Can Performance Fall Below the Line?

People who believe in the "efficient markets hypothesis," believe that all prices always reflect all available public and non-public information. The market, they say, is "efficient" because it automatically processes all of this information. Efficient markets advocates might argue that all returns always fall on the line. Just as it is impossible to earn out-sized returns above the line, it is also impossible to earn sub-standard returns which fall below the line.

To start at the beginning of the Investment Heresies eBook, click here

I am not an efficient markets advocate. I've seen plenty of investment groups deliver sub-par performance. Kelsoe wasn’t an “efficient” investor. He took a foolish risk in order to try to look good in the short term. Piper Jaffrey’s Worth Bruntjen made a similar miscalculation.

Trust departments are famous for explaining away bad performance (i.e. performance which falls short of the risk/reward line) by claiming that they achieved their returns by investing in high quality companies and by taking less risk than the market, generally. They argue, in effect, that their performance does not fall below the line, but rather that their results should be moved over to the left so that it will fall on the line, but at a point of much lower risk.

I have been involved with several boards and heard more than one investment advisor, when confronted with their sub-par investment performance, try to turn the tables by questioning, “I wonder what kind of risk they are taking? We have a very conservative portfolio.”

I think it is possible to fall consistently below the risk/return line. The best known example of this is the Steadman Funds, which had a long and dismal history of underperforming the market. Near the end of 1996, the Steadman American Industry fund had lost 40% over a five-year period, while the average domestic diversified stock fund had doubled. The Steadman Investment fund fell 32% during the same period. Is it any wonder that industry pundits have labeled these the "dead man" funds? At least part of this underperformance is due to extremely high expense ratios, which sapped investor return regardless of how well (or, in this case, poorly) the fund investments perform. Believe it or not, over a decade later, after changing its name to the Ameritor Security Trust, a Steadman fund has survived through 2009. The current gross expense ration of the fund was 2.45% (down from 12.84% as recently as 2008).

Is it possible to fall consistently below the risk/return line? Absolutely! Small trust shops which lack a coherent investment philosophy, or which don't invest in adequate research, can't effectively compete with larger banks and fund companies with their dozens of analysts and thousands of dollars in research service support. Expensive products, like fee-heavy WRAP accounts which pay several layers of expenses, are also consistent underperformers which end up south of the risk/reward line. Individual investors are famously on the wrong side of the risk/return line.

A famous 2003 study by Dalbar of Do-It-Yourself investors showed that from 1984 – 2002, while the market was appreciating 12.22% per year, the average stock fund investor in the study earned an annual total return of 2.57%. The Dalbar study showed that individuals tend to time the market very poorly. They watched the market rise from the sidelines, with few dollars invested. Then, at just the wrong moment, they dumped much more money into the market and watched it all fall. While the indexes returned double digit returns, on a dollar-weighted basis these individual investors were just barely breaking even.

In fact, it is so easy to find yourself below the line due to high product expenses and poor market timing that John Bogle has been sainted by the financial world for arguing forcefully that investors shouldn’t even try to beat the market. Index funds have become a rallying cry for academia, most in the media, and even a very large number of advisors. These advisors are charging clients 1% - 1.5% of assets under management annually in order to, get this, buy clients a bunch of index funds. These advisors admit that they bring nothing to the table on the investment side of things, and for their honesty charge clients as much as $10,000 to $15,000annually on a million dollar portfolio just to park the money in index funds. What they lack in investment smarts, they make up for in chutzpah.

What, exactly is the problem?

As a result of academia saying over and over, louder and louder that risk and return are always and everywhere absolutely correlated, we create a few problems for ourselves.

First of all, we no longer teach portfolio managers how to properly research a company. And if the “efficient markets” theory were really correct, why bother? If everything that could be known is already reflected in the stock price, why not just go back out to the golf course and work on your drive, instead?

Consumers operate under the assumption that all investment advisors are the same. If markets are efficient and all returns lie somewhere on the curve, then why hold your current advisor accountable for poor performance? He or she was just too conservative. And given the pain the clients felt due to the poor performance, they thank the advisor for not putting them any further out there on the risk spectrum.

As a corollary, investment advisors with good track records find themselves being labeled as “too aggressive” simply based on the fact that they’ve provided better than average returns.

Indeed, a friend of mine with a background in consulting observed that the incompetence of most advisors creates a barrier to entry in the industry. Investors move from advisor to advisor and each time manages to underperform the market. One advisor, anxious to sell the client what the client wants (instead of what he needs), allows the client to go in too heavy into technology stocks right at the top of the market. Another advisor uses his firm’s proprietary research and products and does well, for the firm, but not for the client. Yet another advisor charges the client 5% up front to buy a bunch of funds, then never calls the client again and years later the portfolio still hasn’t grown.

Sound familiar?

By this time, clients are convinced that it doesn’t matter whom they choose. So why bother? Switching advisors takes time. It is scary. It requires an uncomfortable call to fire the former advisor. There is paperwork to fill out. There may be taxes to pay when changing strategies. There are automatic deposits that need to be changed. There are dozens of reasons to let inertia rule the day, particularly when it appears that all advisors are equally bad.

The overall incompetence of advisors creates a barrier to entry in the industry. With so few clients willing to undergo the switching costs, absolutely convinced that one alternative is as bad as the next, it makes it difficult for new advisors to enter the industry.

I recently had an opportunity to meet a prospect but had little time to get to know him. In the short period I had, I wanted to let him know how our investment strategies were performing. I quickly presented how we do things differently, and presented some performance examples.

