Active portfolio management

Last week, I was reading the letters Warren Buffett wrote to the partners of his Buffett Partnership Limit (BPL) between 1957 and 1970. In these letters he stresses over and over that the goal of BPL is to outperform the Dow Jones index (DJ; Dow) by as a high a margin as possible and with as low risk as possible over periods of at least 3, but preferably 5 years.

Buffett stresses that for both professional money managers and individual investors, measurement is key: how do your investment results compare to the benchmark? Also, he shows that it is very difficult to outperform the index, even if you are very smart, work very hard, have integrity, etc.

The records of Warren Buffett, George Soros, Peter Lynch, John Templeton, and others have shown that it is possible to outperform the market over longer periods of time. The article written by Warren Buffett in 1984 titled ‘The Superinvestors of Graham-and-Doddsville’, has shown clearly that this is the case, so the market is definitely not efficient all of the time.

But how difficult is it to beat the market? I decided to compare the results of some well-known investors today, with some benchmarks to see whether they outperform and if so, by how large a margin.

This article will first look at mutual funds investing only in the US, then it will look at mutual funds investing globally. After that, a comparison will be made with formula investing, and finally there will be a discussion.

Mutual funds investing only in the US

The table below (click on the picture to go to the Google Spreadsheet) shows the 10 year records (period between 18 August 2000 and 13 August 2010) of some well-known funds compared to the S&P 500 index. The results are sorted on their results (descending).

A period of 10 years has been chosen, since investment results should not be viewed over the short term, because plain luck can play a large role over the short term. Also risk is not properly accounted for: had you invested in dot com and telecommunications stocks in 1999 and 2000 (especially if you had used leverage), you would have done very well during that period, but you would have had enormous losses in 2001 and later. What is the point of having huge gains and then losing it all?

Some remarks with regards to the table and the data:

  • All data is total return: it is assumed that dividends are reinvested. The total return data was found via, except for the data of Jeremy Grantham which found in the GMO European Quarterly Update (2Q10) which can be downloaded from the GMO website.
  • For the mutual funds the results are net of fees. For the S&P 500 the results are before fees: if one were to own an index fund of the S&P 500, one would have to pay 0,15% yearly.
  • AUM stands for Assets Under Management. This data was found through Google Finance. The AUM data is important, since the more assets an investor has under management, the more difficult it is to outperform the market.
  • Beta is a measure of the correlation of a fund to the benchmark (in this case the S&P500, which has by definition a beta of 1). A beta of 1.5 for instance would mean that if the market goes up (down) 10% over the short, the mutual fund would go up (down) on average 15% over the short term. A mutual fund whose value moves totally unrelated to the market, would have a beta of 0. Data for the beta is over the past 10 years, and from Google Finance.
  • Mutual funds which were in existence for less than 10 years were not taken into account, except for the First Eagle US Value Fund which was incepted April 9th 2001.
  • Only mutual funds are mentioned which are open to the general public (even if they are not open at this time). This rules out superinvestors like Seth Klarman (Baupost Group) and Li Lu (Himalaya Capital). For purposes of comparison, I would very much liked to have added the data of these funds/partnerships, but I don’t have the data available.
  • Taxes play an important role when investing. I am not 100% sure, but I believe the Morningstar data does not take taxes into account taxes. Of course, after tax results are worse than displayed above. Also, for investors from the US the relative results of the active managers compared to the index will be worse, since probably all of the active managers have a higher turnover rate than the index.

The results shown above are not a fair comparison between the managers. Some funds that are supposed to be mostly fully invested in equities, while others can choose to have large amounts of cash and also invest in bonds, commodities, real-estate, special situations (like companies in bankruptcy), etc. Also, some funds are allowed to concentrate on just a few investments, while other have to diversify.

Also the choice of the benchmark is not without discussion. Especially given the freedom that some managers have to invest in whatever they like, a different index (or mix of indexes) than the S&P 500 might have been better. However, I believe that the S&P 500 is a generally accepted benchmark for investors who invest mostly in equities.

Mutual funds investing globally

The table below compares two mutual fund investing globally with the MSCI EAFA index (click on the picture to go to the Google Spreadsheet).

Formula investing

It turns out there are very simple mechanical formulas which can outperform even the best managers. One of such formulas in Joel Greenblatt’s Magic Formula. Data at show that this formula has produced 14.5% average annualized return in the 10 years ending 30 September, 2009.

Discussion of results

The above results have shown that the investors mentioned are definitely able to outperform their benchmarks, and I believe that this is very much because of skill and not because of luck. Furthermore, I believe that they will continue to be able to outperform their benchmarks in the future, although possibly not by as wide a margin as in the past 10 years (mainly due to the facts that their assets-under-management have mushroomed).

Having read this all, what will you do with your portfolio? How will you measure your results?

If you choose to invest in a mutual fund, which one? The last data I have available show that the Fairholme Fund for instance is currently very concentrated in shares of companies which played a very important (negative) role during the credit crisis, like AIG, Citigroup, MBIA, General Growth Properties, etc. Can you handle this as an investor? How much do you trust the manager’s integrity? How do you know that he/she is not another Bernard Madoff? How much do you trust that the manager is going to do the right thing with your money in the future?

If you choose not to invest in a mutual fund or a stock of a super-investor, do you think you can achieve better results by yourself? Remember that large investors can sometimes do things that individual investors cannot. Also, do you believe it is worth to spend so much time on investing? As Charlie Munger (partner of Warren Buffett at Berkshire Hathaway) had said:

On a net basis the whole investment management business together gives no value added to all stock portfolio owners combined. That isn’t true of plumbing and it isn’t true of medicine. Warren agrees with me 100%. We shake our heads at the brains that have been going into money management. What a waste of talent. … I join John Maynard Keynes in characterizing investment management as a low calling because most of it is just shifting around a perpetual universe of common stocks.”

With investing, every possible investment should be compared with all alternatives. I believe this is the same when deciding where to spend your time.


Ease of investing in the index

At the time Buffett wrote these letters, index funds were not available. That means that if an investor wanted to buy the index, he had to go out and buy all the shares separately and rebalance manually. Currently, it is very easy to own an index fund, so that is one reason less to choose an active manager or to manage your investments yourself.

Different investment goals

The above discussion assumes that the investment goal is to outperform the index over longer periods of time by as wide a margin as possible and with lower risk, but it is possible to have entirely different goals.

Other possible reasons to not invest in index funds:

  • You feel better investing only in high quality companies or companies that you understand.
  • You enjoy doing the investment process yourself.
  • You like a fund with less volatility (smaller beta): if you invest in stalwarts (high quality mega cap companies), you can expect lower volatility.
  • You want a fund with less down years (the number of years that the market value of your portfolio at the end of year is less than at the start of the year): this is related to the previous point.
  • You may want a fund with the least amount of risk.
  • You may think income is more important than long term capital appreciation.

A short word about risk

Like many value investors, I feel that volatility and risk are different things. Risk is not the squigglyness of a line (as Seth Klarman says), but the possibility of permanent capital loss. However, if you are not a good investor, volatility can be a great risk. If, during a crisis, you cannot stand the volatile share prices and sell your shares or you get forced to sell for whatever reason (loss of job, margin call, etc.), now volatility is definitely a factor in risk even though it shouldn’t be.


Full disclosure: I own shares of the Fairholme Fund.