Research Affiliates, a highly respected market research firm, recently conducted a study on 45 years of mutual fund returns. The results were not surprising. Of 350 mutual funds available to investors in 1970, only 45 beat the market through 2014. Underperforming mutual funds is old news here, as I’ve covered in many other updates. The remarkable aspect of the study was that the mutual funds that beat the market significantly spent, on average, a third of the time underperforming the market on a rolling three-year basis.
You can imagine the discipline it took for these managers to stay focused on their process as they lagged the market for long stretches. Clients surely pulled money out of their funds. Journalists stopped calling them. Their personal pay must have taken a hit. But in the long run, they outperformed most of their peers.
The great investors have to have enormous discipline to come out ahead in the long-run. Poor short-term results often beg for action, to switch things up, to chase better returns elsewhere. It’s human nature to see a downward trend, assume it will continue, and try to get out of the way. The winning managers, however, stuck with the process they knew would work over time, knowing the process will yield long-term results.
Once you have a process that works, the key is to stick with it and add more and more data points over time. It’s like having a coin that is weighted so that heads comes up 60% of the time. If someone offered to bet you a dollar on every coin flip for as long as you wanted to play, the smart person would bet on heads every time. Statistics tells us there would be long streaks where tails would come out ahead, but that would not mean you should start betting on tails. As long as you stick with heads, in the long-run you would win about 60% of the time and take a tidy profit. Small-cap value investing is like our weighted coin, we know it will win in the end, but we have to keep hammering away at it.
History doesn’t crawl; it leaps, as the saying goes. We can safely categorize investment returns into four groups: consistently bad; mostly bad and occasionally good; mostly decent and occasionally good; and consistently good and fraudulent. This is because there are no crystal balls, and markets are inherently unpredictable.
As I’ve written before, the yearly and quarterly reporting cycles are problematic for many managers (especially at mutual funds). When a manager feels he needs to perform on a 12-month, or quarterly, basis, he starts doing all kinds of counterproductive trading maneuvers to window-dress year-end returns. It’s much better for managers have one time horizon, long-term, and to consistently focus on there.
Yale economist Robert Shiller once noted the absurdity of racing to meet one-year goals. “I don’t know why people keep using one year earnings,” he said. “That is the time it takes the Earth to go around the sun. I don’t see any other significance.”
You have to act differently if you want different returns. That seems obvious, but there’s safety in numbers, and for most managers, there is more job security being consistently mediocre. Too many fund managers effectively run a high-fee index fund and aren’t really trying to outperform, instead focusing on marketing. The best way to outperform the market is to be comfortable with being uncomfortable, keep a disciplined approach, and to understand that you will lag the market from time to time.