Investors, beware: It’s THAT time of year again!

Chris Leithner

Leithner & Company Ltd

How important are rankings of managed funds’ results during the past 12 months? How should investors interpret them? In a key sense, rankings ARE important – but NOT in the way the mainstream assumes. At this time of year, and again at mid-year, when they come thick and fast, as an investor you should heed them in one respect only: use them to consider culling funds that have greatly “outperformed” (if you own one or more) or exclude them from consideration as new holdings (if you don’t). Otherwise, ignore them – and certainly don’t chase short-term outperformance! 

What the speculating crowd – which includes most professionals – mostly ignores is what really matters: in the short-term, it’s vital to avoid the risks that occasionally achieve astounding but ephemeral gains but eventually produce hefty and often permanent losses. The prudence that generates unexceptional outcomes year after year and through thick and thin might be monotonous; yet it also cumulates into rewarding long-term results.  

 ‘Tis the Season for Ranking and Bragging

“It’s January,” wrote Mark Hulbert (“The Year’s Fund Returns Are In – Do They Matter?” The Wall Street Journal, 7 January 2018), “which means it’s time for all those performance scoreboards, highlighting top-performing financial advisers, investment-newsletter editors [and managed] funds of the previous year.” In Australia, this ritual occurs shortly into the new calendar year and also after the end of the financial year on 30 June:

  • According to the latest rankings, a handful of funds and managers “outperform” – that is, their returns for the previous 12 months greatly exceed their peers, yardsticks such as the S&P/ASX 200 Index, etc.
  • Journalists don’t just profile short-term outperformers; they laud their seeming brilliance – particularly their ostensible prescience. “A year ago, Fund A’s managers anticipated that X, Y and Z would occur,” runs the standard patter, “and these things did come to pass. Its managers implemented an appropriate strategy, and the results speak for themselves.”
  • Mainstream and “social” media don’t merely imply that short-term outperformance is a matter of foresight: they also hint that top-performers’ alleged insight will continue during the next 12 months – and that you would do well to mimic or join them.

What Short-Term Rankings Seldom Mention

“In theory,” writes Jason Zweig (“What We Already Know about Investing in 2021,” The Wall Street Journal, 8 January), “investing is all about markets; in practice, it’s more about marketing. What will financial marketers sell in 2021? The same thing they always sell: whatever did the best last year.” What they don’t tell you is that chasing short-term outperformance – that is, ploughing your capital into one or more of the current crop of star performers – is a thoroughly bad idea. Short-term outperformance is mostly the consequence of chance rather than skill. Moreover, repeated short-term outperformance is more likely a sign of recklessness than of shrewdness. Hulbert cautions that speculators who enjoy terrific results today will, more often than not, suffer terrible ones tomorrow:

Consider the Persistence Scorecard that is periodically updated by S&P Dow Jones Indices. It measures the odds that a [managed] fund will remain an above-average performer for several years in a row … S&P DJI found that “an inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status.” In other words, as you focus on shorter and shorter time periods, there is a higher and higher chance that the top performer in one period will be a bottom performer the next.

If that’s not bad enough, it gets even worse:

These scorecards can provide some worthwhile information. But beware: They also can be hazardous to your wealth. That is because sooner or later, but probably sooner, ... investing kingpins will incur losses so large as to make it almost impossible to ever recover.

Consider the performance of a hypothetical portfolio that each January invested in the recommendations of the investment newsletter at the top of the previous calendar year’s performance rankings. According to [research conducted by Hulbert Interactive], this portfolio created from each year’s winners has lost almost everything – incurring an 18.0% annualized loss since 1991. So, $100,000 invested in this portfolio back then would be worth just $471 today. This suggests that the appropriate response to the one-year performance sweepstakes is to run, not walk, the other way (see also “How to Lose 93% of Your Money … And Be Happy About It,” The Wall Street Journal, 12 January 2018).

What causes a handful of advisors, funds and managers, during almost any 12-month interval, to produce results that greatly exceed that period’s average? Hulbert finds that it’s NOT skill. It’s probably mere chance; and if it’s not a lucky roll of the dice then it’s the draw of a dodgy set of cards. Most short-term outperformers, in other words, are mere flukes; and a few “pursue wildly risky strategies.” Accordingly, 

Though on average they lose, occasionally one of them will hit the jackpot and rise to the top of the annual rankings. By choosing that lucky adviser or manager, investors who invest [“speculators who speculate” is more apt] with the previous year’s top performer are in effect betting that lightning will strike twice. They inevitably get sabotaged by … sky-high risk.

