Two Star Managers and the Wheel of Fortune

Here is an idea that is doomed to fail: a podcast or interview series with 2-star fund managers. We hear about strategies, portfolio managers, and asset classes after the fact—when they’ve delivered performance numbers that make our mouths water. We cannot blame the financial complex for focusing on strongest returns: it leads to more interesting stories, more sales, more page views, more…pick your metric. To do it any other way would be like putting the Boston Celtics on the cover of Sports Illustrated after this year’s NBA playoffs, instead of the Lebron James- or (more likely) Steph Curry- led champions, which would make no sense.

Interviewing, profiled, and buying at performance peaks is the central problem in active investing along the entire chain: from end/individual investor, to intermediary, to asset manager. Styles and strategies tend to be cyclical, but we are humans and we extrapolate in straight lines, not in circles. The entire industry is branded with “past performance is not indicative of future results” because we are wired to think that way: in most other places, past performance is indicative of future results!

When I said I would love an interview series with 2-star fund managers, the most common response was “just go watch the 5-star interviews from a few years ago.” That is funny, because it is so often true. We know that strategies—and the portfolio managers behind them—mean revert. The wheel of fortune, “rota fortunae,” follows this pattern of mean reversion (you can read more in Deep Value). Starting from the top in the image below, we see these four stages: 1) I reign (5-stars!) 2) I reigned (2-3 stars) 3) my reign is finished (massive outflows) 4) I shall reign (performance comeback).

rota fortunate


Picture this big wheel of fortune, because it sits–always turning–behind financial markets. 5-star managers (or, in institutional-speak, top quartile/decile managers) “reign.” Some reigns last a long time, but the numbers show that precious few last forever—especially when AUM grows and reduces one’s potential edge. When a manager reigns, it is usually because of strong performance, which brings spoils: assets, personal wealth, clout, and requests for interviews. Hidden behind the spoils: scrutiny, attention, competitors who mimic, steal, or improve your strategy, and an increased probability that the strategy will work less well or not at all in the near- to mid- term future. This all fuels the wheel!

Having lived all of this myself, I can say with a confidence earned through several spins of the wheel that the most important things, for any strategy/portfolio manager are:

i. To remain extremely disciplined by working a system.

Having a system is the most important thing, but that is pretty common these days. Abandoning a system happens most often at the top and bottom of the wheel. At the top, many managers who relied on less liquid/smaller cap opportunities to achieve strong performance move up the capitalization spectrum, or launch new strategies (spreading/diluting their attention) to accommodate more assets under management. (Side note: I have no clue how any non-quant could manage multiple strategies/portfolios and succeed). At the bottom, any system will feel broken—out of date and out of touch. Which leads to…

ii. Can withstand increased external pressure causes by periods of underperformance

This should be 1A), because it is related to discipline. The pressure to change your stripes during periods of underperformance is immense. In my experience, managers have more resolve than their investors (on average—I know many wonderful exceptions to this rule).  During initial drawdowns, investors understandably want to know what managers are doing to “fix” the problem. The problem is usually that there is nothing to fix. Even the best system will fail very often. Just a little more than 50% of value stocks beat the market, on average. This is so frustrating, because, in almost every other pursuit, failure means something can be improved upon. In investing, you are guaranteed to have lots of failures, and most of those failures say very little about the quality of the system that produced them! What produces so many awful investor outcomes is mistaking a single failed investment for a failed system.

iii. Humility

When I see hubristic PMs, my first thought is always: they have not dug deep enough. I am often reminded, studying financial markets, of Umberto Eco’s concept of the “anti-library:” a collection of books not yet read. What I find is that the more I dig—on a factor, a stock, a strategy, whatever—the less I know. Sure I learn as I dig, but for every one thing I learn, I become aware of three new things that I don’t know. I know a few incredibly talented, deep fundamental stock pickers who have had great and sustained success. They are confident, but they are also insanely humble—because they realize how much they don’t or can’t know.

iv. A willingness on the part of the portfolio manager(s) to communicate and educate as much as possible, especially during tough times.

For all involved, maybe this is the most important thing. To survive a full turn of the wheel, you need true conviction. The only way for investors to gain that conviction is to understand the strategy. This requires a lot of care, because there is always more to learn. This is all I do and all I think about, yet still there are still nuances I find, almost every time I go looking. This means that for an investor to stick with a strategy—especially an active once which is unique enough to make it worth the investor’s while–net of fees—they need to understand it deeply.

v. Be open to change, which means admitting you don’t do everything perfectly

I always hear the joke that allocators/investors in the industry love innovation but hate change. Again, funny because it’s true. Investing strategies need an immutable underlying set of principles—a bedrock philosophy—like, say, value investing. For me, it’s that certain factors drive returns (value, momentum, shareholder yield). But the implementation of that philosophy can and should evolve and improve. We can measure “value” far more accurately than we could 15 years ago. Constant tinkering is bad, but smart, infrequent improvements almost always make sense.


While an interview series with 2-star or bottom quartile managers may be doomed to failure, it may prove to be a great hunting ground for managers you want to invest with—provided they have attributes like the ones listed above (humility is all but assured ;). The same system that makes you feel brilliant at the top will make you feel like a moron at the bottom, and the wheel will keep turning. Markets are incredibly hard to beat. You can probably only gain a small edge. Letting that edge work is the hardest part.

There is a Taoist story of an old farmer who had worked his crops for many years. One day his horse ran away. Upon hearing the news, his neighbors came to visit.

“Such bad luck,” they said sympathetically.

“We’ll see,” the farmer replied.

The next morning the horse returned, bringing with it three other wild horses.

“How wonderful,” the neighbors exclaimed.

“We’ll see,” replied the old man.

The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. The neighbors again came to offer their sympathy on his misfortune.

“We’ll see,” answered the farmer.

The day after, military officials came to the village to draft young men into the army. Seeing that the son’s leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out.

“We’ll see” said the farmer.