About 7 years ago I had the privilege on 2 occasions of meeting Michael Aronstein, manager of the Marketfield Fund. Michael was launching a new mutual fund that was basically a "go-anywhere-I-think-there-is-an-opportunity" fund. Not only would he look for opportunities, but he would also hedge the portfolio by shorting investments he thought would underperform. This strategy is called long-short investing, since you buy (go long) the good investments and sell (go short) the bad ones. Back to my story. The fund was just getting off the ground and only had about $10 million under management, which is tiny for a mutual fund. His story was very compelling though. Michael had a very diverse background, a great understanding of finance and the investment markets, and a fantastic ability to communicate with his audience. Many of my colleagues at other firms were some of this first investors.
His performance from the start was spectacular. He managed to avoid most of the losses of 2008, then rode the recovery after that, outperforming nearly all of his peers from 2009 through 2012. Investors took notice and several years later the fund was sold to NY Life, fueling continued growth as their distribution network grew considerably. His assets went from essentially zero in 2007 to over $20 billion. If I am honest with myself, I have to admit that I was wondering if we had missed the boat. That if someone was smart enough and took a common sense approach to investing, there should be an ability to provide value.
Thankfully, that thought in the back of my head was in stark contrast with a deeply held belief we have as well. That markets work and those that try to add value by predicting the next move in the market will fail at some point, since most of their outperformance will be based on luck. It is easy to believe that in theory, but when you meet a manager that seems to defy those core values and you see colleagues profiting from that investment, you can see why it is hard for so many to keep the faith.
Luckily, we did. I hadn't paid much thought to the fund and that manager until I read a story last week at the Wall Street Journal about the fund:
Investors yanked more than $5 billion so far this year from the largest and most popular “liquid-alternative” mutual fund as losses mounted on bad bets tied to the global economy, according to fund-research firm Morningstar Inc. Assets in the MainStay Marketfield fund have fallen 45% from a February peak of $21.5 billion.
Here is another excerpt a little later in the story:
MainStay Marketfield, controlled by a unit of New York Life Insurance Co., was “this huge success story,” said Morningstar analyst Josh Charney, but its stumble “highlights that the strategy is a lot riskier than people think.”
The Marketfield fund made a series of bad bets that put its performance in its category nearly dead last. All of that great performance for the past several years has been nearly wiped out. Most of the advisors quoted in the article talk about now getting out of the fund because of the poor performance. While this is just another example of how hard it is to consisently outperform the market, there is another lesson to be learned. Have a belief system that is based on evidence. When making investment decisions, everthing about the new investment should align with these beliefs. This type of alignment will help you avoid hot stocks, star managers and other complicated strategies that tend to be a major cause of underperformance for investors.
A common theme of this blog is showing how difficult it is to pick stocks or beat the market over time. Having started in this business as a broker at a major firm, I can tell you that we were taught to sell this fallacy. From a sales perspective it sounds terrific. “Our analyst covering this stock is the best in the industry and has a tremendous track record.” Or, “this fund manager has outperformed his peers in each of the last 5 years and has beat the market by 2 percentage points per year.” To an unsophisticated investor, this sounds pretty tempting. The idea that “insiders” can generate better results seems intuitive. Once I started to do my own research I realized how investors were being duped. Here is some more evidence from the Motley Fool about how accurate wall street analysts were this year:
The divergence really is spectacular. The ten stocks with the highest number of sell ratings were up an average of 75%, while the ten stocks with the highest number of buy ratings were up an average of 22%. During this same period, the S&P 500 was up 27.4%, so the highest conviction stocks from wall street’s analysts could not even keep pace with the broad market.
In addition to telling us how lousy and unreliable stock analysts are at predicting returns, this study also tells us something else. There can be value in going against the herd. Investing in companies that are unloved. There is substantial academic evidence that shows that value stocks (which can often be thought of as the unloved area of the market) tend to outperform growth stocks. Greenspring has embraced this philosophy, not just because WE think it is right, but because there is compelling evidence that has shown this strategy to generate higher returns for clients throughout history.
There is a great post at the Big Picture blog about whether luck or skill are the determining factors to outperforming the market. The short answer: luck is the main determinant. The research has shown this to be the case but there are some other points in the article that are worth reviewing. First, survivor bias. When research is done on this topic, typically the researchers will look at the funds that are available today and determine how many of them outperformed the market over the past one, three, five, ten years, etc. The problem with that method (which many have pointed out) is that all of the really poor performers have probably folded up shop or merged into another fund.
The reason is what statisticians sometimes call the Wyatt Earp Effect. Earp is famous largely for one simple reason: he quite remarkably survived a lot of duels. We only calculate the odds in these highly improbable situations when we already know what happened and are surprised by it. Thus, in terms of predictive value, these instances don’t mean very much at all.
One of the other reasons to be careful reading into outperformance is outright dishonesty:
It’s important to note at the outset that whenever tremendous investment streaks or returns are claimed, there is considerable reason (see here, for example) to doubt the factual basis for the claim. Sometimes the problem is mathematical, sometimes it’s a matter of a faulty memory, and sometimes people are simply dishonest. In the “professional” space, it is commonplace to see survivorship bias as well as phony measurement and benchmarking (for example, asset-weighted performance typically tells a very different story than more traditional performance measures). That’s why, in a discussion of the likelihood of getting “heads” 100 coin-flips in a row (we should expect it to happen once in 79 million million million million million — that’s 79 with 30 zeros after it – fair sets of tosses), the probabilities favor a loaded coin. Barry dealt with this dishonesty among the pros earlier in the year, noting how common it is to hear from “Pinocchio traders.”
