Determining whether a decision to sell an investment was correct seems like one of the simpler judgements that we make. If it continues to perform well after we have sold it then it was a mistake; whereas if it goes on to struggle it was a wise choice. Unfortunately, it is not always that easy. Focusing on the outcome of a decision alone can often be deceptive and lead us to draw entirely erroneous conclusions.

To explore why this is often the case, it is useful to offer some examples. The main issues we face when assessing the quality of a sell decision is dealing with known costs, hindsight bias, and tail risks:

Known Costs

The manager of a value fund sells a stock once it returns to its fair value. Following its sale, the stock continues to perform well and reaches a historically expensive price.

This can easily be viewed as a fund manager making the error of selling too soon or failing to run their winners. But is it? The manager has a philosophy and process built on buying undervalued securities, should we really expect them to continue to own a position when it becomes expensive?  This would invalidate the process. In such situations following the process is the correct decision even if it appears to be a mistake from a pure outcome perspective.  

If a manager persistently encounters situations where they are selling stocks that go on to outperform, they could adjust their process to capture this momentum. The alternative route is simply to state that missing out on these returns is a known and accepted cost of their approach.

Hindsight Bias

We are investing in an actively managed fund that undergoes significant changes; the asset management company is acquired, and the fund manager departs. An individual with minimal experience is appointed to run the fund. We decide to sell our position in the fund. It performs incredibly well over the next five years and is amongst the strongest in its peer group.

When we review a sale, we will inevitably incorporate information that was not available at the time the decision was made. The potent combination of hindsight and outcome bias means that not only we will think it was a mistake to sell the fund, but that it was obvious that we should not have done so.

In this instance, the new manager may simply have been lucky. Even if they do possess skill, we did not have sufficient knowledge at the time to make such a judgement. The choice to sell the fund was unequivocally the correct one. It will appear, however, as if we sold a talented fund manager at precisely the wrong time.

Tail Risks

We are investing in a fund which has a stellar track record but are becoming concerned about certain developments, particularly around the behaviour of the fund manager. We are not sure how serious these are but estimate that there is a 5% chance of the fund ‘blowing up’. Given this, we decide to sell the position. The fund continues to deliver outstanding returns in the years that follow.

This is a simplified example designed to portray the most difficult type of sell situation faced by an investor. Despite the decision being correct, we will likely be considered foolish for making it. As if we were worrying about nothing and have needlessly forgone performance.

When we judge the success of decisions solely on outcomes, we are likely to consistently penalise those choices that seek to avoid the cost of low probability, high impact failures. As, by definition, they do not often come to pass. Prudent, risk conscious choices will frequently appear unnecessarily cautious.

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It is not that results are unimportant when assessing the quality of sell decisions. They can tell us a significant amount about our investment behaviour, particularly if we can build a large enough sample size. They do not, however, tell us everything. Successful investment is about creating a process that gets the odds on our side. In a system where randomness and chance can exert an overwhelming influence, we need to think less about the result of a given decision and more about whether it was consistent with a robust process.

If you asked a traditional active fund manager whether they could effectively replicate their investment approach in a systematic fashion they would almost certainly say no. They would likely cite the advantages of human judgement and the nuances of their process that cannot be captured in a purely quantitative system. And, of course, they have to say this. To suggest otherwise is to infer that the activity they are richly rewarded for can be efficiently and cheaply emulated. Yet incentives and self-interest aside, developing a systematic replica of their fund or portfolio is exactly what every active fund manager should be doing. There is no better way of isolating the noise that impacts their own judgements or better understanding the often-ambiguous advantages that come from qualitative input.

It should not be difficult for a fund manager to create a version of their fund that is run on a systematic basis. All that is required is an algorithm built on a defined set of decision rules.  It can be more sophisticated than this – you might use some form of machine learning – but this is not essential.  The only question the fund manager needs to answer is: if you had to run your fund in a purely quantitative fashion, how would you do it?

In its most basic form all that is required is a set of portfolio construction rules (number of positions, position sizes, concentration) and criteria about when to buy or sell securities. This can be as simple or complex as is desired, provided it can be managed and maintained by a computer with minimal human involvement.

