Succeeding Unconventionally

Fact: Between 1984 and 1999, during a great bull market in America, roughly 90 percent of mutual fund managers underperformed the Wilshire 5000 Index, a relatively low bar to beat.

Ninety percent. Think about this for a moment. Only one out of 10 "expert" mutual fund managers generated a return higher than that of the overall general market. Why does this happen? How is it that an overwhelming majority of intelligent professionals fail to produce a par result for their investors?

The sad truth
The answer is twofold. First, mutual fund managers tend to focus on short-term results, and second, they tend to follow the herd. Mutual fund managers define their investment strategy with particular styles such as "small-cap value" or "small-cap growth" to isolate the parameters that guide their portfolio selections. Any business that does not fit into the particular investment focus of the fund is screened out, regardless of its suitability for investment. The reason mutual fund managers limit themselves to a particular class of equities is because doing so appears rational and is therefore seen as the safest option. Who ever wants to appear irrational? This rationality (or lack thereof) is how mutual fund managers are able to justify their performance to their investors.

Investors, wanting evidence that a mutual fund manager's decisions are reasonable, compare managers' decisions and performances with those of their peers. Mutual fund managers, knowing this investor behavior and anxious to protect their jobs, simply mimic their peers. This mimicking destroys any informational advantage they may have had, leading to a shortage in investment possibilities. As John Maynard Keynes wrote in The General Theory of Employment, Interest and Money, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." What does all this say about mutual fund managers? That, in their goal of wanting to do what seems to be safest, they follow the crowd, resulting in performance below that of the general market by sticking to the same investments as their peer groups.

A different way
Here at the Fool, we are anything but conventional. In fact, some might go so far as to say that we are an extremely unconventional band of brothers. That's a good thing, you see, because it means we filter out most of the nonsense and give you the skinny on what really matters in order to multiply your money.

Fortunately for investors, they have some options. Two of them are index funds and what legendary investor Warren Buffett terms "super investors." While the focus of this article is on the latter, here's a simple word on the former: Index funds are a great way to mimic the market without the necessary (sometimes outrageous) fees of a mutual fund. These low-cost, passively managed funds are, in general, far superior investments to mutual funds in many asset classes.

However, it is possible to have consistent market-beating returns in mutual funds - and by a healthy margin, at that. When you think about trouncing the market, names such as Bill Ruane of the famed Sequoia Fund, Warren Buffett of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , and Peter Lynch of Fidelity come to mind. Some of these names stand out more than others, but all of them and dozens like them have amassed equally astonishing performances year after year through bull and bear markets -- and they did it in their own way. Buffett owned stocks Ruane did not own, Ruane owned stocks Lynch did not own, and so forth. The common thread amongst these "super investors" is their relentless pursuit for quality investments at attractive prices, otherwise known as value investing. Warren Buffett beautifully illustrates this idea as "buying dollar bills for 50 cents." This discipline, coupled with patience and a total lack of emotion about the market's daily swings, has served these investors amazingly well over decades.

Buffett once remarked, "Investing is simple, but not easy." One simply needs to find good businesses run by able management selling at a good price. 

Take a businesslike approach
Over at Motley Fool Hidden Gems, we've delivered some pretty amazing returns of our own. Year after year, Tom Gardner and his team of analysts have smashed the market. Hidden Gems' picks are up more than 60% versus a 26% return for the S&P over the same period. And they, too, have done it in their own way, utilizing a focused approach for finding well-run, attractively valued small-cap companies.

Ben Graham, the dean of value investing and a mentor to the some of the greatest investors, has said "investing is most prudent when it is most businesslike." A simple concept, but one that very few mutual fund managers practice. When you purchase a home, you hunt for a good price, safety, and a quality neighborhood and neighbors. You do your research and then purchase the most attractive home, giving strong consideration to these factors. Investing and investment managers must be the same way, so as not to be mistaken for speculation. You want a bargain, safety, and a quality business and management. While I certainly cannot expect all investors to manage their own money, investors must demand market-beating performances from their financial gatekeepers if they are to justify the fees they pay them to manage their money.

To see all of our Hidden Gems small-cap selections, click here for a free trial.

Berkshire Hathaway is a Motley Fool Inside Value selection.

Fool contributor Sham Gad loves bargains and will pay $0.50 apiece for any old dollar bills you have laying around. Sham is currently working to establish Gad Partners Investment Fund, an investment partnership inspired by the work of Graham, Buffett, and Mohnish Pabrai. He owns shares in Berkshire Hathaway. The Fool has a disclosure policy.


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