Smart Money? Maybe Not…

Many financial advisors and investors like to keep tabs on what the largest institutions are doing with their money.  Organizations like Harvard, Yale and large public pension plans are thought to be some of the most sophisticated investors, always on the cutting edge of investment strategies.  With that being said, it was with great curiosity that I read this article in the Wall Street Journal about CALPERS, California’s state pension fund, and largest pension plan in the US.  Here is an excerpt from the article:

Those having second thoughts include officials at the largest public pension fund in the U.S., the California Public Employees’ Retirement System, or Calpers. Its hedge-fund investment is expected to drop this year by 40%, to $3 billion, amid a review of that part of the portfolio, said a person familiar with the changes. A spokesman declined to comment on the size of the reduction but said the fund is taking more of a “back-to-basics approach” with its holdings.

So here is what’s crazy about this.  Hedge fund performance for the past 5 years has been absolutely dismal.  For the 5 years ending June 30, 2014, the HFRX Global Hedge Fund Index has averaged 2.97% per year, while the S&P 500 has averaged 18.83%.  These large institutions are supposed to be AHEAD of the curve, but it doesn’t seem to be the case in this instance.  They are getting out of hedge funds after a long period of underperformance.

We have been beating this drum for a while.  We believe that investors in hedge funds are destined for lackluster returns because of the excessive trading, concentration and high fees they charge.  While the timing is suspect, we are happy to hear that they are making this change.  This should generate much better results for their participants over time.

Randomness And Mutual Fund Returns

Top performing investment managers seemed to be placed on pedestals.  When managers like Warren Buffet, Peter Lynch and Bill Gross come on TV, everyone stops to listen, waiting for these successful money managers to impart some wisdom on how to generate fantastic returns.  Have you ever wondered if this is all a big lie?  What if these managers don’t really have any better skills than all the other managers out there, but produced their results from sheer luck?  You may think I sound crazy…I mean, how can managers like the ones I mentioned above not be brilliant stock and bond managers?  Their track record speaks for itself.  Right?

When you think about the universe of all money managers, every year you are going to have some that outperform and some that underperform, and the largest chunk will be around average (compared to their peers).  We can’t all be above average, and if there really is skill involved in outperforming your peers, you would expect to see persistence in the data.  For example, a really terrific money manager would be able to stay in the top quartile of his peers over a number of years if he/she was exceptional.  Standard and Poors has released a study finding that it is extremely rare for this to occur.  Here is an excerpt from the NYT article on the study:

The team selected the 25 percent of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

The answer was a vanishingly small number: Just 0.07 percent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.

While this may seem convincing, many proponents for active funds would counter saying it doesn’t matter if you outperform every year, but whether you outperform over longer periods.  But here is the kicker:   

For the three years ended March 2014, 14.10% of large-cap funds, 16.32% of mid-cap funds and 25.00% of small-cap funds maintained a top-half ranking over three consecutive 12-month periods. Random expectations would suggest a rate of 25%.

Let me put that bolded statement above a different way.  If you were to to pick mutual fund names out of a hat to determine outperformance you would basically get better results.  What that means is that there is a high probability that their returns are the result of luck, or put another way, completely random.  Please remember this the next time you hear a star manager talking about why he/she outperformed.  There is a good chance they are taking credit for random chance.

Real Life Returns vs. Expectations In Financial Planning

Financial planners use assumptions when developing projections for their clients.  Those assumptions include investment returns which have a major impact on results.  After several meetings, most of our clients understand that our assumptions are for portfolio returns that typically range between 4 to 7% per year depending on the risk a client is willing to accept.  What often times gets lost in those projections is how unlikely they will experience those returns in a SINGLE YEAR.  The chart below shows the distribution of annual returns for the Dow Jones Industrial Average:

Bet on GreenA lot of people came into 2014 thinking that after such a strong year for equities, the indices were due for a pause.Looking at the data tells us a different story. There have been eighteen instances since 1921 that the Dow Jones Industrial average was up at least 25% (including last year). The average annual return following these periods has been 11.81%, nearly 50% higher than the 7.93% average we have seen over the last ninety-three years.Looking at the data makes a few other interesting points:Double digit returns are the norm, not the exception. The Dow is almost 3x more likely to be up 10% or more than up single digits.On average, one in five years the markets are up at least 25%The Dow has been up double digits 51% of all calendar years.Just as strength begets strength, weakness begets weakness. The average return for the year following a 25% loss was just 1.91%, ~75% less than the 93 year average.It’s important to remember these numbers are just averages. Markets don’t follow a schedule, often going through periods that don’t rhyme or reason. Consider that since 1921 there have only been five years when the market has been right near the average return of 7.93%.Using a normal bell curve, we can say that 68% of the time, annual returns will be between -11.5% and 27.4%, which is a pretty huge range that doesn’t inspire much confidence. However, we can say with plenty of confidence that if you had to set your portfolio on auto drive, it pays to be long stocks, bet on green.

 

The highest probability is for your stock portfolio to generate returns above 10% per year.  Almost one-third of all annual returns are negative.  The point here is to remember that projections and plans don’t unfold over one year periods.  They happen over lifetimes.  We need to make sure we think about our investments over those periods as well.  This will help us mitigate the urge to “tweak” the portfolio during the periods where we have much higher or lower returns than expected, since we know that returns that deviate from our expectations in a given year are the norm, not the exception.

A Stock Pickers Market?

I am not sure how many times I’ve heard that this is a stock pickers market, but it seems like it is a pretty common comment among pundits.  In a bull market their argument is that a good stock picker will be able to search out the cream of the crop and avoid those laggard stocks that can drag down performance.  In a bear market, a stockpicker can practice risk management, focusing on defensive stocks that will reduce volatility.  It all makes sense in theory.  Unfortunately, the data disputes the execution of that theory.  A recent Merrill Lynch report gives us the facts:

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So far this year only 19% of all active large cap managers have outperformed their index.  This is pretty horrific for investors in active funds and continues to validate our strategy of focusing on low cost, passive strategies.  You may not ever own the best performing mutual fund, but you are virtually certain to never own a fund in the bottom half of their peers.  We think that trade-off is well worth it.

Another Example Of Chasing Performance

Yet another example of how investor behavior is by far the largest drag on performance.  We just can’t seem to get out of our own way when it comes to investing.  We tend to sell funds after lackluster performance and buy funds after they’ve had positive results.  The St. Louis Fed put out a research report showing how performance is driving fund flows:

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The results are pretty dismal for investors.  Here is an excerpt from the article:

The result shows that return-chasing behavior had a significant impact on the performance of return.  The buy-and-hold strategy earned an average annual return of 5.6 percent in the sample period, while return-chasing behavior only realized 3.6 percent.  In other words, chasing returns caused the average U.S. mutual fund investor to miss around 2 percent return per year, which is very significant.

So how much does this really matter?  If I had $1 million and earned the returns stated above for the next 30 years, the buy and hold strategy would be worth $5.13 million, while the return chasing strategy would be worth $2.89 million.  That’s a difference of $2.24 million!  Investors need to understand that past performance has no bearing on future results.  Their future wealth depends on it.

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.