I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch.  As he said in his blog post at The Wall Street Journal’s The Experts blog:

WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance.  “No problem,” you might think—buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.”

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

CGMFX Dollar Weighted_1552_image002That’s why I wanted to write this post.  Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions.  As such, his investors buy high and sell low with his funds.  The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database.  The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data.

The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports.  This is all public data, but somewhat difficult to aggregate.  I do it by hand.

I use annual cashflows for most of the calculation.  For the buy and hold return, i got the data from Yahoo Finance, which got it from Morningstar.

Note the pattern of cashflows is positive until the financial crisis, and negative thereafter.  Also note that more has gone into the fund than has come out, and thus the average investor has lost money.  The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance.

This would be an ideal fund to rebalance.  Talented manager, will do well over time.  Add money when he does badly, take money out when he does well.  Would make a ton of sense.  Why doesn’t it happen?  Why doesn’t at least buy-and-hold happen?

It doesn’t happen because there is a Asset-Liability mismatch.  It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short.  If you underperform for less than a few years, they yank funds.  The poetic justice is that they yank the funds just as the performance is about to turn.

Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in.  It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out.  The more volatile the fund, the more rapidly that happens.  And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months.

Pretty astounding I think.  This highlights two main facts about retail investing that can’t be denied.

  1. Asset prices move a lot more than fundamentals, and
  2. Most investors chase performance

These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees.  remember as well that passive investing does not protect retail investors from themselves.  I have done the same analyses with passive portfolios — the results are the same, proportionate to volatility.

I know buy-and-hold gets a bad rap, and it is not deserved.  Take a few of my pieces from the past:

If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets.  If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets.  Rebalance to those percentages yearly.  If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon.  (Why 120?  End of the mortality table. 😉 Take it from an investment actuary. 😉 We’re the best-kept secret in the financial markets. 😀 )

Okay, gotta close this off.  This is not the last of this series.  I will do more dollar-weighted returns.  As far as retail investing goes, it is the most important issue.  Period.

One of the constants in investing is that average investors show up late to the party or to the crisis.  Unlike many gatherings where it may be cool to be fashionably late, in investing it tends to mean you earn less and lose more, which is definitely not cool.

One reason why this happens is that information gets distributed in lumps.  We don’t notice things in real time, partly because we’re not paying attention to the small changes that are happening.  But after enough time passes, a few people notice a trend.  After a while longer, still more people notice the trend, and it might get mentioned in some special purpose publications, blogs, etc.  More time elapses and it becomes a topic of conversation, and articles make it into the broad financial press.  The final phase is when general interest magazines put it onto the cover, and get rich quick articles and books point at how great fortunes have been made, and you can do it too!

That slow dissemination and gathering of information is paralleled by a similar flow of money, and just as the audience gets wider, the flow of money gets bigger.  As the flow of money in or out gets bigger, prices tend to overshoot fair value, leaving those who arrived last with subpar returns.

There is another aspect to this, and that stems from the way that people commonly evaluate managers.  We use past returns as a prologue to what is assumed to be still greater returns in the future.  This not only applies to retail investors but also many institutional investors.  Somme institutional investors will balk at this conclusion, but my experience in talking with institutional investors has been that though they look at many of the right forward looking indicators of manager quality, almost none of them will hire a manager that has the right people, process, etc., and has below average returns relative to peers or indexes.  (This also happens with hedge funds… there is nothing special in fund analysis there.)

For the retail crowd it is worse, because most investors look at past returns when evaluating managers.  Much as Morningstar is trying to do the right thing, and have forward looking analyst ratings (gold, silver, bronze, neutral and negative), yet much of the investing public will not touch a fund unless it has four or five stars from Morningstar, which is a backward looking rating.  This not only applies to individuals, but also committees that choose funds for defined contribution plans.  If they don’t choose the funds with four or five stars, they get complaints, or participants don’t use the funds.

