It's quite ironic, isn't it? Those of us who've dedicated our careers to investment management have unknowingly created three significant problems for ourselves.
And you know what?
Two of these issues are our very own errors – mistakes we've committed, and their consequences are becoming more serious by the day.
But you know what's even worse? The third problem is a grave mistake of omission. It's like we've been neglecting something crucial all along, and if we continue down this path, it could seriously harm the profession that has been both intellectually and financially rewarding for so many of us. We simply can't afford to let that happen.
So, let me break it down for you. I'll explore each error in a different letter, so you can grasp the full picture. And of course, I won't leave you hanging without a solution. We need to find a way to address these issues head-on and safeguard the future of our beloved profession. It's time to take action and set things right!
Error 1: Falsely Defining Our Mission - "Beating the Market"
The first mistake we've made is falsely defining our professional mission to our clients and prospective clients as solely "beating the market."
I mean, let's be honest; this used to be a reasonable goal about fifty years ago, but times have changed, and so have the markets. Nowadays, with intense competition in the security markets, only a handful of active managers manage to outperform the market, and that too, by a mere 1 percent over the long term.
It's crucial to face the facts – most managers fall short of beating the market, and the extent of their underperformance far outweighs any outperformance.
Besides, let's not overlook the fact that identifying the future "winners" among managers is an incredibly tricky task. The ones who were once considered "market leaders" often end up facing subsequent failures.
So, it's high time we reconsider our mission and redefine it for the present reality. Holding onto outdated expectations will only lead to disappointment for both us and our clients. In the next letter, we'll explore the second error we've made, which is equally important to address. Stay tuned!
NYSE trading volume is up over 2,000 times from about 2 million shares a day to about 4 billion. Other major exchanges around the world have seen comparable changes in volume.
The mix of investors has changed profoundly from 90 percent of total NYSE (New York Stock Exchange) "public" trading being done by individuals to 90 percent being done by institutions. Anyone with a long memory will tell you that today's institutions are far bigger, smarter, tougher, and faster than those of the olden days.
Concentration is extraordinary: The 50 most active institutions do 50 percent of all NYSE stock trading, and the smallest of these 50 giants spends $100 million annually in fees and commissions buying services from the global securities industry.
Derivatives have gone in value traded from nil to larger than the cash.
Nearly 100,000 analysts-up from zero 50 years ago-have earned CFA charters and another 200,000 are candidates, led by those in North America, China.
Regulation Fair Disclosure, commonly known as Reg FD, has "commoditized" most investment information now coming from corporations.
Algorithmic trading, computer models, and numerous inventive "quants" are all powerful market participants.
Globalization, hedge funds, and private equity funds have all become major forces for change in the security markets' competitive intensity.
Bloomberg, the internet, e-mail, and so forth have created a technological revolution across the globe. We really are "all in this together."
Investment research reports from major securities firms in all the major markets around the world produce an enormous volume of useful information that gets distributed almost instantly via the internet to tens of thousands of analysts and portfolio managers around the world who work in fast-response decision making.
As a result of these and many other changes, the stock markets, often referred to as the world's largest and most active "prediction markets," have evolved into highly efficient arenas.
It's no easy task to outsmart the sharp, hard-working professionals who have access to vast information, powerful computing resources, and years of experience in setting those market prices.
And if you're thinking about beating the market after accounting for costs and fees, well, brace yourself, because it's a much, much tougher challenge than you may think.
Among mutual funds, for instance, the numbers don't lie. The proportion of funds, after deducting fees, that typically lag behind the market averages has reached a staggering 60 percent in any given year.
Over a 10-year period, that percentage jumps to a daunting 70 percent, and if we extend it to 20 years, the figure shoots up to a staggering 80 percent.
You see, it's becoming increasingly clear that trying to outperform the market consistently is an uphill battle. The combination of increasing market efficiency, tough competition, and the weight of costs and fees all play a role in making it exceedingly difficult for most mutual funds to achieve that sought-after edge.
Now, I know what you might be thinking – is there any hope left for active managers? Can we still add value and deliver returns that justify our fees to clients?
