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Time to Reevaluate
Recent market turmoil has left many investors re-evaluating their portfolios and investment managers. This environment provides me with fertile ground to raise some of my favorite peccadilloes and bugaboos about the investment management industry. I hope that my observations are both informative and useful for making sound investment decisions going forward.
#1: Yes, Let’s Look at the Long-Term
Short-term performance is a poor indicator of a manager’s true skill. Monthly, quarterly, or even yearly results are often an inaccurate predictor of a strategy’s true long-term desirability. Consequently, I take no issue with managers who state that they are long-term focused and that they do not emphasize shorter-term investment results.
Nevertheless, if a manager has underperformed her/his benchmark over the past 5-10 years (or more), then her/his long-term focus has not yielded long-term results. At the very least, such a scenario constitutes reasonable grounds for reassessment.
#2: Fees and Results: Fundamentally Estranged
Many managers charge fees that are completely disconnected from the value they provide their clients. Imagine that you invested $1 million with a manager who charges a 1.5% management fee and a 20% performance fee. The manager achieved a 20-year annualized return of 6.5% compared to 8% for the benchmark (not an uncommon occurrence). At the end of the period, your investment would have earned a pretax profit of approximately $2,524,000 vs. approximately $3,661,000 that you could have made by investing in a passive index fund.
If the manager eliminated performance fees and lowered the management fee to 1%, then your gains would increase from $2,524,000 to $4,734,000. The excessive fees resulted in $2,210,000 lower profit, which is 47%of your total gains. THIS IS AKIN TO HAVING A 47% PARTNER THAT DIDN’T PUT UP ANY CAPITAL!
#3. Risk Management: Talking the Talk vs. Walking the Walk
It’s hard to find a manager that doesn’t “talk the talk” when it comes to risk management. After all, it sounds great and it’s what clients like to hear. Marketing materials and websites are adorned with impressive terms such as “capital preservation” and “risk minimization”.
According to Warren Buffet, “it’s only when the tide goes out that you learn who’s been swimming naked.” Unfortunately, recent market turmoil clearly demonstrates that some managers are nudists! Many successful managers (in terms of assets under management) were down at least 20% in March, with some suffering losses of over 30% on a year-to-date basis.
Compounding is the magic of long-term investing. The best way to harness this magic is DON’T HAVE LARGE LOSSES. The average postwar bear market loss of 38.6% requires a 63.3% gain to recover. A loss of 56.4%, such as that experienced during the global financial crisis requires an astounding 129.4%. Once you’ve suffered such losses, a significant part of any subsequent bull market merely involves getting your money back.
All bear markets have historically come to an end, and stocks eventually recovered their losses and went on to make new highs. Unfortunately, the fact is that BEAR MARKET LOSSES DO PERMANENT DAMAGE TO YOUR COMPOUNDING RATE.
#4 It’s Always A Great Time to Buy!
Many managers who suffered substantial losses in March are dissuading clients from redeeming, and in some cases are even encouraging them to increase their investments. They claim that recent market turmoil has created a swath of bargains and that investors should take advantage of the opportunity to scoop up undervalued assets.
The recent decline in markets has by no means left assets cheap by any historical standard. Moreover, the behavior of previous bear markets suggests that the current malaise can run far deeper and longer. During the tech wreck of 2000-03, the S&P 500 Index declined 49% over the course of 31 months and took 56 months to recover. The global financial crisis of 2008 resulted in a 56% decline over 17 months and took 49 months to recover.
Neither I nor anyone else knows whether this time will be different or if, in retrospect, now will have proven to have been a great time to buy. History suggests that stocks could certainly decline 35%-40% from current levels over the next year or so. As the saying goes, investors should HOPE FOR THE BEST, BUT PREPARE FOR THE WORST, and reallocate towards strategies with superior defensive qualities.
#5 Risk or Skill: Which One Are You Paying For?
Borrowing money to purchase assets expands the range of possible returns – leverage can transform ordinary gains into home runs and ordinary declines into “there goes my house” losses.
From the bottom of the previous bear market in March 2009 to late February of this year, many levered strategies fared extremely well, only to get crushed when markets plummeted during late February and March. This suggests that their admirable performance during the good times was not the result of managerial skill, but rather stemmed from leverage/risk, which came back to haunt them when markets headed south.
Some managers who do not use leverage have exhibited a similar pattern of bull market outperformance and bear market underperformance. These managers tend to invest in concentrated, highly volatile portfolios which tend to outpace the market when asset prices rise and implode in bear markets. Well, if it walks like a duck and talks like a duck, it probably is a duck! Volatile portfolios represent a form of hidden leverage. Although these strategies may not actually borrow money, the excessive volatility of their portfolios has the same effect as leverage in terms of amplifying gains and losses.
INVESTORS SHOULD PAY MANAGERS FOR SKILL, NOT FOR LEVERAGE (either explicit or hidden). If a levered strategy doesn’t look so hot on an unlevered basis, you should have a sober second thought about the risks you are assuming and about why you should pay the manager for something that creates no value.
Franco Modigliani was awarded the Nobel Prize in Economics for the Modigliani-Miller theorem, which states that that the value of an asset is unaffected by how it is financed. If you want to assume more risk and accept the potential consequences in exchange for higher potential returns, you can easily open a margin account at a discount brokerage, borrow money to buy an index-racking ETF, and save yourself a lot of money.
We Haven’t Lost the Plot
The Outcome Funds are BUILT FROM A CLIENT PERSPECTIVE. From their machine learning-based approach to risk to their fee structure and liquidity terms, they were created from the viewpoint of what is best for the investor. This philosophy has and will continue to benefit our clients. For those readers who are not clients, we welcome you to partner with us on our journey to proving better investment outcomes.