To start at the beginning of the Investment Heresies eBook, click here
Rates of return are fact-based. As such, there shouldn't be a lot of play in them. A number is fixed, not subjective, after all. But with the millions of dollars at stake in fund flows and management fees, the industry has a tremendous incentive to make their fund returns look as good as possible.
To understand the tricks that fund sponsors play, and why they play them, all you have to do is understand the incentive system under which they compete for customers. In today's world, funds which post peer-busting top-of-the-chart fund returns will experience inflows of millions of dollars of customer money. Because management fees are assessed as a percentage of assets under management, ballooning fund sizes mean ballooning management fees.
Now, let's pretend you are a fund family with customers to solicit. All that matters is that you get to the top of the charts. How do you do that?
The first question you ask in seeking top of the chart performance is, "which chart?" If a fund's long-term performance stinks, maybe a different period could be selected which doesn't look so bad. Fund companies start slicing and dicing time periods every which way possible to see where their funds rank. The next trick is to find the best possible index to which the fund can plausibly be compared.
If you're really, really smart (and companies like Fidelity are really, really, really smart), you create a lot of different funds so that some fund, somewhere in your long list of funds, is always at or near the top. Investors remember seeing Fidelity's name always near the top of the list, while forgetting that last year it may have been Fidelity's technology fund, but this year it might have been Fidelity's gold fund that topped the charts.
One of my college professors at Stanford sponsored an investment contest and offered to pay $100 to the winner. We were all diligent in our stock picking, selecting some of the best (and worst) picks of the day. But we all lost to the professor, as had been the case in his class for several years running. Why? Because our professor realized that he wasn't really involved in an investing contest. The game theory behind his contest was much different than is the case with investing. It wasn't real money being invested. Losses didn't really matter. Only winning mattered. Furthermore, it was a winner-take-all situation. Only truly outstanding performance would have a shot at winning that $100. The best blue chip portfolio in the world wasn't going to win that contest. But a leveraged bet on gold, or S&P futures, might have a shot. By setting up a few highly leveraged portfolios and not caring that most of them flamed out in complete failure, my professor was able to come up with a winning portfolio each year.
From the fund manager’s perspective, hedge funds are a very similar contest. Dramatic outperformance is attributed to skill and results in billion dollar investor inflows. Reasonable outperformance is attributed to luck – the markets are efficient after all, and the sales effort will be difficult. Mediocre and underperforming funds close their doors. Only dramatic upside pays off.
And, generally speaking, it’s not the managers’ money at risk so the downside doesn’t theoretically matter. Hedge fund managers get bonuses based on 20% of gains. When managing large sums, a one-year payoff results in several lifetimes worth of reward. A $10 billion portfolio, up 20% in a year, rakes in $400 million for the senior members of the management team.
Mutual funds are involved in a similar contest. They "incubate" small funds and hope to buy volatility that generates top of the chart performance. Successful funds are hatched and marketed to the investing public. If they can market this record and attract a lot of customer dollars, they achieve the financial industry equivalent of winning the lottery. In a little over a year, Fidelity's popular Contrafund grew from a colossal $10 billion fund to an almost unthinkable $20 billion fund. As a result, the management fees that Fidelity earned on this fund doubled from $70 million a year to about $140 million. Now that's a lottery worth entering! By 2007 the fund had grown to $80 billion.
The huge sums of money which flow into these fund will probably dramatically change the nature of the fund's investment process. Can anyone at Fidelity, with a straight face, really tell you that Contrafund's investment strategy has been unaffected by the ballooning of that fund from $8 billion in 1995 to $80 billion in 2007?
On the flip-side, bad records are merged out of existence. Fund managers change funds and leave good performance records behind them. Beginning in 1997, the opposite is now true. The Securities and Exchange Commission has decided to let portfolio managers claim their previous track record, on an existing fund, when starting up a new fund. The managers can take their old record along with them when they decide to change jobs! Suddenly, two different funds may be advertising the same successful track record!
The very performance contest which drives fund managers to go all out for their shareholders, also makes it extremely difficult for fund investors to sort through the competing claims made by fund companies who are all looking for your money.
- The Investment Advisor's role:
Investment advisors subscribe to services which track fund performance over long periods of time. By comparing a fund with its peer group and appropriate indexes, standout fund managers begin to shine through. If the portfolio managers for these funds jump ship, the advisors can move investors into a safe haven.
Advisors should help investors allocate assets to the most appropriate asset classes, not dump clients in all asset classes. In addition, the advisor should be tracking the performance of funds against appropriate benchmarks to be certain that the funds being used are providing satisfactory returns, and advisors should know how the fund performance was derived. Did the fund make a bet on a particular industry that paid off? Is the manager a whiz at stock-picking? Did the manager let cash build up? Was the outperformance an accident? It happens. All of these are critical questions to ask regarding a fund's performance, and investor should delegate the job of asking them to their professional advisor. This is not the time for amateur hour.
Any advisor who says the attribution analysis effort is easy either doesn't know what they're talking about, or is just blowing smoke. Mutual funds are a black box between reporting snapshots. There are very few advisors who have the information necessary to really know what is driving a particular fund's performance. It is hard enough for me to really know what is driving performance in my own fund. Without direct access to the trading data, it is extremely difficult for an outsider to determine whether a fund is performing well due to stock selection, industry concentrations, trading calls, or other factors. Staying on top of portfolio construction, however, is an important part of managing total portfolio risk.
Don't be afraid of risk. Learn more about it. Develop a process that evaluates risk and invests your portfolio in asset classes where non-normal risk/return distributions mean that you are more likely to have above average returns. Don't assume a normal bell-shaped curve. Seek out long-tail investments where the upside scenarios and payoffs are relatively larger than the probability of experiencing a loss.
Be flexible in the amount of risk you accept. Attractive markets can justify above average risk. Unattractive markets should drive money to the sidelines. They should make investors risk averse. There’s nothing wrong with taking smart risks. Sometimes being overly conservative is a problem. Sometimes being conservative is the prudent thing to do.
Money is often made when perceived risk is high. Money is usually lost when actual risk is high. To make more and lose less, you have to understand what risk is, and what it isn’t.
Next post: Heresy#3: Successful Investing Can Be Easy
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.
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