Underperformance

September 26, 2013

Whether you are an investment manager or a client, underperformance is a fact of life, no matter what strategy or methodology you subscribe to.  If you don’t believe me, take a look at this chart from an article at ThinkAdvisor.

Source: Morningstar, ThinkAdvisor  (click on image to enlarge)

Now, this chart is a little biased because it is looking at long periods of underperformance—3-year rolling periods—from managers that had top 10-year track records.  In other words, these are exactly the kinds of managers you would hope to hire, and even they have long stretches of underperformance.  When things are going well, clients are euphoric.  Clients, though, often feel like even short periods of underperformance mean something is horribly wrong.

The entire article, written by Envestnet’s J. Gibson Watson, is worth reading because it makes the point that simply knowing about the underperformance is not very helpful until you know why the underperformance is occurring.  Some underperformance may simply be a style temporarily out of favor, while other causes of underperformance might suggest an intervention is in order.

It’s quite possible to have a poor experience with a good manager if you bail out when you should hang in.  Investing well can be simple, but that doesn’t mean it will be easy!

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3 Keys to a Simple Investment Strategy

August 8, 2013

Simplicity is the ultimate sophistication.—-Leonardo di Vinci

This quotation doubles as the title of a Vanguard piece discussing the merits of a simple fund portfolio.  However, it occurred to me that their guidelines that make the simple fund portfolio work are the same for making any investment strategy work.  They are:

  • adopt the investment strategy
  • embrace it with confidence, and
  • endure the inevitable ups and downs in the markets

Perhaps this seems obvious, but we see many investors acting differently, more like this:

  • adopt the investment strategy that has been working lately
  • embrace it tentatively, as long as it has good returns
  • bail out during the inevitable ups and downs in the markets
  • adopt another investment strategy that has been working lately…

You can see the problem with this course of action.  The investment strategy is only embraced at the peak of popularity—usually when it’s primed for a pullback.  Even that would be a minor problem if the commitment to the investment strategy were strong.  But often, investors bail out somewhere near a low.  This is the primary cause of poor investor returns according to DALBAR.

Investing well need not be terribly complicated.  Vanguard’s three guidelines are good ones, whether you adopt relative strength as we have or some different investment strategy.  If the strategy is reasonable, commitment and patience are the big drivers of return over time.  As Vanguard points out:

Complexity is not necessarily sophisticated, it’s just complex.

Words to live by.

 

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Factor Performance and Factor Failure

July 30, 2013

Advisor Perspectives recently carried an article by Michael Nairne of Tacita Capital about factor investing.  The article discussed a number of aspects of factor investing, including factor performance and periods of factor underperformance (factor failure).  The remarkable thing about relative strength (termed momentum in his article) is the nice combination of strong performance and relatively short periods of underperformance that it affords the investor seeking alpha.

Mr. Nairne discusses a variety of factors that have been shown to generate excess returns over time.  He includes a chart showing their performance versus the broad market.

Source: Advisor Perspectives/Tacita Capital  (click on image to enlarge)

Yep, the one at the top is momentum.

All factors, even very successful ones, underperform from time to time.  In fact, the author points out that these periods of underperformance might even contribute to their factor returns.

No one can guarantee that the return premia originating from these dimensions of the market will persist in the future. But, the enduring nature of the underlying causes – cognitive biases hardwired into the human psyche, the impact of social influences and incremental risk – suggests that higher expected returns should be available from these factor-based strategies.

There is another reason to believe that these strategies offer the prospect of future return premia for patient, long-term investors. These premia are very volatile and can disappear or go negative for many years. The chart on the following page highlights the percentage of 36-month rolling periods where  the factor-based portfolios – high quality, momentum, small cap, small cap value and value – underperformed the broad market.

To many investors, three years of under-performance is almost an eternity. Yet, these factor portfolios underperformed the broad market anywhere from almost 15% to over 50% of the 36-month periods from 1982 to 2012. If one were to include the higher transaction costs of the factor-based portfolios due to their higher turnover, the incidence of underperformance would be more  frequent. One of the reasons that these premia will likely persist is that many  investors are simply not patient enough to stay invested to earn them.

The bold is mine, but I think Mr. Nairne has a good point.  Many investors seem to believe in magic and want their portfolio to significantly outperform—all the time.

That’s just not going to happen with any factor.  Not surprisingly, though, momentum has tended to have shorter stretches of underperformance than many other factors, a consideration that might have been partially responsible for its good performance over time.  Mr. Nairne’s excellent graphic on periods of factor failure is reproduced below.

