A Few Good Money Managers

John Mauldin | Thoughts from the Frontline
September 16, 2005

This week I let you peek over my shoulder while I try to find some new money managers. Like the old army ad, I am looking for a few good men and women who have figured out some part of the investment world. How does one go about the task of finding and sorting? How can we figure out who deserves to get our money and who we should set aside? It's not as easy as you would think.

But first, a follow-up to my letters of the past few weeks. I think it is looking less and less like the Fed will raise rates at the September 20 meeting, even though recent speeches by Fed governors would suggest they are still thinking that way. The calls from all quarters for a one meeting pause to assess the damage from Katrina are quite loud, and the bond market is certainly indicating they expect the pause.

But it would not surprise me if this was just a one meeting pause. There are worrisome signs, like the proverbial cloud no bigger than a man's hand, that inflationary forces, if left unchecked, could work their way into the economy. I do not believe the Fed will make the mistakes of the 70's and let broad monetary inflation get a toehold in the US economy. Such an unfortunate event would trigger even higher long term rates, thrusting mortgage rates far too high and halting the current expansion rather abruptly.

Right now, it appears the economy is going to adjust to Katrina rather faster than originally expected. Ports are opening back up faster, and refineries are coming back on line. While a great deal remains to be done to get harvests and shipping back up to speed, and caution is the best policy, it may be that things are back to "normal" for most of the country by late October and the re-building process will be going full blast by then. If so, Katrina will only slow the economy by a small amount.

Then we can go back to worrying about the concerns we were focused on in late August: a housing bubble, slowing consumer spending coupled with high energy costs, trade and budget deficits, etc. If the housing price increases do not slow down, I think the Fed will resume its course of measured rate increases.

In my August 26, 2005 e-letter I analyzed Greenspan's latest speech at Jackson Hole. This is a very important speech, and one where you really need to understand the implications. He could not have been more clear about targeting "asset prices," and specifically the rise in housing prices. He intends to at least slow, if not stop, the rise in home prices. My expectation is that they resume the measured increases in November.

They will continue until home price increases have stopped and inflation in other quarters is not a threat. This will slow the overall economy. Make no mistake about that. But Greenspan made clear he views not doing anything to have far more serious consequences. This will be a continuing topic in future letters.

A Few Good Money Managers

As long time readers know, I rarely talk about my actual business, other than the occasional suggestion to go to another web site for more information. Today, I am going to depart from that policy, but hopefully as a means to share some thoughts on how one should go about choosing a money manager. If you are not interested in my personal business background, then skip to the next headline called "Choosing a Money Manager."

I have been a "manager of managers" for nearly all of my investment management career. That is, instead of choosing stocks or bonds or commodities, I try to find other managers who are good at some specific aspect of money management, and then help clients place money with them. Typically, those managers share a portion of their fees with me. For the past five years, I have been almost exclusively focused on hedge funds and other alternative investments for high net worth investors (see below for more information on that program).

I continually get asked to recommend managers or funds for investors who do not qualify for hedge funds or other private offerings, but have not really been in a situation where I could do so. In the next quarter, that is going to change. We are adding staff and capacity to allow us to recommend money managers with a broader potential client base, using technology and experienced associates to minimize the time impact on my workload, yet make sure everything works as smoothly as possible.

Basically, we will create a website where we introduce you to a variety of money managers who operate in a wide variety of styles and services. If you are interested, you can get a larger special report on that manager and then deal directly with them if you are interested in investing. We expect the program to be up and operating in the middle of the 4th quarter. I will announce it in this letter when it is ready.

I already know, and have known for a long time about several money managers we are going to put into the program. But I also know there are some managers I have not yet met who should be exposed to a larger audience. So, with this letter, if you are a money manager or investment advisor who thinks that you have a better mousetrap, I want to hear from you. Or actually, my associate Harry Ward wants to hear from you. You have to get past Harry before you can talk to me. (You can reply to this letter and he will get back to you.) Harry passed level III of the CFA program in 2004 and has his CAIA designation (Chartered Alternative Investment Analyst). He is smart, cynical and skeptical. In short, perfect for the job of screening managers.

I have talked to literally hundreds of money managers over the years. Bluntly, most of them should not be managing money. I have actually made that a theme for a talk I give every now and then to conferences on money management. As you might imagine, that is not always a popular message. But I do have one softening note. I would include myself in that group.

