mental mistake, year in and year out. They invest with a manager just as he or she has delivered a string of superb returns. And when returns trail off, as they inevitably do, they abandon ship, often just before performance rebounds.

Name any "star" manager from the last few decades and what you're likely to see is that investors systematically mistimed their purchases and sales of their funds. Morningstar's Investor Returns statistics tell the tale. These figures, which marry cash inflows and outflows at a fund with its total returns, provide a stark illustration that the average investor in some marquee-name funds don't earn anything close to the funds' published total returns.

Even where the divergence between the investor return and the published total return isn't huge the gap can be as large as a fund expense ratio. And in some cases, the gaps are stunning. Ken Heebner's CGM Focus in the US is a stark example of investors' tendency to put a manager on a pedestal at the worst conceivable time. Assets flowing into the fund peaked in 2007, following an 80% commodity-fuelled return that year, just in time for the fund to shed half its value in 2008. Not only have most investors not pocketed any of the fund's 18% gain during the past decade, but the typical investor in the fund has lost near 14% per year--a stunning 32-percentage-point investor return/total return gap.

The decision not to invest with a Heebner in 2007 or a Helen Young Hayes in 2000 looks obvious in hindsight. Surely all those people piling into those funds at inopportune times were greedy performance-chasers, and they deserved what they got, right? Yet there always seems to emerge another star manager, one better and smarter than the ones who came before, and the vicious cycle continues.

So is the takeaway to avoid active funds entirely? That's certainly a reasonable idea. If knowing that you're at least earning the market's return, less expenses, helps you avoid the "star manager" mental trap and concentrate on even more-impactful investing decisions such as asset allocation and saving enough, that's a strong case for indexing right there.

But you don't have to take the investor return/total return data to such an extreme conclusion to improve your investment results. My colleague Russ Kinnel threw out some helpful ideas for improving investor returns in a recent column, and I'll provide a few of my own.

First, if you're eyeing a fund that has managed to deliver much better returns than its peers' or that of the market during a given time period, plan to pound-cost-average into it rather than piling into it in a single shot. Better yet, put it on your watch list rather than buying it right away. The fund may continue to outperform, but chances are that if you wait long enough, you'll get a crack at buying in at a more attractive time later on--ideally after performance has cooled off and the hot money has departed.

We've noticed that funds that have closed in the past often have better investor returns than those that have not, probably because the closing serves as a "cooling-off period" for some investors and protects them from their own worst impulses. The idea behind waiting to buy a fund is to impose your own cooling-off period on yourself.

The flip side of this strategy is that you've got to be willing to put new money to work with talented managers after they've stunk up the joint. If you think a manager has real skill, you should like the fund even more when it's in the dumps, because the securities in the portfolio are probably trading more cheaply now than they were when the fund was flying high. From that standpoint, Russ' comment about paying attention to valuations makes a lot of sense.

Finally, if you own a fund that has recently outperformed dramatically, recognise the strong possibility that its upside volatility could very easily swing to the downside because the manager is probably using a bold strategy of some kind. In that case, you have to either be comfortable with that volatility or combine it with some other, different investments so that you won't freak out when your volatile fund hits a patch of poor performance.

Too often, investors enamoured with a star manager-run fund strip money away from other holdings and send it to the star, which is a recipe for disaster. Steering at least some of your equity portfolio to broad-market index funds can help mitigate the volatility associated with any one individual holding. Alternatively, you could pair together investments with different characteristics and behaviours.