By Professor Leonard Kostovetsy of The Blindfolded Chimpanzee, Guest Writer
Many disciplines divide practitioners into two basic types: the specialists, who are experts in one specific area, and the generalists, who have a certain level of expertise and understanding across many different areas. While medicine is an obvious example, one also finds this split in fields such as law, mathematics, science, entertainment, management, and finance. Among financial analysts and investment managers, some specialize in one particular subdivision of the stock market, usually defined by industry or sector, while others deal with all parts of the market. In a paper that I co-authored with dermatologist Vladimir Ratushny, we study which type of skillset is better for generating higher portfolio returns.
Healthcare-Related Specialist Mutual Fund Managers
In order to answer this question, we looked at the performance of a set of mutual funds that invest entirely in healthcare-related stocks, called health sector mutual funds—a natural laboratory for understanding whether specialized knowledge about one industry is helpful in picking stocks that are likely to outperform. We define a specialist mutual fund manager as someone who is either a medical doctor or has a degree in a field related to medicine such as biology, chemistry, biochemistry, etc. (or both). In practice, the majority of health sector mutual fund managers who are specialists are doctors who decided they could make more by managing portfolios than practicing medicine. Every fund manager who is not a specialist is defined to be a generalist.
One example of a specialist is Kris Jenner who finished Johns Hopkins School of Medicine in 1993 and decided, after his residency, to go into asset management. He became a fund manager for T. Rowe Price, the well-known company in Baltimore, managing the T. Rowe Price Health Sciences Fund from 2000 to 2013. After 2013, he left T. Rowe Price to start his own hedge fund firm Rock Springs Capital. As the graph below shows, the percentage of specialists, such as Dr. Jenner, among healthcare mutual fund managers grew until 2012, and has stayed in the 30-40% range over the last decade.
Fund Performance Comparison
Once we determine which health sector mutual funds are run by specialists and which are run by generalists, we compare their fund performance. We compare risk-adjusted returns and control for other characteristics of the managers (such as their age, gender, etc.) and funds (such as fund size, fund age, expense ratio, etc.). The graph below has the key takeaway.
If you started with $1,000 at the start of the sample period in 1998 and each month re-allocated your capital across all health sector funds managed by specialists, you would end up with more than $13,700 in December 2018, the end of the sample period.
On the other hand, if you did the same thing but re-allocated your capital across all funds managed by generalists, you would only have $5,500 in December 2018, just slightly better than the $4,700 from a passive investment in the entire healthcare sector. The average specialist-run fund outperforms by about 0.4% per month which is about 5% per year, a highly significant difference which shows the advantage that specialists have when picking healthcare stocks.
Specialists Benefit from Healthcare-Related Work Experience
In the remainder of the paper, we perform a bunch of additional tests to understand how specialists are able to obtain better returns. When we separately define specialists based on education versus work experience, we find that having healthcare-related work experience provides an extra bonus in performance, suggesting that on-the-job skills or connections could be part of the puzzle. When we compare fund managers with other STEM-related degrees such as mathematics, engineering, or physics, they are not able to perform like those from health-related fields, suggesting our main findings are not due to a higher rigor or intelligence required from those working in STEM fields.
Specialists Are Better Able to Interpret Sector-Specific Information
In our last experiment of the paper, we look at whether specialists are better able to time their purchases or sales of stock around important market-moving events including FDA decisions on whether to approve or reject a new drug application, and mergers and acquisition announcements. The average three-day stock return around FDA rejections is -13.2% and specialist fund managers hold a smaller stake in such stocks than generalists during these adverse events. In contrast, the average three-day stock return around an announcement that the firm will be the target of an acquisition is +32.7%, but there is no difference in the holdings of specialists and generalists during these positive events.
Our interpretation of these results is that our main findings are NOT due to specialists being able to get insider information (as that would allow them to perform better during both FDA decisions and M&A announcements), but due to specialists being better able to predict or interpret sector-specific information affecting the prospects of the firm.
