More Evidence of How Hard It Is to Beat the Market

by: Lawrence Weinman

The WSJ's monthly review of investing in funds has a few interesting articles on just how difficult it is to beat the market:

A review of the record on quantitative funds (much the rage over the last decade or more) finds that quantitative managers have discovered that they need to supplement their computer models with the "human touch":

Quant managers need to understand "that financial markets are better understood through the lenses of a biologist rather than a physicist," says Andrew Lo, a finance professor at the Massachusetts Institute of Technology who also manages quant funds. That is, they need to focus on the adaptation to changing environments that characterizes the biological realm, rather than the sort of immutable laws that form the foundation of physics. While quant managers might like to think that three laws govern 99% of investor behavior and thereby drive securities prices, he says, "we're lucky" if 99 laws explain even 3% of investor behavior.

A second article in the section reviews the dismal performance of 130/30 funds, a hot product which was to combine long and short positions leverage purportedly to provide higher return without increased risk. Ironically, the above cited Professor Lo is involved with the management of an etf employing this strategy. I have written in the past questioning this claim and calling these funds a "product not a strategy", The article begins:

A Hot Fund Design Turns Cold

So-called 130/30 funds aim to boost performance with borrowed money and bets against overpriced securities

There are good ideas that are badly implemented, and there are bad ideas that are, well, bad ideas.
It's a matter of debate which construct—if either—best describes 130/30 mutual funds, a leveraging strategy that seemed to be the next hot thing just a few years ago.

I am firmly in the camp of this harsh critic of the funds quoted in the article:

Investors "are fooling themselves if they really think they're getting anything but a jacked-up, more volatile S&P 500 proxy that's expensive and doesn't work and can hurt you in the long run," says Lee Munson, chief investment officer for Portfolio Asset Management, Albuquerque, N.M.

In a familiar story in the money management industry the fad gathered momentum under a barrage of marketing as the new new thing and money flowed into these funds. Following a relatively short period of poor performance (which in fairness was probably too short to make any conclusive judgements) the money flowed out.

What is particularly disconcerting is that the money that flowed in came from institutional investors --in other words supposedly sophisticated investors often with fiduciary responsibility in managing investments for others. Since the funds were new, the money went in based on hypothetical "backtested results" and then went out based on a short period of actual performance. Not exactly the sort of actions one would expect of a fiduciary responsible for $100s of millions in investment dollars. The article reports:

Interest in 130/30 funds and portfolios that employ a similar leveraging strategy but in different ratios (such as 110/10, 120/20 and so forth) boomed around 2006 and 2007, particularly in non-fund vehicles for institutional investors. In 2007, the number of U.S. mutual funds with "130/30" or "120/20" in the name surged to 21 from four, according to Morningstar Inc., and their assets more than doubled to $373 million. In the following years, launches dried up and several funds closed, leaving only 12 with some variation of 130/30 or 120/20 in their name. Combined assets are a little over $1 billion.
Morningstar says a broader universe of 130/30-like institutional accounts and mutual funds has grown to about $30 billion in total assets—a far cry from the $1 trillion that some market watchers predicted a few years ago.

A third article in the section outlined the virtues of a super simple index investing strategy of 50/50 stock /bonds making use of only 3 ETFs or mutual funds: one for bonds, one for US stocks and one for international stocks. While I would favor a more sophisticated approach particularly one that had a higher weighting towards emerging makets in the international allocation and small caps in the domestic allocation, the virtues of the strategy are undeniable. Such a strategy with annual rebalancing is low cost, tax efficient, keeps the investor disciplined away from market timing and chasing hot (and expensive ) actively managed funds. I have little doubt that investors pursuing a variant of this strategy would do far better over the long term than most individual investors. Simply sticking to the discipline of the strategy will account for much of the relative success.