Source: Advisor Perspectives/Tacita Capital (click on image to enlarge)

Once again, whether you choose to try to harvest returns from relative strength or from one of the other factors, patience is an underrated component of actually receiving those returns.  The market can be a discouraging place, but in order to reap good factor performance you have to stay with it during the inevitable periods of factor failure.

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Serenity for Investors

October 9, 2012

Grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference—-Reinhold Niebuhr

Serenity is in short supply in the investment community!  Capital Group/American Funds recently posted a fantastic commentary on uncertainty, pointing out that investors are much better off if they focus on what they can control and don’t sweat the other stuff.  Here are some excerpts that struck me—but you should really read the whole thing.

Powerless. That’s how a lot of investors feel. In a recent Gallup poll, 57% of investors said they feel they have little or no control over their efforts to build and maintain their retirement savings. What’s causing them to feel so lost? According to 70% of those polled, the most important factor affecting the investment climate is something they can’t control, the federal budget deficit.

On the flip side, among investors with a written financial plan having specific goals or targets, the poll showed 80% of nonretirees and 88% of retirees said their plan gives them the confidence to achieve their financial goals. It seems like some investors have figured out what they can control and what they can’t.

Life for investors would be simpler if there were a handy timetable by which these issues would be resolved in a quick and orderly fashion. But successful investors know they can’t control the outcome of the euro-zone summits or American fiscal debates, much less plug politics into a spreadsheet.

They can, however, review their goals, manage risk, be mindful of valuation and yield and remember that diversification may matter now more than ever. It’s easy to overlook in such a challenging environment, but unsettled times can also offer opportunities for long-term investors. In the midst of uncertainty, there are companies with strong balance sheets, smart management and innovative products that continue to thrive, and whose shares may be attractively valued.

All true!  We’ve written before about what an important investment attribute patience is.  Maybe in some important way, serenity contributes to patience.  It’s hard to be patient when you’re worried about everything, especially things you have no control over!  They even include a handy-dandy graphic with suggested responses to all of those things disturbing your serenity.

Source: American Funds Distributors  (click on image to enlarge)

At some level, perhaps we are all control freaks.  Unfortunately for us, in a relationship with the market, it’s the market that is in control!  We can’t control market events, but we can control our responses to those events.  Finding healthy ways to manage market anxiety is a primary focus for every successful investor.

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Quote of the Week

October 1, 2012

[NYC] cabbies drive in much the way that people typically manage portfolios – alternately “putting pedal to the medal” and slamming on the brakes.—-Bob Seawright, CIO Madison Avenue Securities

I laughed when I read this, thinking back to a NYC cab ride to JFK to catch an ill-fated flight back to Los Angeles.  One of our portfolio managers, John Lewis, was in the cab with me and I thought he was either going to yak out his window or club the cabbie with his briefcase.  Let’s just say that the cabdriver made full use of both the accelerator and brake pedals.

Is it any wonder investors have a tough time making money when they can’t discipline themselves to coast occasionally?

It’s important to make portfolio changes when necessary—and equally important to know when to leave things alone.  As investment professionals, we spend our careers trying to learn the difference.

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Quote of the Week: The Ebb and Flow of Investment Style

August 14, 2012

Ninety percent of what passes for brilliance, or incompetence, in investing is the ebb and flow of investment style (i.e., growth, value, foreign vs. domestic, etc.). Since opportunities by style regress, past performance tends to be negatively correlated with future relative performance. Therefore, managers are often harder to pick than stocks. Clients have to choose between fact (past performance) and the conflicting marketing claims of various managers. As sensible businessmen, clients usually feel they have to go with the past facts. They therefore rotate into previously strong styles, which regress [to the mean], dooming most active clients to failure.—-Jeremy Grantham

This is a pretty long quote, but it’s a gem I found sandwiched into an Advisor Perspectives commentary by Jeffrey Saut.  (I commend Mr. Saut for having the perspicacity to throw the quote out there in the first place.)

Mr. Grantham not only has a way with words—he has a valid point in every single sentence.  That paragraph pretty much sums up everything that goes wrong for clients.

It’s also true from the standpoint of an investment manager.  Our investment style constantly exposes clients to high relative strength stocks or asset classes.  Some quarters they perceive us to be brilliant; other quarters, not so much!  In reality, we are doing exactly the same thing all the time.  Clients are actually reacting to the ebb and flow of investment style, as Mr. Grantham puts it, rather than to anything different we are doing.

The ebb and flow of investment style takes place over a fairly long cycle, often three to five years—in other words, usually an entire business cycle.  During the flow period, clients are very excited by good performance and seem quite confident that it will never end.  During the ebb period, it’s easy to become discouraged and to become convinced that somehow the investment process is “broken.”  Clients become confident that performance will never improve!  Grantham’s observation about the when and why of clients changing managers corresponds exactly with DALBAR’s reported poor investor performance and average 3-year holding periods.

