Is it better to be smart, or lucky?
When it comes to investing, it can sometimes be difficult to separate hard-earned skill from simple luck. When a novice plays the stock market and outperforms major indexes, it’s hard to tell if that person is really smart or just had a good roll of the dice.
This becomes a real dilemma when considering the merits of smaller funds run by emerging managers. Some of these funds are beating the S&P 500 and other indexes in the near term, but they don’t yet have a long-term track record. How is an investor to judge them?
Before dismissing the success of small new funds as a case of beginner’s luck, keep in mind that small funds may have some real advantages over larger established ones in the same way that a startup business has some fundamental advantages over a large corporation. Startups and startup funds are operating in a narrower scope and are not slowed down by a cumbersome corporate structure.
Think about Netflix (NASDAQ: NFLX) when it was a young business in its prime about a decade ago. It was pretty clear at the time that there was an opportunity to transform the video rental business, but a nimble startup like Netflix was far better positioned to take advantage of these emerging trends than a lumbering business like Blockbuster, even with its extensive physical presence. Some things are just easier when you’re small. And when a fund has fewer investors to answer to, that can work to its advantage.
Likewise, young funds may have more options to take on high-growth investments.
When you have a smaller portfolio, you come across opportunities to invest in businesses that are on their way up but are still so small that they just won’t scale very well. These opportunities give emerging funds an advantage over the bigger players who are, quite simply, managing too much money. The emerging manager can look at these opportunities and do the due diligence. If he identifies them correctly, he can do quite well.
When you are small, you don’t need to invest much in promising young businesses to generate outsized returns. It’s a key difference between the small, nimble players and the large, established ones, and often, it explains the differences in performance.
How can investors digest these differences to make informed comparisons? For starters, it’s important to compare similar funds.
Instead of just comparing the merits of emerging and established funds, remember that not all emerging funds are created equal and some managers will be more skilled at using their small size and nimble structure to their advantage. Identify a group of funds of similar size and age and see how performance differs.
Also, consider the end game. How will these young funds scale over time as they attract more investors? If they are succeeding now because of some high-growth holdings, are these the sorts of investments that can be sustained over time?
Finally, take as long a view as possible. The more information you have about how a fund performs in different market conditions, the better equipped you are to make a smart decision.
Emerging funds will by definition have shorter track records, and this sometimes explains why they appear to be outperforming other funds. But the manager’s skill will be revealed over time, so even if you’re seeking out an up-and-coming fund, it’s better to know the performance over at least a few years.
If a fund has one good year, it may be luck. But if it has outperformed the market for the past year, three years and five years, chances are the person in charge is smart.
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