About the Author: William J. Bernstein is a retired neurologist, co-founder of investment management firm Efficient Frontier Advisors, and 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 adapted with permission from McGraw Hill from Bernstein’s latest book, The Four Pillars of Investing: Lessons for Building a Winning Portfolio, below.
The highway to riches is strewn with another kind of hazard: the superstar manager’s pothole.
Human beings are wired to react more to stories than dry numbers and facts. The financial media have understood this well. It’s one thing to absorb compelling academic evidence that investing in actively managed mutual funds is futile; it’s quite another to resist the almost constant drumbeat of media coverage of the riches unleashed by winning investment funds.
So I’m going to tell you what the financial media don’t know about their coverage of successful funds and managers: how these stories usually end.
The financial press is a revolving shark in the water, constantly on the lookout for compelling stories that will attract eyeballs and advertisers, a voracious imperative that prevents financial journalists from providing sensitive information: buy index funds at low cost and ignore every bit of 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 anything above the fold has already been forfeited in price. As Bernard Baruch would have said, “What everyone knows is not worth knowing.”
Among financial journalism’s 50 shades of investment porn is the story of a superstar fund manager. As we have already seen, at some point, by pure chance, one fund or another will die out, and the genre of star managers is a robust perennial of financial media. As I was writing the first drafts of this book, the superstar of the day was Cathie Wood, the charismatic founder of ARK Investment Management. THE
ARK Innovation ETF
(ticker: ARKK) posted a stunning 61% annualized return from 2017 to 2020, far exceeding the 16% annualized return of the
S&P500
.
Wood’s earnest statements about the riches to be had from companies deploying “disruptive technologies” still fill the financial media.
Unfortunately, 2021 hasn’t been so kind to its investors. That year, ETF ARK Innovation lost 24% (compared to a gain of 29% for the S&P 500). As usual, most of its investors were attracted by its spectacular returns and joined the party at the end of 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 annualized return since inception in October 2014 was 28%, the average dollar invested n only earned a return of 9.8%, versus 14% annualized for the S&P 500.
Investors would have done well to heed the advice offered by Ms Arnott at the end of 2021; in 2022, the ARKK lost 67%, compared to an 18% loss for the S&P 500. Not that the warning signs hadn’t flashed long before that. Before founding ARK Investment Management in 2014, Wood worked as a fund manager at AllianceBernstein, where she managed several funds that, on average, underperformed. Before that, she co-founded Tupelo Capital Management, which died out in the tech crash of the early 2000s. Even if you weren’t aware of Wood’s less than stellar career in money management, Likely the result of high costs and frenetic trading, the bloodline’s kind of superstar fund manager serves up a generous dollop of George Santayana’s saying, “Those who do not remember the past are doomed to repeat it.
In 1943, a Harvard-trained lawyer named Edward C. Johnson II, with nearly two decades of investment experience under his belt, purchased the moribund Fidelity Fund, which had been founded in 1930 as one of the first mutual funds. investment in the country. (The fund continues to operate to this day.) A few years later, he founded the 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 ability, drive and vision earned him a place as director of the Fidelity Capital Fund. (Johnson, something of a maverick, appointed Tsai as sole manager, an unusual move at a company where committees managed funds.)
Tsai’s specialty was investing in growth stocks. In the mid-1960s, growing companies…
Photocopy
,
IBM
,
LTV, Polaroid – have become fashionable. The Go-Go years, as they became known, mirrored the dot-com bubble of the late 1990s and the recent craze for big tech companies, with valuations close to those seen during the most recent crazes.
Tsai was the prototypical “gunslinger,” in 1960s money management slang. He bought and sold stocks aggressively at a rapid pace and posted attention-grabbing returns in the process. . In the aftermath of the 1962 recession, his Fidelity Capital fund gained 68%. In 1965 he gained another 50%, compared to just 12% for the S&P 500. Journalist John Brooks wrote that his trading was… so quick and nimble in getting in and out of specific stocks that his dealings with them, far from look like a wedding. or even a companion wedding, were more like those of a roué with a chorus line. Sometimes, to continue the analogy, the sheets were barely fresh when he was done with one and the other.
Tsai considered Johnson a father figure, but when young Edward C. Johnson III joined the company, Johnson Sr. told Tsai he was not in line to run the company, and Tsai left to found the high-octane Manhattan Fund.
At that time, Tsai found himself in Randomovia. The years 1966-1967 were poor for the Manhattan Fund; in 1968 it stagnated. In the first half, Manhattan lost 6.6% of its value while the market gained 10%. The Manhattan Fund was ranked 299th among 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 at the Manhattan Fund? The press told a story of speculation and hubris, followed by the inevitable crude justice – at least for the fund’s investors, some of whom had paid an initial charge of up to 50%. Tsai eventually went on to a successful career in business, eventually becoming president of Primerica. But the media missed something much more important. The Manhattan Fund fell into what later became a pervasive destroyer of actively managed funds: asset bloat.
We have already encountered this phenomenon with Wood. Let’s say you buy shares of XYZ company. It’s unlikely anyone noticed your order – millions of dollars worth of stock trading every day, and your paltry order is absorbed without affecting the price of XYZ. On the other hand, if you have $50 million to invest in the stock of a small company, or even $1 billion to invest in a large one, you now have a problem: you cannot execute your purchase without inflating the price of the stock, since not enough stock is available at the current price to meet your needs. To attract sellers, you need to offer a higher price. The reverse 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 that has become gigantic with speculative money is inexorably forced to do the opposite. The resulting drag on performance is known as the ‘impact cost’, and it can depress the performance of a large fund.
Tsai was the first in a long line of superstar fund managers to suffer from this phenomenon. In its early days, Tsai’s reputation attracted $1.6 billion into its fund, a huge sum for the time. His subsequent successful business career suggests he may have had some truly persistent skills before he hit the inevitable brick wall of impact costs. Indeed, Manhattan shareholders were paying a “Tsai tax” each time he bought or sold, which destroyed the fund’s performance.
William Miller, director of the Legg Mason Value Trust, and who beat the S&P 500 for 15 consecutive years between 1991 and 2005, is an impressive recent example of the collapse syndrome of a superstar fund manager. In the early 2000s, I admitted to being impressed: after all, the probability of returning 15 straight heads is only 1 in 32,768.
When contacted for comment, Miller said the true odds of an actively managed fund beating the market in each of the 15 years of its winning streak was 1 in 2.3 million. “Of course luck was in play because all long streaks are a combination of luck and skill,” he said.
Then, over the next three years, asset bloat, the fund’s 1.75% expense ratio and Lady Luck all combined to almost completely wipe out the fantastic performance of the previous 15 years, barely outpacing the S&P 500. 0.6% per year between 1991 and 2008. When Miller transitioned from co-manager to sole manager of the fund, it held only $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 lagged the S&P 500 by almost 4% per year. The worst was yet to come: by 2006, Mr. Miller had amassed more than $20 billion in assets, which he stormed off. In retrospect, Mr. Miller’s metronome-like outperformance between 1991 and 2005 mirrored that of the mortgage lenders or mortgage-backed security holders he overweighted – Countrywide, Bear Stearns, Washington Mutual – whose stocks boomed in the years leading up to the 2007-2009 Global Financial Crisis. After 2006, that same overweight to mortgage lenders reversed completely, dragging Mr. Miller and his hapless investors with them.
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