Patience and the acknowledgment of ebb and flow would go a long way toward improving investor performance.

Is the ocean broken, or does it just ebb and flow?

Source: Eve Sob blogspot

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From the Archives: The $ Value of Patience

June 25, 2012

The annals of investor behavior make for some pretty scary reading.  Yet this story from the Wall Street Journal may take the cake.  It is an article about the top-performing mutual fund of the decade and it shows with remarkable clarity how badly investors butcher their long-term returns.  The article hits the premise right up front:

Meet the decade’s best-performing U.S. diversified stock mutual fund: Ken Heebner’s $3.7 billion CGM Focus Fund, which rose more than 18% annually and outpaced its closest rival by more than three percentage points.

Too bad investors weren’t around to enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the 10 years ending Nov. 30, according to investment research firm Morningstar Inc.

It’s hard to know whether to laugh or cry.  In a brutal decade, Mr. Heebner did a remarkable job, gaining 18% per year for his investors.  The only investment acumen required to reap this 18% return was leaving the fund alone.  Yet in the single best stock fund of the decade investors managed to misbehave and actually lose substantial amounts of money—11% annually.

Even Morningstar is not sure what to do with Mr. Heebner:

The fund, a highly concentrated portfolio typically holding fewer than 25 large-company stocks, offers “a really potent investment style, but it’s really hard for investors to use well,” says Christopher Davis, senior fund analyst at Morningstar.

I beg to differ.  It’s really hard to use well??  What does that even mean?  If it is, it’s only in the sense that a pet rock is really hard to care for.

Investor note: actively managed or adaptive products need to be left alone!   The whole idea of an active or adaptive product is that the manager will handle things for you, instead of you having to do it yourself.

Unfortunately, there is an implicit belief among investors—and their advisors—that they can do a better job than the professionals running the funds, but every single study shows that belief to be false.  There is not one study of which I am aware that shows retail investors (or retail investors assisted by advisors) outperforming professional investors.  So where does that widespread belief come from?

From the biggest bogeyman in behavioral finance: overconfidence.  Confidence is a wonderful trait in human beings.  It gets us to attempt new things and to grow.  From an evolutionary point of view, it is probably quite adaptive.  In the financial arena, it’s a killer.  Like high blood pressure, it’s a silent killer too, because no one ever believes they are overconfident.

At a Harvard conference on behavioral finance, I heard Nobel Prize winner Daniel Kahneman talk about the best way to combat overconfidence.  He suggested intentionally taking what he called an “outside view.”   Instead of placing yourself—with all of your incredible and unique talents and abilities—in the midst of the situation, he proposed using an outside individual, like your neighbor, for instance.  Instead of asking, “What are the odds that I can quit my day job and open a top-performing hedge fund or play in the NBA?” ask instead, “What are the odds that my neighbor (the plumber, or the realtor, or the unemployed MBA) can quit his day job and open a top performing hedge fund or play in the NBA?”  When you put things in an outside context like that, they always seem a lot less likely according to Kahneman.  We all think of ourselves as special; in reality, we’re pretty much like everyone else.

Why, then, are investors so quick to bail out on everyone else?  Overconfidence again.  Our generally mistaken belief that we are special makes everyone else not quite as special as us.  Overconfidence and belief in our own specialness makes us frame things completely differently:  when we have a bad quarter, it was probably bad luck on a couple of stock picks; if Bill Miller (to choose a recent example) has a bad quarter, it’s probably because he’s lost his marbles and his investment process is irretriveably broken.  We’d better bail out, fast.  (A lot of people came to that conclusion over the past couple of years.  In 2009, Legg Mason Value Trust was +40.6%, more than 14% ahead of its category peers.)

Think about an adaptive Dorsey, Wright Research model like DALI.  As conditions change, it attempts to adapt by changing its holdings.  Does it make sense to jump in and out of DALI depending on what happened last quarter or last year?  Of course not.  You either buy into the tactical approach or you don’t.  Once you decide to buy into—presumably because you agree with the general premise—a managed mutual fund, a managed account, or an active index, for goodness sakes, leave it alone.

In financial markets, overconfidence is the enemy of patience.  Overconfidence is expensive; patience with managed products can be quite rewarding.  In the example of the CGM Focus Fund, Mr. Heebner grew $10,000 into $61,444 over the course of the last ten years.  Investors in the fund, compounding at -11% annually, turned $10,000 into $3,118.  The difference of $58,326 is the dollar value of patience in black and white.

—-this article originally appeared 1/6/2010.  Unfortunately, human nature has not changed in the last two years!  Investors still damage their returns with their impatience.  Try not to be one of them!

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