Investing Classroom: Measuring Manager Skill

The fund landscape is littered with former "star" managers. Oakmark Fund manager Bob Sanborn crushed his peers in the early 1990s, but was "reassigned" in 2000 after posting poor relative returns in the late 1990s. Kinetics Internet Fund gained a phenomenal 196% in 1998 under manager Ryan Jacob; at Jacob Internet Fund in 2000, however, Jacob disappointed, as the fund lost 79% of its value.

That begs the question, How talented were these "stars" in the first place?

There's no easy way to figure out whether a fund manager is a gifted stock-picker who can keep it up or merely a lucky one who was in the right place at the right time. But that doesn't stop investors from trying.

This lesson will cover the various ways that investors measure fund-manager skill and the limitations of each. It also suggests things to consider besides fund-manager skill.

A Manager Consistently Beats Their Peers
Investors think that because managers have done well in the past, they'll continue to do well in the future--even if the evidence they're drawing on amounts to just a couple of years. But a manager may have been riding a trend, such as Internet mania. Is that investment skill or dumb luck? Returns can't tell the difference.

What about looking at a five- or 10-year period? If a manager outperforms for that long, won't he or she continue to outperform? Maybe, maybe not.

Oakmark Fund's returns landed in the top third of the fund universe every year between 1992 and 1997. That seemed like a reasonable stretch of good returns; surely it would continue. It didn't. In 1998 and 1999, the fund's performance sank to the fund industry's lower depths.

Further, statisticians say you need 20 years' worth of data--that's right, two full decades--to draw statistically meaningful conclusions. Anything less, they say, and you have little to hang your hat on.

But here's the problem for fund investors: After 20 successful years of managing a fund, most managers are ready to retire.

A Manager Has a High Alpha
Alpha is probably the most popular--and most misunderstood--statistical measure that investors use to gauge a manager's skill.

Alpha is the difference between a fund's expected returns, based on the amount of risk it's taking on, and its actual returns. It's often referred to as the value added by management.

But alpha isn't an airtight measure of skill, for a couple of reasons. It depends on two other variables--beta and R-squared--which are themselves shaky. Alpha only means something if beta is meaningful, and beta is only meaningful if a fund's R-squared (a measure of correlation) versus the comparable index tops 80. (Morningstar's Glossary can help you understand investing terminology).

Perhaps more important, a high alpha could come from plain old luck. There's no way to tell.

The Fund Earns a 5-Star Rating
There are a couple of problems with using Morningstar's star rating for funds as an indicator of manager skill. For starters, though we've found that the star rating has some predictive abilities, all it really tells you is how well a fund has performed in the past, given the risks it has taken on. Just as past performance and alpha can't indicate future success, neither can star ratings. Moreover, we don't rate fund managers--we rate funds.

This is where Morningstar's qualitative fund ratings come in--a great tool that can help you make better decisions and truly understand your investments. Our fund analysts assess five key areas for each fund: People, Parent, Process, Price, and Performance. Using our own industry leading in-house data, public documents, and comprehensive interviews with fund managers and key fund company executives, our analysts evaluate each of these areas in depth, thoroughly debate and discuss their assessments with senior researchers, and then aggregate this into the final rating. Instead of having three "good" ratings, as is common practice with other services, we have five qualitative ratings that span the quality spectrum: Elite, Superior, Standard, Inferior, and Impaired. You can find a list of our qualitative research reports for fund available for sale in the UK here.

The Manager Marches to Their Own Drummer
Departing from the norm certainly can lead to greatness. Berkshire Hathaway's Warren Buffett didn't make himself an investing legend by following the conventional wisdom of spreading out his bets; instead, he focused on a few companies.

Yet going against the grain doesn't always pay. Just look at investors, such as former FPA Paramount manager Bill Sams, who spent a good part of the late 1990s waiting for gold's rebound. Plenty of concentrators eventually suffer, too. Take Don Yacktman. He generally keeps about half of Yacktman Fund's assets in its top-10 holdings. That strategy worked wonderfully--until top holdings Philip Morris and Department 56 DFS each shed nearly half their values in 1999. The fund lost 17% that year, placing it in the bottom 1% of all mid-cap blend funds.

What To Look For Instead
This doesn't mean that you should ignore performance, ratings, iconoclasts, and managers who can string together complete sentences. Nor does it mean that skilled managers don't exist.

What it does mean is that skilled managers are tough to spot and even tougher to quantify, and that historical information is an inadequate indicator of future performance.

So rather than trying to find the most skilled manager out there, do the following:

- Discover how your managers invest and think about how their styles will fare in different climates. No style will thrive at all times, and understanding when a manager's style will excel and suffer will help you keep performance in context.

- Figure out if too many assets will adversely affect performance. Great managers can become mediocre ones if they have too much money to invest.

- Examine expenses. The higher a fund's expense ratio, the higher the hurdle the fund manager must overcome year in and year out.

For more investing lessons on equities, bonds, funds and portfolio management, visit our Learning Centre.