Markets

Two Fairholme Fund Alumni Strike Out on Their Own -- Should You Follow?

By Nathan Hale

Updated on: February 7, 2011 / 10:53 AM EST / MoneyWatch

A few weeks ago two former co-managers of the Fairholme fund -- Larry Pitkowsky and Keith Trauner -- announced that they had opened up their own shop and were preparing to launch a fund of their own later this year. The announcement garnered a good deal of attention largely because the Fairholme fund -- led by Bruce Berkowitz -- has been one of the industry's most successful funds over the past decade, outpacing the Russell 1000 Value index by more than eight percentage points per year.

Will the managers of the new fund be able to replicate that tremendous success? Anything is possible. In the five-plus years since he left Franklin to strike out on his own, for instance, David Winters has done very well with Wintergreen fund.

But investors by and large would do well to be skeptical that any manager -- no matter how successful in the past -- will be able to continue their run. Despite the historical and academic evidence that past mutual fund winners do not repeat, investors -- and many in the media -- are always searching for "the next Peter Lynch," a manager who's able to outsmart the market for an extended period of time. Unfortunately, the reality is that the vast majority of star fund managers shine brightly for a while before ultimately dimming.

For instance, here's how a few of the industry's former darlings ultimately fared:

Gerald Tsai: Tsai was possibly the industry's first star manager, earning staggering returns for his investors before leaving Fidelity to launch the Manhattan fund in 1965 with a great deal of fanfare. Tsai timed the market well on one front -- he sold his new firm to a conglomerate in 1968. But even though he remained at the helm of the Manhattan fund until 1973, Tsai was never able to replicate his earlier success. From 1966 through 1973, the Manhattan fund lost 43 percent.
Michael DiCarlo: The manager of John Hancock's Special Equities fund was profiled in a cover story in the New York Times Magazine in December 1996, which described the how the wunderkind's golden touch had produced a 24 percent annual return in his eight years at the fund's helm. (His fame was reportedly at such a height that after speaking engagements he was approached for autographs.) When the reporter asked him how he might deal with a bear market, DiCarlo replied "I haven't seen nothing out there I can't beat." He didn't have to wait too long. His fund lagged the market badly in 1996 and in the year-and-a-half that followed, and DiCarlo was relieved of his duties in July 1998.
Garrett Van Wagoner: One of the superstars of the late-1990s tech bubble,Van Wagoner was identified as one of the industry's rising stars on PBS's Frontline in 1997. His Emerging Growth fund earned a stunning 291 percent in 1999 -- the best return in a market that had more than its share of funds sporting triple-digit returns. (It turned out that some of his fund's gains were the result of Van Wagoner mis-pricing its holdings, a violation that cost Van Wagoner and his firm $800,000 in SEC fines.) The 2000s weren't kind to Van Wagoner, and when he finally stepped down in 2008, his Emerging Growth fund had produced a cumulative loss of -62 percent since 1995, lagging the S&P 500's 191 percent gain by more than 250 percent.
Bill Miller: The manager of Legg Mason Capital Management Value famously beat the S&P 500 for 15 consecutive years, seemingly quenching the industry's thirst for the next Peter Lynch. His go-anywhere style and willingness to ignore conventional wisdom served his investors extremely well -- until it didn't. The losses Miller's fund has endured since his streak ended have ravaged his long-term record. Over the past decade, his fund has trailed the S&P 500 by more than 3.5 percent annually -- ranking among the bottom four percent of its peers. In May 2010 Legg Mason named Miller's successor as part of their long-term succession plan.

I could go on, but I think the point is made. The fact of the matter is that at any given moment in time there are a handful -- or more -- of fund managers with impressive track records. In interviews and television appearances they sound confident and impressive, intelligently describing the reasons why their fund has flourished over the past few years. (Which is usually attributed, in part, to their willingness to do what other fund managers will not or cannot. See this profile of Berkowitz from the Wall Street Journal for a fine example.) At some point they're almost inevitably labeled -- as both DiCarlo and Van Wagoner were -- as the industry's next Peter Lynch, which I always find humorous. Not because the odds are great the today's market-beater will be tomorrow's laggard, but because Peter Lynch has not managed a mutual fund in more than 20 years, and in that period investors would have been burned time and again chasing after his would-be successor.

In viewing the performance of so many supposed star managers, it becomes increasingly clear that perhaps Lynch's greatest feat was not his track record in his 13 or so years at Magellan's helm, but rather the fact that he got out before the market's odds caught up with him.

Keep those odds in mind the next time you find yourself reading a profile of the industry's newest would-be star manager.

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