By MARK HULBERT
Do hot hands always turn to ice?
Just ask Bill Miller, who in ten days' time will step down as the manager of the Legg Mason Value Trust [LMVTX]. At the end of 2005, he had one of the hottest hands in U.S. mutual fund history, having beaten the S&P 500 index in each of the 15 previous years.
Even Bernie Madoff at his prime couldn't boast a record as good as that.
Unfortunately, as Paul Harvey was fond of saying, there's the rest of the story. In the six calendar years since 2005, Miller has lagged the market in all but one. This has caused such a diminution in his long-term record that his fund is now behind a buy-and-hold for each of the 1-, 5-, 10-, 15- and 30-year periods.
He, therefore, will go down in the history books with a record far less worth bragging about.
It would be easy to catalog Miller's record as yet another illustration of how difficult it is to beat the market.
But I think a more profound lesson has to do with how success in the mutual fund arena is self defeating.
In drawing this lesson, I follow the lead of Jonathan Berk, a finance professor at Stanford University, who several years ago developed a theory about how the flow of funds into a successful fund affects its performance: A fund manager who initially exhibits what appears to be genuine stock picking ability will soon become swamped with more assets than he can profitably manage.
As a result, according to Berk's theory, this successful manager's performance sows the seeds of his own destruction.
An analogy is to the Peter Principle, which is the tendency for employees to get promoted until they reach their level of incompetence. Similarly, a successful fund manager such as Miller, who is beating the market, will continue to attract more and more money until he reaches the point he can no longer beat the market.
The long-term result of these fund flows, the theory predicts: Successful fund managers' records will eventually drop back to that of the market itself.
Miller's case certainly appears to fit Berk's theory. The fund ended 1982, its year of inception, with just $6.8 million in assets under management. At the end of Miller's 15-year market-beating streak, the comparable total was over $20 billion.
And, sure enough, over the fund's entire history, it has produced an 11.5% annualized gain, according to Morningstar -- slightly below, but nevertheless remarkably close to the 11.6% return of buying and holding.
One implication of this theory is that Miller's downfall was not entirely his own fault. It was all but inevitable that it would happen eventually, and it remains remarkable that he was able to postpone it as long as he did.
Nevertheless, the lesson for the rest of us is to think twice before we rush to invest in a fund that lots of other investors are investing in as well. The ideal is to find a fund manager with a long-term record of success who is nevertheless relatively undiscovered.
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