How Investors Cause Their Fund Managers to Blunder
From 1999 to 2009 the CGM Focus Fund managed by Ken Heebner produced a compounded return of 18% per annum. However, during that decade the average investor in that fund lost 11% on average. How could that possibly happen? Most investors bought the fund after periods of strong performance and sold the fund when performance was down. Meanwhile Ken Heeber stuck to his knitting and did great work. Sadly, most of the investors in the fund were not helped by his efforts.
Imagine an investment opportunity that will beat the market by 10% every year on average over the next 10 years. Here is the catch: You will have to “pay” for the outperformance with psychological pain. There are several years of underperformance mixed into that 10-year period. No big deal you might say now. In practice, however, most investors cannot stomach the pain once it moves from theoretical possibility to their actual brokerage statement. They bail at just the wrong time, selling when things feel worst, and reentering well after an optimal point.
It is exactly this type of behavior on behalf of investors that drives many fund managers to hug their benchmarks and produce lackluster results. Most fund managers, like anyone else, would rather keep their income rather than lose it. They know that most of their clients are going to be short term and would rather fire them than lag an index. So they hug it. To quote Seth Klarman:
“Frequent comparative ranking can only reinforce a short-term investment perspective. It is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term performance, the long-term view may well be from the unemployment line.”
It is popular in some circles to suggest most professional investors cannot beat the market. Actually most professional investors are relatively competent. Sure there are a few that don’t have the goods, but most actually can produce some degree of alpha. Yet they fear for their jobs and tilt their portfolios away from their best ideas in order to stay closer to the index. There are enough investors with long and successful track records, along with enough market anomalies to exploit, to ensure that the market can be beaten by a reasonable number of pros consistently, even after fees. Yet, the fact is most of these professionals will never realize the returns they could precisely because they know their clients would not tolerate the deviations from the index.
Investors suffer from several critical psychological biases. Regret avoidance, known more commonly as fear of missing out, is one of the worst. This psychological bias manifests itself in trading turnover, and is apparently getting worse among investors. Investors are holding stocks for less and less time as the graph below shows.
In days gone by, investors were just as vulnerable to regret avoidance as today, however, with 24/7 availability of real-time information, and constant focus on the indices, the grass can look greener much more often, simply by constant comparison. Investors are constantly jumping in and out to try to not miss the latest or hottest opportunity. Investors tend to feel disappointed when they miss out on potential gains. In 2013, for example, the S&P 500 was up 32%, leaving some investors who made “only” 20 or 25 percent feeling slighted. Instead of sticking with their investing plans, many investors started deviating into higher-beta strategies, engaging in a vicious cycle of chasing past instead of future returns.
This strategy of buying last year’s winners is counterproductive to long-term investment success. If you, as a professional asset manager, weren’t in tech stocks in 1999, you had huge career risk. Many top fund managers went out of business when they wouldn’t buy tech stocks. Then a few years later, other managers who were big into tech went out of business. In 2011, everyone wanted to emerging markets after a large run. Returns have gone nowhere since. In 2013 and 2014, investors piled into high yield stocks, particularly in the energy sector, to try to earn income. Just after the sector reached peak excitement, the price of oil declined by more than 60% and many of the formerly popular MLPs went bust. Investment cycles and fads always change. The winners buy early and stick to their guns. Those who chase the fads and enter late end up losing.
When mutual funds were first created many years ago, they were primarily research driven stock-picking operations with concentrated portfolios that didn’t really try to follow or imitate any stock market index. In recent years, more and more mutual funds have switched either openly or secretly to passive approaches. Researchers developed a metric called “active share” to determine the amount of a mutual fund performance driven by individual stock picking and general market exposure. A fund with active share of 100% has no shared holdings with its index; all returns come from stock picking. A fund that perfectly tracked the index – such as the SPY ETF – would have an active share of 0%. And a fund with a 50% active share would derive half its returns from market beta and the other half of its returns from stock picking. Here’s the evolution of active share in US mutual funds:
As you can see, as recently as 1980, virtually no funds had active shares under 60%; funds relied on stock picking to succeed. That changed; by 2009, almost 20% of funds were effectively S&P index funds in disguise, with minimal differences from the market as a whole. Just half of funds had active shares of 60% or greater. The trend has continued in the current decade. Thus it is no wonder that the general public has come to expect underperformance.
A low active share minimizes career and business risk for professional money managers. If all funds have the same or similar returns in comparison to each other and the overall index at all times, there is no reason for investors to switch and therefore no fund manager is ever at risk of losing clients. When clients have very short term horizons, it’s suicidal for a professional money manager to be contrarian. Any sort of short-term underperformance leads to massive fund outflows and thus a serious business threat to the professional money manager. Yet, that short-term underperformance is a tell-tale sign of a fund manager who runs a market-beating strategy. The best investors, including Warren Buffett, have had periods of dramatic underperformance versus the S&P 500 Index. Berkshire Hathaway for example, badly trailed the market during the tech boom, leading some to lose patience with the firm. However, Berkshire gained nicely between 2000 and 2002, years when the S&P dropped massively. Those of you who watched or read The Big Short, can remember how Michael Burry’s investors were constantly pressuring him and trying to pull their money during 2005-2007 while he waited for the mortgage market to crumble.
So what’s the takeaway for investors and how can we get improve as investors, both retail and professional? The first step is to become aware of our psychological biases. Creating awareness helps us combat our urges. Regret avoidance, and an excessive focus on comparisons to how much money others are making, are unhealthy traits for all investors. Secondly, education helps. Managers and clients need to thoroughly understand the investing strategy and when it is likely to outperform and underperform. Lastly, managers and clients need to focus on long term results. Total alpha delivered against the market over whole economic cycles is the key metric, not how the manager did last year. Reducing risk with sound hedging strategies also adds to an active manager’s real value to investors, especially in down market, by helping clients avoid the real pain of loss and stick with a sound investing strategy.