First Quarter 2016 Letter to Clients
The New Year began on a rather glum note, as January 2016 went into the books as the worst start to a calendar year for U.S. stocks since 2009. The Dow Jones Industrial Average lost 5.50%, while the Russell 2000 small stock index dropped 9.11%. The downturn continued into mid February before stocks, as they often do, suddenly reversed course.
All during the downturn, the predictable Wall Street canard popped up on the financial news shows, as it always does in times of volatility:
It’s a stock picker’s market.
The assertion behind this claim is that up markets are easy money, but it’s in downturns when smart stock pickers show their value by leading their clients through the minefield of volatility.
It sounds great on paper, but the historical record continues to demonstrate otherwise. For example, in 2015 – a year that saw considerable volatility from August through year end – some 66.11% of actively managed large cap funds and 72.20% of actively managed small cap funds failed to beat their market benchmarks (source: S&P Dow Jones SPIVA U.S. Scorecard, 2015).
As the time periods get longer, the underperformance of active managers becomes truly staggering. For the five-year period ending in 2015, 84.15% of large-cap funds and 90.13% of small-cap funds failed to beat their market benchmark. It is also worth noting that 23% of domestic equity mutual funds were shut down over the same time period – most all for poor performance – and their data is not included in these figures. Taken together, these statistics paint a breathtakingly dismal track record for active management.
But what of the other group – those funds that do manage to outperform their market benchmark? Slim as that crowd may be, there are undeniably a handful of managers who do outperform the market, sometimes for extended periods. Does it therefore make sense to invest in these proven “winners”?
There are two points to consider here. First is the question of whether a market-beating manager can be considered truly skilled, or merely lucky. Some studies have indicated that it would take more than a century’s worth of performance history before it could be reliably determined whether a manager’s outperformance was attributable to luck or skill. So until active managers attain 150-year lifespans, investors probably won’t have the data necessary to draw that conclusion.
Moreover, while it’s easy to identify the top-performing funds in hindsight, there is strong evidence that such funds have little chance of continuing to be the high flyers going forward. The table that follows shows the number of top-quartile mutual funds in September 2011 and then shows the percentage of those funds that stayed in the top quartile at one-year increments for the next four years.
Source: S&P Dow Jones Indices LLC. Data for periods ending Sept. 30, 2015. Past performance is no guarantee of future results. Table is provided for illustrative purposes.
A mere two years later, only a handful of the top-quartile funds from September 2011 were still clinging to that distinction. Four years later, almost none of those funds were still in the top quartile.
The second, and more important, point to consider is the risk that an active manager must assume in order to beat the market. The reason most funds fail to beat the market is that they are, in effect, the market. The typical actively managed fund owns hundreds of stocks, and it therefore becomes very difficult to outperform the market because their portfolio holdings closely resemble the market. When you factor in management fees and trading costs it’s easy to see why so many funds underperform.
To have any chance at all of beating the market, therefore, a manager must make bets by taking concentrated stock positions. While such bets sometimes pay off, they are just as likely to blow up and take the fund’s performance with it. This is known as manager risk – the risk that a fund manager makes bad guesses and suffers losses unrelated to the broad stock market’s performance. There were three high-profile examples of manager risk this quarter:
1. The once-venerable Sequoia Fund suffered a 30% loss from August 2015 through March 2016 after its manager made a huge bet on Valeant Pharmaceuticals, placing nearly a third of the fund’s assets in that one stock. When Valeant tanked it took Sequoia’s performance with it. Ironically, Valeant, a Canadian company excluded from the S&P 500 index, was considered to be a shining example of why index funds missed out on golden opportunities. As Morningstar.com noted: “What better symbol of active management’s overconfidence than the leading actively managed fund being sunk by a stock that was called indexing’s mistake? The good ship Active, it appears, ran aground on the rock of hubris.”
2. Vaunted hedge fund Pershing Square likewise made a huge bet on Valeant, and suffered a similar fate as the Sequoia Fund in first quarter, posting a 25% decline.
3. The hedge fund Tiger Global – which at its peak had $20 billion in assets – plunged more than 22% in First Quarter after its big bets on Amazon.com, Netflix and JD.com went south. The fund had placed half of its assets in those three stocks.
While assets continue to flow out of active strategies and toward market-based solutions similar to those we employ in our portfolio strategies at Capital Directions, it is telling that fully 60% of mutual fund assets continue to flow to active strategies. This represents the ultimate example of hope over experience and is indicative of how effective the Wall Street hype machine remains.
When it comes to investment selection, our responsibility at Capital Directions is to objectively assess the evidence and select the best investments for our clients based on what the evidence shows. Should active strategies one day start to show compelling proof that they can deliver above-market performance – reliably and with reasonable risk – then we will factor that into our recommendations. Until that day comes, however, we will continue to advocate for market-based investment solutions.
Instead of chasing the siren song of market-beating investments, we believe it makes much more sense to devote our efforts to understanding your wants and needs, and designing an investment strategy to reflect them. We also think it is vital that we coordinate with your other tax and legal professionals to be sure we are achieving maximum efficiency in the areas of tax planning, wealth transfer, wealth protection and charitable giving.
This is the true essence of wealth management, and it is what we are devoted to at Capital Directions.