The Globe and Mail, Report on Business
Published April 15, 2011
By Tom Bradley
Value managers make a habit of scanning the 'new lows' list on the stock page. They’re hoping to find good companies that have stumbled and are oversold.
Buyers of the funds run by those same managers, however, rarely do that. They most often go for the 'new highs.' Typically, money flows into funds, and fund categories (technology, precious metals, energy), that have done well in recent years. While other factors come into play – such as the manager and firm’s reputation, marketing efforts and long-term returns – good recent results are buyers’ prerequisites.
This bias is unfortunate because it narrows the field unnecessarily. If the best managers are going through a tough patch, which they invariably do, then their funds may not be considered. It’s particularly unfortunate because those are often the times when managers are feeling the best about their portfolios.
The performance requisite can also suck investors into what I call the Cycle of Hope. By consistently rotating to funds or sectors that have done well in the recent past, they can get caught in a downward spiral. They’re positioning themselves for what’s already happened instead of what might be. As a result, their returns suffer.
Can a fund that’s led the way in your portfolio continue to do well? Absolutely. It may stay at the top of the rankings for years and deliver excellent long-term returns. But be assured that it too will experience some down times.
There are a number of reasons for this. First and foremost, it’s impossible to be right all the time. Even top managers have periods when they’re out of sync with the market.
Also, when stocks go up, so do valuation multiples. Funds that have done well aren’t as cheap as they previously were. Managers make adjustments – sell expensive stocks and buy cheaper ones – but it’s difficult to do completely. And it isn’t easy to part with companies that fit perfectly with the manager’s philosophy, particularly in Canada where there are so few alternatives.
It’s important to remember that what works in one environment may be totally unsuitable in another. For instance, a manager with strengths in resource stocks will thrive in an inflation-driven market, but will likely struggle in an economic slowdown.
And we shouldn’t forget about luck. It definitely has an impact in the short term, but the last I checked, it evens out over time.
Can investors fight this tendency to chase performance? I think so. A number of years ago, I had an experience where a client did just that. My partner and I were given the opportunity to present to a pension committee that was looking for both Canadian and U.S. equity managers. We thought the only chance we had was on the U.S. side, where our numbers were smoking hot. Our Canadian returns were just okay.
When the decisions were made, they hired us for ... wait for it ... Canadian equities. The committee liked the firm, people and approach. As the CFO said to me, “We’re pleased to be hiring a good manager when they’re down.”
Now jump ahead a number of years to when I was doing a semi-annual review with the committee. It went well and they were pleased with the returns. But later that day I met with a newer client who had hired us after our returns had improved. Their choice was more influenced by short-term returns and as a result, the session had an entirely different feel. The relationship was fine, but it never attained the same level of confidence and the returns (since inception) weren’t as good. Same portfolio. Same personable manager. Different result.
I’ve always had a high regard for the first committee, because they did something that few investors do. They ignored the short-term results and chose us for the right reasons. And they were rewarded.
So it’s not a bad thing when the short-term data are misaligned with the long-term factors. There’s a lot to be said for going against the grain and hiring a proven manager whose strategies have yet to play out. Your cycle has more chance of being a virtuous circle than an “always hoping” death spiral.