I do not have the personality to directly manage money. I can watch a manager do it all day and not flinch, but would not want to do it myself. I like to be able to think about the big picture and try to decide where to allocate general resources among broad asset classes rather than focus on one narrow niche and choose among a limited variety of potential investments. This also allows me to change asset classes and managers. If all you do is one thing or style of investment, then when your style is out of favor (which all styles will eventually be), it is not fun.

But, advisors like me need those specialists, so I encourage them to stick to their knitting and to get really good at what they do. Just please don't get offended if I do not choose to be in your chosen asset class. I am sure you are a nice person, but personality doesn't do much for bottom line returns if the markets are moving against you.

Choosing a Money Manager

OK, you still want me (well, Harry) to look at your fund or program? Here are a few ground rules.

First, please do not show me your hypothetical system and expect me to get excited over the numbers. I know this is hard for some to hear, but I want to see actual results from actual trading. And yes, I know it is chicken and egg. How can you get started if someone doesn't give you money? Just know that I am very unlikely to be that someone.

I swear this is true. Last year I met with a very sophisticated advisor who was convinced he had found the Holy Grail. He had these physicists who had developed financial investment models based on the nine dimensional string theory. The back-tested numbers were amazing. I mean off the charts amazing.

But besides the fact that I get lost after four dimensions (and have been known to get lost with a two-dimensional map), I could not get excited. Maybe this system would be the best thing since sliced bread, but how could one know?

There were no real world results. I would love to see the results (and hope to) after two years of trying to actually execute the system. There are a lot of Holy Grails which lose their luster in the minutia of execution. If you have been in the business long enough, you have seen more than your share. Full disclosure requires that I have even been involved in one such quest. Which makes me all the more cautious.

So, if you are starting up your brand new Holy Grail, we will be glad to put you on the radar screen, but we will want to see real numbers before we do anything.

Is there an exception? Yes, if you have been running a program for a long time and then are leaving to set up your own shop, and we can absolutely verify that the numbers from the previous firm were yours, then we will look at you.

Why Investors Fail

Second, please remember that past performance is not indicative of future results. While the professionals typically explain their problems in very creative ways, the mistakes that most of us make are much more mundane. First and foremost is chasing performance. Study after study shows the average investor does much worse than the average mutual fund, as they switch from their poor performing fund to the latest hot fund, just as it turns down.

Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He is one of the more astute analysts of trading systems, managers and funds that I know. He has put more start-up managers into business than perhaps anyone in the fund management world. He has a gift for finding new talent and deciding if their "ideas" have investment merit.

He has a team of certifiable mathematical geniuses working for him. They have access to the best pattern recognition software available. They have run price data through every conceivable program and come away with this conclusion:

Past performance is not indicative of future results.

Actually, Mark says it more bluntly: Past performance is pretty much worthless when it comes to trying to figure out the future. The best use of past performance is to determine how a manager behaved in a particular set of prior circumstances.

Yet investors read that past performance is not indicative of future results, and then promptly ignore it. It is like reading statements at McDonalds that coffee is hot. We don't pay attention.

Chasing the latest hot fund usually means you are now in a fund that is close to reaching its peak, and will soon top out. Generally that is shortly after you invest.

What do Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals. As they look at scores of managers each year, the common thread for success is how they incorporate some set of fundamental analysis into their systems.

Great track records are not enough. I am going to need to know how you made that track record and then why. We will need to be able to break your program down into its components. Did you get lucky and have a few parts of your program go through the roof, making your overall track record look stellar? How likely is it that you can repeat? I mean, can you find more hot investments like you did in the past, or will your overall portfolio in the future look like your average without the hot components.

If you are looking over my shoulder, this is called attribution analysis. In other words, to what can we attribute your good performance? Did a manager have a very diversified portfolio, or did he only have a few positions and those went through the roof, which made his whole portfolio look good?

Two examples are warranted here. One of the managers that will be on the list has a trend following system. I like the system from a philosophical and theoretical standpoint, and have known and trusted the manager for years. The numbers look good. But they are meaningless.