There are three key reasons why such an approach should be valuable to active fund managers:

Idea Generation: Although not its primary purpose, it can function as a buy and sell idea generation tool that is more sophisticated than a screen or filter. If you continue to hold a stock that the systematic version of our strategy has sold, you should be able to justify why.

Noise Cancelling: The most impactful feature of the approach is the ability to observe investment decisions being made absent much of the noise that influences human judgement. There are a multitude of factors that lead us to make inconsistent and erratic choices. Running a systematic version of a fund removes this issue by focusing solely on the rules prescribed.  How much of the potential loss in rigour and detail is compensated for by the removal of noise?

Identifying Value-Add: Active fund managers often struggle to convey what their true value-add or edge is. Too often it is overly generic (‘growth at reasonable price’) or suitably vague (some kind of ‘secret sauce’ or ‘art’). This is a problem. If fund managers are attempting to sell a skill at a high price, it would be helpful to know what it is. Running a systematic version of a fund can be incredibly beneficial in this regard. 

By comparing the behaviour of the standard (qualitative) fund to the systematic replica it is possible to contrast the divergences in decision making. Through time a history of disparity can be built. By understanding when and why these occur a fund manager can identify exactly what the specific tasks or behaviours are that add value relative to a systematic approach.

Not only is creating a systematic replica useful in conveying to potential investors what the skill of the manager or team might be, it should also greatly assist the manager in refining their process. It should allow them to focus on circumstances and situations where they are most likely to prosper, and abandon those where they consistently fare worse than an algorithm.

There is a glaring problem with this whole idea. What if it tells a fund manager what they don’t want to hear? What if a simple systematic approach consistently makes better decisions? But this shouldn’t really be the case because most fund managers must believe that what they are doing is superior, otherwise it would be a fairly unfulfilling (if lucrative) endeavour. Fund managers should also always be willing to better understand their own decision making and seek to improve it.

Before worrying about beating a benchmark, active fund managers should first try and beat a systematic version of themselves.

Based on years of observation and bitter, painful experience; here are my thoughts on the ten most significant mistakes made by fund investors:

1) Searching for performance consistency 

There is perhaps no more damaging feature of the fund selection industry than the quest for performance consistency. By this, I mean the reverence for funds / managers that deliver outperformance compared to their benchmark over a variety of short time periods (consecutive months, consecutive quarters, consecutive calendar years). The problem is not that it is a bad outcome (it is clearly an incredibly positive one), but that it is used as a shorthand for skill or an indication that such patterns will persist into the future. Both notions are false. 

For performance consistency to tell us something meaningful about future fund returns or the presence of active management skill, we need to believe one of two things: 

a) That the manager or team have the foresight to predict short-term market movements: Most investors would surely accept that market returns over the short-term (at the very minimum) are highly unpredictable and variable, yet by using fund performance consistency as an indicator of skill or quality we are suggesting that the manager responsible can indeed predict market movements over the next month, quarter or year. If they couldn’t then their fund would not deliver consistent excess returns. 

b) The tailwind a fund is enjoying from style or market conditions will persist indefinitely: If we reject the notion that any individual or team can accurately and regularly forecast future market conditions, then performance consistency must arise from some style or bias inherent in a fund that has been in-vogue for a sustained period. Whilst style and factor performance can persist for prolonged spells (often much longer than we think), they will not be maintained forever. So often fund investors mistake factor and style momentum for skill. There is nothing wrong with using fund performance consistency / momentum to make investment decisions, provided we are clear about our intentions and set appropriate rules. We shouldn’t pick a fund because it has outperformed for six consecutive years and then carry out four manager meetings and hours of due diligence to justify a decision based on performance momentum.  

The only consistency fund investors should worry about is consistency of expectations -is a fund behaving in a manner that is consistent with reasonable expectations about its approach? It is critical to remember that if the returns of active funds were all entirely random, there would still be those that produced a remarkable consistency of returns by sheer chance. 

Not only does the search for performance consistency lead us to misattribute skill and luck, but it encourages some of our worst behaviours – most notably lurching between outperforming and underperforming funds. If we buy a fund based on performance consistency, what happens when it inevitably falters? We sell and move on to the next name at the top of the performance tables.

