Spotting the Next Superstar Fund Manager

From 1991 through 2005, Legg Mason Capital Management Value (symbol LMVTX) beat Standard & Poor's 500-stock index every calendar year. The fund, managed during that period by Bill Miller, set a record for consistency that no other mutual fund has ever approached.

Think you can identify the next Bill Miller? Good luck. Michael Mauboussin, managing director for global investment strategies at Credit Suisse, predicts that no manager will ever surpass Miller's record. He made his comments at the Morningstar investment conference held last week in Chicago.

Why won't Miller's record be broken? Because, Mauboussin says, the difference in returns between the best big investors and the worst of them has steadily lessened over the last 50 years. The data show a clustering of investment results — fewer managers do much better or much worse than the average manager or an index such as the S&P 500. As skill levels compress, it becomes less likely that any manager will beat his or her peers as frequently as Miller did.

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It's not that managers have gotten dumber.It's precisely the opposite, Mauboussin says. The average manager is more skillful than in past years. But, Mauboussin maintains, improved skills throughout the money-management industry have led to less difference in performance among professional investors.

Investing is a bit like baseball, Mauboussin says. Statistics show that the best players today are closer to the average player today than was the case 50 years ago. Ironically, Mauboussin contends, most players are much better than they were a half century ago. But with skill levels closer to equal, luck becomes more important in determining winners. "The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results," he says.Mauboussin explores these matters in his book "The Success Equation: Untangling Skill and Luck in Business, Sports and Investing." His topic is particularly important to investors in actively managed mutual funds. Those investors often try to determine how much of a manager's market-beating returns are due to luck, which is unlikely to be repeated, and how much is due to skill, which presumably can be repeated.

He concludes that luck is the main element in investing success. That makes it difficult to pick funds that will do well in the future. "Investors in the aggregate are very skillful," Mauboussin says. "But that skill means that stock prices reflect the information and expectations that are out there." In other words, financial markets are pretty efficient.

The obvious conclusion from all this: The case for low-cost index funds, already strong, just got stronger. "If an investor believes that he or she can assess skill, they should use active managers," Mauboussin says. "If they have no time to think about managers, then indexing makes sense."

I agree. Index funds dare to be average — that is, they aim to mirror a market index, such as that represented by the S&P 500, not to beat it. Over the years, only about one-third of stock funds have been able to beat their benchmark index.

I still think that if you work hard at it, you can pick actively managed funds that will beat their benchmarks over time on a risk-adjusted basis (that is, when taking into account a fund's volatility). Russ Kinnel, director of fund research at Morningstar, says the real message from historical fund returns is to favor low-cost funds (both actively managed and index funds) and to study past risk-adjusted returns rather than raw returns. Staying with your fund picks for the long term is also crucial. "Go low-cost and long-term," he says.

Mauboussin says that individual investors typically make the wrong move at the wrong time. Investors "should be mindful of their emotions — there's a pernicious pattern of investors selling out at the bottom and buying toward the top."

Bill Miller never did that. He was quite open about the reason for his success. If he owned a stock and it went down, he almost always bought more. If it fell further, he bought even more. "The [manager] with the lowest average cost wins," he was fond of saying.

That worked for years, but it failed miserably during the 2007-09 bear market, when some of the low-quality companies he favored went to zero or were taken over at low prices. His returns turned so ugly that by the time he relinquished the reins at Legg Mason Value last year his 20-year record was essentially the same as that of the S&P 500.

So was Miller skillful or lucky that we didn't have a financial meltdown until after he set his record? I think he is a talented investor, but, in my view, the record that made him famous really was due mostly to luck.

[link]steven t. goldberg is an investment adviser in the washington, d.c. area.">Steven T. Goldberg is an investment adviser in the Washington, D.C. area.