Chasing Top Fund Managers

from time to time seemingly brilliant fund managers emerge professing to have the unique wisdom and knowledge required to successfully invest in a rapidly changing world they prove their apparent clairvoyance with astronomical returns which in turn result in their fund having explosive growth as new investors rush in to benefit from the manager's infinite wisdom seeing people around you pouring money into a hot fund that only seems to get hotter can make sticking with any previously well thought out investing strategy difficult as if your diversified portfolio only returned 10 percent last year when you could have earned 200 percent in the best fund well each hot fund manager will seem brilliant at their peak the phenomenon of star fund managers including their powerful narratives huge returns and media adoration is nothing new and it's not a story that tends to end well for investors i'm ben felix in this episode of common sense investing i'm going to tell you why the best performing funds are typically the worst investments in 1958 high flying technology companies like ibm and texas instruments were dominating the stock market electronics companies were going public in droves and seeing their share prices skyrocket none of this seemed crazy at the time the companies were different the world was different technology was changing everything by 1968 stock prices measured by the shiller cyclically adjusted price earnings ratio reached levels that had not been seen since late 1929 and would not be seen again until 1995. around the same time that this meteoric rise in the prices of technology companies began fidelity investments launched the fidelity capital fund their first publicly sold aggressive growth mutual fund this fund was led by 29 year old gerald tsai jr the media portrayed him as cool and a golden boy he could do no wrong and his fun's returns proved it sai was known for his ability to perfectly time his buys and cells in high-flying stocks like polaroid xerox and ltv after seven years of huge market beating returns attracting an increasing amount of investor capital to his fund with infidelity along the way tsai decided to go out on his own he started the manhattan fund in 1966 and quickly raised 247 million dollars in investor capital the largest raise for a fund in history at that time the manhattan fund started with a good year delivering 39 percent but quickly faltered and went on to be one of the worst performing funds in history syde sold the fund in 1968 and resigned as fund manager in 1973. an investor who stuck with the manhattan fund from the beginning would go on to lose 70 percent over eight years fred carr's enterprise fund was similarly famous for identifying emerging growth stocks like kentucky fried chicken and tonka before they really took off carr notably had a tv in his bathroom at home so that he could watch the stock market open while he shaved in the morning from 1961 through 1966 he delivered a substantial 17 percent annualized return nearly doubling the return of the u.s market over that period then the fund really took off in 1967 the enterprise fund returned 117 percent and in 1968 it returned 44 the fund managed over a billion dollars by february 1969 many of those dollars arriving late to the party then it lost about 25 percent in 1969 and again in 1970 after the performance suffered car departed and the fund was taken over by a different manager with a less aggressive strategy by the 1990s the world was changing again and investors were ready for a new breed of star fund manager to navigate the internet boom garrett von wagoner's emerging growth fund launched in 1996. it didn't do anything too exciting at first up 27 in 96 down 20 to 97 and up eight percent in 98. von wagoner was managing 189 million dollars in december of 1998. in 1999 von wegener delivered a 291 return to his fund holders attracting 506 million dollars of new investor capital by the end of the year mostly in november and december it's important to note that von wagener wasn't just some guy who happened to fluke a great return he had a strong narrative prior to starting his own fund he made a name for himself producing big returns managing a small cap growth fund plus he was in san francisco his personality and investment style seemed perfectly suited to the new types of companies that were emerging he understood how innovation was going to impact the economy he was even featured in a pbs frontline episode in 1997 where viewers were told that no one had the golden touch more than von wagoner after the huge 291 percent return in 1999 von wagoner lost 21 in sixty percent in two thousand one and another sixty four percent in two thousand two von wagoner stuck with the fund until early two thousand eight to try and make a comeback if you'd left a one hundred thousand dollar investment in the fund from inception until von wagener's departure in 2008 you would have had as much as 625 thousand dollars in august 2000 and been left with 35 000 by february of 2008. this amounts to losing more than 8 percent per year while the u.s stock market gained more than eight percent per year over the same period if you had gotten in after the big year in 1999 as most investors in this fund did and held until von wagener's departure you would have lost an annualized 24.87 per year turning 100 000 into 9 000. ryan jacob took over the kinetics internet fund in december 1997. he posted a 196 return in 1998 and a 216 percent return in 1999. like the other anecdotes here the dollars rushed in after jacob's unbelievable performance the fund went from managing 22 million in 1998 to managing 1.2 billion in 1999 with more than 700 million of that increase coming from new flows into the fund on the back of his huge returns jacob left kinetics and started his own fund in 2000 the jacob internet fund the fund lost 79 in 2000 56 in 2001 and 13 in 2002. 100 000 invested in jacob's fund in 2000 would have been worth 8 000 by the end of 2002. despite of rocky's start jacob's persistence is respectable he is stuck with it and the fund returned 123 percent in 2020 but that doesn't help much if you bought the fund and held it since 2000 from 2000 to the end of 2020 the fund returned an annualized 3.09 percent while the u.s market delivered 7.04 these high-flying fund managers had high conviction betting on the companies driving forward the next technological paradigm they may have been right about the potential for these companies to produce outsized stock returns in the short run but in the long run they were unable to escape the realities of asset pricing as great as a company may be paying too high of a price for that greatness will inevitably result in poor stock returns after their huge years in 1999 von wagoner's and jacob's funds had holdings with extremely high prices relative to their business fundamentals this example of overpaying for growth extends far past the experience of the star fund manager that i've been picking on the nasdaq 100 index has handily beaten the u.s stock market since its inception in april 1999. here's how nasdaq describes the index with category defining companies on the forefront of innovation apple microsoft alphabet intel facebook amgen starbucks tesla the nasdaq 100 index defines today's modern day industrials innovative companies in growing industries tend to be large and have high prices and from april 1999 through december 2020 the nasdaq 100 returned an annualized 9.47 percent easily beating the u.s market by an annualized 1.91 while the nasdaq 100 index is full of huge high-priced innovative companies that we hear about every day the msci us small cap value index is full of small low priced companies that we never really hear about the largest holding in the msci small cap value index as of december 2020 is darling ingredients a company that collects and transforms animal byproducts into things like gelatin edible fats and pet food ingredients for anyone keeping score i'd say that's less exciting than self-driving cars from april 1999 through december 2020 the msci u.s small cap value index beat the nasdaq 100 by an annualized 0.26 percent i'm not just cherry-picking data here either from 1926 through december 2020 u.s small cap value stocks beat u.s large cap growth stocks by more