Here’s how it works now.
Courtesy of Joshua M Brown
A mystery! Who doesn’t love a good mystery?
Bloomberg headline:
A Once-Hot Fidelity Fund Is Outperforming Again. Investors Still Don’t Care
Magellan’s journey from icon to afterthought may be the starkest example of the eroding trust in professional stockpickers. Feingold’s record is strong: Under his tenure, which began in September 2011, Magellan has bested the S&P 500 index every full year but 2016. Annualized gains have averaged more than 15 percent, currently putting the fund just a bit ahead of the index. The fund has outdone more than 90 percent of funds with a similar investing style over the past one, three, and five years.
Fidelity Magellan was a $110 billion fund in 1997, so big it had to close itself to new investors. And then a funny thing happened – it saw net client outflows every year for the next 18 years. It’s now a $17.5 billion fund, and that’s after beating the market in recent years.
Here’s a quote from the current manager, who’s done 15.3% a year since taking over in 2011 vs the S&P 500’s 15.1%:
“If we do our job well and generate alpha, hopefully that is what will matter to shareholders.”
Nope. That’s not true at all.
Here’s how it works now, and I’m generalizing so try not to have a conniption…
“I need help.”
Investors heading into retirement look at what they’ve been doing with their money – whether self-directed or working with a wirehouse brokerage firm – and decide it’s time for some professional advice. They are somewhere between the ages of 45 and 65 when this takes place.
They meet with an independent advisor, typically someone at a Registered Investment Advisor (RIA) whose client assets sit on a custodian firm’s platform (Schwab, Fidelity, TD, Pershing, Raymond James, etc). They find this advisor the same way they find other professionals – referrals from friends, word of mouth in town, an introduction from their bank / online brokerage or, increasingly, on the web through Google searches, social media mentions or even (the smart ones) reading blogs and articles in which advisors share their opinions.
They say “Here’s how I’ve been investing so far, here’s all the accounts I’ve got scattered around, here are the things I need my money to accomplish for me and here’s what I’m most worried about.” If the advisor they speak with can address these issues to their satisfaction and show them the path to financial security and future happiness, they come aboard and become a client.
Here’s what’s not going on:
The advisor they are meeting with, in the modern era, is not promising them a way to “beat the market” or “discover hidden gems” on the Nasdaq.
Enlightened customers are not expecting their financial advisor, who works in an office complex off the side of the highway, or out of a storefront next to PF Chang’s, to be able to trade tech stocks for them and make world-trouncing macro calls in between handling required minimum distributions from their IRAs and mailing out birthday cards.
Enlightened advisors are focusing on the client’s needs and talking about what they can actually deliver – high quality, highly personalized ongoing advice and counseling. The portfolio being proposed, and the proposal itself, are geared toward explaining why a specific allocation to a mix of asset classes is going to help the client reach their goals.
No one is talking about alpha, sharpe ratios, sortino ratios, etc. Mutual fund manager due diligence has also become something of an anachronism. If things like “research department headcount” or “manager tenure” had any predictive value, then you could throw away your Bloomberg terminal and just use LinkedIn.
The lessons we’ve learned
Advisors have learned that hot managers grow cold at precisely the moment they’ve raised the maximum amount of money (hence, the gruesome data on dollar-weighted returns, as opposed to time-weighted returns that appear in all the advertisements). High performing managers sometimes leave the fund to start a new one, or they start drinking or they get divorced or they lose touch with what made them successful or they start making business decisions rather than investing decisions, or fill in the blank. There are a million reasons for why performance isn’t persistent, we’re all human.
Clients and their advisors have learned that there is no length of time by which historical returns can be used to forecast future returns for a specific fund. 2008 put a permanent end to that notion. Sequoia blowing up decades worth of outperformance in the span of two years because of a single bad trade recently was the icing on the cake – if you can’t trust Sequoia, then everyone is suspect. Caesar’s wife must be above suspicion.
Proposed portfolio allocations are being shown written in the language of after-fee, after-tax returns and indexes are increasingly being used to represent the asset classes, not fund picks. You can always count on an index to be representative of an index when you’re proposing a portfolio. You can’t built a proposed portfolio with ten active managers in it and count on anything – unless you’re selecting closet indexers, in which case you’re overpaying and opening the client up to future taxable distributions.
Basis points are the new past performance.
Michael and I took a meeting last week with one of the largest asset managers in America. They came in with a one sheet showing all of their ETFs in each category. The one sheet had three columns:
- Name of fund / ticker
- Category of investment
- Basis point fee
There was no past performance column. Most of the funds were less than three years old and no one would look anyway. If we’d asked for past performance they’d say “Well, here’s the backtest of the custom index we had built going back to the 90’s. Same shit.”
The basis point fees were shockingly low. They’ve boiled down, distilled and quantified a few dozen strategies that were once the province of high cost active managers into an index-like, rules-based ETF that replicates them closely enough. You want “cheap stocks”, “dividend stocks”, “momentum stocks”, “small cheap stocks”, “large growth stocks that are cheap”, “momentum small stocks that pay dividends”, “international value stocks”, “international stocks with a currency hedge”? You can have it, for what it used to cost to just buy the S&P 500.
Or even less in some cases.
Plus, you can have the backtest data to plug into your allocation proposals to clients. And you can stand by the backtest because, while it may not repeat going forward, at least it wasn’t dependent on some guy in Boston being at the top of his game. It was generated by the markets themselves and a set of rules that will be in force going forward.
The new advisor algebra
Advisors are trying to minimize three things in order to help their clients and keep their own jobs – randomness, uncertainty and cost.
- Active funds can do well versus a benchmark, but randomness can get in the way and have them underweight a given year’s top performing sector or overweight the worst stock.
- Active funds can do well versus a benchmark, but uncertainty around how long this streak can continue or whether or not the people generating the returns will stick around cannot be excluded from the list of concerns.
- Active funds can do well versus a benchmark, but do they earn their keep after factoring costs? That’s not always clear from simply looking at Morningstar’s time-weighted returns data or star system.
And because active funds introduce randomness, uncertainty and cost into the equation, the new advisor algebra simply eliminates them so as to remove these variables from consideration. An index fund never made an allocator look stupid, unless it was excluded or used in disproportionate size. In contrast, how many allocators have been made to look stupid over the years by Janus Funds, Bill Gross, Bill Miller, Sequoia, etc? Thousands?
Magellan may see a return to inflows for the remainder of the year and even beyond, but nothing on the scale of what it would have seen two decades ago. Because everyone is getting redeemed and it’s not personal. Just business.
I’m not saying it’s good or it’s bad. This is just how it works now.
