The recent departure of Bill Gross from PIMCO had us thinking about the strengths and weaknesses of a portfolio manager who takes highly publicized positions and is perceived as a thought leader. How do investors react to funds and managers who outperform the markets with bold and sweeping investment styles? The answer in general is quite badly.
Nothing gets the investors' juices flowing like a massive outperformance versus the general markets. Like an elk in late autumn, both individual and institutional investors charge through the proverbial forest brush to lay their hands (or other members as the case may be) on this shiny new object of their affection/need.
Generally – like the elk in hot pursuit – things don't turn out the way investors think or want. The first pin to pop the bubble is that almost immutable law of “return to the mean.” For nearly every fund with that 90% return is the following five years of underperformance. Second, investors seem to inevitably buy at exactly the wrong time when their own bovine needs come to the fore. Turning the investing world upside down they buy high and all too often sell low. Last, the markets have no respect for sentimentality. Either you buy the right stocks or you don’t. Purchase the ticket and take the ride. The important decision isn’t simply where you get on and get off – it’s whether you take the bus at all. It's really that simple.
Fund returns versus investor returns: A definition
Which leads us to investor returns versus fund returns. Several years ago Morningstar began providing information on both total fund returns and investor returns. Morningstar Investor Return™ (also known as dollar-weighted return) measures how the average investor fared in a fund over a period of time. Investor return incorporates the impact of cash inflows and outflows from purchases and sales and the growth in fund assets.
A fund’s published total return reflects a buy and hold strategy. This information is widely available on fund family websites, in marketing material and from independent sources such as Morningstar. Not all investors buy and hold though. Investors move their money in and out of funds as they search for the best return.
In contrast to total returns, investor returns account for all cash flows into and out of the fund to measure how the average investor performed over time. Investor return is calculated in a similar manner as internal rate of return. Investor return measures the compound growth rate in the value of all dollars invested in the fund over the evaluation period. Investor return is the growth rate that will link the beginning total net assets plus all intermediate cash flows to the ending total net assets.
Since this concept is critical, let me summarize these definitions. Fund return represents how an investor would have fared if he bought and held the fund for a set period of time. For instance, John buys CGM Focus fund on January 1, 2007 and holds it until December 31, 2013. In this case, John’s investment return would be the same as the fund return.
Now let’s look at investor return. We have CGM Focus’ fund return for the five (5) years of 2007-2013. But let’s assume Bob bought shares of CGM Focus on July 1, 2007, sold them all in November 2008, repurchased them in March 2009 and sold them again in November 2013. Bob’s investor return will be vastly different than the fund return – simply because Bob attempted to time his buying and selling of his shares.
What we have now are two sets of returns – those who bought and held the shares for the duration of the time period (the FUND return) and returns generated by the average investor in light of his/hers buying and selling patterns (the INVESTOR return).
Fund return versus investor return: CGM Focus
Let’s use an actual case and analyze fund returns versus investor returns. CGM Focus (CGMFX) is a fund managed by Ken Heebner (Trades, Portfolio) (and a listed Guru on this website). He has been managing the CGM portfolio since its inception in 1997. Heebner came to the attention of many investors when the fund returned an eye popping 80% in 2007. Heebner’s investing methodology is based on remarkably short holding periods – the fund has 464%, 363%, 496%, 360%, 291% turnover for the years 2009-2013.
Let’s use 2007 as the date where we begin evaluating CGM’s fund return versus investor returns. After the remarkable returns in 2007, the funds assets swelled from $1.3B to $10.3B in 2008 as investors flocked into the fund to catch some of Heebner’s magic.
Nearly all of the $8B in cash inflows to the fund occurred between July 2007 to July 2008. The next year can only be described as an investment tsunami. Heebner’s picks produced a stunning -48% return in 2008. In addition, there was nearly $2B in redemptions over the same period.
Before we analyze the next several years I want to pause and highlight some of the decisions made by investors. First was the decision to chase past performance and roughly quadruple the size of the fund after a stellar 2007. Investors assured themselves they were purchasing at the height of the CGM craze and locked in the highest purchase price. Next, they redeemed roughly $2B in assets at exactly the wrong time – thereby locking in a shocking -64% return in 2008. In this case, investors’ buy and sell decisions assured they would underperform the fund in general. These returns are reflected in the 2008 returns seen below.
The next (6) six years were no better for investors. In each year, the investor return was significantly worse than the fund return. Again, individuals were attempting to time their purchases and in doing so continued a process whereby they would have been better served with buying and holding the fund.
CGM Focus: Fund versus Investor Returns 2009 - 2013
| 2008 | 2009 | 2010 | 2011 | 2012 | 2013 | |
| Fund Return | -48.2% | 10.4% | 16.9% | -24.5% | 14.2% | 37.6% |
| Investor Return | -63.8% | 7.9% | 13.2% | -26.8% | 11.7% | 32.8% |
During the five (5) calendar years of January 2007-December 2013, an initial investment of $100,000 in the fund with no additional deposits or withdrawals decreased to $76,200. During this same period, the average investor’s $100,000 shrunk to $48,000 – a difference of roughly $28,000. Looking at it from another angle, investors’ decisions as to when to buy and when to sell allowed them to underperform the fund by 42%.
I want to make clear this isn’t an attack on Ken Heebner (Trades, Portfolio)’s approach to investing. We could have used many other funds to illustrate our point. The point of this exercise was to highlight the inability of investors to time the market as well being blinded (like our eponymous elk) by extraordinary investment returns.
So why does this matter?
Many of you are probably saying by now “but I don't invest in funds. That’s why I’m a user of Gurufocus.” We believe there are valuable lessons to be learned from the CGM example. These include:
1. It’s not about timing, it’s about valuation
An underlying lesson in the CGM example is less about the timing of individual investors’ purchase of CGM funds, but more about the underlying value of its holdings. We are comfortable in predicting most of CGM’s investors had little to no idea about the quality or valuation of the underlying holdings in their purchase. If you can’t value the business behind the stock then you have little to no probability of achieving adequate returns on your stock (or in this case fund) purchase.
2. Regression to the mean
Much like anything else based on the four fundamentals of nature – in this case, gravity – many funds that excel regress back to the mean over time. To achieve this regression, many funds that out perform at one point in time must under perform at a later date. While not guaranteed (what is in the investment world?) CGM was a classic case seen all too often on Wall Street.
3. Where fools rush in … even greater fools follow
As with a Black Friday 2 a.m. mob, with the sight of outperformance or a fund focused on the latest must-have fad (the “Nano Green Coffee Bean Cloud Based Triple Leveraged” ETF or “Chinese Network Green Technology Based Driver Service” stock) we can expect Wall Street to hype – and investors to rush into – such opportunities at exactly the wrong time. When you see such a crowd, put your headphones back on and walk slowly away.
Conclusions
In this time of nearly daily new highs, it is sometimes unbearable to sit on the sidelines and watch other funds/investors generate enormous returns. We believe our investment thesis – great companies led by wise management with wide competitive advantages, low leverage, high returns on invested capital and purchased at significant discount to fair value – promises our investment partners better than average returns over the long term. By rushing into stocks – or funds – to chase performance, we would be doing our investors a grave disservice. If we can ignore the elk in all of us, the patient and disciplined investor will be the winner in the long term.
