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And the Myth of the Investing Holy Grail

If you follow the financial media, you likely can’t go a day without seeing some sort of coverage of the famous fund manager Cathie Wood and her approximately $20 billion ARK Innovation Fund. As the name implies, the fund invests in some of the world’s most innovative companies. It became all the rage last year as investors fled “old school” companies tied to the economy in search of stocks that would benefit from the COVID-induced lockdowns. The ARK Innovation Fund returned an eye-popping 150% in 2020 versus the S&P 500’s 16%, but as of May 14, it’s down 18% in 2021 versus the S&P’s positive 12% gain.1

In this article, we look beyond the generally common knowledge that most indexes are hard to beat, and further explore the flawed strategy of searching for either a star manager or active funds that seem to have the “magic touch.”

In other words, if it seems too good to be true, chances are it is.

A look at investor behavior

One of our main jobs as advisors who manage money for clients is behavioral coaching. One might assume this is too “soft” a discipline to make a sizable impact. However, in my experience, investor behavior can have a more powerful impact than asset allocation decisions, manager and security selection, tax efficiency, expense management, withdrawal strategies and more. This isn’t only my opinion, it’s also backed by hard research from numerous studies, including the one illustrated below from market research firm Dalbar, Inc. As you can see, equity and bond market returns have been drastically higher than the returns of investors over the past 30 years.

There are several reasons for this performance gap, but the main one is what I would describe as the search for the “holy grail of investing” and the failure that comes with that pursuit. In this case, the grail is an investment manager with the “magic touch” who can consistently beat market returns without the pain of loss that comes with taking extra risk.

It does not surprise me that some people spend a lifetime on this quest. The financial and social media are full of “expert” opinions, and it’s common to hear stories about investors “hitting it big.” Unfortunately, similar to what happened to many of the oracles who predicted the 2007-2008 global financial crisis, the press doesn’t seem interested in highlighting these managers’ subsequent, and equally big, failures. Friends and acquaintances love telling everyone about their investment winners, even if they conveniently fail to mention they only represented 1% of their portfolio and were accompanied by several losers.

The problem with chasing returns

You may be thinking, “I know there are legendary investors out there… what about them?”

Counterintuitively, many investors end up performing worse with winning managers than they would have if they never knew they existed. Yes, you read that right. For example, legendary fund manager Peter Lynch ran the behemoth Fidelity Magellan Fund from 1977-1990. During his tenure, his average annual return was an astounding 29%, beating the S&P 500 in all but two years. But (and there’s always a but), the average investor in the Magellan Fund slightly lost money during that stretch.2

How can that be? Quite simply, it’s performance chasing. By the time investors realized Peter Lynch was a needle in a haystack, they had missed a lot of his returns. Investors then piled into the fund after great years, but also sold during his rare down years. The in-and-out game slowly eroded all the positive returns.

The exact same thing happened 10 years later when Ken Heebner’s CGM Focus Fund had, by far, the best decade of any U.S. diversified mutual fund, with an 18% annual return. During that same stretch, the S&P 500 had its “lost decade” with a -0.95% annual return. Despite this nearly 19% per year outperformance versus the index, the average CGM Focus investor lost 11% annually, a similar investor versus investment ~30% annual discrepancy as the Fidelity Magellan Fund experienced years earlier.3