He made money in the past because there were trends he could catch. There is simply no way to know what trends will develop in the future, whether his system will catch them or get whip-sawed, how big (or small) the trends will be and so on. Past performance is only useful to help us understand how his system worked in the past. It is of absolutely no-zero-none-nada value when it comes to trying to figure out what will happen in the future. His record will only repeat if the conditions in which he delivered the past performance repeat, and then only if he does not mess around with his system and has the same discipline. That, gentle reader, is the tricky part. You would choose this manager only because you think there is a macro-economic possibility his chosen, very narrow niche will have trends in the future.

So bringing me (or Harry) a kick-butt track record and expecting us to believe you can repeat it just doesn't fly. It might get us interested, but it is not enough. Ladies, if you will permit me a rude analogy, it is like some men who are only focused on the short skirt, not paying attention to the rest of the person. They are doomed to be involved in some very unhappy (and probably short and expensive) relationships. If the only value in a lady is the short skirt, or the only value to an investment program is the past performance, you will not end up happy.

And sometimes focusing on past performance can make you miss good opportunities. One manager who will be in the program has a very lack-luster recent past performance, going on almost two years. His record for the almost ten years before that was pretty good. Did he lose his way? Why would I be interested? Because for the last few years, he has had very little opportunity to make money. And surprise, surprise, he hasn't. The surprise would have been if he had made money. You can't make something out of nothing. But I think the field (again, a quite narrow niche) in which he plows has the potential to become fertile again. If I am wrong, he will still be boring in the future. And I could be right and he could miss it. As investors, we have to decide where we want to put our money to work. But there is always risk. We work to quantify it, but it is a lot harder to quantify future risk than looking at a few past performance numbers.

Tails You Lose, Heads I Win

I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb called "Fooled by Randomness." The sub-title is "The Hidden Role of Chance in the Markets and in Life." ( Amazon.com: Fooled by Randomness) I consider it essential reading for all investors, and would go so far to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he gives us a very thorough treatment. He also has a gift for expressing complex statistical problems in a very understandable manner. I try to read the last half of his book at least once a year to remind me of some of these principals. Let's look at just a few of his thoughts.

Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their 7 figure salaries prove it.

The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!

So, Mr. Manager, in addition to not having past performance upon which to rely, we now have to figure out if you are one of the lucky 313. Now, I know a lot of managers resent it when we bring that up. But there is luck and there is skill, and it is easy to get them confused. Sometimes just being in the right markets at the right time is lucky. As an example, being in technology stocks was a wonderful thing for 18 years up until early 2000. The guys who plowed in the value fields got left in the dust. And commodity stocks? Who wanted an oil stock manager? And gold was really no fun.

The Problem of Survivors

In the mutual fund and hedge fund world, one of the continual issues of reported returns is something called "survivorship bias." Let's say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.

If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.

I've Got A Secret System

If you go to an investment conference or read a magazine, you are bombarded with opportunities to buy a software package which will show you how to day trade and make 1,000% a year. For $5,000 you can buy an "exclusive" letter (Just you and a thousand other readers, and their friends and clients) which will give you a hot option or stock tip. You will be shown winning trades which make 100% or more in a short time. You, too, can use this simple tested method to enrich yourself. Act Now. (Add 6.95 for shipping and handling.)

Most of the funds I look at are in the private fund or hedge fund world. I get to see the track records and talk with some of the creme de la creme of the investment universe - the true Masters of the Universe. These are the managers available only to accredited investors ($1,000,000 or more net worth.) This world is growing leaps and bounds as more and more sophisticated investors and institutions are looking at these managers now that mutual funds and stock managers are having bad years.

None - not one - nada - zippo - zero of the best managers in the world can deliver the consistent results that you read about in these ads. The best offshore fund in the world for the five years ending in 2000 did about 30% a year. You can't get into it. But in 2001 and 2002 they were flat. They have since not rebounded to those early years. Past performance is not indicative of future results.

Steve Cohen can deliver some spectacular returns and has for almost 20 years. He has been closed to new money for years. But even this legend can't put up numbers like I see in the ads.

Here's the reality. If you could make 20% a year steady, in five years - ten at the most-- you will be managing all the money you can run. Trust me, the money will find you. You will charge a 2% management fee and 20% of the profits. On $1 billion, that amounts to $60 million dollars in fees. That's every year, of course. Why would you sell a system that could do 20% a year?

Once everyone knows about a system, it won't work like it has in the past. One of the problems I wrestle with every day is trying to figure out which investment styles may be at the end of their run. Every dog has its day in the sun. The trick is to figure out when the sun is setting.

