|Summary: Data shows that retail DIY investors often underperform benchmark returns by a long margin. If investors continue to receive materially worse returns than those benchmarks, effective returns are likely to be even worse.|
|Key take-out: The outlook is for low returns ahead, as measured by common benchmarks.|
|Key beneficiaries: General investors. Category: Portfolio management.|
One of our favourite long-time contributors at Eureka Report, Gerard Minack of Morgan Stanley, has finally handed in his calculator after two decades and filed his final piece, which we publish below. As always with Gerard, it is sharp, surprisingly frank (for anyone ever employed by a major corporate) and as compelling for the retail investor as for any institutional client. It is a measure of Gerard’s influence that he rose to take a global research role at a Wall Street investment bank while operating from Sydney. It’s also worth noting that his departure from Morgan Stanley was noted in key US financial news outlets such as the Wall Street Journal and BusinessInsider.com.
Regular readers of Eureka will know he has always been willing to break from the pack. Most notably, as the ASX 200 index plunged in 2007 from 6,800 through 5,000 in early 2008 and then through 4,000, Gerard bravely said what nobody wanted to hear … that the ASX could still go lower. As it turned out the local market went to rock bottom of 3,145 in March 2009 (compared to 5,171 today).
More recently, Gerard was quick to confirm the upward turn in the markets. He’s off on a well-earned sabbatical but we look forward to more top commentary from Gerard in the months ahead. If you want to learn something about the pack you’re in … the retail investor population, don’t miss the note below. (Managing Editor James Kirby).
Investing is an unusual profession: perhaps the only one where amateurs have a good shot at beating the pros. However, evidence suggests that amateurs don't: flow data indicate that retail often buys high and sells low. That means actual returns often fall significantly short of benchmark returns. I think benchmark returns in many markets and assets will likely be low over the medium term, which means actual returns to asset owners are likely to be derisory.
Amateurs normally stand no chance against professionals. It's not just that none of us could take a point off Roger Federer, or a hole off Tiger Woods – that is, no chance against the best professional – it's that amateurs would stand little chance of beating the lowest qualifier at Wimbledon or the US Masters.
Investing is different. It's not unusual for the majority of professionally-managed funds to under-perform their benchmark. Exhibit 1 shows the percentage of US large-cap equity funds that under-perform the S&P500 index. On average, over the last decade 60% of funds have returned less than the S&P 500 (after fees) for a calendar year. Moreover, the share of funds that under-perform increases over longer time horizons: 86.5% of funds under-performed the S&P 500 on a rolling three year basis to end-2012.
US large-cap equity investors are not special in this regard. Exhibit 2 shows the percentage of funds in a range of assets that have under-performed their benchmarks on a one, three and five-year rolling basis. This is Lake Wobegone upside-down.
None of this would matter if achieving index returns was extremely difficult. But an industry's been built on indexed funds that seem capable of replicating index returns at relatively low cost. The good news for the professionals is that many amateurs persist in trying to beat the market and, in aggregate, they seem to do a significantly worse job than the professionals.
The biggest problem appears to be that – despite all the disclaimers – retail flows assume that past performance is a good guide to future outcomes. Consequently money tends to flow to investments that have done well, rather than investments that will do well. The net result is that the actual returns to investors fall well short not just of benchmark returns, but the returns generated by professional investors.
This point rests on the distinction between returns reported by funds and the returns to investors in those funds. Take the TMT boom as an example. Exhibit 3 shows the NASDAQ index and monthly flows to aggressive growth funds. Inflows to these funds peaked as the NASDAQ peaked and there were often outflows around market lows (such as 2002-03).
As more money went in at high price levels, and money was withdrawn at low price levels, the dollar-weighted return was significantly less than the index return. Exhibit 4 shows returns from start of 1997. A $100 lump sum investment made at the start of 1997 – a ‘buy-and-hold’ investment – would now be worth $150 (ignoring dividends). The dollar-weighted returns – which I have calculated assuming that the funds achieved the same return as the NASDAQ – would have lost 75%. This calculation effectively dollar-weights the price paid by investors. Put another way, it is equivalent to the internal rate of return on the monies invested.
This, to be fair, is an extreme example. But investors’ poor timing means that dollar-weighted returns are typically well below fund returns. Exhibit 5 shows the result from an academic study looking at hedge fund returns in ‘index’ terms – the buy-and-hold equivalent – and the dollar-weighted returns, which is what investors actually make. The gap is several hundred basis points per year.
In short, amateurs may be able to beat the investment professionals, but most do far worse. This keeps professional investors in business (and that keeps people like me employed, which is nice).
But it means that returns to investors typically lag benchmark returns by a long margin. The outlook, in my view, is for low returns ahead, as measured by common benchmarks. If investors continue to receive materially worse returns than those benchmarks, effective returns are likely to be derisory.
I’m retiring from Morgan Stanley, so this is my last note. Thanks for the brickbats and bouquets over the years – at least I knew you were reading. I’ve always said that those that can, do; those that can’t, broke; and if you can’t broke, consult. On that basis I’m off to do the latter, after a three month break. Cheers, Gerard