November 2021
IN THIS ISSUE
The Case for Patience
Mr. Goxx has died
Mr. Goxx’s obituary
Signal vs Noise
Quiver Quantitative tackles the Elon Markets Hypothesis
They underperformed. Again.
Traditional active management is not performing, and the industry’s underperformance is one of the reasons I started Likely Capital Management - to provide an outperforming alternative to passive S&P 500 indexing.
The story goes like this. The S&P 500 Index (the “Index”) generally increases in value over long time horizons. Since 1929, the Index has finished with positive returns in 62 years and negative returns in 31 years. Further, those twice-as-many positive years averaged annual returns of 17.94%, whereas the half-as-many negative years averaged annual returns of -12.88%. Clearly there is a positive bias toward the Index’s returns.
Most traditional active managers seek to reduce losses in down markets through uncorrelated stock picking, taking both long and short positions, and other strategies. In exchange for trying to lose less during down markets - and whether they succeed is questionable anyway - inevitably these managers also make less during up markets.
As they say, there is no free lunch. Systematic outperformance without an increased risk of loss just does not exist.
To justify their services, many traditional active managers will explain away their underperformance relative to the Index by saying things like:
“We offer risk-adjusted returns - we are not trying to beat the S&P 500 Index.”
“We offer positive returns in both up and down markets.”
“Just wait until the next recession when we will outperform.”
I have argued that each of these claims is unconvincing. Inevitably those down markets come, and active managers’ promises leave investors hanging. But don’t take my word for it. Morningstar’s Active/Passive Barometer, a semiannual report that measures the performance of U.S. active funds against their passive peers, presents the reality with some truly damning statistics. The full report is 31 pages with the full data disaggregated and presented in many ways. Here is CNBC’s Bob Pisani summarizing the findings with In one of the most volatile markets in decades, active fund managers underperformed again:
If there ever was a year active management should have outperformed passive, indexed strategies, 2020 and the first half of 2021 should have been it.
For decades, active managers have claimed that in boring markets, don’t expect them to outperform. When things change fast, however, when there are rapid changes in the economic outlook and high volatility in the markets, active managers who can make quick decisions will crush their passive competitors.
They had a chance during 2020 and 2021, one of the most volatile markets in decades.
Two recent reports by Morningstar and S&P Global come to the same conclusions: It didn’t pan out.
Of the nearly 3,000 active funds Morningstar analyzed, only 47% survived and outperformed their average passive counterpart in the 12 months through June 2021.
“Roughly half beat, and half lagged. It was what you would expect from a coin flip,” said Ben Johnson, director of global ETF research and the author of the Morningstar report.
The Morningstar Active/Passive Barometer is a semiannual report that measures the performance of U.S. active funds against passive peers. It accounts for two factors when assessing fund returns: the cost of fees, and survivorship bias.
It’s critical to account for survivorship bias. About 40% of all large-cap funds fail over a 10-year period. That’s because many fund managers are terrible stock pickers, and their funds are closed.
“We include all funds, including those that didn’t survive,” Johnson told me. “There was real money trapped in those funds.”
A recent report from S&P Dow Jones Indices came to a similar conclusion: Over the 12-month period ending June 30, 58% of large-cap funds, 76% of mid-cap funds and 78% of small-cap funds trailed the S&P 500, S&P MidCap 400 and S&P SmallCap 600, respectively.
Long-term performance is even worse
The performance of active managers gets much, much worse when you look at longer time horizons: over a 10-year period, only 25% of all active funds beat their passive counterparts, according to the Morningstar report.
It’s even worse among large-cap equity funds, which are what most investors hold: Only 11% of actively managed large-cap funds outperformed their passive peers over 10 years.
The conclusion: fund managers may get a hot hand for one, two, or three years, but it rarely lasts. Over longer time horizons, even those with short-term “hot hands” fail.
Johnson’s conclusion: “There’s little merit to the notion that active funds are more capable of navigating market volatility than their passive counterparts.”
The case for traditional active management is crumbling. There is a better way - the Likely way.
What goes up…
I write often about stock picking and underperformance. Naturally, humans suffer from psychological biases and flawed decision-making processes. The consequences of these phenomena reveal themselves in many ways, including performance chasing and fear of missing out.
Take, for instance, this incredible finding from Hsu, Myers, and Whitby in Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies:
Over the last 20 years, mutual fund investors appear to have given up almost 2% per year because of their trade timing. There is ample evidence that excessive securities trading is detrimental to returns (see Odean [1999], Barber and Odean [2000, 2002], Barber et al. [2009], and Bailey, Kumar, and Ng [2011]).
