Current “bull market heroes” may have a good two or three year track record, but it has been achieved in only one set of market conditions and so has little informational value. Using a coin flipping analogy, if 1,000 people competed against each other, after three flips, 250 would have a perfect record (three heads or three tails in a row), just from pure chance.
Those that managed six in a row would be more plausible candidates to be called “skilled”, but even then, chance would suggest that there would still be a random 31 who had got that far. Warren Buffett’s 2014 letter to Berkshire Hathaway shareholders makes the obvious point that none of the initially successful coin flippers can expect to profit (over time) if they continue the game, i.e. heads and tails will roughly even out.
Leave luck to one side – look at track records
Standard & Poor’s, in their 2013 year end review, made the point that over a five year period, US equity funds broke down as (roughly) 25% outperformed, 25% underperformed by a little bit, 25% underperformed by a lot, and 25% “disappeared”, e.g. closed down due to poor performance.
So, only one in four of the original list were outperformers, while two of the possible four outcomes (containing 50% of the funds) were extremely bad. This chimes with our own research which suggests that a bottom quartile US equity fund is twice as ‘bad’ as a top quartile equity fund is ‘good’. That is, if you own a fund that is bottom quartile then you will need two others in the top quartile, just to counter this and get back to square one.
Further, we then have to account for investor behaviour
Of the funds that were top quartile from 2000 to 2010, 79% were in the bottom quartile in at least three individual years of that decade. Did investors buy them after poor years, or just before?
Most investors, as psychology and history dictates, are more likely to be buying in after a top quartile year, and maybe mistakenly selling after one of those bottom quartile periods. The impact investor behaviour has on their actual returns can be illustrated by looking at the difference between a fund’s track record and the average investor return from that fund
For example, the best performing US diversified stock mutual fund of the decade (1999-2009) – the CGM Focus Fund – produced an equivalent return of 18% per year. Yet the average investor in this fund lost 11% annualised ie they did indeed buy and sell at completely the wrong time.
It is no surprise then that we take a passive approach to investing in some asset classes, such as large cap US equities.
Andrew Wilson is head of investment at Towry