than 4 percent annualized over the full period for rolling 10-year periods going back to 1927 u.s small cap value has beaten u.s large cap growth 83 percent of the time expected stock returns come from how much you pay for future profits not from investing in the most hyped up innovative companies paying a low price for an okay company is far better in terms of expected returns than paying a high price for the best company in the world that was a bit of a digression but it is relevant and important because many of the historically extreme examples of fund managers with eye popping and investor attracting returns have resulted from those managers holding concentrated portfolios of companies that happen to see big short-term increases in their prices unless the fund manager is truly skilled more on manager skill in a minute investing in a fund holding extremely high priced stocks is not typically good in terms of expected returns the risk of buying into a portfolio with extremely expensive companies is significant but so is buying into any fund that has recently done well despite this it is unfortunately common practice a 2008 paper in the journal of finance titled the selection and termination of investment management firms by plan sponsors examined the selection and termination of investment management firms by 3 400 pension plan sponsors between 1994 and 2003 similar to what we've seen anecdotally pension plan sponsors tend to hire investment managers after they have produced large positive excess returns for the past three years these newly hired managers tend to fail at continuing to deliver positive excess returns once they've been hired and then they are fired and replaced with a new manager that has trailing three-year access returns and the cycle continues pushing the empirical finding that investors chase performance one step further a 2017 paper in the journal of portfolio management titled does past performance matter in investment manager selection asked how performance chasing behavior affects investor returns the study authors built a winner strategy that invests in an equal weighted portfolio of funds with top decile performance against their prospective benchmark for the trailing three years a median portfolio that invests in the funds that fall between the 45th and 55th percentile of benchmark adjusted returns and a loser portfolio that invests in bottom decile funds each strategy is rebalanced monthly for 36 months and then reconstituted based on the methodology that i just described they found that the average benchmark adjusted return for the loser strategy exceeds that of the winner's strategy by 2.28 percent per year and the median strategy beats the winner strategy by 1.32 percent per year the loser and median strategies outperform the winner strategy across the performance metrics commonly employed in academic studies like the sharpe ratio cap m alpha and carhart 4 factor alpha this finding implies that picking the top funds from the previous three years underperforms for reasons that go beyond their exposure to known risk factors mean reverting fund performance where recent winners go on to be losers is what we might expect if fund manager success is due to luck rather than skill if a manager beats their benchmark because they are truly skilled it would be reasonable to expect them to continue delivering strong performance however a lucky manager would be expected to eventually revert to the mean in two landmark papers mark carhart's 1997 on persistence in mutual fund performance and fama and french's 2009 luck versus skill in the cross section of mutual fund returns the authors found that the vast majority of mutual fund managers do not have enough skill to deliver returns in excess of what would be expected based on the risks that they are taking the evidence suggests that successful fund managers are more likely to be lucky than skilled the semi-annual standard and poor's persistence scorecard lends further support of the 556 u.s domestic equity funds that ranked in the top quartile in june 2016 only nine of them or 1.6 percent of them managed to remain top quartile through the end of june 2020. well lucky but unskilled managers almost certainly play a role in the mean reverting behavior of top fund returns another factor affecting the persistence of even skilled managers could be the decreasing returns to scale that actively managed funds experience in a 2016 paper title does scale impact skill the authors demonstrate that as the size of a fund increases it becomes increasingly difficult for the fund manager to beat a passive benchmark specifically they find that for an average fund in the cross section that doubles its size in one year its alpha drops by around 20 basis points per annum the impact of scale is significant both statistically and economically this empirical finding supports a 2005 theoretical paper by jonathan burke and richard greene titled mutual fund flows and performance in rational markets birk and green propose a rational equilibrium model where there is dispersion in active manager skill investors compete to allocate their capital to the most skilled managers and active managers have decreasing returns to scale investors will supply more capital to managers who have delivered good performance driving down their ability to generate excess expected returns due to the fund's increasing size in this model which predicts many of the empirical observations on fund returns and flows investors in active funds do not earn positive excess returns when managers are skilled fund managers on the other hand benefit greatly from their skill skill is scarce with increasing skill a manager has more capacity to increase the size of their fund managing a larger fund means that they earn more fees capturing the economic gains from their skill this is good for the fund manager but it in no way benefits the fund's investors birk and green offered the analogy of individual stocks a profitable innovative business will have a high share price reflecting its favorable business prospects the result is that investors do not expect to earn excess returns by owning shares in great businesses they only expect to earn returns commensurate with the amount of risk they are taking in their model the same effect is at work with skilled fund managers instead of an increasing share price being the equilibrating mechanism like we see in stocks it is increasing flows into the fund stated simply when a fund appears to have a skilled manager it will receive capital inflows to the point that investors can no longer expect to benefit from the skill due to the fund's decreasing returns to scale star fund managers have come and gone throughout history investors in their funds most of whom arrive after the enticing performance numbers have already been posted typically end up losing big one reason for this as seen by the anecdotes of star managers in the tronix and internet booms is that extreme short-term fund returns stemming from companies that become the largest and highest priced stocks in the market have historically been followed by bad long-term outcomes relative to investing in smaller and lower priced stocks this asset pricing effect is not unique to top fund managers the same effect of extreme high prices leaving the lower expected returns applies with an index like the nasdaq 100 though an active fund may have a more concentrated exposure to the most expensive stocks whatever the reason for their big returns we know empirically that the best performing funds are more likely to go on to be the worst performing funds this may be due to previously lucky but unskilled fund managers reverting to the mean or skilled fund managers seeing their funds grow to the point that the benefits of their skill accrue to them not their investors no matter how we explain it the empirical fact remains intact the best performing funds tend to make the worst investments thanks for watching my name is ben felix and this is common sense investing if you enjoyed this video please share it with someone who you think could benefit from the information don't forget if you've run out of common sense investing videos to watch you can tune into weekly episodes of the rational reminder podcast wherever you get your podcasts [Music] you

