The annual paperwork from one of my mutual funds came recently, and it scared me. The fund lagged the market in 2014, though I wasn’t surprised because the manager tends to be a contrarian. The problem wasn’t performance, therefore, but in the manager’s explanation for what happened. “Given our approach,” the manager said in his annual note to shareholders, “it’s a challenging market right now.” Boo. That’s not an explanation so much as a cover-up. That’s a manager hoping shareholders either don’t read the statement (typically the case), or agree without digging deeper. That’s a cop-out in any year, but it’s doubly annoying now because it’s a manager being lazy, knowing that somewhere between 80% and 90% of active U.S. equity managers lagged their benchmark in 2014, one of the worst years in memory for active management. That result, again, will be used to support a case that active management is dead, and that passive low-cost index funds are the better way to invest. Because recent numbers support that case -- and the benefits of a savvy indexing strategy are undeniable — managers can’t fall back on clichés. After all, past performance is no guarantee of future results, and most active fund shareholders had reasons for making their picks. Moreover, average fund investors must guard against tendencies to make changes at just the wrong time, abandoning long-range strategies based on short-term results. For example, an investor in a large-cap growth fund that lagged the Standard & Poor’s 500 index SPX, -0.03% last year still could have made good money. It just wasn’t a return that topped the benchmark. Because your ability to stick with a strategy may be more important than the actual tactics the fund follows, management owes you a real description of what happened. “Challenging market” is an excuse, not an explanation. If it lacks details — maybe the manager made a call on when to buy or sell energy stocks, for example, or moved anticipating interest-rate hikes that never came — it says nothing. The other way managers sometimes say this is with the cliché, “It’s a stock picker’s market.” Investing is always challenging, even in good times. Making good choices, in all market conditions, is what separates winners from the pack; since you are paying for the manager’s expertise, you should expect reasonable results compared with the competition. A manager who blames underperformance on market conditions — without explaining how they reacted to those circumstances — is saying that their real strategy for delivering good results is to get lucky and hope the market sees that as some form of brilliance. The “challenging market” line isn’t the only one that scares me, just the most common. Here are other phrases that should make your Spidey senses tingle as you read the annual letter from management in your fund documents this year: ‘We underestimated the risk…’ A fund manager’s job involves taking risks that they believe will deliver appropriate rewards. If a manager concentrated the portfolio or made a move — and that’s when this explanation commonly happens — they should explain their thinking with specifics. A value-oriented manager may have decided too early that oil stocks were a bargain; it might have hurt the portfolio in 2014, but if it’s in keeping with the fund’s long-term mission, shareholders can at least understand why it happened. Since managers are paid to judge risk, every mistake could fall under this label. Demand specifics. ‘Our long-term record shows that last year was an anomaly.’ This is a misdirection play, trying to get you off of what looks bad. Worse, it doesn’t tell you if the fund was acting consistently with the tactics that produced the long-term results. Any manager who can discount what went wrong for them in 2014 can also explain why the year should, over time, prove to be the exception not the rule. That’s about the process, and not the performance; managers should accept and explain their role in any disappointing period. ‘We’re cautiously optimistic…’ The most overused expression in fund management, and perhaps the most meaningless. If a manager told you they were pessimistic about their ability to make money, you’d bolt. They won’t say they expect to make a killing going forward, because their lawyers muzzle those kinds of statements. Shareholders are “cautiously optimistic” about the prospects of any fund they own; fund managers need to say something specific to instill and maintain confidence after any rough patch. ‘We’ve made changes that should help…’ Managers always try to do better, but when a manager starts talking about steps they have taken to improve returns, look closely to see if the fund is about to change its stripes. When a manager no longer believes his tried methods can lead to good returns, it’s time to go; once a manager starts flailing around trying to find solutions for lagging the market (again), they’re showing that the fund has big, hard-to-fix problems. Source:http://www.marketwatch.com/