Another Exercise in Dollar-Weighted Returns

One of the ways this investing shortfall gets expressed is looking at the difference between time-weighted (buy-and-hold) and dollar-weighted (weighted geometric average/IRR) returns.  The first reveals what an investor who bought and held from the beginning earned, versus what the average dollar invested earned.  Since money tends to come after good returns have been achieved, and money tends to leave after bad returns have been realized, the time-weighted returns are typically higher then the dollar-weighted returns.  Generally, the more volatile the performance of the investment vehicle the larger the difference between time- and dollar-weighted returns gets.  The greed and fear cycle is bigger when there is more volatility, and people buy and sell at the wrong times to a greater degree.

(An aside: much as some pooh-pooh buy-and-hold investing, it generally beats those who trade.  There may be intelligent ways to trade, but they are always a minority among market actors.)

HSGFX Dollar Weighted Returns

HSGFX Dollar and Time Weighted Returns

That brings me to tonight’s fund for analysis: Hussman Strategic Growth [HSGFX]. John Hussman, a very bright guy, has been trying to do something very difficult — time the markets.  The results started out promising, attracting assets in the process, and then didn’t do so well, and assets have slowly left.  For my calculation this evening, I run the calculation on his fund with the longest track record from inception to 30 June 2014.  The fund’s fiscal years end on June 30th, and so I assume cash flows occur at mid-year as a simplifying assumption.  At the end of the scenario, 30 June 2014, I assume that all of the funds remaining get paid out.

To run this calculation, I do what I have always done, gone to the SEC EDGAR website and look at the annual reports, particularly the section called “Statements of Changes in Net Assets.”  The cash flow for each fiscal year is equal to the net increase in net assets from capital share transactions plus the net decrease in net assets from distributions to shareholders.  Once I have the amount of money moving in or out of the fund in each fiscal year, I can then run an internal rate of return calculation to get the dollar-weighted rate of return.

In my table, the cash flows into/(out of) the fund are in millions of dollars, and the column titled Accumulated PV is the accumulated present value calculated at an annualized rate of -2.56% per year, which is the dollar-weighted rate of return.  The zero figure at the top shows that a discount rate -2.56% makes the cash inflows and outflows net to zero.

From the beginning of the Annual Report for the fiscal year ended in June 2014, they helpfully provide the buy-and-hold return since inception, which was +3.68%.  That gives a difference of 6.24% of how much average investors earned less than the buy-and-hold investors.  This is not meant to be a criticism of Hussman’s performance or methods, but simply a demonstration that a lot of people invested money after the fund’s good years, and then removed money after years of underperformance.  They timed their investment in a market-timing fund poorly.

Now, Hussman’s fund may do better when the boom/bust cycle turns if his system makes the right move somewhere near the bottom of the cycle.  That didn’t happen in 2009, and thus the present state of affairs.  I am reluctant to criticize, though, because I tried running a strategy like this for some of my own clients and did not do well at it.  But when I realized that I did not have the personal ability/willingness to buy when valuations were high even though the model said to do so because of momentum, rather than compound an error, I shut down the product, and refunded some fees.

One thing I can say with reasonable confidence, though: the low returns of the past by themselves are not a reason to not invest in Mr. Hussman’s funds.  Past returns by themselves tell you almost nothing about future returns.  The hard questions with a fund like this are: when will the cycle turn from bullish to bearish?  (So that you can decide how long you are willing to sit on the sidelines), and when the cycle turns from bearish to bullish, will Mr. Hussman make the right decision then?

Those questions are impossible to answer with any precision, but at least those are the right questions to ask.  What, you’d rather have the answer to a simple question like how did it return in the past, that has no bearing on how the fund will do in the future?  Sadly, that is the answer that propels more investment decisions than any other, and it is what leads to bad overall investment returns on average.

PS — In future articles in this irregular series, I will apply this to the Financial Sector Spider [XLF], and perhaps some fund of Kenneth Heebner’s.  Till then.

This is the first episode of “We Eat Dollar Weighted Returns” where the fare is yummy.  Here’s the twist: investors in some bond ETFs have done better than one who bought at the beginning and held.

