Ten years ago I had lunch with a prospect who was interested in getting a little better return on his investments. He was about 70 years old. He had made fortunes, and lost fortunes, and made them back again. I felt that I had a lot to learn from this man, which is typical of many of the investors who come to me for advice.
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During the mid-1970's, this man made over a million dollars running a small company which developed a medical cream used in fighting cancer cells. Never allowed to sell the product in the U.S., his company developed markets in Latin America and Europe. A small Denver brokerage house took his company public at 10-cents a share. The 400,000 shares for which he'd paid a penny each were suddenly worth $6 in the penny stock market! He sold his last block of shares for $16 a share.
My point is that this man was not unsophisticated about finances. Nevertheless, as he sat in my office, I soon found myself explaining - once again - the basic facts of investment life. Risk and return go hand in hand. Many people forget this rule, which is as fundamental to investing as gravity is to natural science.
Nobody likes risk. Everybody wants a high return. Prospects searching for high return but little risk, like the man I met for lunch in 1997 and the prospects I met last week and the couple I'll likely meet next month, are the norm. Risk and return generally go hand in hand.
Investors want portfolio results above the line. They want returns that exceed the normal return for a given level of risk.
A portfolio could end up in position (A) for only a couple of reasons. One good example would be when short-term performance of the portfolio gets ahead of itself. Sometimes investors just get lucky! Experienced investors know that returns are typically "bunched." They are not spread evenly over time. In a given period, some portfolios will, for many reasons mostly having to do with chance, see their portfolio surge in value. When a concentrated portfolio meets a significant investment fad, such as the hype which surrounded "internet" stocks in 1995, performance can surpass all reasonable expectations. In the short run, returns can leap above the risk/reward line. In the long run, however, this position is hard to sustain.
Another reason that a portfolio could end up in position (A) is that its risk might not be properly recognized. For example portfolio (A) might be using options or warrants to take on more risk than most investors realize. Options and warrants, like other forms of financial leverage (borrowing money to purchase additional assets), can increase returns in a bull market, but will also exaggerate the declines of a bear market. Sometimes above-average returns are signals that you are using the wrong average! Properly classified, the return might still be attractive --- but, more importantly, the portfolio might be taking much greater risk than investors realized. Some hedge fund managers are addicted to leverage in the same way that extreme sports fanatics are addicted to adrenalin. But once again, over time the use of leverage can be fatal. Many hedge funds have reported several years of spectacular performance, with increasingly large sums of money, and blow themselves up in the end when the strategy fails and the bankers move in to sell what is left.
Looking for strategies that provide above-normal returns requires an ability to determine how returns are being earned in the first place, as well as a solid understanding of the investment risks inherent in the strategy.
A famous example of out-sized returns:
In 1993, Worth Bruntjen managed a Piper Jaffrey mutual fund that was winning accolades by investing in government securities. In fact, the fund was investing in "government-guaranteed" mortgage-backed securities which were highly sensitive to swings in short-term interest rate levels. As rates declined through 1992 and into 1993, these securities performed very well. The attractive returns drew hordes of investors into this "government bond" fund. Some of the most naive investors believed that the fund was paying out great rates of return but that their principal was not at risk. The fund received high rankings by both journalists and fund rating services. Nobody bothered to look too closely at the reason for these above-average returns.
The fund's real risk/return posture became readily apparent when rates reversed themselves. In late 1993 and throughout 1994, this fund's reliance on speculative mortgage-backed derivatives became quite clear. While rates declined, these securities paid increasingly higher rates of interest, leading to the fund's outperformance. When rates reversed, however, these securities started paying out lower rates of interest. Even worse, the bid side for these hard-to-value mortgage-backed securities plunged. Bids dried up. News about "derivative-related losses" splashed across the top of newspapers (and not just the business section, either).
Piper Jaffrey's fund lost 25% of its value in a matter of months as sharp investors bailed out of the fund. The fund manager sold the most liquid securities first, but that left the manager and the remaining fund owners holding a bunch of hard to sell derivative securities that were falling precipitously in value. This was clearly a case where the portfolio's out-sized returns were achieved by taking some "hidden" risks. Had these additional risks been factored in, the outperformance would not have been so hard to explain, and the debacle during 1994 might not have come as such a surprise.
In 2008 an almost identical scenario unfolded in Memphis, Tennessee when Jim Kelsoe’s formerly top-ranked Regions Bank/Morgan Keegan Select Intermediate Bond fund imploaded under the weight of too many securities backed by sub-prime loans. You may have been wondering who was foolish enough to buy bonds backed by optimistic home owners who, though they may have lied about their income and probably couldn’t afford their home, somehow managed to get someone to loan them the money anyway. And who, ultimately, was lending them the money? Why, it was the investors in Kelsoe’s bond fund! For four years running, from 2003 to 2006, Kelsoe’s investors beat their bond benchmark by 2.5% to almost 3% per year. In the bond arena, that’s a bunch. But there was more risk in those loans to jughead borrowers than Kelsoe realized, and when the market for this garbage dried up, Kelsoe was left with a major part of his portfolio where there was no bid. His fund lost 50% in 2007, and then another 50% in the first part of 2008.
Kelsoe also made his "expertise" available to closed-end fund investors. In 2009, the brainiacs at Morgan Keegan changed managers at just about the worst time imaginable. The new managers sold nearly all of the holdings into extremely illiquid markets, permanently locking in losses for fund investors, so that they could start with a clean slate.
The homework assignment is not to avoid funds with above-average track records, but rather to do the work necessary to understand how that performance has been achieved.
Next post: Can performance fall below the line?
To start at the beginning of the Investment Heresies eMag, click here
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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