Career Risk + Investment Risk + Fund Mortality = Overstated Long-Term Results 

Why, according to Hulbert, do some advisors and managers act so recklessly? The risk to their careers that results from underperformance compels them to jeopardise other people’s money. Unless they take big risks, they can’t hope to generate the stellar short-term results that attract the mainstream media’s fawning attention. The publicity that results from a lucky roll of the dice, in turn, enables the large inflows that underpin fat management fees. Yet as time passes risky actions produce increasingly bad results. For this reason, before long many funds (their average lifespan in the U.S. is ca. 7 years) close or merge; the rotation of managers within funds is even more frequent. This high rate of “mortality” obscures many funds’ poor long-term records; it thereby encourages their managers to resume (albeit under a new guise) their risky short-term ways. The resultant “survivorship bias” understates most managers’ – and funds’ – long-term “underperformance.”

In its annual survey, S&P Dow Jones has for years found that at least 80% of investment managers worldwide have failed to meet their benchmarks over periods of five years; of the rather small number that last long enough, ca. 95% fall short over 15 years. No wonder they’re culled so ruthlessly! In the decade to 2012, according to John Bogle, the founder of Vanguard, every year an average of 7% of all funds closed or merged. That’s versus just 1% per year in the 1960s. Of the roughly 6,500 funds that existed in 2002, approximately 5,500 – an astounding 85% – had “been liquidated or merged” by 2012. Bogle expected that this very high rate of mortality would continue. If so, then at least 3,000 of the 4,600 funds that existed in 2012 won’t in 2022.

In “The Mutual Fund Graveyard … and Its Implications for Investors” (Seeking Alpha, 1 June 2016), Louis Kokernak asked: “what problems arise from all these ‘deaths’? One of the foremost is the survivorship bias introduced to mutual fund performance aggregates.” Survivorship bias is the error of logic that occurs when you observe and measure only the people or things that passed (or survived) some selection process – and overlook those that didn’t. If the average scores of survivors and non-survivors differ significantly, then biased inferences occur.

 In other words, if we take surviving managed funds as representative of all funds (and thereby ignore those that have closed, failed, merged, etc.), and if existing funds’ performance exceeds extinct ones’ then we exaggerate funds’ performance. Survivorship bias plagues the managed funds industry. Kokernak concludes: “The funds that disappeared tend to be those that have logged poor investment performance … It’s pretty clear that a lot of skeletons are getting stuffed in the closet” (see also “Can We Be Brutally Honest about Investment Returns?” The Wall Street Journal, 19 January 2018). 

What, Then, To Do? A Hypothetical but Realistic Example

Consider a well-to-do couple, family trust, SMSF, etc., which possesses a long-term perspective and the brains, but not the desire, to invest and manage their own funds. What should they do? First, given the results of Hulbert’s, S&P’s and others’ research, they should either ignore the latest performance rankings – or else use them to exclude recent “outperformers” from consideration. In Hulbert’s words, managers who invest prudently and thereby possess strong records of “long-term performance … are hardly ever at the top or bottom of the calendar-year rankings. Slow and steady really does win the race.”

This point is fundamental. To see it as clearly as possible, consider as a hypothetical but realistic example the three managed funds in Table 1. (As an aside, the order of each’s annual results doesn’t affect its three-year compound rate of return.) Fund A greatly outperforms in Year 1 – at whose end, and as a result of laudatory media reports, it likely attracts hefty inflows from speculators. Alas, it incurs a hefty loss (and wins the wooden spoon) in Year 2 – which prompts strong outflows. Speculators who thought they were investors (or investors advised by speculators) bought its units high and sold them low – which is hardly a recipe for success! Fund B greatly lags in Year 1 but excels in Years 2 and 3.

 Table 1: Three Funds over Three Years: the Steady Tortoise Beats the Erratic Hares

In contrast, in no single year does Fund C lead the field; indeed, each year its return is just one-half of the top-ranked fund’s. Furthermore, in Year 3 it trails the others – and its results fall year by year. Yet two key points distinguish it: first, it never incurs a loss; second, from year to year its results are the steadiest (i.e., its standard deviation is the lowest by far). Over the three-year period, these traits make all the difference: Fund C’s three-year return, expressed as an annualised compound rate of return, handily exceeds A’s and B’s. Ignoring costs, fees, taxes, etc., $100 invested in Fund C at the beginning of Year 1 would compound to ca. $125.64 at the end of Year 3. That amount exceeds Fund B’s cumulative total ($116.44) by almost 8% and Fund A’s ($115.50) by almost 9%. If this disparity persists, then as time passes Fund C will leave A and B ever further in its wake.

