Distinguishing skill from style or luck is an important element in picking a successful long-term manager, but it’s more difficult than people think.
By Kerry O'Boyle, Aston Asset Management
“Investors who lack skill simply earn the return of the market and the dictates of their style. Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction. These investors contribute nothing beyond their choice of style. Each does well when his or her style is in favor, but poorly when it isn’t.”
- Howard Marks
The Most Important Thing1
Highly regarded institutional investor Howard Marks sums up neatly the problem faced by all investors—distinguishing true investment skill from random results. In their search for superior and consistent performance, many mutual fund investors often overlook how much style can influence results. Style can be more than just the defensive or aggressive tendency to which Marks alludes. It can also include fundamental or systematic biases that favor certain market environments. A particular strategy bias could outperform for years, luring in investors when conditions favor it before falling off when the market changes.
A troubling aspect of Marks’ keen observation is that performance achieved by style or luck is not repeatable. This may explain why investors seeking the best and most consistent performers of the recent past often seem to suffer from subsequent poor results.2 These investors inevitably choose the best “style-locked” managers in an environment ideally suited to that style. When market conditions change, these less-skilled managers are then unable or unwilling to adapt with performance suffering accordingly.
According to Marks, the skilled manager who adds value tends to deliver asymmetrical results. In other words, the variability of results for skilled managers tends to be greater, not less, than unskilled managers. The implication being that performance derived through skill doesn’t fit a neat pattern, and is likely to seem less consistent and less predictable, especially over relatively short time horizons. Thus, investors need to be careful in how they parse performance in seeking skilled managers to ensure that it is not mere methodological bias or false patterns of consistency or predictability.
Finding Skilled Managers
There is no preordained or universal identifier for skilled managers other than superior performance over decades of investing, a span much longer than the typical manager tenure. While some common traits—adaptability, high-conviction, a truly active management approach—allow manager skill to emerge, every manager is unique. Superior skill remains dependent on the many variables and nuances of a manager’s investment strategy and process. The process of finding skilled managers often comes down to identifying key differentiators and understanding how they allow skill to flourish. Absent any universals, we think examples best highlight what investors can look for.
Randell Cain of Herndon Capital Management, manager of the ASTON/Herndon Large Cap Value Fund (AALIX), employs a relative value approach that results in a different type of portfolio. Tapping into the precision of his engineering education background, Cain developed an extremely methodical approach that builds adaptability into the process. He starts with the full Russell 1000 Index of stocks, not just its value component, allowing him to seek the best values amongst the entire large-cap universe. He compares the relative price/earnings of a company (versus the universe) directly with the company’s relative return-on-equity (again, versus the universe), with return-on-equity serving as a proxy for the quality of a company’s fundamentals. The idea being that price has little meaning without regard to quality. Stocks with a meaningful discount by this method he considers Value Creating Opportunities—candidates for inclusion in the portfolio after more rigorous fundamental research.
By normalizing the data and comparing valuation directly with fundamentals, Cain’s methodology seeks to minimize a number of biases common to value managers. The process reduces the potential for so-called “value traps” (when cheap stocks become cheaper due to a deterioration in fundamentals) as well as runaway momentum factors that can trip up typical “relative value” strategies based on sector or historical trends. Many different types of companies—cyclical stocks, non-cyclicals, fast growers, slow growers, high quality, low quality—have moved in and out of favor by this method over time, while the common thread remained the valuation discount threshold relative to company fundamentals.
Cain also controls for sector bias using his calculation of Value Creating Opportunities. By determining the number of such opportunities in each sector, he can calculate a ratio versus the entire universe. Sectors with a greater proportion of Value Creating Opportunities garner an overweight position relative to the benchmark, reflecting the greater opportunity set. This feature again attempts to overcome a common bias with investment managers—over- or underweighting sectors based on an ad hoc fondness for particular sectors or underlying holdings, unreliable top-down calls, or index weightings biased by market momentum.
We think Cain’s skill is enhanced by the adaptability and bias control built into his methodology. All fundamental managers conduct detailed bottom-up company analysis, but avoiding built-in biases is critical in determining an appropriate valuation across a changing market landscape. Cain’s thoughtful approach to identifying Value Creating Opportunities leads us to believe that results will come from skill more than luck over the long term.
Process matters little without discipline and conviction. Along with Herndon, the management team at Fairpointe Capital, subadviser to the ASTON/Fairpointe Mid Cap Fund (CHTTX) has that in abundance. Fourteen-year veteran lead manager Thyra Zerhusen, with help from co-managers Marie Lorden and Mary Pierson, has developed an expertise in mid-sized companies focused on one or two core business lines, backed by an in-depth bottom-up research process. We think the team’s performance record, however, owes much to a concentrated, low-turnover portfolio and contrarian trading style that comes from knowing the companies they own extremely well.