Now, all of this is history-dependent.  The particular bond funds I chose were among the largest and most well-known bond ETFs — HYG (iShares iBoxx $ High Yield Corporate Bd), JNK (SPDR Barclays Capital High Yield Bond), and TLT (iShares Barclays 20+ Year Treas Bond).

As bond funds go, these are relatively volatile.  TLT buys the longest Treasury bonds, taking interest rate risk.  HYG and JNK buy junk bonds, taking credit risk.

Let’s start with TLT:

Date

Cash Flow

Buy & Hold Return

Cumulated

11/9/2002

248,935,892

1

8/31/2003

-73,889,166

12.31%

1.1231

8/31/2004

439,348,999

3.11%

1.15802841

8/31/2005

73,509,821

6.72%

1.235847919

8/31/2006

442,211,811

6.12%

1.311481812

8/31/2007

165,784,828

3.37%

1.355678749

8/31/2008

-344,202,681

9.54%

1.485010502

8/31/2009

887,336,789

12.30%

1.667666793

8/31/2010

120,142,522

-5.85%

1.570108286

8/31/2011

-452,062,384

4.64%

1.64296131

2/29/2012

-3,038,265,474

32.32%

2.173966406

IRR

Buy & Hold

Difference

11.47%

8.42%

3.05%

I analyzed this back in June, saw the anomalous result, an decide to sit on it until I had more time to analyze it.  The way to think about it is that investors reached for yield at a time when stocks were in trouble, and indeed, rates went lower.  The average investor beat buy-and-hold by 3%.

Here are the results for the junk ETFs:

HYG

4/4/2007

2/29/2008

2/28/2009

2/28/2010

2/28/2011

2/29/2012

Distributions

-9,708

-92,708

-358,324

-512,979

-694,209

Net Additions

371,140

1,989,303

1,781,425

3,201,608

5,840,594

Net Assets

352,636

2,089,054

4,611,414

8,257,928

14,258,718

Investment Return

-8,796

-160,176

1,099,260

957,884

854,406

ROA

-4.57%

-13.12%

32.81%

14.89%

7.59%

4/4/2007

9/16/2007

8/29/2008

8/29/2009

8/29/2010

8/30/2011

2/29/2012

13.40%

IRR

-361,432

-1,896,594

-1,423,100

-2,688,629

-5,146,384

14,258,718

6.04%

Buy-and hold

7.36%

Difference
JNK

11/28/2007

6/30/2008

6/30/2009

6/30/2010

6/30/2011

6/30/2012

Distributions

-9,011

-111,409

-361,521

-616,525

-735,822

Net Additions

404,658

1,481,309

2,180,582

2,366,102

3,928,526

Net Assets

394,346

1,900,709

4,301,252

6,915,538

10,780,535

Investment Return

-1,302

136,463

581,481

864,710

672,292

ROA

-0.61%

11.89%

18.75%

15.42%

7.60%

IRR

11/28/2007

3/14/2008

12/29/2008

12/29/2009

12/29/2010

12/30/2011

6/30/2012

13.22%

IRR

-395,648

-1,369,900

-1,819,061

-1,749,577

-3,192,704

10,780,535

6.49%

Buy-and hold

6.73%

Difference

Both funds were small in advance of the credit crisis, and investors bought into them as yields spiked, and bought even more as income opportunities diminished largely due to the Fed’s low-rate monetary policies. The average investor beat buy-and-hold by 6%+.

Now, the  junk funds were small during default, and grew during the boom, amid unprecedented monetary [policy from the Fed.  (Note: I think that Bernanke will rank below Greenspan in the history books in 210o, and both will be judged to be horrendous failures.  It is better to let things fail, and clear out the bad debt, rather than continue malinvestment.  We need fewer banks, houses, and auto companies, among others.  The government, including the Fed and the GSEs, should not be in the lending business.  Lending should be unusual, and applied mostly to financing short-term assets.  Long-term assets should be financed by equity, or at worst, long-dated debt.

