- FPG
Patience, Patience, Patience.
Updated: Feb 20, 2019
Losing money when investing is as inevitable as death and taxes.
“Losing money when investing is as inevitable as death and taxes. Those who immediately fire their advisers for incurring such losses will never be satisfied. I’m referring to short-term losses, over periods as long as a year, if not more. Even advisers with the very best long-term records regularly lose money in many calendar years along the way.”
So writes Mark Hurlbert in a USA Today post entitled “Your financial adviser will lose some of your money. Here’s what to do.” on July 23rd of last year. [Emphasis ours]. He goes on to refer to findings based on the Hurlbert Digest’s forty years of analysis of more than 1000 model portfolios the Digest has audited.
Specifically, that:
A “small minority” [unspecified as to number or percentage] outperformed the S&P 500 over any 20-year period
On average those “market beaters” lost money in 1-of-every-4 years
They “lagged the S&P 500 in 1 of every 2 years
None of those models “has come close to beating the stock market in every single year”
He further observed that “Wall Street’s professional money managers, who presumably really know what they are doing…do no better.”
What’s an investor to do? Well, one thing they clearly shouldn’t is what, in fact, many individuals and investment fund performance monitoring systems actually do: Switch from funds and/or strategies that have under-performed in a 12-month period to those that have outperformed during the same time frame. According to Hurlbert, someone following this approach over the “last four decades…would have lost more than 90%” of their investment capital.
Hurlbert’s answer to “What’s an investor to do?” when their adviser (or fund manager) under performs is, in a word or three, patience, patience, patience. (He doesn’t actually use the word “patience.” Rather, he recommends “shift[ing] our focus away from the short-term winners and losers towards those who beat the market over the very long run” which he suggests “be at least 15 years”!)
Hmmm. That’s a long time...very long...especially if your manager or adviser is under-performing appropriate benchmarks and peers. You better have done your homework in the initial selection process! Which, I suspect, Hurlbert is assuming to be true but doesn’t really make clear. In fact, his guidance for making a decision to replace an adviser (to fund we presume) is “[f]ire your adviser only when you would no longer choose him if you were to freshly apply the same criteria that led you to choose him in the first place.”
There’s sound advice there but, in our view, it needs some elaboration. First of all, just plunking your money down randomly and not looking at it again for 15 years is probably not what he’s actually suggesting. We suspect he has something in mind that is more like the process we at FPG described about a year ago in our series Is Using Active Investment Management a Fiduciary Breach? (The series has been combined into a shorter paper that you can download here.)
In that series we evaluated studies claiming to have identified ways to identify investment managers who are likely to outperform over the long run. We also turned the focus around and looked for characteristics that may identify managers who are less likely to under-perform. In each case, the net result was the same: The characteristics the studies claimed would work didn’t.
The Results
First, a word on method. Since the studies we were evaluating focused on domestic large cap funds, we restricted our analysis to that group. Our first threshold was finding funds having at least thirty years of performance history. Where applicable we looked only at the lowest cost fund shares. That gave us 76 funds to evaluate.
We then looked at eleven consecutive 20 year periods, the last beginning 1/1/1995. Of the original 76 funds, 23 received a D- or better grade, meaning they outperformed their benchmarks (the S&P 500 and the Russell 1000 indices) in 7 of the 11 periods (11/7 = 64%).
We then evaluated how those D- or better scorers had performed for the 3-, 5-, 7- and 10-year periods ending 12/31/2015 which was the last full calendar year at the time we did our analysis.
Here’s what we learned:
Of 23 funds,10 (44%) received a C or better (75% or higher) grade in the recent performance study by outperforming in at least three of the four periods measured;
Those 10 funds represent 13% of the original 76 funds in the long term performance study;
Five of those (6.5% of the original group) outperformed in all of the more recent periods.
The fund expense ratio fee distribution for those 10 funds was a perfect bell curve of the five lowest cost deciles: 1 of 10 funds was first (lowest) and fifth decile; 2 each were from the second and fourth decile and 4 were from the third decile.
We then looked to see how often and for how long each of those 10 top-performing funds under-performed either or both of their benchmarks using annual return data from 1986 through 2015 (30 periods).
We found:
All of the funds under-performed in at least 40% of the periods (12 years);
The highest number of under-performing periods was 18 years (60%);
The average number of under-performing periods was 14.5 (48%);
The shortest consecutive period of under-performance was 2 years;
Six of the ten funds under-performed for four consecutive years;
Three of the ten under-performed one or both indices for three years;
One fund under-performed the S&P 500 for five consecutive years.
One inference we drew at that time was that “there may not be a clear way of evaluating whether an under-performing manager is unskilled (and, therefore, not fit to manage your money) or skilled but going through an ‘out of favor’ period.” How then to determine whether sticking with an adviser or fund manager for Hurlbert’s 15-year period makes sense?
In the FPG research project we described above we present only summary information. In actually evaluating adviser/manager skill we believe it is essential to begin with long periods of time because that allows for identification of patterns that, in our observations, tend to repeat and can, to some extent, be anticipated or, more accurately, recognized as characteristic of a particular adviser/manager’s approach. Once identified, either prospectively or concurrently, an evaluation can be made as to whether performance is what it should be under a particular set of circumstances. That judgement can then be the basis on which a sound decision to hire, retain or fire can be made.
In practical terms, as we recommended at the conclusion of Is Using Active Management a Fiduciary Breach?, the foundation of an investment strategy should be indexed (or passive) investments providing broad, inexpensive market exposure. To the extent that active, including factor-based, management is going to be utilized, an investor (or fiduciary) should be able to clearly articulate a set of characteristics offering a sound basis for believing the strategy has a likelihood of not under-performing (if not outperforming) over reasonable periods of time such as a market cycle covering trough-to-peak-to-trough-to-peak-to-trough.
It should be testable and verifiable. Those same criteria should also be applied in regularly evaluating the adviser/manager’s performance over time.
The decision to fire an adviser/fund manager such be made in the context of a violation over time of the criteria for selection and evaluation. “Over time” is the critical qualifier here. The fifteen year hold Mark Hurlbert recommends strikes us as a bit extreme. However, patience, patience, and more patience is sound advice if the process of selection has followed as rigorous a course as we’ve alluded to above.
Clearly advisers and fund managers, even the “best of the best”, go through sometimes significant and protracted periods when, as we put it in our series last year, “over long periods of time and year-by-year, the same manager will look both highly skilled and incredibly incompetent.” The job of an investor or fiduciary is to not be overwhelmed by the fierce urgency of now; to rise above and look beyond the immediate moment, the urge to change because we aren’t getting the result we most desire at this moment. It is from that long, informed perspective that success most readily will come.
Ed Lynch is founder and CEO of FPG. He has worked with ERISA-qualified plan sponsors and designated fiduciaries in most aspects of plan development and maintenance since the early 1980s.
Ed founded FPG with the mission to be a leader in the field of employee benefits and the most trusted source of information and evaluation in the retirement plan industry.