“Hot hands” — in sports, business, and investing — don’t last forever. But why? One explanation is that it’s not because outstanding money managers lose their touch (though, of course, that sometimes happens). Instead, the hot hands of even the best investors must eventually cool because their success attracts too much money and eventually overwhelms their market-beating abilities.
The key to finding a market-beating investment adviser, therefore, is to find someone after they’ve played their hot hand but before they’ve attracted too much money. That’s easier said than done.
Bill Miller, former manager of the Legg Mason Value Trust
, (now ClearBridge Value Trust) is the investment arena’s poster child of an adviser whose incredibly hot hand suddenly became as cold as ice. In each of the 15 calendar years through 2005, Miller’s fund beat the S&P 500
— a notable feat that has hardly ever been matched, either before or since. Yet, from 2006 until 2012, when he stepped down from the fund, Miller’s fund performed so poorly that, when combining those awful years with his hot-hand performance, he ended up lagging a simple index fund over the entire period in which he managed the fund.
A more recent example, according to Stephen McKee, editor of the No Load Mutual Fund Selections and Timing newsletter, is Fairholme Fund
managed by Bruce Berkowitz. For the decade through the end of 2009, for example, Fairholme beat the S&P 500 by an annualized margin of 10.5 percentage points, according to FactSet. Over the most recent decade, however, it has lagged by 3.2 annualized percentage points.
Yet these investors’ rapidly cooled hands doesn’t mean that they weren’t good stock pickers, according to research pioneered by Jonathan Berk, a finance professor at the University of California, Berkeley. Instead, according to a theory he devised, both Miller and Berkowitz would have had a greater chance of continuing to play their hot hands if their funds hadn’t attracted so much money.
A basketball analogy is helpful. Imagine a player who starts hitting basket after basket. His teammates naturally will start passing to him more and more, even when he is not in good position to make a shot. His opponents will start double- and even triple-teaming him. Because he will start taking shots with lower probabilities of success, his field-goal percentage will begin to drop.
In the investment arena there are many functional equivalents to the double- and triple-teaming that causes the basketball player’s hot hand to cool. One is that bigger funds must focus their investments on larger and larger companies, since smaller stocks are not big enough to make an appreciable difference to the fund’s overall performance.
Warren Buffett, CEO of Berkshire Hathaway
has acknowledged that this has been a major factor in his company’s performance as it has grown over the years.
The chart, below, illustrates the impact; it plots the amount by which Berkshire Hathaway’s net asset value beat the S&P 500 over the trailing 10 years. Notice the steady downtrend in this margin of victory, from a high of almost 20 annualized percentage points four decades ago to just two percentage points over the most recent ten-year period.
A recent study of hedge funds finds the same phenomenon: “Size, Age, and the Performance Life Cycle of Hedge Funds,” by Chao Gao and Chengdong Yin, both at Purdue University, and Tim Haight of Loyola Marymount University. They found that “diseconomies of scale significantly contribute to performance declines with age in the hedge fund industry.”
The investment implication: Other things being equal, you should favor advisers with fewer assets under management. Had you the choice in 2006 between two mutual funds with Bill Miller’s success of beating the market for 15 straight years, for example, you would have wanted to go with the smaller one.
The problem, of course, is that success inevitably undoes itself. Which successful adviser doesn’t want to yell from the mountaintops about how much he’s beaten the market? Which fund management company doesn’t want to attract more assets under management? The odds are virtually nil of finding an adviser who’s beaten the market for 15 straight years who’s name isn’t plastered across the financial media.
If you find such a manager, invest. Just don’t tell anyone.