For all three funds, we have the historical accident that the Fed dropped Fed funds rates to near zero, leading to a yield frenzy.  But what happens when defaults spike?  What  happens when no one want to buy long dated Treasuries at anything near current levels?

I think bond investors are more rational than stock investors; they have more rational benchmarks to guide them.  Bond investors have cash flows to analyze against EBITDA (earnings before interest, taxes, depreciation and amortization.  Stock investors wonder at earnings, which are easily gamed.

The real question will come when we have the next credit crisis?  How many holders of HYG or JNK will run then?  Or when inflation starts to run, and the Fed stops buying long Treasury bonds, and even starts to sell them, what will happen to dollar-weighted returns then?

This is an interesting piece for bond assets in a bull market.  We need to see bear market results to truly understand what is going on.

Full disclosure: long TLT for myself and clients

I think one of the largest areas for practical investigation in finance is reviewing dollar-weighted versus time weighted returns, especially for vehicles that are traded heavily.  I am going to try to analyze one major ETF per month to see what the level of slippage is due to trading.

But if my hypothesis is wrong, I’ll post on it anyway.  The last post I did on this was on SPY, the S&P 500 Spider.  The slippage was 7%+/year.

Now I have done the calculation for the QQQ, the PowerShares QQQ Trust, which mimics the Nasdaq 100.  The Nasdaq 100 is more volatile than the S&P 500, so I expected the gap to be worse, but it wasn’t: from the inception in March 1999 to the end of the fiscal year in September of 2011, the dollar weighted return was 0.38%/year versus a time-weighted return that a buy-and-hold investor would get of 0.77%/year.  0.4% of difference isn’t much to talk about.  It still indicates a little bad trading.

That said, the net amount of unit creation and liquidation tended to be small.  Maybe that is the difference.  I have to think more about this, but my advice to anyone using exchange traded products remains the same — read your prospectus carefully, and understand the weaknesses of the vehicle.  If creation units don’t have to be something exact, ask what that might imply for your returns.

Anyway, here were the figures from my dollar-weighted return calculation:

I used annual data, and assumed midperiod dates for the cashflows.

The next ETF I plan to analyze is XLF, the Financial Sector Spider.  I suspect that will look bad, but who knows?
Full disclosure: short SPY in some hedged accounts.

Somebody notify the Bogleheads, they will like this one, or at least Jack will.  Yo, Jack, I met you over 15 years ago at a Philadelphia Financial Analysts Society meeting.

How bad are individual investors  at investing?  Bad, very bad.  But what if we limit it to a passive vehicle like the Grandaddy of all ETFs, the S&P 500 Spider [SPY]?  Should be better, right?

I remember a study done by Morningstar, where the difference between Time and Dollar-weighted returns was 3%/year on the S&P 500 open end fund for Vanguard, 1996-2006.

But here’s the result for the S&P 500 Spider, January 1993- September 2011.  Time-weighted return: 7.09%/year.  Dollar-weighted: 0.01%/yr.  Gap: 7%/yr+

Why so much worse than the open-end fund?  Easy.  Unlike the professional managers at Vanguard, and the relatively long term investors they attract, the retail short term traders of SPY trade badly; they arrive late, and leave late on average.

There is far more analysis to be done here, but to me, this confirms that Jack Bogle was right, and ETFs would be a net harm to retail investors.  The freedom to trade harms average investors, and maybe a lot of professionals as well.  It may also indicate that short-term trading as practiced by technicians may underperform in aggregate.  Not sure about that, but the conclusion is tempting.

One thing I will say: I am certain that profitable trading is not easy.  If you are tempted to trade for a living, the answer is probably don’t.

Anyway, here’s my spreadsheet on the topic:

 

Full disclosure: I have a few clients short SPY, hedged against my long positions.

