Picking a winning money manager is a losing game

Why did Pacific Investment Management recently lose its crown as the world's largest bond mutual fund to Vanguard? The answer might be very deep.

Financial economists are always telling you that you cannot beat the market. Any time you think you know something the market doesn't, you are wrong and the market is right. This is known as the efficient markets hypothesis. This also extends to professional money managers and to your ability to pick a money manager who will outperform.

But what about superstar managers? They might be inclined to laugh at efficient markets theory. Berkshire Hathaway's Charles Munger said in 2003 that there was a Nobel Prize-winning economist who said Berkshire beat the market in common stock investing through one sigma of luck. This version of efficient market theory was taught in most schools of economics at the time. The professor went to two sigmas, and three sigmas, and four sigmas, and when he finally got to six sigmas of luck, people were laughing so hard he stopped doing it.

So maybe the efficient market purists have been mugged by reality. It looks like you can pick a winning money manager - just go for one with a great long-term performance record.

But there is another big downside to chasing performance. Strategies that work for a small amount of assets under management (AUM) may not work for a large amount.

Almost any manager's strategy is vulnerable. A manager who uses computers and mathematical models to exploit short-term predictabilities in price movements will see his transaction costs rise as he takes bigger positions against the anomaly. A manager who invests in distressed companies will find that the number of distressed companies that want his investment is not infinite. Eventually, almost any manager will see his alpha run out as his AUM goes up