Everybody makes some money in a bull market. In fact, it is quite hard not to show some degree of profits when the market is ripping for a period of months or years.
To paraphrase William Jiler, this makes common sense – a generally hopeful attitude of the public towards business outlook and the economy will be transposed not only on valuable and profitable companies, but also on its industry group and wider sector, leading to buying demand rising prices in stocks that would on their own merit go nowhere.
Thus, diversified equity mutual funds will always be swept up along such tidal waves in the market, the degree of their performance depending on their strategy, and usually inversely proportional to the degree of diversification.
Why we need to carefully chose who takes care of our money
Problems arise when the market starts rolling back. Once in a while, such as now in 2022, the trend can turn down for months and years. Performance erodes, and the fund’s client money with it.
I believe it’s a fallacy to say that the average person has no time to actively manage their stock holdings. In fact, 2-3 hours on a weekend or less can be sufficient for many people to save themselves from drawing their account down severely in such bad times, with the proper knowledge. But of course, I’m not a government-certified financial adviser, so don’t listen to me.
But for those that really do lack the time, I believe I can lend some initial ideas for making the choice of an advisor/ money manager of one’s retirement- or other savings, and the capital appreciation surrounding such.
This decision is not trivial and should be done with great care. Drawing one’s life savings down 30-70% in a bad market may well be the difference between retiring early, or never.
The central questions are – what makes a money manager, an asset management firm or an adviser good, and what does ‘good’ mean?
I think that when interviewing or researching possible candidates to safeguard and grow one’s savings, the following five core questions should be raised.
1. What is their approach to risk management, and how would they keep portfolio risk minimal during a bear market?
People worry most about finding the fund with the best performance. They are blinded by fear of missing out on profits, a typical rookie mistake.
Risk management is the number one job of anyone navigating the muddy waters of financial markets.
Managers wooing their clients with annualized performance numbers while carefully avoiding the topic of strict risk management should raise a yellow (or rather deeply orange) flag.
A skilled fund manager should know where to draw a line in the sand, and when to say ‘I was wrong’. In stead, the average mutual fund manager tends to shift money out of the the winning holdings into the losers, with to my eyes questionable tactics such as “rebalancing” and “averaging down”.
As Jesse Livermore admonished, they shouldn’t hope for small losses and shouldn’t fear only getting small profits … instead they should fear large losses and hope for large profits. It’s like back in school – the bad students tend to continue to get more bad grades, while the good students tend to continue to get more great ones. Who would you put your money on?
2. How do they manage exposure and stay flexible with the market they’re in?
Only after it has been established that they’re able to protect existing capital, should one turn their attention towards how they may be able to grow it.
Most people are aware of the simple baseline idea that the fund’s performance annualized over a decade or longer should at the very least outperform the S&P 500 – otherwise you might as well put your money in a passive ETF strategy.
This calculation needs to include management fees, which can be substantial and severely impact the compounding effect.
Basic logic, so far. However, just to reiterate here, most funds in reality fail to outperform or even under-perform the general market indices when put to the test.
One should find out what their selection model is, their general strategy for finding profitable opportunities, and whether it makes common sense. Don’t be intimidated by jargon, ask for simple clarification. As Einstein said, if they can’t explain it in simple terms so that even a child would understand, they don’t understand it deeply themselves.
If one doesn’t have the necessary understanding to gauge the effectiveness of their approach, no problem. There is a simple litmus test to see if someone is good at protecting capital and able to make reasonable profits above market return – the equity curve (see below).
I think it’s important for many people to realize that fund managers are paid management fees for a reason – that they work. Here, ‘working’ does not mean buying something once and holding it forever no matter the changing market landscape. Nor does it mean spending working hours mostly in boardroom meetings. A portfolio manager’s job is to watch the market, first and foremost.
Risk management and management of portfolio exposure goes hand in hand with understanding market stages and environments. What goes up, will go down, or chop sideways. While interviewing fund managers, one should fish for what they think about riding down-trends while having all their client capital declining in equities, and whether they believe it could be a problem.
In this context, it is key to know a fund’s cash mandate, and their willingness/ability to exit hostile markets. Most equity mutual funds are mandated to stay invested to high degrees at any time, for various reasons. This can be as high as 90-100%, i.e. a maximum of 10-0% cash even in a severe market downturn. Very problematic in my eyes.
3. Where did they get their “education”?
An obvious one … or is it?
In my opinion, there is one thing for sure when it comes to actually operating in the markets – a university degree in finance is not worth the paper it’s printed on.
After scrutinizing the careers and life stories of many successful money managers and receiving close mentorship from one, I have come to the following conclusion. It is the people with street smarts and with lessons learned “in blood”, i.e. through making mistakes and putting their own money where their mouth is, that are the ones that have the baseline skills to be consistently profitable in the long term.
A fancy degree and good scores do not predict success, and lack of them does not precede failure. Jack Dreyfus, of the Dreyfus Funds in the 1950-70s, barely managed to get passing grades during his studies at Lehigh University, an article in Life magazine recalls – hardly a standout student. His fund later returned 604% over a 12-year period where the Dow Jones Industrials only returned 346%. An outsized and gigantic number for a mutual fund, and it only came after a few years of Dreyfus first under-performing the markets and cutting his teeth by first-hand experience.
True education in the markets comes from being, surviving, and thriving in the markets.
Today’s fund managers have on average been in the business of handling client money for less than a decade. Many will not have experienced that markets can more than halve in value every 8-15 years or so, and only know markets that are supported by ultra-loose monetary policy. A dangerous combination.
4. Are they handling their own personal money and their savings in the fund, and how much of it?
If you want to see the conviction someone has in their own ability to manage money, find out whether they walk the walk, and are willing to put at risk what matters to their and their children’s wellbeing personally. Enough said.
5. The ‘Litmus test’: How does their equity curve look, and what was the maximum drawdown in their career?
In my opinion, the best single question to sum everything up. One should never be complacent when some hotshot advertises an annualized return number, or some “record” profits for a cherry-picked year.
Fund managers love to window-dress, as they always want to attract new customer funds. This works especially well in ripping markets, when FOMO is high in mom-and-pop ‘investors’ and their fingers tingle to put their money to work (what sadly often occurs close to market tops).
The older one grows, the more critical consistency and lack of portfolio volatility becomes – young people can always wait years or decades to recover from a market downturn, but for anyone over 50 waiting may not be a possibility.
Consistency means profitability year in, year out. If someone has not experienced at least one complete market cycle and they don’t have this data yet, or they do not want to show you, it might be safer to head for greener pastures.
Here, the ideal is a smoothly uptrending staircase pattern, small drawdowns in bad markets and steady uptrends in good ones.
The worst patterns to have are see-saw patterns, which should at the very least (but may not even) be in an uptrend in the very long term. These boom-and-bust cycles can be a big problem for those in need to cash in profits at a specific time, for example to pay ivy-league tuition fees for their children, or generally for retirement.
Passive holding of ETFs unfortunately yields comparable results, as the same dynamic arises from tracking the gyrations of the general market. Dividend-paying stocks can help, but the average market participant does not have the multiple millions worth of dividend-paying stock necessary to solely live off the yield payments in their retirement while awaiting market recovery.
These questions should bring your list of candidates down drastically, and might make you think twice about whether it’s not worth grabbing the fishing pole yourself.
The bottom line equals the first commandment of any market operator. Concern yourself more with what you could lose than with what you could gain.
A last important point – don’t be seduced by celebrity fund managers. Fame is temporary, hubris detrimental.
