Market Pullback Providing Hope to Actively Managed Funds

Actively Managed Funds

Just like losing teams tell us they will get them next year, losing investment strategies always say that their advantage will come next year. Wishing this so is never enough.

You really have to wonder what has continued to inspire people to keep investing in all those actively managed investment funds year after year in the face of the great majority of these funds failing to achieve their objective of beating the market.

It’s not that the goal of the market is a nice to have, adding value to these funds, this is where their entire value resides, and if they can’t do this, this in itself makes them bad investments. If we can invest in a passive fund and beat them, there’s no reason for them to even exist, except for providing a way that investors can choose poorer results if they wish,

Many investors do choose poorer results though, perhaps not with outright intention, but due to their lack of diligence, due to negligence. We’ve been moving away from people doing this so much over the years though, as the amount of money invested in passive funds grows more year after year and is now poised to eclipse active funds finally, and this trend is expected to continue.

You would think that investors would at least look at the returns that their fund has achieved and compared this to what the best passive funds have earned, but so many investors want to do the least amount possible and this well carries over into even making this simple comparison.

The industry does try to confuse people by limiting the comparisons that they make to those in a certain category, and that may seem reasonable enough given that the funds themselves subscribe to these categories. We might see one specialize in small cap stocks with low price to earnings ratios for instance, and then their active fund gets compared to passive funds who are comprised of the same type of stocks.

This misses the big question of why anyone should want to focus on these categories in the first place, and the categories themselves need to be compared to other alternatives such as the S&P 500 or the Nasdaq 100, because we could be investing in passive funds that track these indexes instead, and if we’re going to choose something else, it needs to at least measure up.

This ends up trying to put lipstick on a pig. Being better looking than most pigs can still have you pretty ugly, but if you confine your comparison to pigs, this can at least serve to distract you.

Comparing with the Nasdaq is really going to deliver a death blow to these actively managed funds, so they do their best to have us look within the category, and if we must compare with the market, the considerably weaker S&P 500 is chosen. This completely leaves open the question of why we shouldn’t want to invest in the Nasdaq instead, but the hope is that we won’t ask that, and a very few investors ever do.

A great deal of investors are also confused about why these active funds struggle so much versus the market, even the S&P 500, where most fail to beat it and the ones that do only tend to beat it by a little in their best years, and beating the S&P 500 consistently is limited to the elite, with even those funds still falling well short of the higher bar that the Nasdaq sets.

We have found three recent quotes for you from advisors that illuminate this problem as clearly as you will ever see, although you have to understand what is wrong with these remarks and why they are so off base to understand how well they expose the broken thinking that guides actively managed funds generally.

It should actually be amazingly easy to beat market averages, because all you really need to do is to exclude some poor stocks and that in itself will have you beating it. Since these stocks remain in the index but not in your basket, and their underperformance is bringing down the market average, not being stuck with them will have your average higher.

Amusingly, if your fund underperforms the index, you can just reverse course and hold everything else but what you have chosen and this will not only improve your performance but it will exceed the market by the amount that your own picks lagged them.

While we can then look to better optimize our selections from here, if the goal is to beat the market, we need to make that our primary goal, and then further refine our picks to increase this advantage. It should not be hard at all to get to the first phase where we’re actually doing what we are supposed to be doing, if we actually know enough about what we are doing that is, but these funds just don’t.

Few comments illustrate what these funds are doing wrong better than the remarks of John Apruzzese, chief investment officer at Evercore Wealth Management. “People would think it would be active managers’ heyday, but it’s very difficult to outperform the S&P 500 when the megastocks are still leading.”

It would probably be very difficult to outperform this index if you avoided these top performing stocks, but on the other hand, why would we want to do that? This should be an active manager’s heyday if they actually were riding these good stocks, and the mere fact that Apruzzese brings this up gets him tantalizingly close to the solution to this problem here, but he still misses it.

Whatever else that you may be in, complaining that there are some good stocks that make it tough to beat the market without being in them should slap us right in the face, because this means that these stocks have to be better than the ones we’re trying to beat them with and keep failing. The S&P 500 weighs them a lot more than you do, and they use this to beat you, so we should be looking to weigh them even more in our fund to leverage the advantage that they provide even more.

If this advantage goes away one day, then the S&P 500 will still be stuck with them, but since we’re actively managing our fund, we can adjust. If we instead look to set up our fund in a way that it is at a big disadvantage, enough to make it very difficult to achieve our goal, that does not make sense at all.

