Everyone wants to beat the market. If you ask any investor whether they can beat the market, you will find that many will either claim that they have the ability to, or that they have done so in the past. In Lesson 32, I talked about behavioral biases and the notion that many people are overconfident in their abilities, including abilities or skills related to investing or money management. This notion of overconfidence is seen all the time in the finance world around beating the market. That is the biggest selling point for any fund manager... whether or not you can beat the market. Reality is that beating the market is extremely difficult, and unless you are an investor who can time ups and downs in the market, or have excellent hedging strategies, you are going to do as good or worse than the market. Why?... because we are human and humans make irrational decisions.
When seeking out mutual funds, there are many mutual fund managers that will proclaim they have and can beat the market. "Please give me your money, look I can beat the market!" While I don't doubt the simple fact that they have beat the market in the past, one should however doubt the fund manager's ability to repeat such performance, and one should question the manager's skill. Did this fund manager beat the market due to skill? Or was it simply luck? Any monkey can throw money into a stock and make a lucky guess and win big, so someone looking to invest their money in a mutual fund must be cognizant of the "lucky loser" dilemma. Lucky losers are simply bad money managers who took a risk and won big. However, such luck or outstanding performance is usually not sustainable and this becomes transparent after a few years of portfolio returns under performing the index. However, after the first big year of stellar performance, investors will start piling money into this mutual fund, firmly believing that past performance will be indicative of future performance.
The mutual fund industry makes us believe that past performance is a good thing. This poses two problems:
Firstly, this aligns with a common behavioral bias of using past market performance to predict the future. While this prediction has been proven to be statistically relevant over short term stock performance, it becomes quite the opposite correlation when comparing across long term returns. Equity annual returns regressing or returning to its mean return over a long period of time is inevitable. Think about how arbitrage works. If Store A sells pens for $10, and Store B sells pens for $12, consumers will catch on and will all buy their pens from Store A. Store A will see increased volume of pen sales, and in response, raise the pen price to $11. Meanwhile, store B has noticed very low pen sales, and in an attempt to regain sales volume, lowers its price to $11. An arbitrage opportunity no longer exists because supply and demand of pens have eventually met an equilibrium.
Secondly, mutual fund managers who post strong performance from the previous year will see a large increase of cash inflows being thrown into their funds by investors. People will keep throwing money at these past fund winners. However, the fund manager only has so many good ideas to be profitable and to outperform the market like they were able to the year before. Now the manager has too much money to manage, and not enough capacity to get returns they want. This capacity issue will lead to partial fills on orders because the trade volumes are so high, which drives up stock prices and limits returns. Capacity problems also mean that the fund manager has more to manage, and less time to manage. Therefore, these once "all star" mutual fund managers begin to see their funds starting to provide returns that more align with the market indices. This is why you see mutual funds rarely outperforming markets, and 99/100 times, these funds will always be performing at or slighting below the market, even if its purpose is to track an index. Transaction costs and, more importantly, capacity issues, will eventually align these fund performances to the relevant market. or sector that it tracks.
Because mutual fund managers want us to believe past performance is a good indicator of future performance, advertising about the fund will be tailored in a suitable fashion. For example, mutual funds tend to show the Holding Period Return (HPR) of the fund over a specific period of time, which is typically 3 years. If the fund had a bad performance year within the 3 years, the HPR is not shown on the mutual fund prospectus. However, once that bad year drops out of the 3 year period, the mutual fund performance will be reported for the new holding period and crank up the advertising of the fund. The year over year performance will look great over the 3 years because the bad year will be dropped off. It could also serve as a basis to compare the last 3 years against, making performance relative to that bad year look amazing. It's like saying that a baseball player has a 0.300 batting average in 2017, and a 0.291 batting average in 2016. However, in 2018, they have a batting average of 0.220. This looks quite bad considering in previous years, the batting average was much higher than 0.220. However, given the next three years, the batting averages are :
2016: 0.291
2017: 0.300
2018: 0.220
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2019: 0.295
2020: 0.291
2021: 0.300
So relative to the 2018 year, the recent 3 year performance from 2019 to 2021 for this player looks fantastic. The 3 year average between 2019-2021 is 0.295, whereas the 3 year average from 2018 to 2020 is 0.269. It's easy to see how a HPR for a mutual fund is affected once a bad year is dropped off.
Investors should also be aware of fund manager behaviors over the course of the year in relation to how the fund is performing. Typically, if mutual fund performance over the first half of the year is terrible, these "fund losers" will crank up the riskiness in their portfolio in an attempt to "catch up" to the market. Winners at the middle of the year will be turning the riskiness down in their funds because there is no need to try and continue to outperform more than you've already done so. This is representative of behaving in a way that your incentives drive you towards. Fund managers are no different (strong statistical significance is shown to support this behavior by a study done by Brown, Harlow and Starks in 1996). Mutual fund managers who are losers for the first part of the year will take on more risk in the second half of the year in an attempt to make up losses. But again, what you may end up with at the end of the year are a bunch of bad fund managers who took a lucky bet and ramped up volatility in the second part of the year and got a big gain. These so called "winners" could just be lucky losers.
It's important to know that beating the market is difficult, and having your money in a fund that tracks the index will provide you with sufficient returns over the long run. Don't be distracted by claims of "secret solutions" and strategies that can beat the market, because chances are, these funds got lucky one year and will not provide consistent and repeatable high returns going forward that consistently beat the market. One data point does not reflect a continuous pattern going forward, no matter what type of fund or equity you are looking to invest in. Otherwise, Amazon stock would continue to exponentially sky rocket to $2000/share by the end of 2018.
To get a sense of trying to time the market to beat its performance, try this fun "beat the market" game. You only get to sell and buy once over a 10 year period. Give it a shot (or two). Try to actually sell once and buy once (as opposed to doing nothing and "matching" the market). You'll be surprised how hard it is to be right and beat the market, and when you are right, how much luck is involved to do so.
My results:
Attempt 1: Did not beat
Attempt 2: Beat
Attempt 3: Beat
Attempt 4: Did not beat
Attempt 5: Beat