Channel: Ben Felix

Views: 67,241

Rating: 4.9636188 out of 5

Keywords: benjamin felix, common sense investing, ben felix

Id: p6HrepdLSu4

Length: 18min 35sec (1115 seconds)

Published: Sat Feb 27 2021

Reddit Comments

[u/brian_47]

If you're only buying ARK because it's popular and it has momentum, you'll bail when the market changes its mind. If you believe in the thesis, it's still undervalued. Tesla was just the first of their holdings to really blow up and if they're right in their predictions more will follow. It might be years, but I'll be there for it.

[u/primmmslimmm]

I like the ETF

[u/kapnklutch]

I think what Ben is highlighting is the age old problem when it comes to investing/trading which is the human factor and human psychology. Many people get fomo and want to chase gains, many times after the "gains train" has left the station and people are left chasing historical returns when the fund manager's mojo may have run out. Ben talks about some instances when this has happened.

In addition, Ben brings up small cap value index, where most of the companies are unheard of but the index has brought on pretty good returns since its inception. However, moderate returns over time isn't sexy and neither are most of the companies in the index.

With that being said, doing your own research, knowing what you invest in and keeping on the course is the best thing anyone can do. That's not to say whatever a fund manager is picking is bad, it's just important to do your own research prior to trying to jumping on a bandwagon..because when the road gets bumpy you're going to get spooked and jump ship since you never actually understood what you were investing in.

[u/Red_bearrr]

I believe in the concept behind Ark. not everything it holds will be Tesla but it’s batting average is going to be higher than the market. I’m buying the dip all day.

[u/istockusername]

Cathie Wood has already discussed this topic a couple times. She actually recommended a time horizontal of several years ar and the money influx is handled differently under the ETF wrapper compared to an active managed Fund.

That being said the part about small cap beating the Nasdaq is interesting. Cathies plan is to only hold stock that are able to at least 2x so we will see how that turns out.