This morning, I looked at the fall in the Chinese stock market, and I said to myself, “It’s been a long journey since the last crash.” After that, I wrote a brief piece at RealMoney, and another at what was then the new Aleph Blog, which was republished and promoted at Seeking Alpha, and got featured at a few news outlets.  It gave my blog an early jolt of prominence. I was surprised at all of the early attention. That said, it encouraged me to keep going, and eventually led me away from RealMoney, and into my present work of managing money for upper middle class individuals and small institutions.

I try to write material that will last, even though this is only blogging.  Looking at the piece on the last China crash made me think… what pieces of the past (pre-2015) still get readers?  So, I stumbled across a way to answer that at wordpress.com, and thought that the array of articles still getting readers was interesting.  The tail is very long on my blog, with 2725 articles so far, with an average word length of around 800.  Anyway, have a look at the top 20 articles written before 2015 that are still getting read now:

20. Got Cash?

Though I write about personal finance, it’s not my strongest suit.  Nonetheless, when I wanted to write some articles about personal finance for average people, I realized I needed to limit myself mostly to cash management.  A few of the articles in the new series “The School of Money,” should be good in that regard.

19. Book Review: Best Practices for Equity Research Analysts

I write a lot of book reviews.  I have some coming up.  I was surprised that on this specialized got so many hits after four years.

18. On the Structure of Berkshire Hathaway, Part 2, the Harney Investment Trust

This is a controversial piece on the most secretive aspects of what Buffett does in investing.  I have tried to get people from the media to pick up this story, but no one wants to touch it.  I think I am one of the few admirers of Buffett willing to be critical… but so what?  Hasn’t worked on this story.

17. Learning from the Past, Part 1

This short series goes through my worst investing mistakes.  It’s almost finished.  I have one or two more articles to write on the topic.  This one covers my early days, where I made a lot of rookie errors.

16. On Trading Illiquid Stocks

I describe some of my trading techniques that I use to fight back against the high frequency traders.

15. De Minimus Laws

Here I do a post aiding all of my competitors, giving the relevant references to the de minimus laws for registered investment advisers in all 50 states, plus DC and Puerto Rico.  Note that I got my home state of Maryland wrong, and I corrected it later.

14. The Good ETF, Part 2 (sort of)

Reprises an article of mine explaining what makes for exchange-traded products that are good for investors.

13. On Bond Risks in the Short-Run

A piece giving advice on institutional bond management.  Kinda surprised this one still gets read…

12. Should Jim Cramer Sell TheStreet or Quit CNBC?

Cramer generates controversy, and thus pageviews as well.  As an aside, TheStreet.com is down another 20% since I wrote that.  Still, the piece had my insights from brief discussions that I had with Cramer, way back when.

11. An Internship at a Hedge Fund

Basic advice to a young man starting a new job at a hedge fund.

10. Q&A with Guy Spier of Aquamarine Capital

I have always enjoyed the times where I have had the opportunity to interact with the authors of the books that I have gotten to review.  Guy Spier was a particularly interesting and nice guy to interact with.

9. The Good ETF

This is the predecessor piece to the one rated #14 on this list.  Brief, but gets the points across on what the best exchange traded products are like.  It was written in 2009.

8. We Eat Dollar Weighted Returns — III

I’ve been banging this drum for some time, and the last one in this series was quite popular also.  This article highlighted how much average investors lose relative to buy-and-hold investors in the S&P 500 Spider [SPY].  Really kinda sad, underperforming by ~7%/year.

7. Portfolio Rule Seven

Now, why does my rebalancing trade rule get more play than any of my other rules?  I don’t know.

6. The US is not Japan, but there are some Similarities

I had forgotten that I had written this one in 2011.  Why does it still get hits?  In it I argue that the US will get out of its difficulties more easily than Japan.  (Maybe this gets read in Japan?)

5. Actuaries Versus Quants

My contention is that Actuaries are underrated relative to Quantitative Analysts, and have a lot to offer the financial markets, should the Actuaries ever get their act together.

