A statutory warning for investing

“Fund managers in the rear-view mirror are dumber and luckier than they appear”

I recently saw a statistic that the average dollar invested in Cathie Wood’s ARKK fund is under-water despite stellar 5-year performance. This is due to bulk of inflows coming after the fund’s violent run-up. There is a similar datapoint on investors in Magellan fund substantially lagging the fund’s stellar returns over its 13-year stewardship by legendary Peter Lynch. This deficit of money-weighted returns compared to time-weighted returns is referred to as ‘behaviour gap’. Average dollar in equity funds does way worse than touted headline returns, especially so in ‘hot’ funds.

It is unfair to blame a fund manager for something that he/she doesn’t control (i.e. timing & quantum of flows in & out of fund). However, behaviour gap is real and hurts the average equity investor quite badly. Without getting into assigning blame, it is worth better understanding this phenomenon. Poor returns to the average investor are rooted in the following:

1.       Every investing strategy experiences (cleverly hidden) cycles

2.       Size is enemy of returns

3.       Substantial money tends to pile into a fund/strategy late in an upcycle

4.       Human nature and institutional (mis)behaviour exacerbate the above

Let’s dive into each.

Investing strategies witness headwinds & tailwinds

I’m in the 15th year of my gig and we’ve have had a decent run so far. But does that mean we’re good investors? I really don’t know because there has been a massive tailwind to my kind of investing. In sticking to decent businesses and not selling, we have benefited from a sizable valuation re-rating. While not unicorn-crazy, current valuations in my corner of the world are near the upper decile of any historical range. Odds are that valuation will be a headwind over next 15 years. As a corollary, future returns will be worse than past. Only question is by how much. Judging (myself) on upcycle performance, as I discovered the hard way with cyclical businesses in 2008, is not a bright idea. Without experiencing an inevitable downcycle for my approach, I cannot eliminate the possibility that I’m just a lucky idiot with a hot hand. Every investing approach experiences such headwinds and tailwinds. They’re often cleverly hidden and can only be deciphered with hindsight after an entire cycle. This is why the #1 criterion for judging an investor is longevity, not quantum, of outperformance. Decades, not years, are required to separate skill from luck.

Size is gravity for returns

Investing strategies don’t scale well, especially when inflows lead to step jumps in fund-size. Warren Buffett has called size the gravity for returns and has been warning Berkshire Hathaway investors to expect modest future returns for over 20-years. Whether Buffett, Lynch or lesser mortals, you can see the deterioration in relative performance as AUM grows. Factors such as ability to build positions, liquidity, inefficiency or impact cost are very different at $ 1 billion AUM than at $100 million. One may not even be able to fish in the same pool any longer. Shallow critics of Berkshire’s recent compounding have no idea what the world looks like as AUM nears $ 500 billion. The only peer-group at that size (pension & sovereign-wealth funds) has delivered single-digit long-term returns. Headlined time-weighted returns usually mix up big returns with small money followed by small returns with big money.

(As a digression, Berkshire’s unusual structure removes distinction between money-weighted and time-weighted returns. As a closed entity that retains every cent without taking in new money, every dollar of book value started as a dollar in Berkshire on Day-zero. In more traditional fund structures where money keeps coming in, different dollars have compounded over different durations. I believe that this distinction makes Berkshire’s compounding all the more impressive.)

We’re suckers for extrapolating recency

Buggy humans declared Hardik Pandya to be the next Kapil Dev after one wild 93 against South Africa. Similarly, we assumed 9% growth forever in 2007 or Armageddon in March-2020. Predictions of asset or commodity prices are severely biased by recent movements. Fund management also has this Hardik-Kapil problem. Unlike in cricket, our Hardiks are shameless about calling themselves Kapil. Naturally, those selling funds for a commission pile onto this ride as it’s easier to palm off whatever’s hot. Everyone, fund managers included, starts believing in permanence of recent success. Topical nonsense (e.g. valuation doesn’t matter, this time is different) is extrapolated as timeless wisdom. Net net, positive feedback loop leads to AUM ballooning in short order. Between misplaced expectations, inherent mean-reversion of any hot-hand strategy and size-effect, majority of inflows are set up for disappointment. Ergo, behavior gap is one of the most persistent effects in equity markets.

System doesn’t help investors’ cause one bit

Self-delusional fund managers on premature victory laps. Intermediaries mis-selling products with ridiculous return promises. Investors not learning from history. Media cheerleading instead of cautioning. Disregard for fundamentals/valuations being rationalized as new normal. Everything around us reinforces this gold rush. Then, there are second order effects that make it worse. What a fund manager does when one’s strategy stops working is the acid test of investing. Going from having it easy & good to lagging on a larger asset base is brutal. Cheers becoming boos or inflows turning outflows further complicate actions. You see this dynamic in Shaw, Mayank or Gill as bowlers sort them out after a great debut. Few clear this test of character. This is why we don’t remember a single fund manager who was popular during late-90s. Next Buffett invariably turns out to be never Buffett.

Aforementioned factors aren’t independent and feed on each other in unknown ways. This leads to outcomes that become evident only after the downcycle phase plays out over many years. If past is any guide, over-the-cycle returns of ‘hot’ funds will be way more sobering than upcycle returns. Dollar-weighted returns will substantially lag time-weighted returns, maybe even SIP-index returns. We will belatedly realize the obvious, that Kapil Devs are quite rare.

What can a retail investor in institutionally managed funds do? Ideally, stick to systematic investment in passive index funds. If going down the active funds route, the only thing that will help an average investor is a skeptical, buyer-beware mindset that’s rooted in long history. Upon seeing a well-attired bloke claim genius based on recent success, it’s best to attach the following statutory warning:

“Fund managers in the rear-view mirror are dumber and luckier than they appear”