why more equity managers don’t outperform

1.  Most US equity managers, prompted by personal inclination and the wishes of their employers and their institutional clients, adopt either a value (buying undervalued assets) or a growth(buying accelerating profit growth) investment style.  In a typical business cycle, the first two years favor value stocks, the latter two growth issues.  Over that cycle, a manager is likely to have two good years, one so-so year and one bad year.  A skilled manager, however, will outperform over the cycle sc s whole, no matter what his style is.

This is another way of saying that the criterion of outperforming every year is unreasonable.

2.  a truism:  the pain of underperformance lasts long after the glow of outperformance has faded.  A manager who builds a riskier portfolio expecting fame and fortune from significant outperformance risks exploding on liftoff and outperforming badly–thereby losing both his clients and his job. He also gives his firm a significant black eye. No one, however, gets fired for underperforming slightly and being in the middle of the pack of competitors.

As a result, many long-lived investment organizations are constructed on the idea of strong marketing and so-so performance.  I’ve always regarded Merrill as the poster child of this approach in the mutual fund arena.

In other words, outperformance isn’t the most important attribute of a successful investment product.

3.  Most investment organizations find that a running a research department of their own is difficult and expensive.  Many, especially (in my view) the majority which are run by professional marketers, have long since eliminated proprietary research and have been depending heavily on brokerage houses to supply this service.   Doing so has the additional advantage that in-house analysts are no longer a drain on management fees received (brokerage house research is paid for with clients’ commissions).  That “solved” a problem and enhanced profits at the same time.

However, brokerage houses gutted their research departments during the market downturn in 2008-09.  The sharp decline has also accelerated an ongoing trend away from traditional investment managers and toward a diy approach using index funds.

So there’s no longer a plethora of high-quality brokerage reports and no “extra” management fee money to reconstitute proprietary research departments. Where are the good new ideas going to come from?  I think this new client preference for investment performance over salesmanship will create severe difficulties for traditional investment organizations.

 

the Mainstay Marketfield fund

I was reading in the Financial Times over the weekend about the Mainstay Marketfield mutual fund.  It gathered the most money of any mutual fund in the US during 2013, $13 billion, but it is now apparently suffering sharp redemptions after very badly underperforming in 2014.

Mainstay Marketfield

Mainstay Marketfield is the leader among “liquid alternative” funds, which purport to provide the hedge fund experience to ordinary investors like you and me through a mutual fund.  Why exactly that’s a good thing is another issue, since hedge funds as a class appear to underperform an S&P index fund on a regular basis (on top of this, the information the public has about them comes from their voluntary self-reporting, whose accuracy academic research has shown to be suspect).

Anyway, on the idea that one can learn a lot by examining things that go wrong, I thought I’d take a look at Marketfield.

Here’s what I found by spending a couple of hours looking at the fund’s SEC filings, the managers’ backgrounds, the Mainstay fund family site and charts of the fund’s performance.  The picture may not be complete, but it’s what I think a careful observer would come away with:

–the lead manager has worked in finance, mostly as a strategist, for 34 years.  His colleague has 21 years in the business.  As far as I can see, neither had any training/experience/supervision in portfolio management before they opened the Marketfield fund in 2007.

–the fund opened to the public in March 2008.  It had a period of strong outperformance vs. the S&P 500 during the stock market decline of late 2008-early 2009, when its losses were only about half those of the market.  From the bottom in March through mid-2013 it matched very closely the performance of the S&P 500.

–in 2012, Marketfield sold itself to the Mainstay fund family of New York Life.  NYL retained the Marketfield managers as subadvisors–meaning the two continued to run the fund.  Sales of fund shares skyrocketed once Marketfield hitched itself to the NYL salesforce.

–in late summer 2013, the fund began to underperform the S&P fairly steadily.  From the beginning of September 2013 though last Friday, the A shares were down by 8.9% vs. a gain by the S&P of 25.6%.  Factor in a 5.5% sales charge holders paid to obtain shares and the results are that much worse.

What happened?

The managers appear to me to be envisioning a world of runaway inflation of the type that beset the US in the late 1970s.  In such an environment, it would be important to own shares of companies that could raise prices at an inflation-beating rate and to avoid those that could not.  In the Seventies, the “bad” sectors were Healthcare, Utilities, Staples and Consumer Discretionary.  The “good”: ones were those that held  hard physical assets, like industrial plant and equipment, real estate or mineral resources.

In the 1970s, financials were losers;  they issued mostly fixed-rate loans, and they were constrained by government regulations that capped the interest rate they could pay for deposits.  In today’s world, those restrictions are gone; loans are typically floating-rate; and the banks can be involved in brokerage/investment banking.  So, arguably, financials would be winners if inflation were to accelerate strongly.

