Lessons from Legg Mason's Bill Miller

Legendary mutual fund manager Bill Miller announced last week that he was stepping down from the helm of Legg Mason Capital Management Value fund. While for a large part of his career Miller was hailed as an example of why investors should choose active management over an indexed approach, his career in sum represented a cautionary tale, with lessons for mutual fund investors that are far too often hard-won.

Miller managed the fund from its inception in 1982, assuming sole responsibility for it in 1990. The next year, the fund outperformed the S&P 500 by 4.5 percentage points, beginning what would become a remarkable run of 15 straight years outperforming the S&P 500.

That streak, of course, made Miller a star. He appeared on the covers of business magazines, headlined investment conferences, and earned millions of dollars for both himself and his firm.

But in the mutual fund industry, very few managers escape with their reputations for genius intact, and Miller was no exception.

After 15 straight years of outperformance, during which his fund beat the S&P 500 by more than five percentage points, Miller gave it all back. From 2006 through 2011, Capital Management Value has lagged the S&P 500 by more than nine percentage points, with an average annual return of -7.4 percent to the index's 2.1 percent.

Miller's losses over the past few years have completely eliminated the long-term record of outperformance he'd earned. A golden touch has turned to dross.

In assessing Miller's career, fellow manager Chris Davis told the Wall Street Journal's Jason Zweig that if the pattern of returns were different -- and Miller was retiring on the heels of his 15-year streak -- he would be hailed as an investment genius.

That's certainly true, but it ignores a near iron law of investing, and one of the most important lessons investors should learn from Miller's career: Eye-catching outperformance, whether notable for its size or its duration, is most often attained when funds are small in size. On the other hand, that performance has a nasty habit of reversing as the fund grows in size. Why? Because smaller funds are far easier to manage, allowing the manager a degree of nimbleness and diversity of investment alternatives that managers of larger funds simply don't have.

When Miller's streak began in 1991, the fund had a mere $600 million in assets. Even five years in the fund had a relatively small $2 billion asset base. But then the deluge came: Over $6 billion of investor cash poured in over the next seven years, and the fund ballooned to more than $20 billion in 2006, just after the streak ended.

What happens when stellar returns are earned when the fund is small, while mediocre or worse returns are earned as assets pour in? Investor returns are lousy, and the experience of Miller's investors was no exception. Since 1982 the fund earned an annual return of 10.3 percent; the fund's investors, because they were late to the party, ended up earning a return of just 5.7 percent in that period. The impact of that lag? While an initial investment of $1 in the fund would have grown to $17, the investors' dollar would have grown to just $5.

The second lesson that investors would do well to learn from Miller's career is just how quickly genius can turn in the investment industry. One of the hardest things for investors to grasp is just how long a record you need in order to attribute success to skill rather than luck. A mere five or ten years of solid performance is entirely useless in trying to differentiate the two. Surely owners of Miller's fund were feeling pretty confident that 15 years of outperformance was a fine indicator of investment acumen, until their star manager completely mis-read the financial crisis, costing his investors billions of dollars.

In the end, rather than serving as a beacon for active management proponents, Miller's career ended up as a case study that illustrates just how incredibly difficult it is to outperform the market over the long term. I give Miller a great deal of credit for accomplishing what he did in his long career, while at the same time I wonder how on Earth anyone has the stomach to play a game in which one or two mis-steps can be enough to wipe out decades of accomplishment.