The problem is that the notion of performance consistency is incredibly compelling and has captured all market participants from regulators to private investors. Unrealistic expectations abound. The simple fact is that if we cannot accept inconsistency and maybe years of underperformance, then we should take as little active risk as possible. 

2) Neglecting the circle of competence 

If we are investing in an active fund, we are assuming that the manager or team possess some form of skill that allows them to outperform, but we are often vague about what the particular skill is. The worst form of this to classify someone as a ‘good investor’ (what does that mean?) Even when we attempt to be more specific – ‘macro’, ‘picking cheap companies’ or ‘selecting companies that beat the fade’, they don’t go anywhere near far enough. If we are not clear about exactly what skill(s) are evident then we are liable to allow managers to stray well outside of their circle of competence and into dangerous waters.  

When a fund manager develops a strong track record, we often seem to be comfortable watching them creep or leap outside of their circle of competence into areas where they have no credible history or expertise. The failure of the UK’s leading fund manager was a circle of competence issue. Neil Woodford’s shift into small and unquoted, often speculative, companies was not hidden, he was (for the most part) very transparent about what he owned. His shift was accepted* because of his past performance; even though this was produced doing something entirely different. 

If we are invested in active funds where skill is an expected feature, we need to be precise and explicit about what it is. If a fund manager shifts away from their core competency, we should start to worry. 

3) Seeking smooth returns 

Investment frauds are often not about stratospheric returns, but instead something that might be even more desirable – smooth performance. The attraction of funds that move on an unperturbed path upwards is entirely understandable – drawdowns and volatility are painful and bring about poor behaviours – but it is an entirely unrealistic expectation. If we are to invest with even a modicum of risk then we will witness variability in returns. Fund investors need to accept this rather than find ways to avoid it. That doesn’t mean we cannot make the journey smoother by implementing sensible investment principles such as diversification, but volatility is inevitable and indeed it is a reason why long-term equity returns are so high. 

Even away from frauds we can easily be tempted into funds that provide apparent diversification and smooth returns, simply because they are priced on a different basis to more liquid assets. The idea that certain private equity strategies, for example, are diversifying and lowly correlated to public equities because their assets are marked to model is nonsense. This type of situation is worsened by employing mean variance portfolio optimisation approaches that compare volatilities across asset classes with different pricing methodologies.

We should never let the attraction of smooth performance leave us blind to what assets a fund is actually investing in. 

4) Ignoring the odds of the game 

The first question we should ask about a fund selection decision is – what are the odds of success? But it is one that is rarely posed. It is possible to argue that it is too difficult to make a reasonable estimate of the chances of a good outcome, but this is not credible. If we want to know whether to participate in a game, then we should at least try to understand the odds. There is no precisely right answer, but there are critical questions we should always ask. If we are investing in an active strategy in a particular asset class, what is the history of success for active managers? Do the underlying returns within the market tend to be highly dispersed? We can easily build a picture that gives us a sense of how difficult or easy our task might be. So why don’t we do it? 

Aside from the difficulty of making an accurate probability assessment, there are two additional issues: 1) We tend to think that our case is special and falls outside of the odds of the normal game, 2) We are overconfident. We don’t care about the odds of the game, because we are that good they don’t apply to us. 

To make informed judgements about fund selection decisions, we need to seek to understand whether an investor has skill and if they are operating in an environment where their skill gives them a material opportunity for success. How difficult is the game being played likely to be and who are they playing against? 

5) Being complacent on capacity 

Capacity is a perennial problem for fund investors. Issues around fund size are only likely to occur in funds that are performing well (making us reluctant sellers) and the asset manager is unlikely to acknowledge that a key revenue generator should be closed to new business. 

Despite a disinclination to act on capacity from either fund buyer or seller, it is inescapable that asset growth serves to constrain a fund (when above a minimum viable threshold). A rising fund size limits the investable opportunity set, restricts flexibility, and fosters liquidity risks. 

We are often warned that we should not expect a fund to repeat historic excess returns because the environment is likely to be entirely different in the future. When capacity problems arise, it means a fund could not replicate past successes even if the environment were identical because it is encumbered by the size of assets managed. 

Fund investors need to take ownership of the capacity question, not rely on assurances from asset managers or wait until performance deteriorates. 