Owning great companies alone usually isn’t enough. An active manager needs to get the timing and position size right more often than not to reap the most benefit. Fairpointe builds sizeable positions in stocks it has owned and followed for years, adding during periods of weakness and trimming after rallies (all else being equal). This contrarian re-balancing approach requires incredible discipline and steadfastness, but allows the underlying skill in identifying truly outstanding companies to shine through over time. Although this truly active and benchmark agnostic approach can lead to short-term bouts of volatility and underperformance amid market gyrations, in the past those periods have often set the stage for periods of outperformance in helping the Fund achieve its outstanding long-term record.
True Active Management
Years of experience meeting with hundreds of managers and having access to longer institutional records helps Aston to assess skill across a wide variety of strategies. As a result, even our newer funds employ managers with established records, evidence of skill from managing money elsewhere.
We think the skill that manifests itself with the recently launched ASTON/LMCG Emerging Markets Fund (ALEMX) is its willingness to analyze and adjust to the dynamic regional and market conditions found in Emerging Markets. Its strategy is not simply a domestic equity model converted for use among emerging market environments that are vastly different from the U.S. Lee Munder Capital Group’s (LMCG) fundamentals-based quantitative strategy customizes its factor weightings according to their effectiveness within that universe. Lead manager Gordon Johnson and his team have also developed proprietary region/industry peers groups, based on whether a company competes regionally or globally, for more relevant peer analysis. The team doesn’t merely base the portfolio’s exposure on market-cap and momentum-biased index weightings, but considers the unique conditions of where individual companies compete as a fundamental part of their process.
Unlike so-called “black-box” quantitative strategies that try to optimize at the portfolio level among hundreds of holdings, Johnson builds the portfolio one stock at a time from the bottom up. He recognizes that what is important is not the quantitative factors one uses, but which ones to emphasize, and when. Thus, the strategy relies on context-driven analysis—emphasizing factors favorable to current economic and market conditions. Johnson doesn’t try to call market peaks or troughs, but seeks to recognize when markets are near such inflection points and to know what factors work best in such an environment.
It’s a quantitative strategy, but one run by people with considerable experience, able to analyze and adapt its parameters to current market conditions. This requires skill, but it also enables skill not found among more- rigid approaches.
“They’re Just Great Stock-Pickers"
When faced with a fund with a great long-term performance record without a discernible pattern, but one without a distinguishable investment process, an analyst at an independent asset manager/ratings firm remarked, “Oh, they’re just great stock-pickers.” More likely, he had no idea what made them stand out. That sums up the dilemma for many investors—if you don’t understand or have a reasonable explanation for why a fund has performed the way it has, then it's less likely you know whether its performance owes to luck or skill. Consistency of returns or obvious performance patterns frequently serve as a proxy for proper analysis, but more often are marks of managers simply benefitting from a particular style in the near-term.
Too few investors really take the time to understand whether the superior performance they covet is sustainable over the long run. Skilled managers able to succeed across multiple market cycles are out there, but they can be overshadowed in the short-term by unskilled managers riding high aided by temporary market trends. In the end, though, it is the skilled manager that survives and thrives over time. Investors looking to succeed in an ever more challenging market environment will need to find such skill if they wish to meet their goals.
1 Howard Marks, The Most Important Thing: Uncommon Sense for the Thoughtful Investor (New York: Columbia University Press, 2011), 171.
2 Sunil Wahal, Arizona State and Amit Goyal, Emory University, The Journal of Finance—Vol LXIII, No 4, August 2008.
Kerry O'Boyle is an Investment Strategist with Aston Asset Management. Prior to joining Aston he wrote on a variety of investment topics as a mutual fund analyst for Morningstar, Inc. He is a graduate of the U.S. Naval Academy, and holds an M.A. in Liberal Arts from St. John's College, Annapolis, MD.
There can be no assurance that any strategy will be successful of produce the desired result. Mutual Fund investing involves risk, including possible loss of principal.
Note: The ASTON/Herndon Large Cap Value Fund Value is subject to risks associated with value investing, which involves buying the stocks of companies that are out of favor or are undervalued. This may adversely affect the Fund's value and return. The ASTON/Fairpointe Mid Cap Fund Mid-cap stocks invests in mid-cap stocks which are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. The ASTON/LMCG Emerging Markets Fund Emerging Markets invests in emerging market securities that tend to be more volatile and less liquid than securities traded in developed countries. Foreign securities involve risks related to adverse political and economic developments unique to a country or a region, currency fluctuations or controls. In addition, Emerging Market securities are subject to risks associated with less diverse or mature economic structures, less stable or developed political and legal systems, national policies that restrict foreign investment, and wide fluctuations in the value of investments.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.