The Pervasive Problem of Short-Termism

I read far too many articles citing a fund's much improved performance since so-and-so manager took over a year ago. Utter nonsense. It makes good copy, but the odds of any one year's performance being much better than random noise are exceedingly small. When evaluating fund performance (and this should only ever be part of a more robust evaluation process), what we look for is to see how it has fared across market cycles and in different market environments. I wouldn't consider anything less than three years dispositive of anything, and even three years is too short to be of much use.

In part because of the media obsession with recent performance, and in part because it's simply human nature, investors all too often try to chase yesterday's winners. They then flee when the going gets rough. The net effect isn't pretty: Instead of buying low and selling high, investors end up doing the reverse, and also incur needless charges for entering and exiting funds. The problem may well be exacerbated by the broadly drawn IMA sectors that many investors rely on. They make it easy for investors to confuse luck with skill and push funds favouring the hottest asset classes to the top of the charts. (This may point to the fallacy of relying on an association of businesses, whose primary aim is to market funds, to classify objectively those same funds. On the other hand,, it may just be an indication of the IMA’s extreme inertia).

Why Short-Termism is Bad
We have systematic evidence of the costs of short-termism available for some markets. Most notably, in the US, Morningstar calculates "investor returns" alongside traditional total returns. Investor returns measure what the typical investor in a fund may have earned over a period, given that some investors will have bought into the fund and sold out during that period. For example, take a fund whose price has risen 10 % in a given year. Next, assume that it was up 20% in the first six months of the year in question, but fell 8.33% in the next six months (leaving it with a 10% return overall). Investors who bought in at the beginning and held until the end earned the full 10%, but those who waited until they saw the fund's strong performance may well have bought in close to its up 20% peak, and endured a significant loss over the year's second half without having participated in the fund's big first half gain.

Our studies have shown that investors tend to exhibit this behaviour more as fund volatility increases. This is true across categories and within a given category of funds. The premier example of an entire category that US investors have difficulty using to best advantage is the Specialty Technology group. Over the past 10 years, the average fund in the category returned 3.25% annualised. In stark contrast, the typical investor actually lost 5.04% annualised in the same period. Put differently, the typical investor's poor timing decisions cost him an average of 8.3% per year. Similarly, another high volatility category, Latin America funds, gained 17.35% annualised over the past decade, but the typical investor only earned 11.23% per year, losing out on 6.1% per year in possible gains through poor market timing.

We are working on calculating similar statistics for the UK market, but it's not hard to find examples of a "gold-rush" mentality gone sour. The most recent example is the late, great bull market in property. Asset flooded property funds until 2007; then, as the market started to slow and then turn down, investors began redeeming in droves. Some will have enjoyed large gains, to be sure, but others will have bought in late in the game and will have suffered a loss.

Asset Managers Need to Focus on Stewardship, Not Just Marketing
So the question becomes one of how to modify investor behaviour. Part of the burden rests with the asset management community itself. At the worst end of the spectrum in this regard are those asset managers who tend to launch new funds investing in whatever asset class is hot, regardless of whether or not it's a sound long-term investment, and often regardless of whether or not they have any expertise in the area. The main objective of such organisations is to grab assets in the near term. At the other end are those who offer sound long-term investments and market their funds responsibly--not by playing up enormous short-term returns, but by suggesting how a fund might be used to diversify a portfolio and help smooth results over the long-term. Our work in the States shows that such firms may have slower asset growth over short periods of time, but they win--and win big-- in terms of investor returns and asset flows in the long-term.

Maintain Historical Archive of Fund Disclosure Documents
Another avenue giving scope for improvement lies in disclosure. The principal piece of information for most funds in the UK is the ephemeral monthly fact sheet. It usually contains some asset allocation information, performance tables, a brief commentary on performance or markets, the manager's name, along with some information on charges. This isn’t bad information--indeed, it's often very useful. You can also obtain long-form annual reports with complete holdings, though you may have to write to the fund company to get them. The problem with all of this, however, is that most fund companies only make their latest documents available. If you want to know who ran the fund five years ago, or what its holdings were during a particularly rough period, you're almost always flat out of luck. This creates a situation where investors and advisers focus on the recent past because, in most cases, that's the only information available to them.

In the Internet age, when the storage and delivery of electronic documents is nearly costless, there's simply no excuse for failing to provide such critical historical information. Fund companies could do it themselves quite easily, or the FSA or a trade body could maintain a central archive. In the US, one can go to the SEC's website and pull a copy of any official fund document (prospectuses, annual reports, manager change notices, and the like) going back to 1994--the date the archive started. If you’re an investor and want to figure out who managed your fund or what it owned when it had a particularly good year 12 years ago, it's simple to find out. That we can't manage some semblance of this in the world's financial capital is depressing, and a scenario that can only contribute to investors' relentless, and detrimental, focus on the short-term.

Focus on Fundamentals
Investors and advisers need to remember what really matters--performance, especially short-term performance, can be a lousy predictor of future results. What's important is to get an appropriate asset mix in place to suit your investment goals and risk tolerance, to ensure that your portfolio is reasonably well diversified, and to select funds that have structural factors working in your favour. These include low costs, the ability of a firm to hire and retain top talent through time, incentive structures that align managers' interest with your own rather than tempting them to line their own pockets by taking big near term risks, and the consistency of the process applied to select securities for the portfolio.

Finally, don't chase performance--investing by looking in the rear view mirror puts you one step behind the market at best and often leaves you holding the bag when others sell. Instead, stick to your long-term investment programme and rebalance yearly--taking profits from your successes and redeploying them back into areas that have underperformed. Don't worry to much about a year or two of sluggish results--investing success is not determined over such a short period--the real question is whether or not you can meet your goals for the future, with a level of volatility you can live with.