We then need to wonder how these people have become so lost as to perceive their being at a big disadvantage and still not be motivated to take remedial action, and the answer lies in the fact that you don’t have to even wonder if what you are doing is making sense if things making sense isn’t even a requirement.

What these managers do is rely on a set of beliefs that have been given to them and these beliefs are pursued come hell or high water, no matter how bad they turn out or even how obvious their mistakes should be. They end up with an assortment of weak big cap U.S. stocks, and instead of picking stronger ones, they look to pick from among other categories such as small and medium cap stocks, foreign stocks, and other assortments that all fail to beat the big cap indexes and take them further away from their goal.

Mixing it up is seen as an end in itself with this investing religion, but it’s actually the process that they use to select their stocks that is the major source of their struggle. It doesn’t matter that these strategies fail year after year, until the day they die, because if you believe strongly enough that your approach is the right one, enough that you cling to them no matter how much or how long you fail, you just won’t ever wake up from this insanity.

This isn’t even a theoretical debate, as consistently poor results speak for themselves, and if you are underperforming the market consistently, you just have it wrong, however you may be deciding these things. It turns out that their theory is wrong as well though, and this is why their results continue to stink.

The view is that there is always tomorrow, and if you fail 20 years in a row, perhaps next year will be better, and if not, one day they do expect to make it to the promised land, when the dastardly market will finally start moving stock prices according to their beliefs.

How Active Stock Funds Really Drop the Ball

The pullback we just got has raised the hope of a lot of active fund managers, who are quick to point out that this gang does better during market crashes, where more of them actually do beat the market for a time. It’s actually a lot easier to beat the market during a crash, even if you have to be fully invested all the time as these funds are required to be. The indexes are stuck with the stocks that are getting hammered, where you can move away from them and into something else.

Back in 2000, 70% of active funds beat the market because they could reduce their exposure to tech stocks, which were the ones that took the biggest beating in that one. In 2008, it was the financial stocks that needed to be sidestepped, and this time around, we saw travel related stocks take it on the chin the most.

It’s not that these funds made money during these times, but they were able to trim their losses more than passive funds could, since passive funds can’t do anything but sit back and take it. Taking a smaller loss once a decade if you are lucky is not anything to get happy or boast about though, and these pitches down the middle of the plate are easier to hit, but if you strike out the rest of the time, you are a terrible hitter overall.

We could just pull the plug when these things happen and cream both types of funds, and we are talking about times where the market is swinging baseball bats at you, in a way so obvious that our not moving out of the way and taking an absolute beating should never be something that we would want to tolerate, let alone see this as our moment in the sun.

What is really behind the mistakes that active fund managers make boils down to a very simple issue, not understanding the nature of public stock trading. They actually think that they are buying the company, the same way that you would if you bought private shares, where the fate of the shares is in the hands of the businesses.

Understanding that public shares are different beasts could even be said to be the keys to the kingdom of successful investing and fund management, and without this understanding, you are going to be left out of the castle and stuck in the mud in the moat, looking up at the high walls and wishing the gate would someday open by itself.

Ron Carson, CEO of advisory service Carson Group, describes the mission of an active fund manager, which he believes is “to find companies gaining market share even if their prices are going down takes a manager digging into a company’s debt structure, free cash flow, fundamentals. Talking to suppliers, looking upstream and downstream. Hours of homework.”

This is another very good quote that really identifies the problem with the way these fund managers do it, how they manage to miss the boat so much. There are many that think that the holy grail lies in digging into company fundamentals as much as you can, and then thinking that this will lead us in the right direction in predicting their stocks, but this is instead a sure way to become lost and confused.

This approach could be described as trying to lose yourself in the present, and they do a very good job of this. Stock prices are based not upon the present at all, but instead on beliefs about the future, and these beliefs are not just a matter of the company’s future, they are about the stock’s future.

Carson’s description, which is indeed the way that fund managers do things, not only looks at the wrong thing, it looks at the wrong thing in an entirely wrong timeframe. Stock prices involve changing demand for them based upon a lot of things besides the future fundamental outlook for the company, including things like macroeconomic factors, changing sociopolitical climates, participation rates with investing, as well as considerations of momentum, which takes the sum of all these factors and adds the influence of trends.

What makes their approach even worse is that it isn’t even understood that stocks change price based upon future outlooks, and they think that they can just look at a snapshot in the present and pretend that this is all there is to know.

