Recently, a friend realised a substantial amount of equity in a property sale.
Out of curiosity, I asked, ‘Did you put the money in the bank and give yourself time to consider your options?’
‘No? We went and saw our Industry Super adviser and put the money into super,’ was his reply.
Gingerly, I said, ‘In the cash option?’
With a knowing nod (because his nickname for me is ‘Doomer and Gloomer’), he said, ‘No. We went for the Balanced option.’
Trying to feign surprise (because I knew the answer to what I was going to ask), my response was, ‘Why?’
‘Cash is earning nothing. The Balanced fund has averaged more than a 10% return over the last five years.’
The operative word in his reply was ‘has’…past tense.
In every Product Disclosure Statement (PDS) there’s this disclaimer…
‘Past Performance is No Guarantee of Future Results’
Yet, time and time again, past performance is what people buy.
Many years ago, I was invited to a meeting with the CEO of one of Australia’s largest fund managers.
At the time, the company was running a series of TV ads promoting the fund’s past performance.
When I challenged him on this blatant appeal to people’s greed, his reply was, ‘Past performance sells.’
Academic studies prove, conclusively, that he was 100% correct.
The College of Business at the University of Nebraska published a research paper titled:
‘Mutual Fund Flows and Investor Returns’
Here’s an extract (emphasis is mine):
‘Our study adds to the growing literature on the behavior and performance of mutual fund investors. By analyzing investor timing at the individual fund level, our methodology preserves cross-sectional differences in the timing performance of investors in individual funds. We not only show that attempts to time the market by fund investors are on average detrimental to investor returns, but we shed light on which fund investors are most likely to exhibit poor timing. Our results are consistent with investor return-chasing behavior.’
My friend is a text book case of ‘return-chasing behaviour’…but he is not the only one.
The most difficult part of being a financial planner was trying to persuade people against running with the herd. Past performance is the story of the past, not the future. Yet this logic was often dismissed, as investors chased yesterday’s winners (which in reality, were tomorrow’s losers).
Attempting to persuade my friend to reconsider his investment into a fund that has done well, solely due to an over-exposure to (Australian and International) shares, I sent him a copy of an article I wrote a couple of years ago for Gowdie Family Wealth.
Below is an edited version:
‘On 22 January 2015 the Wall Street Journal reported on the collapse of New York hedge fund — Canarsie Capital LLC.
‘In the space of three weeks the boy genius running the fund lost $99.8 million of the $100 million he was “managing”. All that was left when he wrote his “I’m sorry” note to investors was $200,000.
‘Owen Li, the 28-year old hedge fund manager (should be, gambler) issued a letter expressing:
‘“sorrow and deep regret for engaging in a series of transactions over the last several weeks that have resulted in the loss of all but two hundred thousand dollars.”‘
‘In 2013, Li made a 50% return for the fund (primarily from investing in the Facebook and Twitter IPOs with borrowed funds). In 2014 he tried to replicate the 2013 experience with investments (cash and borrowed money) in the FireEye Inc. and Splunk Inc. IPOs. Never heard of these companies? Me neither. They both tanked.
‘2014 was not so good for the young Li.
‘To make up for lost ground, Li did what every gambling addict does, he double-downed hard on the dream of winning big. In his own words to investors, Li said:
‘“I engaged in a series of aggressive transactions over the last three weeks that—generally speaking—involved options with strike prices pegged to the broader market increasing in value, but also involved some direct positions.”
‘Needless to say, Li made the wrong calls with these aggressive transactions and evaporated $99.8 million in the space of 3 weeks.
‘Contrary to Li’s opinion of himself as an investment professional, he was nothing more than a gambler. Worse still, he was gambling with other people’s money.
‘His 2013 success was due to luck, not good management. However, the average investor sees the 50% return and says “looks good to me, I’m in”. This is why past performance can be such a poor indicator of what investors can expect in the future.
‘In my experience, average investors are so bedazzled by the big return percentage, they rarely ask “how was the return achieved?”
‘Fund A returns 15% and Fund B returns 25% – the odds are most will opt for Fund B.
‘However, Fund A may have achieved its result from selecting 7 winning positions out of 10. More good management than good luck.
‘Whereas Fund B may have had a massive win on one investment while the other 9 floundered. More luck than good management.
‘I cannot stress enough how important it is to know your downside!!!!
‘Far too many investors focus on the ‘smell of sizzle’ and not ‘the heat of the fire’.
‘The extrapolation of past returns is a mug’s game. Market conditions are constantly changing. The conditions that produced yesterday’s returns are not necessarily going to be in play tomorrow.
‘Owen Li failed because he did not have a plan on how to create and retain wealth in variable market conditions. When his gambling strategy failed, he panicked and lost the lot.
‘We [Gowdie Family Wealth] have a clear strategy on how to navigate these markets…winning by not losing. Our value investing approach — looking for low-risk/high-return opportunities — means we err on the side of caution. In due course the ugly duckling will become a swan.
While this was an example of how a hedge fund got it so wrong, the same ‘performance chasing’ mentality exists in institutionally managed funds.
In days gone by, a balanced fund was invested according to the old ‘1/3rd rule’…
1/3rd in cash/fixed interest;
These days the average ‘balanced’ fund has migrated to holding anywhere between 50% to 70% in shares.
Because shares have been the standout performer in recent decades.
And, when you know investors buy past performance, a fund cannot afford to be lagging in the performance tables.
Therefore, the managers move further and further out on the risk curve to generate returns to maintain funds under management.
But, shares markets move in cycles…some longer than others.
And all cycles have two phases — rise and fall.
We’ve already seen the rise, so now — in next Monday’s Markets & Money — we’ll show you why this market is on the cusp of an historic fall.
Editor, The Gowdie Letter