But what about some of those traders/investors that have generated outperformance for decades? At what point do you have to attribute some skill to a manager’s outperformance? The author has a story that many of us in the Baltimore area know all too well:
Bill Miller of Legg Mason famously beat the S&P 500 for 15 straight years from 1991-2005. During that time, he was the poster boy of investment skill. Michael Mauboussin calculated the odds against that happening randomly as exceptionally long indeed. Miller himself was much less self-congratulatory. “As for the so-called streak, that’s an accident of the calendar. If the year ended on different months it wouldn’t be there and at some point the mathematics will hit us. We’ve been lucky. Well, maybe it’s not 100% luck — maybe 95% luck.” As Mauboussin points out, such streaks indicate skill, but luck is heavily involved. Indeed, in the five years after the streak ended, Miller lost 9 per cent annually and ranked dead last out of the 840 funds in the same category. He lost 55 percent in 2008. That said, he’s hot again now.
By understanding how statistics can be manipulated along with how lopsided the research points to luck as the determining factor in outperformance, investors are in a much better position to not be “sold” an investment in some hot-shot fund manager or promise of outperformance in a hedge fund. Understanding these simple facts can save you from falling victim to one of the most common sales techniques in the industry : selling performance.
Several days ago Bloomberg wrote a scathing article on Managed Futures Funds. These funds are fairly complicated, but most follow a strategy called “trend following” in which they buy as things are going up and sell as things are going down. It is obviously much more complex than that and they use computer algorithms to determine their trading, but the general gist is a momentum based strategy. These funds started to gain much more popularity after 2008 as they tend to be non-correlated to the overall market which was very appealing to investors after losing over half their money in the stock market.
Bloomberg’s reporter does an absolute take down of these funds. Here is an excerpt:
Clients jumped in. During the decade ended in 2012, more than 30,000 investors entrusted Morgan Stanley with $797 million in a managed-futures fund called Morgan Stanley Smith Barney Spectrum Technical LP. The fund already had $341.6 million invested during the previous eight years.
Top fund managers speculated with that cash in a wide range of asset classes. In that period, the fund made $490.3 million in trading gains and money-market interest income. Investors who kept their money in Spectrum Technical for that decade, however, reaped none of those returns — not one penny. Every bit of those profits — and more — was consumed by $498.7 million in commissions, expenses and fees paid to fund managers and Morgan Stanley.
After all of that was deducted, investors ended up losing $8.3 million over 10 years. Had those Morgan Stanley investors placed their money instead in a low-fee index mutual fund, such as Vanguard Group Inc.’s 500 Index Fund, they would have reaped a net cumulative return of 96 percent in the same period.
We have written about how we’ve avoided these types of funds in the past. The story sounds great…”we make money no matter which direction the market is going!”, which is only partially true. Over the past decade these funds have made profits, but their fees end up consuming nearly all of those profits.
When will investors learn that complex, high fee products nearly always fall short of expectations? These are some of the most expensive lessons that investors have to learn. As investors we are entitled to a market rate of return. Fees, excessive trading, taxes, and unsuccessful market timing strategies are all things that can reduce that market return. An investment strategy that attempts to remove those speed bumps tends to work best.
A well diversified portfolio consists of multiple, unique investment strategies. These could be strategies that invest in things like US equities, real estate, foreign stocks, or bonds. We have found there a few traits that are essential when choosing a strategy. We have listed them below:
- Avoiding “star managers”- star managers only become so after they have a long period of outperformance. This tends to attract a lot of assets which can often be difficult to manage. In addition, any strategy that is contingent on one person is bound to fall apart at some point, when that person leaves the fund. This philosophy tends to weed out most of the top stock pickers and funds that have been in the top of their peer group over the last 5 or 10 years.
- Common sense- if we can’t explain an investment strategy to a client in a way they completely understand, we have a hard time adding it to a portfolio. We should be able to explain very simply how a strategy makes money (and environments where they would lose money as well). Because of this quality, we tend to avoid certain types of hedge funds, trend following strategies and strategies that use complex algorithms.
- No need to know future- any strategy that requires the manager to know the future in order to be successful is bound for failure at some point. The future is unknowable so choosing a strategy that is predicated on a manager’s knowledge of an uncertain future is very difficult to execute. Strategies like long-short and market neutral fall into this camp. In effect, these managers attempt to buy investments that are going to go up and short investments that will go down. The strategy is entirely dependent on these managers knowing what will happen in the future and it is why we avoid them.
So where does that leave us? We tend to select low cost, passive investment vehicles for our clients that are very understandable. Areas like stocks, bonds, real estate and commodities are basic building blocks of a diversified portfolio. It may not be the sexy, complex strategy that people like to hear, but it works well. One of the best indicators we have for a successful investment is that it did what we thought it would do. That doesn’t mean it will always go up, but it does provide consistency which makes it easier to incorporate into a portfolio of diversified investment strategies.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.