Cy Young-to-sayonara, equity investing version

Graig Nettles of the NY Yankees used this phrase to describe the ebb and flow of the career of reliever Albert “Sparky” Lyle. There’s an analogue in the mutual fund/EFT market.

One of the things rookie securities analysts and portfolio managers often hear is “don’t chase.” I certainly did, practically every day from one of my mentors. That is, don’t buy the latest hot stock that’s surging and has already doubled or tripled in price. It’s too late. Instead, look for a complementary play–a key supplier, a rival, an end-user, something that’s a logical extension of the economic forces moving the hot stock upward but which hasn’t been realized by the market yet. Wait for a pullback. Or look in a completely different area.

My experience is that retail investors tend not to do this. They chase. And the higher an ETF or fund price goes, the more eager they are to buy it. Experienced PMs, or if not them, their supervisors, know–most times from bitter experience–that sustained, extra large inflows of retail cash are a huge red flag signaling that a downturn is near and that the PM should become more defensive.

That’s easier said than done. Turn the question around. What not to do? The #1 not is maintaining extreme concentration (increasing concentration would be even worse) in the names that have done the best–and which are the most likely to suffer the most in any market decline.

Most managers have an understandable aversion to maintaining large cash positions. This amounts to making an always-tricky bet on the direction of the market. Almost thirty years as a professional PM and supervisor of other PMs tell me the best thing to do is to broaden out the portfolio to look more like the market, for a while at least. The actual occurrence of a market downturn will be the signal to sharpen the portfolio’s focus again. As another one of my mentors often pointed out, “the pain of underperformance lasts long after the glow of outperformance has faded.” In other words, defense is not a bad thing.

This morning I was reading the report of a recent Wall Street Journal interview with Cathie Wood about the performance of ARKK since its peak in early 2021, a period when $6 billion in new money apparently poured into the fund. According to the WSJ, the fund’s assets are down from $30 billion then to about $9 billion now, mostly due to portfolio losses rather than redemptions. Ms. Wood is quoted as being “astonished” at the low level of redemptions she has been experiencing, and even those she attributes to profit-taking.

Knowing nothing about the flows in and out of ARKK, my sense is that this is right, as far as it goes. It could easily be that traders bought the fund early in the year, on the idea of a short-term bounce from last year’s losers, and are now exiting, having made 60% on their money.

I’m not sure this retention is a vote of confidence in ARKK, though. My (extensive) experience in turning around underperforming funds is that retail investors are very stubbornly focused on their entry price. They generally wait for breakeven, when nothing can stop them from redeeming. The one exception is when a shareholder has a professional advisor. In this case, red ink is a continuing issue in meetings to discuss performance. In such cases, the advisor will likely try to persuade the client to switch to a fund with similar goals, mostly to eliminate the eyesore.

Redemptions, though, aren’t a totally bad thing. If the PM comes in every morning needing to sell something to meet shareholders’ requests for their money back, the mind is hyper-focused on what is wheat and what is chaff. …much more than when boatloads of new cash are coming in.

There will of course be no sayonara for Ms. Wood, since she controls the ARK firm. It’s hard to evaluate whether this is good or bad, but the manager change (which is what usually happens in cases like this) is often a trigger for redemptions by devotees of the former head stock picker.

BTW, the Journal article attributes the poor performance of ARKK to its having concentrated on early-stage unprofitable companies where investors have had high hopes for eventual earnings. To me, holdings like TSLA, ROKU and SQ argue that this is much too simplistic.

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