Should You Follow Your Fund Manager?

By Shauna Carther AAA

The average fund manager only lasts around 4.5 years at his or her fund according to investment-research firm Morningstar Inc. This high turnover rate means there is a good chance one day your current fund manager will no longer be guiding your investments, leaving you to face the question: should I stay or should I go?

Why Fund Managers Matter
The whole idea of investing in a mutual fund is to leave the stock and bond picking to the professionals. Investors study the performance of mutual funds to search for the winners, the funds run by managers who - year over year - consistently beat the market and their peers. Comfortable that they have found a winner, investors place a bet for the long term.

But frequently, events don't turn out quite as expected - the manager resigns, gets transferred or dies. A big part of the investor's decision to buy a managed fund is based on the manager's record, so changes like these can come as an unsettling surprise.

Fund Manager Changes
Investors are bound to face this kind of troubling situation from time to time. In early 2002, investors with London-based HSBC Unit Trust Funds were left wondering what to do with their holdings after the abrupt departure of five flagship fund managers. Given the market-beating performance the unit trust team had chalked up at HSBC, investors were probably counting on the managers staying put for years to come.

Still, investors who stuck with the HSBC fund had little to complain about. Six months later, the fund's successors more than matched their predecessors' records, and investors who stayed on enjoyed strong performance.

But not all investors make out as well when managers leave. Another U.K. fund, Solus Special Situations Fund, topped its sector under manager Nigel Thomas. But when Nick Greenwood took his place in 2001, the fund performed below the sector average. Thomas, meanwhile, outperformed the sector with his new ABN Amro Select Opportunities fund until he left it to go to yet another mutual fund.

So, which one is typical: the HSBC or the Solus case? There are no rules about what happens in the wake of a manager's departure. It turns out, however, that there is strong evidence to suggest that managers' real contribution to fund performance is highly overrated. Managers are often turned into stars by marketing departments. So, when managers move on, it is big news. But investors should not rush to hasty decisions about whether to keep their money in the fund, follow their manager or change their investment entirely. (For more insight, read Will A New Fund Manager Cost You?, When To Sell A Mutual Fund and Assess Your Investment Manager.)

Perspectives on Fund Manager Tenure and Performance
Funds are promoted on their managers' track records, which normally span a three to five-year period. The significance of these records should be taken with a grain of salt. Performance data that goes back only a few years is hardly a valid measure of talent. To be statistically sound, evidence of a manager's track record needs to span, at a minimum, 10 years or more.

For example, research company Morningstar compared funds that experienced management changes between 1990 and 1995 with those that kept the same managers. In the five years ending in June 2000, the top-performing funds of the previous five years tended to keep beating their peers - despite losing any fund managers. Those funds that performed badly in the first half of the 1990s continued to do badly, regardless of management changes.

The research of Klaas P. Baks, finance professor of Wharton School of Business, indicates that the value managers add is small - 30% of performance can be attributed to managers, 70% to the fund. Baks argues that while mutual fund management companies will undoubtedly continue to create star managers and tout their past records, investors should stay focused on fund performance.

The mutual fund industry may look like a merry-go-round of managers, but that shouldn't worry most investors. Many mutual funds are designed to go through little or no change when a manager leaves. That is because, according to a strategy designed to reduce volatility and succession worries, mutual funds are managed by teams of stock pickers, who each run a portion of the assets, rather than by a solo manager with co-captains. The American Funds, for instance, manages its funds this way. (For more on this strategy, see Mutual Fund Management: Team Players Or All-Stars?)

Some fund groups, like Fidelity, make it a practice to promote successful managers to ever-bigger funds and to quickly get rid of poor performers. Changes are not necessarily a sign of trouble. Meanwhile, even so-called star managers are nearly always surrounded by researchers and analysts, who can play as much of a role in performance as the manager who gets the headlines.

Advice for Investors in Managed Funds
Don't forget that if a manager does leave, the investment is still there. The holdings in the fund haven't changed. It is not the same as a chief executive leaving a company whose share price subsequently falls. The value of the fund will not fall overnight. The best thing to do is to monitor the fund more closely to be on top of any changes that hurt its fundamental investment qualities.

In addition, don't underestimate the breadth and depth of a fund company's "managerial bench." The larger, established investment companies generally have a large pool of talent to draw on. They are also well aware that investors are prone to depart from a fund when a managerial change occurs. Morningstar does a good job of tracking changes in fund management, and its opinions on such events can be found in the analyst commentary section of its mutual fund reports. (For more on Morningstar's reports, see Morningstar Lights The Way.)

Lastly, for investors who worry about management changes, there is a solution: index funds. These mutual funds buy stocks and bonds that track a benchmark index like the S&P 500 rather than relying on star managers to actively pick securities. In this case, it doesn't really matter if the manager leaves. At the same time, index investors don't have to pay tax bills that come from switching out of funds when managers leave. Most importantly, index fund investors are not charged the steep fees that are needed to pay star management salaries.

For everything you need to know about index investing, see The Lowdown On Index Funds and our Index Fund Tutorial.

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