Whether this was their thinking or not, this description fits the portfolio they created.

my look at the portfolio

on the long side

The Marketfield portfolio held/holds Financials, Industrials and Materials.

It has no Healthcare, little IT, no Staples, no Utilities (all of which have been the stars of 2014).  It also has little Consumer Discretionary and almost no Energy, both of which have been good things.

on the short side

The fund shorted Utilities, Staples, and Retail.  It also appears to have winning bets against the euro and the yen, the latter offset by significant holdings in Japanese stocks.

What I find striking is that while the market has been going against Marketfield for over a year, the portfolio strategy I see is basically unchanged.

more going on

There’s also more going on than I’ve been able to see.  Everything I’ve said until now would lead me to believe that the fund’s year-to-date return should be around zero  not -12+%.  The long US stocks should be up 5% -10% (the only sector in negative territory is Energy).  I’m figuring that shorting industries that are, say, +20%, wipes out those gains, but does little more damage because the shorts are a lot smaller than the longs.

So something else is happening.  I don’t know what.  Broadly speaking, the reasons may be staring me in the face in the quarterly SEC filings I’ve seen (the stock selection looks uninspired, and maybe a little weird–of the holdings, I own only INTC and SPLK–but it’s almost impossible to lose 12 percentage points through bad stockpicking, particularly with the large number os stocks the fund holds).  Or there could be transactions that are opened and closed within the quarter and therefore don’t appear in the quarter-end statements.

my take

Th Mainstay site contains a Barron’s reprint from October in which the author touts Mainstay Marketfield as having double the returns of similar long-short funds since the market bottom in 2009.  Hard to believe that other long-short funds have lagged so far behind the S&P.

I find the $5 billion in redemptions (about 30% of peak assets) the FT says Marketfield has had ito be a stunningly large amount for a load fund.  My experience is that even in deep bear markets load funds have redemptions of maybe 10%.  This implies to me that neither the financial advisers who recommended the fund nor the clients who purchased it really understood what they were buying.

What I find most odd is that NY Life, which presumably has an older and more risk-averse clientele, should have chosen Marketfield to offer to its customers.  What’s odder still is that the move was spectacularly successful as a marketing move–until the wheels came off the performance.

It will be interesting to see if Marketfield can stage a comeback.  If the FT is right about the extent of redemptions (I presume it is; I just don’t know), the first indication will be whether the managers use the selling they have to do to reshape the portfolio.  Standard procedure would be to take some of the edge off the losing bets.  To my mind, “staying the course” would be the worst thing to do (personally, I think the runaway inflation idea is just wrong).  We’ll see when the next SEC filings come out next month.

 

 

 

 

a professional portfolio manager performance check

I subscribe to the S&P Indexology blog.  Like most S&P communications efforts, I find this blog interesting, useful and reliable.

Anyway, two days ago Indexology published a check on the performance of equity managers who offer products to US customers.

In one respect, the findings were unsurprising.  For managers with US stock portfolio mandates, well over half underperformed their benchmarks over the one-year period ending in June.  Over five years, more than three-quarters failed to match or exceed the return of their index.

This is business as usual.  Why this is so isn’t 100% clear to me.

One of my mentors used to say that ” the pain of underperformance lasts long after the glow of outperformance has faded.”   I think that’s right.  In other words, clients will punish a PM severely for underperformance, but reward him/her by a much smaller amount for outperformance.  In a world where risks and rewards aren’t symmetrical, it’s probably better not to take the buck-the-crowd positions necessary to outperform.  Instead, it’s better to accept mild underperformance, keep close to the pack of rival managers and spend a lot of time marketing your like-me/trust-me attributes.

(To be clear, this isn’t a strategy I wholeheartedly embraced.  I generally achieved significant outperformance in up markets, endeavored not to lose my shirt in down markets.  My long-term US results were a lot better than the index, but at the cost of short-term volatility that was greater than the market’s.  Pension consultants, heavily reliant on academic theories of finance, tended to demand a smoother ride, even if that meant consistently less money in the pockets of their clients.  Yes, a constant problem for me.  But it illustrates the systematic pressure put on managers to conform, to look like everyone else.)

 

The surprising news in the blog post comes in international markets.   Generally speaking, the markets overseas are simpler in structure, information flows much more slowly than in the US, and PMs tend to be ill-trained and poorly paid.  Rather than being the culmination of a long a successful career, being a PM abroad is often only an early stepstone to something better.  So pencil in outperformance.

On a one-year view, however, Indexology reports that the vast majority of managers of global, international and emerging markets portfolios all underperformed their benchmarks.  This is the first time this has happened since S&P has been checking!!