Well, I believe there is a way, but it requires a different approach, a new strategy that acknowledges the realities of today's investment landscape. In a future letter, I'll dive into that very solution, one that could potentially save us from the pitfalls of these errors and pave the way for a brighter future in the investment profession. Stay tuned for the next installment!
It's truly unfortunate that when discussing investment performance, the most critical aspect of all – risk – often gets overlooked or sidelined. We need to emphasize that in this investment game, risk plays a crucial role, and it's essential to remember this as we evaluate performance.
You see, the "losers" in the market tend to underperform by twice as much as the "winners" outperform.
This is a significant discrepancy that can't be ignored. But that's not the only factor to consider. The data we often see doesn't even account for taxes, especially the hefty taxes on short-term gains that have become all too common with the now-normal 100 percent portfolio turnover.
Furthermore, when we look at performance data for funds, we must keep in mind that it's typically reported as time-weighted, not value-weighted. This distinction is crucial because it means the reported data may not reflect the true investor experience accurately. The value-weighted record, which shows how real investors fare with their actual money, is a better measure of the reality on the ground.
Unfortunately, when we take all these factors into account, the picture is not pretty. It highlights the challenges and complexities investors face in navigating the market successfully. It's essential to be aware of these limitations and biases in data reporting when assessing investment strategies and making informed decisions.
But fear not! In the next letter, I'll introduce a promising solution that addresses these issues and offers a more realistic approach to achieve sustainable success in our investments. It's time to shed light on the right path forward. Stay tuned!
It's disheartening to witness how both individual and institutional clients tend to react negatively to their investment managers after a few years of underperformance. They often switch to managers who have had a "hot" recent record, thinking it will lead to better outcomes. But sadly, this pattern tends to repeat itself, resulting in a cycle of buying high and selling low, ultimately eroding around one-third of their funds' actual long-term returns. It's a frustrating reality that investors, both individual and institutional, fall prey to this pattern of behavior.
And if that's not bad enough, individuals who actively manage their own investments fare even worse. The results can be quite disappointing and can seriously affect their long-term financial goals.
The sad truth is that this costly behavior is often encouraged by investment firms themselves. They focus their advertising efforts on funds that have had good results over selected time periods, making those results seem even "better." It's a marketing strategy to boost sales, but it can lead clients down a path that's not in their best interest.
Adding to the complexity, some fund managers offer an overwhelming number of different funds, perhaps to ensure they always have a few that appear as "documented winners." This approach may give investors an illusion of choice, but it can also make it harder for them to make well-informed decisions.
In the next letter, I'll reveal a solution that aims to break this cycle and protect investors from such pitfalls. A prudent strategy that aligns with long-term success and steers clear of the hype-driven short-term gains. Let's explore a better way to approach investing and secure brighter financial futures. Stay tuned for the next installment!
When it comes to hiring new managers, individual investors have a notorious tendency to heavily rely on past performance as a decisive factor. However, studies analyzing mutual funds have shown that for about 9 out of 10 deciles of past performance, future performance is essentially random. It's a surprising finding that throws a wrench into the common belief that past success guarantees future gains.
Strangely enough, only one decile's past results seem to carry any predictive power, and that's the worst or 10th decile.
Apparently, this is because high fees and chronic incompetence tend to have a consistently negative impact on a manager's results.
The unfortunate outcome of this behavior is that both institutional and individual investors end up repeating the same mistakes over and over again. They tend to buy into funds after witnessing the best results and sell out after the worst is already behind them. It's a classic case of buying high and selling low, which undermines their long-term financial objectives.
To make matters more ironic, around 83 percent of plan sponsor investment committees rate themselves as "above average" when it comes to investment expertise.
However, the reality is quite different. In many cases, the managers they decide to fire actually achieve slightly higher returns over the next few years compared to the average managers they hire.
Furthermore, institutions' decisions to switch investment products often have unexpected outcomes. The products they move out of, contrary to expectations, end up outperforming the ones they move into. It's a trend that indicates how unpredictable and challenging the investment landscape truly is.
In the next letter, I'll reveal a solution that will help investors break away from these counterproductive patterns and create a more successful investment approach. It's time to take a step in the right direction and improve our investment decisions for the long run. Stay tuned!
Thank you for reading!
Don Bird
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