We Eat Dollar Weighted Returns — VI
One of the constants in investing is that average investors show up late to the party or to the crisis. Unlike many gatherings where it may be cool to be fashionably late, in investing it tends to mean you earn less and lose more, which is definitely not cool.
One reason why this happens is that information gets distributed in lumps. We don't notice things in real time, partly because we're not paying attention to the small changes that are happening. But after enough time passes, a few people notice a trend. After a while longer, still more people notice the trend, and it might get mentioned in some special purpose publications, blogs, etc. More time elapses and it becomes a topic of conversation, and articles make it into the broad financial press. The final phase is when general interest magazines put it onto the cover, and get rich quick articles and books point at how great fortunes have been made, and you can do it too!
That slow dissemination and gathering of information is paralleled by a similar flow of money, and just as the audience gets wider, the flow of money gets bigger. As the flow of money in or out gets bigger, prices tend to overshoot fair value, leaving those who arrived last with subpar returns.
There is another aspect to this, and that stems from the way that people commonly evaluate managers. We use past returns as a prologue to what is assumed to be still greater returns in the future. This not only applies to retail investors but also many institutional investors. Somme institutional investors will balk at this conclusion, but my experience in talking with institutional investors has been that though they look at many of the right forward looking indicators of manager quality, almost none of them will hire a manager that has the right people, process, etc., and has below average returns relative to peers or indexes. (This also happens with hedge funds… there is nothing special in fund analysis there.)
For the retail crowd it is worse, because most investors look at past returns when evaluating managers. Much as Morningstar is trying to do the right thing, and have forward looking analyst ratings (gold, silver, bronze, neutral and negative), yet much of the investing public will not touch a fund unless it has four or five stars from Morningstar, which is a backward looking rating. This not only applies to individuals, but also committees that choose funds for defined contribution plans. If they don't choose the funds with four or five stars, they get complaints, or participants don't use the funds.
Another Exercise in Dollar Weighted Returns
One of the ways this investing shortfall gets expressed is looking at the difference between time-weighted (buy-and-hold) and dollar returns weighted (weighted geometric average/IRR). The first reveals what an investor who bought and held from the beginning earned, versus what the average dollar invested earned. Since money tends to come after good returns have been achieved, and money tends to leave after bad returns have been realized, the time-weighted returns are typically higher then the dollar weighted returns. Generally, the more volatile the performance of the investment vehicle the larger the difference between time- and dollar weighted returns gets. The greed and fear cycle is bigger when there is more volatility, and people buy and sell at the wrong times to a greater degree.
(An aside: much as some pooh-pooh buy-and-hold investing, it generally beats those who trade. There may be intelligent ways to trade, but they are always a minority among market actors.)
HSGFX Time and Dollar Weighted Returns
That brings me to tonight's fund for analysis: Hussman Strategic Growth [HSGFX]. John Hussman, a very bright guy, has been trying to do something very difficult — time the markets. The results started out promising, attracting assets in the process, and then didn't do so well, and assets have slowly left. For my calculation this evening, I run the calculation on his fund with the longest track record from inception to 30 June 2014. The fund's fiscal years end on June 30th, and so I assume cash flows occur at mid-year as a simplifying assumption. At the end of the scenario, 30 June 2014, I assume that all of the funds remaining get paid out.
To run this calculation, I do what I have always done, gone to the SEC EDGAR website and look at the annual reports, particularly the section called “Statements of Changes in Net Assets.” The cash flow for each fiscal year is equal to the net increase in net assets from capital share transactions plus the net decrease in net assets from distributions to shareholders. Once I have the amount of money moving in or out of the fund in each fiscal year, I can then run an internal rate of return calculation to get the dollar weighted rate of return.
In my table, the cash flows into/(out of) the fund are in millions of dollars, and the column titled Accumulated PV is the accumulated present value calculated at an annualized rate of -2.56% per year, which is the dollar weighted rate of return. The zero figure at the top shows that a discount rate -2.56% makes the cash inflows and outflows net to zero.
From the beginning of the Annual Report for the fiscal year ended in June 2014, they helpfully provide the buy-and-hold return since inception, which was +3.68%. That gives a difference of 6.24% of how much average investors earned less than the buy-and-hold investors. This is not meant to be a criticism of Hussman's performance or methods, but simply a demonstration that a lot of people invested money after the fund's good years, and then removed money after years of underperformance. They timed their investment in a market-timing fund poorly.
Now, Hussman's fund may do better when the boom/bust cycle turns if his system makes the right move somewhere near the bottom of the cycle. That didn't happen in 2009, and thus the present state of affairs. I am reluctant to criticize, though, because I tried running a strategy like this for some of my own clients and did not do well at it. But when I realized that I did not have the personal ability/willingness to buy when valuations were high even though the model said to do so because of momentum, rather than compound an error, I shut down the product, and refunded some fees.
One thing I can say with reasonable confidence, though: the low returns of the past by themselves are not a reason to not investment in Mr. Hussman's funds. Past returns by themselves tell you almost nothing about future returns. The hard questions with a fund like this are: when will the cycle turn from bullish to bearish? (So that you can decide how long you are willing to sit on the sidelines), and when the cycle turns from bearish to bullish, will Mr. Hussman make the right decision then?
Those questions are impossible to answer with any precision,