I don’t watch this arena closely enough to have a worthwhile opinion on how this happened.  The fact of underperformance itself is surprising–the fact that more than 75% of managers of international funds underperformed is stunning.  My guess is that no one saw the deceleration of Continential European economies coming.

For anyone with international equity exposure, which is probably just about everyone, current manager performance is well worth monitoring closely.

 

information: finding a focus

Most professional portfolio managers start out as securities analysts.  That’s where they learn how to read and interpret financial statements, and how to make estimates of what the financials will look like in one or two years.  They also begin to learn how to decide whether the current stock price is higher or lower than would be justified by these projections.

In doing all this, they may work as assistants for a more experienced analyst.

In any event, they specialize in following only companies in a given industry, like retail, or a subsector of an industry, like department stores.

being a portfolio manager

This situation changes drastically if/when an analyst becomes a portfolio manager.  Suddenly, the rookie pm is looking at a benchmark index that contains hundreds of stocks in multiple sectors, each containing several industries.  Panic sets in, as he/she realizes that there’s no way to have an informed opinion on so many diverse companies.

The key to success as a portfolio investor, however, is not to have a superficial opinion about everything.  It’s to have a deep understanding of one or two things that will make a positive impact on your wealth.

my first encounter with real success

By far the most successful manager at the firm where I had my first portfolio management job worked in the office next to mine.  He had a very simple system:

at the beginning of each year he identified one or two companies that he thought would do relatively well, and one or two that he thought would do poorly.  He would build larger-than-index weightings in the former, using money he got by reducing his positions in the latter to below index weighting.

Then he’d monitor.

If the positions did what he expected, he’d let them ride until they’d made, say, +30% vs. the index (or -30% for the underweights).  Then he’d close them out (by returning the positions to neutral weighting) and repeat the process.  If the positions started moving in the wrong direction before they reached the goals he’d set, he’d close them immediately.

Usually, by May or June he’d amassed enough outperformance to achieved his maximum bonus.  When that happened, he’d make his portfolio look just like the index and essentially go on vacation until the next January.

how this applies to you and me

Essentially, my former colleague ran an index fund with most of his portfolio, with two added long positions plus two shorts, where he intended to make outperformance.

The first thing you and I should do is forget about the short positions.  They need a lot of attention, and they require a different mindset (I ran a very successful short-only portfolio early in my career.  It’s unusually risky and definitely not for everyone.)

We can replicate the “most” of  the portfolio with one or more index funds/ETFs.

My old friend had individual stocks in the “added” portion of the portfolio.  We can do that too, or we can expand the idea to include industry ETFs/funds–thereby outsourcing the stock selection function.  We might expand the idea further to permit small-cap, international or emerging markets ETFs/funds as “added” positions.  Or we might expand the number a bit.

The key, however, is to limit the “added” positions to ones we have an informed positive opinion about and which we are committed to thinking about and monitoring every day.

 

Tomorrow:  where to look for “added” positions.

 

 

 

information: taking the long view

the short view

Academic research claims that the best explanation for short-term stock price movements–meaning price changes over periods less than a month–is white noise.  That is, you can safely ignore them as simply random deviations from a longer-term trend.

The result isn’t quite true, as the rise of computer-based algorithmic trading, which sifts through gigantic amounts of data and pounces on the tiniest arbitrage opportunities, shows.  In addition, at least some experienced professionals, who carefully, and over long periods, observe the trading patterns of the stocks they own, develop a knack for identifying unusual price action that can have meaning.

 

But that’s not you and me.  We’re not plugged directly into stock exchange trading computers (at least, I’m not), and we don’t spend our entire day watching a Bloomberg machine with peripheral vision while we process the thousands of pages of research material fed into our inboxes each morning.

We don’t have the computer power or the ultra-low commission structure to stand a chance against algorithmic traders.  And, let’s face it, we have lives.  We’re not going to devote the time needed to be a good short-term trader, even assuming we could match wits and reflexes with a seasoned professional.

Why, then, do all the commercials for discount brokers tout the supposedly fabulous trading tools they offer clients?  …it’s because brokers make their money from trading.  Whether our net worth rises or falls makes little difference to their bottom line.

the long view

To my mind, the best strategy for you and me is to have most of our money in index funds and to spend our research time looking for a few stocks that we can get to know very well as time passes, which have a solid growth story  and which we can hold for three, or five, or ten years.  An AAPL, in other words, or an AMZN, or a GOOG, or a DIS, or a SBUX.

In fact, many of such names are what are called “retail” stocks, meaning they are discovered and supported by the yous and mes of the world and only embraced by professionals when a steadily rising stock price forces them kicking and screaming, to examine the story.

More tomorrow.