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
In summary, the more volatile the fund and/or the larger the performance gaps versus the market, the more pronounced the fear and greed response by investors, which leads to greater timing mistakes. The same thing is happening again with the ARK Innovation Fund. At the start of 2020, there was only $1.9 billion in the fund. At the end of its stellar year, it was worth $17.7 billion thanks to $9.5 billion of new contributions, more than half coming in the last quarter.4 Since then, the fund is down 18%, taking a bigger pile of investor money down with it.5
Not isolated events
The next question I typically receive is, “But, these could be isolated incidents. What else you got?”
You know all those fund company commercials and advertisements that tout a fund’s Morningstar 4- or 5- Star rankings? One would think that buying a high-ranking fund is a good thing. Not so. A Vanguard study crunched the numbers from 1992 to 2015 and found that the higher the star rating, the worse the subsequent returns. For example, as illustrated in the following chart, funds that were rated 5-Star due to their previous performance and risk management success ended up subsequently underperforming their benchmarks by a greater margin than the lower ranked funds. It was the 1-Star funds that did the best. (Note, too, that every group underperformed the benchmarks.)
So, what happened here? Did every rolling group of top performing managers over this period lose its magic touch at the same time? Did all the poor-performing managers see the light and get smarter? Not at all. It’s because managers have a strategy and a style of investing, and they generally stick to that style.
For example, “growth” managers pick companies that are aggressively growing their businesses and are willing to buy their stocks, even at high prices. These managers tend to not drift into other segments of the market. “Value” managers seek stocks that are cheap relative to the underlying companies’ fundamentals and they, too, stick to their knitting. These types of stocks move in and out of favor, making the managers look good and bad and back again. In reality, the managers are just sticking to their discipline through changing market cycles.
However, many investors who believe an underperforming manager has lost his or her touch sell after the losses have occurred, and subsequently buy a fund that has done well for the opposite reason, only to have the market rotate again. Rinse and repeat until returns are eroded.
This is what has happened to the ARK Innovation Fund. In 2020, “innovation” stocks (many of which are technology stocks) were in favor due to the COVID-induced lockdowns. The herd of investors allocating money into the “work from home” sector of the market forced stock prices up to dizzying and expensive heights. As vaccines were approved and then distributed in 2021, the economy improved and investors scurried to buy cheap industrial, energy, material and financial stocks that had been left for dead the year before. Value investors like Warren Buffett suddenly look smart again and Cathie Wood looks like she’s in a slump. Not so. She’s sticking to her strategy. It’s the investors who are making the mistakes.
The purpose of this article isn’t to knock Cathie Wood or predict the performance of her the ARK Innovation Fund, but rather to provide some educational context to help you avoid common investing mistakes. I believe that there is in fact a “holy grail of investing,” and it is the realization that there is no holy grail. The best strategy is not the one that achieves the highest long-term returns, but rather the strategy that achieves the highest long-term returns that you can adhere to.
At Creative Planning, we help our clients develop custom investment strategies to achieve their long-term goals. As a nationally recognized wealth advisory firm, we deliver a team of credentialed, educated, experienced and action-oriented advisors, including CERTIFIED FINANCIAL PLANNER™ practitioners, certified public accountants, insurance specialists, attorneys and other professionals dedicated to helping you achieve your goals. We work together to help ensure all aspects of your financial life are well cared for. If you’d like help developing your investment strategy, or for any other financial matter, please schedule a call.
- Source: YCharts
- “One of the Most Successful Active Managers of all Time Shows Why Active Management Doesn’t Work”, retirementresearcher.com
- “Best Stock Fund of the Decade: CGM Focus”, wsj.com
- Source: YCharts
- “Morningstar publishes its first ARK analysis. And it’s rough!”, citywireusa.com
- Notes: Data covers the period from June 30, 1992 through December 31, 2015. Morningstar changed its rating methodology during this period, but there was no material impact on our analysis. The analysis includes all share classes of U.S. Equity funds, both live and obsolete. To be included, a fund had to have a Morningstar Rating and 36 months of continuous performance following the rating date. Fund returns are net of expenses, but not of any loads. The results are relative to the funds’ category benchmark as defined by Russell, however similar results were achieved relative to MSCI and Standard and Poor’s indexes as well.