4. Can the “Permanent Portfolio” Work Today?

Does it still make sense to split your portfolio into equal proportions of stocks, long Treasuries, T-bills, and gold?!  Maybe.

3. The Venn Diagram Method for Greatest Common Factors and Least Common Multiples

I was shocked at this one, written in 2008.  This post explains a math concept in simple visual terms for teachers to explain greatest common factors and least common multiples.

And now for the last three:

2. On Berkshire Hathaway and Asbestos

1. On the Structure of Berkshire Hathaway

0. Understanding Insurance Float (oops, miscounted when I started… so much for being good at math 😉 )

Should it be any surprise that the last three, the most popular, are on Buffett, Berkshire Hathaway and Insurance?  People go nuts over Buffett!

The one novel thing I bring to table here is my understanding of the insurance aspects of BRK.  Each of the three deal with that topic in a detailed way.  Aleph Blog is pretty unique on that topic; who else has written in detail about the insurance company-driven holding company structure?  Aside from that, many don’t get how critical BRK is to covering asbestos claims, and don’t get the economics of insurance float.  Many think float is magic, when it can lead to an amplification of losses, as well as an intensification of gains.

These last three pieces got really popular in March, around the time that BRK released its 2015 earnings, even though they were one year old.

Anyway, I hope you found this interesting… I was surprised at what gets read after time goes by.  One final note: for every time the most popular pre-2015 article was read, articles that would have been rated #22 and beyond got read 10 times… and thus the long tail.  It’s nice to write for the long term. 🙂

Full disclosure: long BRK/B for myself and clients

Photo Credit: sea turtle

Photo Credit: sea turtle

This is another episode in my continuing saga on dollar-weighted returns. We eat dollar-weighted returns.  Dollar-weighted returns are the returns investors actually receive in a open-end mutual fund or an ETF, which includes their timing decisions, as opposed to the way that performance statistics are ordinarily stated, which assumes that investors buy-and-hold.

In order for active managers to have a reasonable chance of beating the market, they have to have portfolios that are significantly different than the market.  As a result, their portfolios will not behave like the market, and if they are good stockpickers, they will beat the market.

Now, many of the active managers that have beaten the market run concentrated portfolios, with relatively few stocks comprising a large proportion of the portfolio.  Alternatively, they may concentrate their portfolio in relatively few industries at a time, as I do.  Before I begin my criticism, let me simply say that I believe in concentrated portfolios — I do that myself, but with a greater eye for risk control than some managers do.

My first article on this topic was Bill Miller, who is a really bright guy with a talented staff.  This is the “money shot” from that piece:

Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.  As Legg Mason Value Trust grew larger it concentrated its positions.  It also did not care much about margin of safety in financial companies.  It bought cheap, and suffered as earnings quality proved to be poor.

Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.  I’m not sure the situation has stabilized, but it is probably close to doing being there.

Investors in the Legg Mason Value Trust trailed the returns of a buy-and-hold investor by 6%/year over the time my article covered.  Investors bought late, and sold late.  They bought after success, and sold after failure.  That is not a recipe for success.

FAIRX_15651_image002Tonight’s well-known fund with a great track record is the Fairholme Fund. Now, I am not here to criticize the recent performance of the fund, which due to its largest positions not doing well, has suffered of late. Rather, I want to point out how badly investors have done in their purchases and sales of this fund.

As the fame of Bruce Berkowitz (a genuinely bright guy) and his fund grew, money poured in.  During and after relatively poor performance in 2011, people pulled money from the fund.  Even with relatively good performance in 2012 and 2013, the withdrawals have continued.  The adding of money late, and the disproportionate selling after the problems of 2011 led the dollar weighted returns, which is what the average investors get, to lag those of the buy-and-hold investors by 5.57%/year over the period that I studied.

(Note: in my graph, the initial value on 11/30/2003 and the final value on 5/31/2014 are the amounts in the fund at those times, as if it had been bought and sold then — that was the time period I studied, and it was all of the data that I had.  Also, shareholder money flows were assumed to occur mid-period.)

