The trap of following superstar portfolio managers like Cathie Wood

About the author: William J. Bernstein is a retired neurologist, co-founder of the investment management firm Efficient Frontier Advisors, and a board member of the John C. Bogle Center for Financial Literacy. He has also written numerous books on investing, history and social psychology. Read a section from Bernstein’s latest book, adapted with permission from McGraw Hill: The Four Pillars of Investing: Lessons on Building a Successful Portfolio, under.

There’s another hazard on the wealth road: the superstar manager’s pothole.

People respond more to stories than to dry facts and figures. The financial media understands this. It’s one thing to embrace compelling scientific evidence that investing in actively managed mutual funds is futile; It’s quite another to withstand the near-constant drumbeat of media coverage of the fortunes that come from winning mutual funds.

So I’m going to tell you what the financial media doesn’t say about their coverage of successful funds and managers: how those stories usually end.

The financial press is a shark circling in the water, in a constant search for compelling narratives that attract attention and advertisers, an insatiable imperative that keeps financial reporters from spreading sensible information: buy low-cost index funds and ignore all the news about the Federal Reserve or this week’s market swings — what journalist Jane Bryant Quinn called “financial pornography.” A useful rule of thumb is that financial headlines can be safely ignored as everything that appears above the fold is already priced into the prices. As Bernard Baruch allegedly said, “Something everyone knows is not worth knowing.”

Among the 50 Shades of Investment Porn in Financial Journalism is the story of a superstar fund manager. As we’ve already seen, it’s always possible for a fund to fail completely by accident, and the star manager genre is a hard hit in the financial media. When I wrote the first drafts of this book, Cathie Wood, the charismatic founder of ARK Investment Management, was the superstar of the day. The

ARC Innovation ETF

(Ticker: ARKK) delivered an impressive 61% annual return from 2017 to 2020, easily beating the 16% annual return

S&P 500
.

Wood’s earnest pronouncements about the wealth that companies can make with “disruptive technologies” can still be found in the financial media.

Unfortunately, 2021 hasn’t been kind to its investors. For the year, the ARK Innovation ETF is down 24% (vs. a 29% gain for the S&P 500). As usual, most of their investors were attracted by their spectacular returns and joined the party in late 2020-2021. A study by Morningstar analyst Amy Arnott, titled “ARKK: An Object Lesson in How Not to Invest,” calculated that while the fund’s annual return since its inception in October 2014 has been a sizzling 28%, it’s the average in the fund However, with dollars invested just 50%, the return was 9.8%, compared to an annualized return of 14% for the S&P 500.

Investors would have done well to heed Ms Arnott’s advice in late 2021; In 2022, ARKK is down 67%, compared to an 18% loss for the S&P 500. Not that warning signs didn’t appear long before then. Prior to founding ARK Investment Management in 2014, Wood was a fund manager at AllianceBernstein, where she managed several funds that, on average, underperformed. She previously co-founded Tupelo Capital Management, which burst into flames in the tech crash of the early 2000s. Even if you weren’t aware that Wood’s earlier career as a wealth manager was far from stellar, likely the result of high costs and frenetic trading, the superstar fund manager genre offers a generous helping of George Santayana’s dictum: “Those who can’t remember .” The past is doomed to repeat it.”

AN INTERVIEW WITH THE AUTHOR

In 1943, a Harvard-trained attorney named Edward C. Johnson II, who has nearly two decades of investment experience, bought the dying Fidelity Fund, which had been founded in 1930 as one of the nation’s first mutual funds. (The fund continues to this day.) A few years later, he founded Fidelity Management and Research Company, the predecessor of today’s giant Fidelity Investments. In 1952, Johnson hired a young Chinese immigrant named Gerald Tsai whose skill, drive, and vision earned him a spot as manager of the Fidelity Capital Fund. (Johnson, something of an outsider, made Tsai sole CEO, an unusual move at a company where committees managed funds.)

Tsai’s specialty was investing in growth stocks. In the mid-1960s, growth companies developed –

Xerox
,

IBM
,

LTV, Polaroid – came into fashion. The go-go years, as they’ve been dubbed, reflected the internet bubble of the late 1990s and recent enthusiasm for big tech companies, with valuations approaching those of recent euphoria.