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We find that average investors do not time their allocations well and actually under- perform the buy-and-hold benchmark by almost 2% per year. This has significant implications. This loss in return through poor timing must be captured by someone else and addresses the question of how the value premium persists and who is on the losing end of the trade. Indeed, for fund categories where the average manager has outperformed the broad market benchmark net of fees, as measured by buy-and-hold returns such as value and small-cap style category, the investor’s negative timing skill actually results in an underperformance, as measured by IRR.
Some managers argue that “ETF picking” captures the best of both sides, the diversification of sector ETFs with the opportunity for outperformance via picking soon-to-be-in-favor sectors. The underperformance, however, comes from the process of trying to time trade entry and exit successfully, not whether those trades consist of sector ETFs versus individual stocks.
Fear of missing out works similarly, in that investors deviate from their existing strategy when presented with a hot new opportunity, one from which “everyone else” is profiting but whose time may have passed. Jumping on hot opportunities may sometimes profit in the short term, but when this strategy is repeated over time the systemic flaws become evident via long term underperformance.
The meme stock mania, perhaps the investing story of this year, gave ample evidence of investors getting burned by being too late to the party. It was not only meme stocks, however. Here is Morningstar’s Katherine Lynch in ARK Innovation Has Likely Been a Disappointment for Most Investors:
ARK Innovation ETF (ARKK) gained 152.5% in 2020 and ranked as the best fund in the mid-cap growth Morningstar Category.
The eye-popping return caused investors to flood into the exchange-traded fund. At one point, ARKK was collecting $1 billion a week.
But now, these investors may feel like they had the rug pulled out from under them. While the Morningstar US Market Index was up 22% this year through Oct. 31, 2021, ARK Innovation was down 2.6%, while the average mid-cap growth fund gained 17%. ARKK now ranks as the worst-performing fund in the category.
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ARKK's story isn't unique. Of the 18 funds that rose more than 100% in 2020, half rank in the bottom half of their category this year. As Morningstar's Jeff Ptak wrote in January, "What to expect from funds after they gain 100% or more in a year? Trouble, mostly."
When it comes to performance-chasing, as was Likely the case with ARKK’s massive inflows at the highs, well, what goes up…
More FOMO
Speaking of what goes up…
Source: Reddit r/CryptoMoonShots
SQUID certainly went up - and certainly went down. The cryptocurrency inspired by Netflix’s hit show Squid Game Crashed from $2,800 to $0.0007 in Five Minutes. Fear Of Missing Out led this investor to jump in, and it cost him his life savings:
“My rush to buy this token is for a single idea that went into my brain that ‘Squid Game’ is very, very popular now, and its token must be popular now,” said Bernard, who lives in Shanghai, and asked to be identified only by his English first name because trading in cryptocurrency is of questionable legality in China. “It’s a tragedy. I don’t know how to recover my loss.”
Bernard tells CNBC that he supports his family and is now worried about how to pay his bills.
“ ‘Squid Game’ is very, very popular now, and its token must be popular now.” Because sure, in the crypto world, a token’s proximity to popular shows creates fundamental value(!)
“In this trading space, everyone will rush,” said Bernard, “and sometimes you feel FOMO.” That sense of FOMO, or the fear of missing out, is a common sentiment among crypto traders who invest in early-stage altcoins, eager for a chance at big and quick returns on their investment.
My wrestling coach used to say “If you’re early then you’re on-time, and if you’re on-time then you’re late.” The same can be said about cryptocurrency speculation these days. The opportunity seems to be with getting in early on the next big coin to catch the wave, and waiting until you see the wave can mean you miss most or even all of the profit potential. So crypto investors like Bernard buy into many different coins early, most of them fail, so they hope that the occasional home run more than compensates for all the failures. And SQUID was a colossal failure.
FOMO is costly.
ONE MORE THING…
The Case for Patience. “Moreover, measures of actual consumer behavior suggest that Americans are responding to higher prices not by hoarding in anticipation of even more inflation, but by postponing their spending in the expectation that affordability will improve.” The Case for Patience on Inflation
Mr. Goxx has died. The crypto community needs a new furry human-beating forecaster. The crypto trading hamster that outperformed the S&P 500 has died
Mr. Goxx’s obituary. Twitter thread obituary includes “You will be missed, and your memory will live forever on the blockchain.” Mr. Goxx (@mrgoxx)
Signal vs Noise. ”They think that intelligence is about noticing things are relevant (detecting patterns); in a complex world, intelligence consists in ignoring things that are irrelevant (avoiding false patterns)“ - Nassim Nicholas Taleb
Quiver Quantitative tackles the Elon Markets Hypothesis. I will follow and report back on this novel metric’s performance, stay tuned. Building the 'Musk Proximity Metric'
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