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Lessons From a Great Fund Manager's Record

This post was prompted by one that my Moneywatch colleague Larry Swedroe made just over a week ago. In his post, Larry discussed the amount of evidence that is required for investors to reasonably believe that a mutual fund manager is skillful.

It's a conversation that -- like Larry, I'm sure -- I've had with countless investors over the years, most of whom find it hard to accept the idea that it's extraordinarily hard to a) to find a manager who can outperform the market over the long-term; and b) profit on that discovery. In most of those conversations, one name is invariably trotted out: Peter Lynch.

But as much as investors might like to believe that Lynch's record validates their search for outperformance, the reality is that it's a cautionary tale, demonstrating just how difficult it is for fund investors to earn above-average returns.

Lynch ran Fidelity's Magellan fund from 1977 to 1990, and there's no denying his success at the fund's helm. During that period, Magellan earned an average annual return of 26.4 percent, nearly double the S&P 500's 13.3 percent return.

That performance is what led the Wall Street Journal -- in a page one article prompted by his retirement -- to call Lynch a "star," a "legend," and a "fund wizard." It's a track record that was -- and, some twenty years later, remains -- truly impressive.

But don't make the mistake of believing that a large number of Magellan investors earned those returns.

For one thing, the public wasn't permitted to invest in Magellan until 1981. Until that point, the fund, which was established in 1963, was, as the Journal article stated, an "incubator" fund, accepting money only from Fidelity insiders. Fund managers often start such funds in the hopes of establishing an impressive track record, whereupon they will open it up and invite the public in, which is what Fidelity did on the heels of Lynch's impressive first four years.

In the nine years during which Lynch's fund was open to the public, Magellan earned an annual return of 21.8 percent versus the S&P 500's 16.2 percent -- still impressive, but a much smaller margin than before.

Of course, when Magellan was opened to the public, its asset base was tiny; about $100 million. But as investors took note of the performance Lynch was producing, assets began to pour in -- a trickle at first, and then a deluge. In 1986 alone, Magellan took in $2.3 billion in new assets, which was more than half the fund's $4.1 billion asset base at the start of the year.

So how did the typical Magellan investor fare under Lynch? After adjusting for the timing and size of those cash flows, it turns out that the average Magellan investor earned an average annual return of 13.4 percent from 1981 to 1990 -- trailing both the fund's lofty 21.8 percent return, and the S&P 500's 16.2 percent return.

How is it that the typical investor in a fund run by one of the most successful managers of all time ended up trailing the overall market? The reason is one that has confounded investors time and again: poor timing. Magellan's investors were lightly invested early in the period (when the largest margins of outperformance were being earned), and heavily invested at the end of Lynch's tenure, when the returns were less extraordinary.

To make matters worse, in 1990 those investors learned that Lynch was retiring at the age of 46. Since then, four different managers have run Magellan, none of whom have been able to match Lynch's record. From 1990 through June 2010, Magellan has earned 7.8 percent annually, lagging the S&P 500 by 0.4 percent per year.

So for all of the accolades that Lynch deserves for his record at Magellan, the reality for fund investors is far different: the average investor in his fund during his tenure earned returns that fell short of the index's performance, saw their star manager depart in his prime, and found themselves in a fund that transformed from one of the industry's most successful into a long-term laggard.

If that doesn't make you think twice about giving up the search for outperformance, I'm hard-pressed to think of anything that will.