Tsai was the prototypical “gunslinger,” as the money management term used to be in the 1960s. He bought and sold stocks aggressively and at a rapid pace, earning attention-grabbing returns in the process. After the 1962 downturn, his Fidelity Capital Fund rose 68%. In 1965, it rose another 50% while the S&P 500 was up just 12%. Journalist John Brooks wrote that his trading…was so quick and flexible in getting in and out of certain stocks that his relationships with them were anything but a marriage, or even a companionship, more like a roué with a refrain. Sometimes, to continue the analogy, the sheets were barely cool when he finished one and moved on to the next.

Tsai viewed Johnson as a father figure, but when the likeable young Edward C. Johnson III joined the company, Johnson’s father told Tsai that he was unfit to run the company, and Tsai left to support the highly motivated Manhattan Fund to found.

At this point, Tsai was in Randomovia. The years 1966-1967 were mediocre for the Manhattan Fund; In 1968 it came to a standstill. In the first half of the year, Manhattan lost 6.6% of its value while the market gained 10%. The Manhattan Fund was ranked 299th out of 305 funds tracked by mutual fund expert Arthur Lipper. Just before Manhattan hit rock bottom, Tsai sold it to CNA Financial Corporation for $30 million.

What went wrong with the Manhattan Fund? The press told of speculation and hubris, followed by the inevitable harsh justice – at least for the fund’s investors, some of whom had paid upfront interest of up to 50%. Tsai eventually went on to have a distinguished business career, eventually becoming the chairman of Primerica. But the media missed something far more important. The Manhattan Fund fell prey to what would later become a ubiquitous destroyer of actively managed funds: wealth inflation.

We have already seen this phenomenon with Wood. Let’s say you buy shares in company XYZ. It is unlikely that anyone noticed your order – millions of dollars worth of stocks are traded daily and your insignificant order will be absorbed without affecting the price of XYZ. On the other hand, if you want to invest $50 million in the shares of a small company, or even $1 billion in a large company, you now face a problem: you cannot make your purchase without increasing the share price because this is not the case There is sufficient stock available at the current price to meet your needs. To attract sellers, you need to offer a higher price. The opposite happens when you sell a large block of shares.

If the essence of successful trading is to buy low and sell high, a mutual fund overwhelmed with hot money is inevitably forced to do the opposite. The resulting loss of performance is known as the “impact cost” and can eat into a large fund’s returns.

Tsai was the first in a long line of superstar fund managers to suffer from this phenomenon. When he started, Tsai’s reputation brought $1.6 billion to his fund — a huge amount for the time. His subsequent successful business career suggests he may have had some really persistent skills before hitting the inevitable wall of impact costs. In fact, Manhattan’s shareholders paid a “Tsai tax” on every purchase or sale, hurting the fund’s performance.

A recent striking example of the superstar fund manager collapse syndrome was William Miller, director of the Legg Mason Value Trust, which outperformed the S&P 500 for 15 years between 1991 and 2005. In the early 2000s, I admitted to being impressed: after all, the odds of tossing your head 15 times is only 1 in 32,768.

When asked for comment, Miller said the true probability that an actively managed fund would outperform the market in each of its 15 years of winning streak is 1 in 2.3 million. “Of course there was some luck involved, because all long streaks are a combination of luck and skill,” he said.

Then, over the next three years, wealth inflation, the fund’s 1.75% expense ratio, and lucky charms almost entirely wiped out the fantastic performance of the previous 15 years, barely outperforming the S&P 500 by 0.6% per year between 1991 and 2008. By the time Miller went from co-manager to sole manager of the fund, he held just $750 million in assets, and anyone who bought after 1993, when he only held $900 million, would have been better off in an index fund .

By 1998 the fund had grown to $8 billion; Over the next 10 years, the fund underperformed the S&P 500 by nearly 4% per year. Worse was to come: by 2006, Mr. Miller had amassed a fortune of more than $20 billion that he tumbled over the cliff. In retrospect, Mr. Miller’s metronome-like outperformance between 1991 and 2005 mirrored that of the mortgage lenders or mortgage-backed security holders he was overweight — Countrywide, Bear Stearns, Washington Mutual — whose stocks skyrocketed in the years leading up to 2007. Global Financial Crisis 2009. After 2006, that same overweight in mortgage lenders completely reversed, sweeping Mr. Miller and his hapless investors with it.

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