What this ends up yielding is their missing out on the valuation of the future that the market prices in, where they pretend that all there is here is things like current debt structure, cash flows, current and near-term earnings, and the like. They understand the gap between their calculations of present valuation and the future valuation that moves the stock as an aberration in need of correction, causing them to prefer stocks with lesser future value and avoid those with higher future valuation.

What we need to be doing instead is looking at how the future beliefs of a stock are playing out in its price, where Amazon is seen by the market as having so much potential that we bid it up several times the average present valuation of stocks, and price stocks like Ford well below their present valuation.

This makes sense, but only if you understand, and if you don’t, you will not only be lost, you will continue to view reality in an inverted way and see your results invert as well, thinking Amazon’s much greater potential to rise in value as a negative and Ford’s much diminished potential as a plus.

Active Bond Fund Managers are Similarly Misguided

We have one more quote for you, involving active bond funds. We have a choice between actively managed or passively managed bond funds as well, and just like with stock funds, the active folks are pretty lost.

We could sum up the confusion with stocks as not really paying attention to price trends, which are what actually moves stock prices. We anticipate that the price will trend in our favor when we buy stocks, and if it does, we make money, so price trends should be seen as pretty important and are actually the whole ball game.

This one is courtesy of Steve Posnos of Wealth Care, and this one is a real jaw-dropper. Posnos believes that “with the 30-year Treasury paying around 1.5%, it’s almost impossible to make money passively in bonds right now.”

This sums up the misunderstanding with bond funds perfectly, and there is more to this remark than meets the eye. This is not about how hard it may or may not be to make money in bonds right now, it is about his focus on yields. As it turns out, bond funds are a terrible place to be right now, but it’s not because they are paying so little interest, it is because their price has come so close to topping out that there is little upside and a whole lot more downside.

This does not discourage Posnos though, as he instead is eyeing bonds that provide more yield, missing the part that the value of these bond funds is much more based upon price than the amount of interest you can earn in a year. This is what investors do as well, pouting at the low yields of treasuries and wanting to make more money by earning more interest, which is a very mistaken way to see things.

A lot of bond investors are so clueless about them that they don’t even pay attention to price, and just look at the yield that they are getting, and don’t realize that the value of bond funds is much more dependent upon price than the interest that they collect. Price isn’t as much of a big deal as it is with stocks, but it’s still the major influencer or the value of these funds.

The view that this interest is the only thing that we need to be looking at is similar to people who invest in stocks for dividends and don’t pay much attention to the changing value of their stocks from price movement, although the bond version of this mistake is even more dangerous, because at least dividend investors are somewhat aware of the impact of falling stock prices upon the value of their portfolios.

They may get their quarterly statements and see their value take a hit and at least have an idea why, where a lot of bond investors don’t even pay much attention to this and don’t really get why their bond fund went down in value when this happens. Like stocks being valued based upon future beliefs, price being a major factor in bond fund values is so poorly understood as this could even be described as a secret.

The yields may have been historically low for treasuries over the last while, but passive treasury funds have performed like a champ and have beaten many of these active stock funds over the last couple of years. This is because the price of treasuries has risen so much lately, and the little bit of interest they pay has been more like a tip, like dividend payments are when stocks rise a lot.

The scary part of this is that bonds have been in a long bull market, much longer in duration than the stock market, lasting 40 years now, and this is very likely to all come to an end soon. We will be moving to a time where the lesser returns of bonds versus stocks will turn into investments that will turn to losers on a net basis, where you gain this little interest but can lose a whole lot more.

This won’t be a bond picker’s market at all, where both actively managed and passively managed bond funds will both get smacked, which is what happens when you get a bear market in something. These active managers are of course looking at yield here primarily, and may think that the yield is a good deal but miss the truck that is heading toward them to knock them off the road.

Higher-yielding corporate bonds have actually significantly underperformed treasuries for quite a while now, but you won’t even be aware of this unless you know to check, to look beyond the interest payments and actually pay attention to a fund’s actual performance. This is far too rare though.

The worst of this is that people can earn a couple of percent and then get robbed and lose that much and more from the value of their bond funds getting smacked, and may still be left smiling, just like so many investors frowned by looking at the low yields during the biggest bond rally of their lifetime no matter how old they are.

You can really help yourself by being selective with your investments, but only if you actually do know what you are doing. Beating the market should be easy, but only if we choose to think and not just bank on a set of twisted beliefs that in themselves will virtually guarantee our failure. Making money is the goal here, and we need to make it ours.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.