The following is in response to Joe Tomlinson’s article,Choosing an Actively Managed Fund: What Works and What Doesn’t, which appeared last week.
Dear Editor,
Joe Tomlinson argued that a great deal of risk-adjusted historical data is needed in order to identify superior managers going forward. He also argued that at best, one can improve the odds of selecting a superior manager, but cannot guarantee outperformance. Thus advisors should not attempt to identify superior funds.
I would like to respond to each of these statements.
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Considerable evidence reveals that past performance is not predictive of future performance, risk-adjusted or not. This is the same conclusion reached by Tomlinson in his article, so it is confusing why gathering past performance information is necessary, since it is not useful for selecting funds going forward.
Instead, current manager behavior and characteristics are predictive of fund performance, as stated in the Jones and Wermers academic research survey article Tomlinson cited. That paper provides a list of behavioral measures found to be predictive of future performance. Based on this and other research, here is my list of fund attributes for selecting superior managers:
- Small assets under management
- Low r-squared
- High tracking error
- High active share
- High style drift
Each of these is predictive of future performance and is readily available from a number of sources. There is no need to gather large amounts of data. In a March 5 Advisor Perspectivearticle, I showed that the manager behavior measures of strategy, consistency, and conviction, when used together, allow one to pick funds that, on average, significantly outperform for up to five years after the fact.
- The attributes listed above increase the chances of selecting a fund that will outperform, but do not guarantee it. This isn’t a problem, since investing is all about tilting the odds in your favor, not guaranteeing results. The longer the time horizon, the more attractive are these higher odds.
The above argues for investing a large portion of a long-term portfolio in active equity funds selected as described above.
Tom Howard
Professor Emeritus, Reiman School of Finance, Daniels College of Business, University of Denver and CEO and Director of Research, AthenaInvest, Inc.