6) Buying thematic funds for the wrong reasons 

The continued growth of thematic funds – particularly in ETF structures – is a problem masquerading as an opportunity for fund investors. The potent combination of strong (often hypothetical) past performance and a compelling narrative can be behaviourally irresistible, but frequently leads to disappointment. Thematic funds are often little more than price momentum strategies with a story attached and absent any of the rules that define traditional momentum approaches.  

There is nothing intrinsically wrong with investing in a thematic fund, provided that the reason for doing so is sound. It is a pure way to benefit from the price appreciation brought about by pronounced flows into fashionable areas and we might profit in a second order fashion by predicting how other investors will behave. The major danger in such an activity is knowing when to exit.

The less credible argument is a fundamental one – that the securities captured by a theme are somehow unknown or undervalued. If a theme has performed so strongly and is sufficiently well known to have funds launched based on it, it is probably already in the price.

Thematic funds need little marketing because its sales pitch is embedded in investment philosophy. Tread carefully.

7) Forgetting we are all active investors 

The binary distinction between active and passive investing is simple and effective, but it is not strictly true. All fund investors exist somewhere on a spectrum between the two extremes, no portfolio or fund decision can be considered purely passive. Even in the most basic 60/40 construct there are decisions to make: Is just developed market equities, or should emerging market equities be included? What is the neutral duration position? Should high yield be incorporated? What about gold? 

The critical point is that investors who believe they are passive are not immune to many of the behavioural issues that more active investors face. In my time running passive only multi-asset funds, most of the questions I received were about why we were underperforming other passive funds with different asset allocations.

The prolonged success of long US and long duration portfolios has led to the assumption that people can simply invest and forget, this is great in theory, but unrealistic in practice. What happens if US equities underperform for five years? How strong will the temptation be to shift to the passive manager with a greater exposure to emerging market equities or a significant non-US developed market bias? 

We are all taking some level of active risk, fund investors need to acknowledge what that is and be aware of the behavioural temptations that come with it. 

8) Getting lost in complexity

We should avoid investing in things that we do not understand or cannot explain.  Owning complex funds is incredibly tempting – it makes us look good (see how smart we are!) and offers the prospect for a stream of returns different from traditional funds (uncorrelated, non-directional, through all market environments etc…) Yet mixing complexity (funds) with complexity (markets) often compounds risks rather than reduces them and in ways that can be impossible to foresee. Returns from simple investment strategies have been incredibly strong in recent years and will almost certainly be lower in the years ahead, despite this we should remain circumspect about complex funds.  

9) Starting with the assumption that a fund manager will outperform 

Selection effects such as survivorship bias can run amok when carrying out fund research. When seeking to identify a fund in a particular asset class the opportunity set will already be biased towards funds have had some solid spells of performance by virtue of the fact that they still exist.  In addition to this, we will probably have filtered the universe further through some form of quantitative performance screen.  As the funds we are researching will likely have been strong performers, we typically seek to discover how they have managed to outperform and why they might continue to do so. This is the wrong starting point. Our default position should be that every active strategy is destined to fail even if they have performed well in the past (maybe because they have). There must be exceptional evidence to the contrary to take a different view.

Framing our shortlist of candidate funds as a group of skilful managers who are likely to outperform in the future sets the bar far too low.  We need to begin by assuming everything will underperform.

10) Having time horizons that are far too short

If there was one thing that could be done to improve the decision making of fund investors it would be to extend our time horizons. The shorter our timescale the more we are captured by chance; consistently making judgements based on random and unpredictable market movements.

The irony is that as we try to become more sophisticated and diligent investors our time horizons inevitably contract making us worse investors. We check our funds too frequently, make confident inferences based on little but noise and overtrade. Unfortunately, it never feels or looks like this at the time. We have so much ‘information’ available to us that every choice appears reasonable and well-informed in the moment. Each switch from an underperformer to an outperformer feels good whilst we are doing it. It is only when we reflect that we are likely to observe the long-term costs.

This is an issue that is getting worse.  Our time horizons are becoming ever shorter. More observation points, more near-term scrutiny, and more unnecessary activity. What is good for preserving our careers or getting us through that next difficult meeting is probably to the detriment of our long-term returns.

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* Private investors can not reasonably have been expected to know this; professional investors should.