Doctors Do Have an Advantage When Picking Healthcare-Related Stocks
What should you take away from the results of our study?
- Doctors (and other individuals from health-related fields) can manage investment portfolios better than individuals with finance and economics degrees and with years of experience in the financial industry.
- Their advantage naturally comes from their specialized expertise, so we would not expect the same to be true for managing portfolios of oil stocks or even well-diversified portfolios, just like we wouldn’t expect cardiologists to be better than internists at treating head injuries.
- Picking individual stocks that will outperform is extremely difficult without a competitive advantage such as having a skillset or connections rarely found among financial market participants.
I would hope our study inspires people from all walks of life to think of investing not just as an exclusive domain of Wall Street traders, but as a field for anyone who wants to use their head, and specialized skillset, to earn money.
[Editor's Note: I thought this was an important enough paper in the financial literature that it had to be addressed on the blog. Absolutely I found it interesting to see that in the past, health care mutual fund managers who had actually been educated, trained, and worked in health care prior to becoming mutual fund managers outperformed health care mutual fund managers who had not. If for some reason you wanted to invest in an actively managed health care mutual fund (I don't but you might), you should definitely pick one run by someone with the experience of actually working in health care.
However, I would not go so far as to suggest that means that individual doctors who are NOT health care mutual fund managers should start picking their own health care stocks. There is no evidence of that in this paper, despite Professor Kostovetsky's assertion above. In fact, there is substantial evidence that picking your own stocks or even your own actively managed mutual fund manager is a bad idea. Is the health care sector an exception, even for funds run by doctors? Maybe. In my opinion, the jury is still out.
A reasonable proxy index fund for Health Care is the ETF XLV, a State Street “SPDR” that has been around for 23 years. It follows the health care sector of the S&P 500, essentially large cap health care stocks. It charges an expense ratio of 0.12%. It owns 64 stocks and has a turnover of just 3%. By any measure, it's a fair representation of this sector of the market. If you look up its returns against its peers on Morningstar (accessed 7/26/21), you will see that it has outperformed 92% of its peers year to date and 74% of its peers over the last three years.
If you go out 15 years, you see the record is not so good, outperforming only 42% of the funds in its category. Now why would that be? That's very unusual for an index fund, isn't it? Well, yes it is. And the usual explanation is survivorship bias. Do we see that in this sector? Well, yes we do. You can see that we only have 15 years of returns for 82 funds, but there are currently 171 funds in the category. I don't know exactly how many health care funds there were 15 years ago, but I'm confident there were a lot more than 82. Probably more like 171.
It's not like the number of mutual funds in existence has gone down over the last 15 years or something.
If anything, there are fewer mutual funds than there were 15 years ago. I have no reason to believe that isn't the case in the health care sector. In general, about 38% of funds go out of business every decade.
Do you suppose most of the funds that were closed were beating the market? No chance. Market beating funds don't get closed. So it makes the remaining funds look a lot better. Keep that in mind before you go out looking for a hot actively managed mutual fund manager, much less try to beat the pros at the game. If the pros (even those who worked in health care) are very unlikely to beat the index, what makes you think you can?
I asked the author about how he accounted for survivorship bias in his study and the basic answer was that when a fund went out of business, they just assumed that the investor reinvested in the remaining funds with no tax or transaction costs. Basically, there was no realistic way for an individual to invest to get the returns produced by the study. I'm not sure that was the best way to deal with it given the Morningstar data above, but certainly health care active fund managers have done better than most non-health care active fund managers against their respective indices over the last decade or two. Not enough for me to believe in them, but enough that I don't think you're stupid if you do. It's a non-issue for me as I don't tilt my portfolio to health care stocks anyway. The author also noted that it really wasn't a study about active vs passive management, but just among the types of active managers available, so don't read too much into that question from the results of the paper.]
What do you think? Do you tilt your portfolio toward health care stocks? Do you try to pick your own? Did this paper change your mind? Why or why not? Comment below!
[Additional Editor's Note: This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]