Fund veteran’s guilty plea ‘knocked me out of my chair’
This essay appeared in Citywire Selector on December 17, 2010.
Reading Michael Lipper’s blogs can be dangerous. I nearly fell out of my chair studying his recent thoughts on selecting funds. It seems that Mr Lipper, one of the foremost architects of fund analysis methodology and for whom “Lipper Leaders” is surely a proud legacy, has been struck by a series of revelations.
He has turned away from key ideas that formed the foundation of his understanding of the mutual fund industry and the well known tools and services he created. After what must have been an arduous journey, he has reached conclusions that, for many of us engaged in evaluating managers, are long standing facts. He is preaching to the converted.
In two recent blog posts published in Citywire, he ‘enlightens’ readers that:
> past performance of funds is an unreliable indicator of future potential performance;
> common ways of categorising and comparing funds are both unsound and problematic; and
> successful fund selection demands that one understands the motivations and decision making philosophy and processes of a manager.
Well, well, well. If only Mr Lipper had come forward with these conclusions 10 years ago, the industry and most importantly of all the investors for whom successful fund selection is of paramount importance in reaching significant financial goals, would likely be better off. Though, certainly the company he had just sold to Reuters would not have reached the level of credibility and profitability that they have with their namesake departing from the party line.
These three above listed facts have been at the forefront of experienced selectors’ ways of approaching fund research and analysis for many years. Mr Lipper is apparently the last to be converted.
For those of you not familiar with the articles to which I refer, I will quote Mr Lipper directly – I don’t want to be accused of making this stuff up.
In the first of two published pieces to which I will refer, he writes: ‘Perhaps it is very strange for me [Mr Lipper], who made money [and lots of it*] by analysing and selling past fund performance data, to now consider… [a]… precaution that the past is an even worse guide to the future than it was in the past. What this means to me is that reliance on past historic patterns could be dangerous to our wealth.’
Of course ‘our’ wealth was not created by selling a service that was instrumental in developing and popularising the methodology we are now renouncing. After recognising what I must assume was a handsome sum from the sale of Lipper Fund Services to Reuters in 1998, Mr Lipper has deserted the idea that relying on past performance (and I must assume other quantitative factors) to select funds is a sound methodology. Are fund companies that readily buy the right to use the awards and rankings from Lipper (the company) in their marketing materials doing a disservice to their investors? Are investors and their advisers misdirected by selecting the fives and avoiding the ones?
I honestly thought that the first article – from which I quoted above – would be the extent of Mr Lipper’s cathartic outcry but more recently we read the following (and this time, upon reading it, I really did fall out of my chair). He writes: ‘I plead guilty. I plead guilty for the crime of characterising mutual funds and their kissing cousins – hedge funds – by the types of securities in their portfolios. My enablers are the fund marketing people and the lawyers. At times we are all guilty of taking the easy way out… Shame on me.’ (see full blog here).
Yes, Mr Lipper, shame on you. But you shouldn’t get so worked up. It’s OK. Really. Most analysts have moved beyond reliance on past performance and narrow categorisation of funds. It is clear that, though incredibly insightful at the time, you gave birth to a monster. The flaws were recognised by many of us long ago. Yet because of the popularity and ease of use of the tools, the challenges of moving beyond them remain.
If Mr Lipper would just correct his ways, it would be easy to forgive, forget and move on. But later in the article, he uses the same logic and human weakness for categorising that he had earlier rebuked. He suggests that instead of categorising funds by their holdings, a better method is to categorise managers by their decision making processes. He describes a range of categories into which individual managers be lumped. The categories include:
> The Discoverer;
> The Anticipator;
> The Immediate Reactor; and my favorite…
> The Resurrection Believers in Recovering Prices… (we’ll call it ‘REBaRP’ for short).
Always willing to try new things – particularly at the suggestion of such an esteemed leader in our industry, I gave it a try. I suggest you do as well. What quickly becomes clear is that some of the most talented managers are difficult if not impossible to label under a single heading. In Mr Lipper’s framework, how should we categorise Edouard Carmignac, Bill Miller, Graham French or Raphael Kassin? Who is the REBaRP manager amoungst them?
Mr Lipper is right when he says, ‘I should have looked at the primary thought patterns of the principal decision maker for each fund’. His drive to categorise accordingly misses the point.
The more nuanced categories become, the less likely talented managers will fit neatly into them. The more likely our descriptions will become prescriptions. That is, the categories will drive not only what is but expectations of what should be in the future. This is a complex and greatly underestimated phenomenon. In reality, manager talent is found in the nuances, subtlety and boldness alike. It is the willingness and strength of character to do things outside of category. This activity is the source of alpha.
Our industry is continuing to learn that the best investors escape conventional categories. They often buy across market capitalisations, geographies and styles. They don’t stick to arbitrary benchmark weightings. They make bold moves. It is the fact that they see and do something unique that makes them great at what they do. They push the horizon of what is possible to be categorised. Human endeavors, such as investing, cannot be contained neatly in pictograms like the Earth’s physical elements.
I am perhaps being unduly critical of Mr Lipper. The professional fund buyer community should be relieved and grateful that one of the great architects of manager analysis has come clean. I, for one, congratulate you in your honesty Mr Lipper. I speak for fund selectors everywhere when I say that you are right: hyper-categorisation and the over-reliance and focus on performance has led the industry down a path that we are only now starting to recover from. But let’s not follow one crime with another to cover up the first.
When investors and their advisors are so dependent on the ranking services to provide guidance that they will only consider buying top ranked funds, we have a serious problem. No matter how many times investors read and hear the contrary, they indeed believe that what will come in the future is foreseeable and predictable via the past (whether they are stars or numbers makes no difference). Lipper Leaders ratings and Morningstar stars have all contributed to this.
Fighting the tide caused by the influence of Mr Lipper’s brainchild and other purveyors of similar methodologies and logic has been a real struggle. With Mr Lipper coming clean, it looks as if there might be light at the end of the selection tunnel after all.
* My emphasis