Monkeys vs. Mutual-Fund Managers

Morningstar: You either love it or you hate it. It’s got the most comprehensive database of mutual funds, and you can look up everything from performance, to individual stock holdings within funds, to obscure statistics such as upside capture ratios and so on.

I typically use Morningstar when I review a physician’s portfolio, since (I’ve found) most doctors or their financial advisors have invested in some bizarre funds. So I have to go to Morningstar to find out what the funds actually invest in.

Every year, Morningstar puts a few fund managers on a pedestal and bestows on them the title of “Morningstar Manager of the Year.” Three exclusive winners are picked -- one for domestic equity funds, one for international stock funds, and one for fixed-income (or bond) funds.

For 2010, Morningstar’s “Domestic Fund Manager of the Year” -- Bob Goldfarb and David Poppe of Sequoia Fund (SEQUX) -- impressed the investment-research giant because, it said, “Sequoia is rooted in decades of deep individual-company research and deft execution of a winning, time-tested investment formula.” Sounds like you can’t go wrong.

For the “International Manager of the Year,” Brent Lynn of Janus Overseas T Fund (JAOSX), Morningstar said that he is “a talented stock-picker rooted in deep fundamental research and is adept at spotting future growth before others see it.” Sounds like he’s got the crystal ball no one else has. Maybe he’d be a good meteorologist.

When you read stuff like this, you might think, “Why even bother putting your hard-earned money anywhere else?” After all, if Morningstar has already found the investment gods, you should be set.

Before you invest in the fund managers of the year, or any hot manager of the week, consider this: Suppose that every year you get 10,000 monkeys together, blindfold them, and stick their hands in a bucket to pick one of two bananas. One banana is yellow (ripe and ready to eat) and the other is green (unripe and unappetizing to the moneys). The chance of picking a green banana, or a yellow one, each time is 50%. Odds are that in the first year about 5,000 monkeys will pick a green banana. After the second year, about 2,500 monkeys will have randomly picked two green bananas in a row. And after a decade, about 10 very hungry monkeys will have picked a green banana every single year -- purely by chance alone.

What do green bananas have to do with investing?

Well, suppose you take 10,000 mutual-fund managers and let’s suppose that 50% of them beat the stock market in any given year. After one year, we know that statistically 5,000 managers will have beaten the market. After two years, 2,500 will have beaten the market. And after a decade, about 10 would have bested the market by random chance alone.

Here's the kicker.

The data show that the actual number of fund managers that beat the market is less than what we would expect by random chance alone. In other words, there’s no way to conclude that a fund manager has beaten the stock market due to skill or simply due to luck. If managers are so skillful, we would expect that there would be more managers that beat the market than what would be expected by chance. Unfortunately, that’s not the case. If these guys are so skillful, they must be hiding under a rock somewhere because we can’t find them. And the ones who do “beat” the market still fall well within a random distribution.

So the next time you get the urge to invest your hard-earned money with a hot fund manager, or your financial advisor tells you that he or she has found the winning money managers, realize that you may get stuck with bunch of green bananas.

This week’s financial prescription: Stop chasing “hot” mutual-fund managers or mutual-fund performance.