Does Your Portfolio Manager Pass the 5-Year Test?

A good first impression goes a long way. It can get you a good table at a popular restaurant. It can give you an edge in landing a plum job. It might even get you a hotel or airline upgrade. Not surprisingly, a strong start pays off for portfolio managers too. They reap rewards for years to come—even after their performance lags.

When I worked in the fashion biz, it was an open secret that certain global cosmetics firms would launch a new product using high-quality ingredients and then switch-out the ingredients for cheaper ones once consumers were hooked. The companies knew that the halo effect from the initial product would keep customers coming back even if the product wasn’t as good as they remembered it.

A recent study published in Financial Analysts Journal examined the performance of 1,824 managers of American mutual funds over a 12-year period. It turns out that active managers do not outperform the general market.

While this isn’t exactly news, it bears repeating because investors are prone to magical thinking about the superpowers of their portfolio managers—for which they pay dearly. Most investors desperately want to believe that paying a premium to a star fund manager is worth it. As the studies show, they are wrong.

For starters, the hotshot will not be able to maintain her stellar performance record over the long term. The study showed that there is no relationship between a manager’s performance in the first five years and the subsequent five years. Factor in the dilutive effects of standard and performance fees charged by active managers and hedge funds and it’s not a pretty picture.

To get a real sense of what long-term market returns will be, take a glance at the risk-free rate. This is the rate of return you would get if you bought a government-secured T-bill, for example. Now look at corporate earnings. They are hovering around two or three-percent, right?

Get the picture? Over10-15 years, it’s likely that you will not do better than five or six-percent (T-bill rate plus corporate earnings rate), even if you’re willing take on some risk. Why twist yourself into a knot for five percent?

One option is to work with a low-cost portfolio manager, so even if returns are on the lower-end, you still keep more of them and thus increase your overall portfolio return. Or, you could go the DIY-route if you have the time and inclination and create a portfolio of ETFs, mutual funds or a diversified basket of common shares of medium-to-large cap, dividend-paying companies in the U.S.A, Canada, Europe, and emerging markets.

That’s not unlike the investment biz. Hotshot fund managers smell great at first. However, the prudent investor should perform a scratch-and-sniff test a few years later. Is the aroma still so rosy?