This is consistent with work done by Dr. Gary Hirst. In 1991, he began to look at technical analysis. He spent huge sums on computers and programming, analyzing a variety of technical analysis systems. Let me quote him as to the results of his research:

"I had heard about technical analysis and chart patterns and, looking at this stuff I would say, what kind of voodoo is this? I was very, very skeptical that technical analysis had value. So I used the computers to check it out and what I learned was that there was, in fact, no useful reality there. Statistically and mathematically all these tools--stochastics, RSI, chart patterns, Elliot Wave, and so on--just don't work. If you code any of these rigorously into a computer and test them they produce no statistical basis for making money; they're just wishful thinking. But I did find one thing that worked. In fact almost all technical analysis can be reduced to this one thing, though most people don't realize it: the distributions of returns are not normal; they are skewed and have "fat tails." In other words, markets do produce profitable trends. Sure I found things that work over the short term, systems that work for five or ten years, but then fail miserably. Everything you made, you gave back. Over the long term, trends are where the money is."

Finally, I am not looking for long only managers (with the possible exception of some very niche areas). There are thousands of those and they are called ETFs and mutual funds. Read my book, Bull's Eye Investing. If you do not fit into some category of Absolute Return investment style, or cannot show me how you are not dependent upon a rising general market, it is going to be hard to get past Harry.

And have a real way to manage money and scale up. We want to see backroom systems, well-known custodians, and support staff. There must be some very clear way to verify where the money is at all times.

And yes, we look at hedge funds. We are always looking. Drop us a note if you like. But the same rules (and a lot more) apply. However, if you can't spell the word transparency, don't bother.

As noted, we will announce the program in the middle of the 4th quarter.

Conferences in Toronto, Houston, London and New York

This week I finish the letter in Palo Alto, where I am getting ready to meet with good friends George Gilder and Andy Kessler, as well as Ray Kurzweil and a host of guys who are really smarter than me talk about artificial intelligence and intelligence augmentation, and then on to San Diego to meet with my partners at Altegris on Monday and then back home.

Then I start a run of speaking engagements. I will be in Toronto September 27 for an evening presentation on behalf of my Canadian partners at Pro-Hedge. That speech will be quasi-public. If you would be interested in getting an invitation just reply to this letter and we will send your name on to Pro-Hedge. They will give you the specifics as to time and place. I will be speaking at the 6th Annual Summit on Alternative Investments for Institutional Investors September 29-30. My presentation is the morning of the 29th. For more information, click on the following link: http://www.strategyinstitute.com/092905_alt_invest_2005/dsp_alt_inv_2005.php

I then fly that afternoon to Houston, where I will be speaking at the Financial Planners Association in Houston September 30. The next day I fly to London. I will be making presentations in London, Copenhagen, and Brussels to various investment groups in conjunction with my European partners, Absolute Return Partners (ARP), and meeting with clients and or potential clients. If you are interested in meeting while I am in Europe, please let me know and ARP will be in contact with times and places.

I will be speaking at the Value Investing Conference in New York November 15-16. There are some really great speakers and I am excited to be part of it. If you are interested, you can go to www.valueinvestingcongress.com and register. My readers can put in the code RVICJM and you will get an extra $100 off the registration price.

My friends and business associates from Altegris Investments will be in New York as well. Jon Sundt (president), Matt Osborne and Dick Pfister from Altegris Investments will be there to meet clients and potential clients. Basically, we help clients develop portfolios of hedge funds, commodity funds and other alternative investments. If you would like to know more about what we do, you can go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds that is just for accredited investors (essentially net worth of $1,000,000 or more). If you want to be able to go into specifics about your portfolio with me and Jon, Matt or Dick in New York, you must sign up soon and start a conversation with a representative from Altegris at least 30 days prior to the conference. We will not go into specifics with anyone with whom we have not had a substantive relationship for at least 30 days. Those are the rules and we follow them.

(In this regards, I am president and a registered representative of Millennium Wave Securities, LLC, which is a member of the NASD. Please see the specific risk disclosures which follow below as well as those on the website.)

I am looking forward to this weekend. As I think about it, this is the only conference this year I am attending where I do not speak. It will be fun to be just a tourist, and this is a very interesting crowd. I need to hit the send button and get on my way. Have a great week!

Your feeling like he needs some personal intelligence augmentation analyst,

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