A month later, after he’d chosen to use another advisor, he explained that, “everybody shows you good performance numbers in the beginning.” The bottom line for him was that it didn’t make much difference which advisor was selected. Performance was a great unknown quantity and any honest advisor would deliver roughly comparable returns.

We are taught that no one does better than anyone else. Control costs. We are taught that it makes sense to pay an advisor 1% to buy index funds. Work with someone you know, because they probably aren’t a crook. But to spend time finding out about the advisor’s investment strategy? That’s thought to be a waste of time, just as it is a waste of time for the portfolio manager to read that quarterly 10-K report that his portfolio company just released.

•  Getting Above the Line:

Mark Hulbert publishes the Hulbert Digest, which tracks the performance of many newsletter advisory services. He charted the risk using standard volatility statistics versus the return and found that at the far right side of the graph, for the newsletters that had provided subscribers with the best performance results, the risks entailed in the strategy were far below what the normal risk/return analysis would suggest. How can that be?

How can investors get "above the line?"

First, understand that the “efficient markets” and Capital Asset Pricing Model were developed by economists, not practitioners, and have some high level math embedded in their theoretical DNA. They make some assumptions about the different investments including a major assumption that returns are distributed in a normal bell shaped curve around a mean return. In other words, if the typical (mean) return to stocks is 10% per year, then there will be just as many years where it underperforms as years that it will outperform. Even in the extremes, there will be as many years where the market is up 35% (25% above the mean) as there are when it is down 15% (25% below the mean). When you plot the returns over time, the assumption is that they will form a nice looking “bell” shaped curve with the most occurrences centered around the mean, and far fewer instances in the outlying areas.

The problem is that returns are not distributed in this fashion, especially for individual stocks. In fact, the stock picker’s goal is to find stocks whose future returns are heavily skewed to the positive side of the curve. One of the reasons that “value investors” have a leg up in the race for performance is exactly this; out-of-favor and distressed security returns often have non-normal return prospects. These investors aren’t fishing in a typical pool of water with lots of normal size fish, and a few whoppers along with a few minnows. These investors are fishing in waters where most of the fish are above average size.

So one way that investors can achieve above the line returns is investing with these experienced value mavens and just being patient. Most great managers will underperform the market for a stretch. It requires commitment not to bail out on them when this happens, but patience and discipline will eventually win out.

Timing the markets adroitly (not perfectly, but with better than random results) is another way to achieve above the line returns.

Remember the university house of terror in which those academic studies were contrived? They required a host of assumptions. One of the key assumptions is that over the course of time, the portfolio bought and held different combinations of securities. The portfolio was static. It never changed. Given a static mix of assets, the results were somewhat pre-ordained. The best performing assets, usually equities, were on the right. The worst performing assets, usually cash over long periods of time, was on the left. Other asset combinations found themselves in the middle.

Over shorter time periods, these pretty risk/return charts, which the economists and financial planners love, break down completely. In some periods, bonds outperform and have less risk. In other periods, cash is king. Sometimes international stocks add return to the portfolio. In other periods, they cause a drag. Small caps usually add zest to the portfolio, but not always. There are entire decades when the risk/return charts look nothing like the traditional graph.

But why assume “buy and hold” other than to keep things simple for the computer?

In fact, go back to the typical investor’s quest for 30% returns and little or no risk. There is no asset class that you can buy and hold and achieve this investment nirvana. Stocks definitely won’t deliver on that promise. Private equity won’t. Neither will venture capital. Real estate certainly won’t. Nothing can deliver on the holy grail of 30% returns and below average risk, unless you are willing to relax the buy and hold assumption.

With perfect insight, it would be possible to deliver high returns and relatively low risk. Over time, by moving between asset classes, it would be fairly easy to deliver that outcome.

True, no one has perfect insight. However, that doesn’t change the fact that by having a flexible asset allocation discipline, instead of a static portfolio, investors can potentially improve portfolio returns rather dramatically.

Part of the proof is that we know that as a class, individual investors typically dramatically underperform the market because they do such a poor job of timing the markets. Why wouldn’t you look into “who’s on the other side of that trade?”

To get above the line, get help from investment professionals who are willing to provide advice on which asset classes to buy, and which ones to avoid. The vast majority of advisors will tell you to buy a little bit of everything. Under the guise of “diversification,” they assure that you’ll receive mediocre results at best, and probably worse (depending on the fees).

Most mutual funds and advisors cling to mediocrity like a drowning sailor to a life preserver. Here’s a secret for you. They are not trying to protect you from risk. They are protecting only themselves.

Given the barriers to entry where all advisors are considered equally inept, and switching costs are relatively high, most clients will not abandon an advisor who provides them with mediocre returns.

They won’t abandon an advisor with excellent returns, either, but few financial service firms are willing to stand apart from the herd and do what is necessary to earn above the line returns.

Above the line returns require an opinion on which markets to buy and which to avoid. If the firm gets that wrong, then some client somewhere will complain and, increasingly, bring a lawsuit. There are giant law firms whose entire business strategy is built upon suing companies as soon as some mistake causes the stock price to drop. If these firms were to start making market forecasts and actually acting upon them with client dollars, what a bonanza that would be for the American Bar Association. It is yet another example of what economist John Maynard Keynes described when he said, it is better to fail conventionally than to succeed unconventionally.”

You don’t get sued for mediocrity, nor do you lose clients. Wall Street’s overdiversified, benchmark-hugging strategies have nothing to do with trying to protect investors.

Next post: Don't Try this At Home 

To start at the beginning of the Investment Heresies eBook, click here

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment  Heresies.

Go to Investments main page.