Mediocre Performance, Outstanding Marketing, and Concealed Investment Risk

Mediocre Performance, Outstanding Marketing, and Concealed Investment RiskHere is an interesting, if not telling, statistic. According to E.S. Browning, as reported in the 6 October 2012 edition of the Wall Street Journal, “Even as stock indexes have doubled in value since the market low in March 2009, investors have yanked a net $138 billion from mutual funds and exchange traded funds that invest in US stocks.” Mr. Browning further states, “[This] marks the first time since 1981 that investors have pulled money from U.S. stock funds for more than a year at a time.” While I am certain there are several reasons contributing to this behavior, I suspect crumbling confidence in the investment management industry is one. To be honest, it’s hard not to feel increasingly cynical toward the industry in which we operate. The data below paints a discouraging picture:

  1. Fewer than 20% of mutual funds outperform their comparable index over time
  2. A study on mutual funds using a statistical method called “False Discovery Rate” found that the percentage of active managers outperforming a comparable index, excluding luck, was only 14.4% in 1990 and has declined to 0.6% by 2006
  3. An estimated one in five hedge funds blows up each year

Here are a few observations for your consideration:

Observation 1: The “investment edge” most firms claim is marketing hype.

It seems every investment fund claims the same investment virtues: deep and independent research, a large analyst team of seasoned professionals with deep experience supported by a bevy of ivy-league graduates, and superior valuation methodologies. If these assertions were true, then why do they not correlate to superior returns? The unvarnished truth is the vast majority of investment firms have mediocre performance but outstanding marketing expertise.

Observation 2: A culture of speculation has crowded out a culture of stewardship.

John Maynard Keynes opined, “A conventional valuation [of stocks] which is established [by] the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really matter much to the prospective yield … resulting in unreasoning waves of optimistic and pessimistic sentiment.”

When Keynes penned the above quote in 1936, the average holding period for US stocks was seven years; today, according to Ben Raybould of Arlington Value Capital, it’s less than five months! If Keynes was then dismayed by a mere seven year holding period I suspect he would be aghast by today’s annual trading volume statistics: for the past five years trading volume has averaged $33 trillion vs. only $250 billion for new stock issuance. In other words, trading activity accounts for 99.2% of the activity of our publically traded market system. Capital formation represents the remaining .08%.

Observation #3: The financial services industry, the quintessential purveyors of hype and nonsense, is obsessed with creating new trading strategies rather than identifying businesses worthy of investment.

If you go to the BarclayHedge Alternative Investment Database, you will find about 60 categories of hedge funds. Charlie Munger explains this foolishness this way, “I think the reason why we got into such idiocy in investment management is best illustrated by a story I tell about the guy who sold fishing tackle. I asked him, ‘My God, they’re purple and green. Do fish really take these lures?’ And he said, ‘Mister, I don’t sell to fish.’”

An investment firm extoling the virtue of style box investment management is, in reality, preoccupied with marketing and asset gathering. I believe it was Warren Buffett who remarked that one way to differentiate between an investor and a speculator is the difference between owning a business vs. renting a stock.

Observation 4: The gulf between the “profession” of investing vs. the “business” of investing is vast.

Remarkably, as vast as this difference is – the profession vs. business of investing – few understand, let alone acknowledge, this distinction. The “professional” emphasis is one that is governed by affording primacy to a fiduciary standard and managing a portfolio with the priority of safety, first. The return on our capital is less important than the return of our capital. Our periodic and occasionally long periods of sizeable cash positions speak volumes to this priority.

In contrast, the “business” of investing is about maximizing the earnings of the investment firm. The industry’s short-term focus (holding periods, trading volume, etc.) unmistakably highlights the speculative priority of the financial services industry, notwithstanding all eloquent assertions to the contrary.