What to do? Secondly, advises Hulbert, focus on those managers, strategies and vehicles with excellent long term results. “The clear implication,” he elaborates, is that

 You improve your chances of picking a [winner] by focusing on performance over periods far longer than one year. How long? Our analysis … suggests that even 10 years isn’t enough. Only when performance was measured over at least 15 years were there better-than-50% odds that a top performer would be able to repeat. [Moreover,] when following a top performer over the previous 15 years, you are unlikely to be at the top of the rankings in any given calendar year ...

To Hulbert’s second point I add a twist. Locate investment managers with a track record of 20 years or more, and then ascertain: 

  • What kinds of results did they generate during the Dot Com Bubble of the late-1990s and the boom years before the GFC?
  • Do these results suggest that they took undue risks? What about their results during the Dot Com Bust of the early 2000s and the GFC? Do their results in the bust confirm that their actions during the boom were unduly risky?
  • How many years did they require to recoup the losses they incurred during bear markets?

The problem, of course, is that few managers possess continuous track records of 20 or more years; fewer still lose comparatively little during bear markets and crises, and are therefore able to recoup their losses reasonably quickly. The good news is that your list of candidates certainly won’t be long; hence your choice probably won’t be difficult! 

Conclusion: Long-Run Outperformers Are Short-Run Quiet Achievers

Three attributes distinguish long-run outperformers: first, year after year they generate reasonably consistent, almost always positive but rarely top-ranked results; secondly, their number is very small; thirdly, in the short term they’re quiet achievers. It’s important to emphasise: long-term outperformers’ results within any 12-month interval are usually unremarkable; indeed, as Table 1 showed, they’re often sub-par. For this reason, journalists’ coverage of performance scorecards ignores them. Hulbert found that long-run outperformers’

average yearly performance rank ... was at the 59th percentile. But that’s a shortcoming only if you’re a thrill seeker who finds it intolerably boring to be merely ... at the top of the rankings for very long-term performance … [Accordingly, and assuming that] you are seriously focused on building up wealth over the long term, you should be more than willing to give up the hope of ever being at the top of the calendar-year rankings.

To the mainstream, the implications are startling and disconcerting:

  1. Short-term outperformance doesn’t promote long-term outperformance; if anything, it hinders it.
  2. Consequently, chasing short-term outperformance depresses long-term results.
  3. Moreover, how much your investments gain during booms isn’t important; what’s vital is how much they avoid losing during busts.

Never forget that investment is a long-term marathon and that speculation is a short-term sprint. Moreover, you’re not competing against others; you’re striving to reach the destination you’ve set. Also recall Aesop’s parable of the tortoise and hare – and its lesson that boringly slow yet reliably steady ultimately prevails. Accordingly, either ignore short-term rankings entirely or heed them in one respect only: use them to consider culling (if you own one or more of them) or exclude from consideration (if you don’t) “hares” that have greatly outperformed during the past twelve months. Those that have merely been lucky almost certainly won’t repeat their good fortune; and those which have taken undue risks will sooner or later receive their comeuppance at your expense. 

In conclusion, if you’re an investor then you should either be a “tortoise” or seek one to manage your funds. It’s not despite their unremarkable results year after year, but because of them, that they generate exceptionally good compound returns over periods of 15-20 years. If you find one, it likely won’t put you in a position to brag at weekend barbeques during the next few years. Equally, you won’t be sobbing into your beer at your next couple of Christmas lunches or New Year’s Eve parties. But in a decade or two, the odds are that you or your heirs will have plenty to celebrate.

This blog contains general information and does not take into account your personal objectives, financial situation, needs, etc. Past performance is not an indication of future performance. In other words, Chris Leithner (Managing Director of Leithner & Company Pty Ltd, AFSL 259094, who presents his analyses sincerely and on an “as is” basis) probably doesn’t know you from Adam. Moreover, and whether you know it and like it or not, you’re an adult. So if you rely upon Chris’ analyses, then that’s your choice. And if you then lose or fail to make money, then that’s your choice’s consequence. So don’t complain (least of all to him). If you want somebody to blame, look in the mirror.

Chris Leithner
Managing Director
Leithner & Company Ltd

After concluding an academic career, Chris founded Leithner & Co. in 1999. He is also the author of The Bourgeois Manifesto: The Robinson Crusoe Ethic versus the Distemper of Our Times (2017); The Evil Princes of Martin Place: The Reserve Bank of...

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