Lessons to Learn

  1. Good managers who have ideas that will work out eventually need to be bought-and-held, if you buy them at all.
  2. Be wary of managers who are so concentrated, that when they receive a lot of new cash after good performance, that the new cash forces the prices of the underlying stocks up.  Why be wary?  Doesn’t that sound like a good thing if new money forces up the price of the mutual fund?  No, because the fund has “become the market” to its stocks.  When the time comes to sell, it will be ugly.  If you are in a fund like this, where the fund’s trading has a major effect on all of the stocks that it holds, the time to sell is now.
  3. There is a cost to raw volatility in large concentrated funds.  The manager may have the guts to see it through, but that doesn’t mean that the fundholders share his courage.  In general, the more volatile the fund, the less well average investors do in buying and selling the fund.  (As an aside, this is a reason for those that oversee 401(k) plans to limit the volatility of the choices offered.
  4. Even for the buy-and-hold investor, there is a risk investing alongside those who get greedy and panic, if the cash flow movements are large enough to influence the behavior of the fund manager at the wrong times.  (I.e., forced buying high, and forced selling low.)
  5. The forced buying high should be avoidable — the manager should come up with new ideas.  But if he doesn’t, and flows are high relative to the size of the fund, and the market caps of investments held, it is probably time to move on.
  6. When you approach adding a new mutual fund to your portfolio, ask the following questions: Am I late to this party?  Does the manager have ample room to expand his positions?  Is this guy so famous now that the underlying investors may affect his performance materially?
  7. Finally, ask yourself if you understand the investment well enough that you will know when to buy and/or sell it, given you investing time horizon.  This applies to all investments, and if you don’t know that, you probably should steer clear of investing in it, and learn more, until you are comfortable with the investments in question.

One final note: I am *not* a fan of AIG at the current price (I think reserves are understated, among other things), so I am not a fan of the Fairholme Fund here, which has 40%+ of its assets in AIG.  But that is a different issue than why average investors have underperformed buy-and-hold investors in the Fairholme Fund.

18593599Investing is paradoxical, as many that read my blog would know. The market has cycles.  There are overall boom/bust cycles.  There are minor cycles between the major cycles.  Strategies fall in and out of favor.  What is an investor to do?  Even harder, what should one who selects assets managers do?

It is hard to select talented investment managers.  I know this, because I have done it many times in my career.  This book points out the difficulties in selecting managers.  Were the returns due to skill, or did he hit a lucky streak?  If you are looking at the numbers only, it would be hard to tell.  Asking managers detailed qualitative questions could help, as could looking at the current portfolio, and asking:

  1. Does the portfolio fit the stated style of the manager?
  2. Does it fit his description of how he tries to make money?

This book summarizes many issues in picking managers:

  • Strict mandates vs looser mandates
  • The ways in which we deceive ourselves willingly, to believe a nice manager, or con man
  • How hedge funds grew and changed
  • Can managers adapt to new market environments successfully, or should they persist with their model which used to work, but is now out of favor?
  • How do you deal with funds that are too complex for the ordinary retail investor to understand? (I would say avoid them.)

The book includes a chapter on Madoff, and while it doesn’t break new ground, it does point out why custodians and auditors are important.  If there had been an independent custodian, or a real auditor, Madoff’s scam could never have happened.  I also appreciated the reference on page 125 as to the methods that scammers use to gain the confidence of those they scam.  This is one case where bright people get fooled.  I would encourage readers to read “The Big Con,” or even marketing books, to make themselves skeptical.

The book has a firm hand on what leads to risk/return among managers — Concentration, Directionality, Compelexity, Illiquidity, and Leverage.  LTCM is held out as an example of a disaster waiting to occur.

The book explains different types of investors, and why they take the risks they do.  Different investors take different risks.

The author gives his own summary of how to interview fund managers, though I found it to be light.  As a former buy-side analyst, I had to interview CEOs, and while I used a few techniques of the author, there are more techniques that can be used.  I appreciated the allusion to “Colombo,” because purposely dumb questions can reveal the honesty of the one being interviewed, and may reveal details that could not be gotten through a smart question.

