When a good process doesn't meet expectations

I just read Barry Ritholtz’s column in the Washington Post “Outcome or process — what investment focus succeeds over time?”

 

Barry said, “Focusing on your investment process, and not the outcome, should be your goal.”

 

He continued, “Over the long term, a good process delivers highly desirable results, and generates better and more reliable outcomes.”

 

I agree. But what does “good” process mean?

 

Sophisticated investors want to understand, among other things, the portfolio manager’s good (disciplined and repeatable) process including the following:

• Where do they start?
• What happens next?
• How do they do research?
• How committed are they to their holdings?
• How do they make buy/sell decisions?
• How do they incorporate macroeconomic research, if at all?
• How do they monitor their holdings?
• How do they manage risk?
• Who is involved?

The big issue, though, in my opinion isn’t the process or the outcome. It’s a combination of both. Does the process deliver an outcome that meets expectations? Or as Barry said, is the outcome reliable?

Most managers have a stated strategy. Sometimes they drift away from that strategy, which can cause sophisticated audiences to put up red flags, ask questions and possibly leave.

Consider a mutual fund that contains “value” in its name and considers itself a value strategy, but because managers have added growth names recently the fund acts more like a growth fund. If an advisor is looking for a value fund, this fund probably isn’t the fund for him. If he’s already a shareholder and notices these changes, he might leave.

Or consider a “small cap” fund that doesn’t sell its winners and now acts more like a mid cap fund. You get the idea.

These strategies might have “good” processes, but if investors can’t confidently predict the outcome of that process, they will find strategies that deliver reliable results. 

I recently sat down with a fund manager who has a great track record. Historically the fund participated in up markets and protected in down markets. It’s a conservative fund to help investors sleep at night. But surprisingly the manager beat the market in 2012 and 2013 when the market went up. When I asked the manager about his fund’s performance, he boasted as if his fund’s performance would continue.

From an investor’s perspective, although the outcome was favorable, it wasn’t expected. So sophisticated audiences have been asking:

• What led to the outperformance?
• Will the outperformance continue?
• Has the strategy changed?

The fund can no longer be relied on to perform as expected. It has become a risk.

However, the fund has started to see inflows by investors chasing performance which is not what this manager really wants. New investors will likely flee when the strategy returns to its more conservative outcomes.

When I asked this manager about the fund’s outperformace, a better answer would have been:

“We have a good process and for the last two years we surprisingly beat the market. If the market continues to be strong, we don’t expect to outperform. My investors want to sleep at night.”