In “Best Ideas,” an industry study by Randy Cohen (Harvard Business School), Christopher Polk (London School of Economics), and Bernard Silli (Universitat Pompeu Fabra and the London School of Economics) the conclusion reached was that, on average, an active mutual fund manager’s highest conviction ideas – but not the balance of their portfolio – consistently outperformed the market each year from 1984 to 2007. The authors offer the following reproachful conclusion on the investment management industry:

“The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over diversify, i.e. pick more stocks than their best alpha-generating ideas. We point out that these factors may include not only the desire to have a very large fund and therefore collect more fees (as detailed in Berk and Green, 2004) but also the desire by both managers and investors to minimize idiosyncratic volatility: Though of course managers are risk averse, investors appear to judge funds irrationally by measures such as Sharpe Ratio or Morningstar rating. Both of these measures penalize idiosyncratic volatility, which is not truly appropriate in a portfolio context.”

In 2005, Jack Bogle published research that showed investment firms with the highest number of mutual fund offerings (evidence that the firm is more focused on marketing and growing assets under management – i.e. the “business of investment,”) have significantly underperformed firms operating with only a few funds.

Concealed Risk

When an investment manager conceals risk he can convincingly promote the illusion of outperformance. Concealed risk manifests in a variety of ways. The most menacing are usually “tail” risks: that is, risks that have a low probability of occurring but have the potential to generate severe adverse consequences. Lehman Brothers and AIG became the poster children for concealing, and ultimately choking on, tail risk. AIG underwrote guarantees against creditors defaulting (CDSs or credit default swaps) and were the envy of their peers, generating excess returns with no apparent incremental risk assumed – until disaster struck. Investors were wiped out and, because AIG was deemed too big to fail, the government stepped in to save the day.

Concealed risks also occur when investors fail to understand valuations and relationships. Until the collapse of the tech bubble, for example, most tech investors had no idea the degree of risk they had assumed. Compounding the phenomena of concealed risk is the herding behavior of investors. Herding can result in prices moving far away from fundamentals resulting in a positive feedback loop reinforcing perceived safety and superior investment skills. (This feedback loop also works in reverse, driving prices well below fundamental value.) The two principle concealed risks are 1. holding securities that are significantly overvalued and 2. the recognition that asset prices can revert to fundamental valuations with startling dispatch.

As something of a sidebar, many investors who intuitively feared the tech miracle were lulled into a false sense of security believing they had “diversified” away the risk of the tech phenomenon by holding a basket of tech stocks – and we know how that ended. Risk was concealed, in this case, by the (intentional?) misapplication of the principles of diversification.

Here’s another illustration. In today’s environment of low interest rates some investment managers are additionally burdened by contractual future obligations. Pension funds and life insurance companies, for example, may be encouraged to assume greater risk as rates fall in order to meet these obligations. Here’s the predicament.

The average pension fund projects they will earn approximately 8% on its plan assets. According to Murray Stahl of Horizon Kinetics, if the average yield of the US investment grade bond market is 1.25%, and if the typical plan has about 40% of its assets allocated to bonds, all else being equal, the bond portion of the portfolio can contribute only 0.5% to the return of the entire portfolio. This leaves the remaining 60%, most of which is invested in S&P 500 type equities, to produce the balance of the 8% return assumption. This means the equities must produce a return of 13% annually.

Consider the enormous amount of concealed risk: How many investors understand the unrealistic and improbable implication that 13% annual return for equities is required by these plans to honor their commitments? In order to meet this 13% return assumption, how many investors understand the temptation of these managers to reach for yield by compromising bond quality in some fashion, and/or to extend maturities; or to ratchet up the risk profile in an attempt to drive equity returns? How many investors recognize that if the manager cannot achieve an overall 8% objective the short-fall will come from the profitability of the enterprise? In our manipulated low interest rate environment one should expect larger funding deficits in the coming years and larger company contributions to these pension plans which will, in turn, detract from shareholder earnings and earnings growth. Ultimately this will create an additional hurdle to future enterprise value and stock valuations. These are all real risks… hidden in plain sight.

Now consider from March of 2003 through October of 2007, the S&P 500 advanced 500 points. How many investors do you believe understood the risks assumed? These risks were hidden from the less sophisticated or conveniently ignored by those higher up the food chain. By March of 2009, after these risks were laid apparent, the price pattern of the S&P 500 resembled a bungee jump, plummeting 57% –and erased more than all the illusory gains dating back to the spring of 2003.

From even the most superficial inquiry, the investment management industry fails to inspire confidence.

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