At the end, he points out how pension plans will not be likely to meet their return goals.  He is right, and efforts to break that paradigm through allocations to alternative investments are also unlikely to work.  Hedge funds don’t respond well to volatility.

This is a good book, but I have one further main objection.

Quibbles

When the author discusses Simon Lack’s analysis of hedge funds (P 190), he wrongly dismisses the significance of dollar-weighted versus time weighted rates of return.  If a manager’s returns are so volatile that it leads investors to buy high and sell low, that is the manager’s fault.  Good managers limit risk so that their investors don’t panic.  Also, since dollar weighted returns are what investors receive as a whole, that is the actual result of the investing, and is the way that all investment managers should be measured.  And as such, Lack’s arguments are correct.  Investors would have gotten more out of investing in T-bills, which absolutely, would not be much more, but less is less.  Lack is correct, and the author is wrong.

Who would benefit from this book: If you hire mutual fund managers, you could benefit from this great book.  If you want to, you can buy it here: The Investor’s Paradox: The Power of Simplicity in a World of Overwhelming Choice.

Full disclosure: I asked the PR people for a copy of the  book, and they sent it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Also, it should be noted that value managers have client bases that often invest more in bad times, and take profits in good times, so their dollar-weighted returns are often higher than the time-weighted returns.  Educated, contrarian investors do better.

These articles appeared between February 2012 and April 2012:

We Eat Dollar Weighted Returns — III

What did a buy-and-hold investor get owning SPY?  7%/year.  What did the average holder get? 0%.  A warning against over-trading.

Against Risk Parity

Against Risk Parity, Redux

Expressing skepticism over a strategy using leverage to extract returns out of lower-yielding asset classes.  Why not but subordinated asset-backed securities instead, and how did they do in the crisis?

Individual Investing Can Be Tough

Individual Investing Can Be Tough, Redux

The investment game is competitive, and I give a few tips on how to avoid the risks.

Musings on the “400% Man”

Understanding small asset managers, and why you might want to invest with them.

Thinking about the Insurance Industry

I take a tour through the insurance industry after the carnage of the credit crisis.

Notes on the 2011 Berkshire Hathaway Annual Report, Part 3 (On Acquisitions)

Lists all of the notable acquisitions of Berkshire Hathaway from 1977 to 2011.  Analyzes Buffett’s strategy, which has been remarkably consistent over 40 years.

Notes on the 2011 Berkshire Hathaway Annual Report, Part 4 (10K Issues)

Goes through the main risks of Berkshire Hathaway.

Replacing Defined Contributions

I propose a hybrid plan that would replace 401(k)s, and other participant-directed DC plans.

The Rules, Part XXXI

The offering of liquidity through limit orders is a real service to the market, and on average gets rewarded in lower overall execution costs.  In choppy markets, it can really add value.

Buy-and-Hold Can’t Die

Buy-and-Hold Can’t Die, Redux

Explains how every investor (even speculators) has the option of holding on  for a long time, and why that can be valuable.

The Anti-Consultancy Consultancy

Call me, and I will tell you to fire the consultant, and listen to your middle managers.

Easy in, Hard out

It is always easier to loosen monetary policy than to tighten it.  The next tightening cycle will be particularly rough, should the Fed ever choose to do it.

Gold does Nothing

This post got a lot of play over the internet.  I was really surprised at how much response it received.  Gold has few industrial uses, but is pretty; that’s why it is so interesting.

Misunderstanding the Tax Debate

Misunderstanding the Tax Debate (II)

The debate should be about what income is, and not about what the rates should be.  Wealthy people have clever advisers that minimize “income.”  Doesn’t matter what the tax rate is.  The debate should focus on income.

Simple Retirement Calculator

Gives a simple way of analyzing whether you have saved enough or not.  Quick answer: you haven’t saved enough, particularly for the wretched investment environment that we are in now.