Systematic Relative Strength

Jason Zweig, in an interview with Morningstar, points out that performance chasing is seen in all parts of the investment world:

There was a beautiful study that was published in the The Journal of Finance a couple of years ago about the selection of institutional money managers. It basically found that the professionals who pick money managers, in this case it was pension funds, tend to buy high and fire low. They invest in whichever managers have the best trailing three-year performance and then sell whichever have the worst trailing three-year performance. The study showed that if they had flipped their decisions–if they had bought the ones with the worst three-year performance and sold the ones with the best–they actually would have gotten better returns. And of course if they had done nothing–if they had just put the portfolio on ice–they also would have done better. Performance-chasing, despite all the propaganda you hear in the financial industry, is not purely the province of retail investors. It’s not the so-called “dumb money” on Main Street that buys high and sells low. Everyone does it.

You have three choices: you can go with a manager when they are hot, you can go with a manager when they are cold, or you can do nothing. Investors, in aggregate, make the worst choice of the three! If you don’t have the emotional resilience to go against the grain, at least have the patience to sit on your hands.

—-this article originally appeared 10/23/2009. We’re a couple of DALBAR reports down the line and investors, in aggregate, continue to make the worst possible choice. Your best bet is to pick a sound strategy and add to it during periods of underperformance.

I have to confess that I am a little confused about this article. First, the author presents information from Morningstar that confirms the QAIB information that Dalbar has been pointing out for many years—that investors in funds do not do as well as the underlying funds themselves.

Then, he appears to blame volatility for making investors behave badly and suggests that funds with lower volatility will create better investor performance. After which he quotes Warren Buffett, who indicates the opposite—that he would rather have the higher return and accept the volatility than take the lower return. All of this is a little unclear to say the least.

Let me clear up a few things then. First, I’m not at all sure it is true that lower volatility enhances investor returns. Dalbar’s QAIB shows that bond fund investors lag bond funds by approximately the same margin as stock fund investors lag stock funds. Bonds are significantly less volatile, but that doesn’t seem to help at all. Dalbar shows only a marginally longer holding period for asset allocation funds than for stock funds, where again there is a significant difference in volatility. If volatility were really the determining factor in whether investors could hang in and perform well or not, these metrics should reflect it.

Second, I believe it is the investor and the advisor’s responsibility to do due diligence and know what they are buying. If you buy an emerging markets growth fund, for example, the fund is not exactly trying to hide that it may be volatile. You accept the volatility as your tradeoff for the potentially higher return. That’s the American way. To blame the volatility for poor returns, to me, is symptomatic of current, soft-headed American culture where no one is ever responsible for their own decisions. After all, wasn’t it that mortgage broker who made you buy a house you couldn’t afford?

No, Mr. Buffett has it right, I think. Ultimately, what makes you wealthy is the return. That means you have to deal with the volatility. And really, what is the big deal? The only ”investment acumen” a fund investor has to have to earn the NAV return is to sit like a slug! That’s it—you don’t really have to do anything clever. There is no magic trick involved, just patience. Research a strategy thoroughly, take a stand, and make a commitment, for goodness sake!

—-this article was originally published on July 7, 2009. Warren Buffett still has the right idea, I think: take the higher return and accept the volatility. Investors are still acting like sheep and running from volatility, or seaching for that holy grail of safe returns. Last year, investors bought bonds in record amounts. This year, muni bonds are already being dumped due to the volatility in that market. Now that we’ve had a couple of volatile days in the equity market, how will you react? Will you stick with a well-researched strategy, or will you bail out?

Christine Benz, the personal finance expert at Morningstar, has an excellent article about the four investment rules to ignore. These “rules” are in wide practice throughout the industry, but they don’t hold up under close inspection. In fact, they will destroy your long-term returns if you let them.

1. Consistency of returns is important in investment selection.

2. If an investment has been a laggard over the past three or five years, cut it loose.

3. Your risk tolerance should determine your asset allocation.

4. It’s ok to go to cash when you are nervous about the market.

This article is a must-read.

—-this article originally ran 6/25/2009. As is the case with all timeless investment wisdom, it’s still true. Ignoring them or pretending they are false doesn’t make them any less true! There are a lot of things in the investment industry that people wish were true, but that doesn’t make it so. Read this article carefully again and get a good start on 2011.