Should you Follow Fund Managers Chasing Returns?

by ETFguide | September 13, 2012 10:00 am

Should you Follow Fund Managers Chasing Returns?

When you were a kid, do you remember wanting to do something and being questioned by your parent, “Why do you want to do that”?  A child would almost always reply, “Because everyone else is”.

Those familiar with this life lesson also know the next part of the story where the parent replies, “if everyone was jumping off a bridge, would you want to also?”

Recently mutual and hedge funds are “chasing returns” in order to catch up to their benchmarks.  This means funds are buying stocks for the sole purpose of being more fully invested in order to keep up with their benchmark returns.

Since benchmarks are the primary measuring stick used by investors to see how their managers and investments are doing, funds must unfortunately play this game.  They must buy stocks, “because everyone else is”.

Alas!  Fundamental Analysts can Explain

Fundamental analysts scour through earnings, revenues, financial statements and other company-specific data points to reach a conclusion as to what a stock’s price is worth.  This all comes down to a company’s earnings and cash flows.  But they also must come up with a company’s “multiple”.  Applying the multiple to earnings is a popular way to come up with a “fair” price for a stock.

For the die-hard academic, the multiple is supposed to be some derivative of a company’s discount rate and weighted average cost of capital (NYSE:JNK[1]) by means of un-levering the Beta and/or use of other sophisticated financial models.  What a mouth full!

This is rarely the case in the real world, though, as the sole use of cost of capital more often than not gives a much lower valuation for public companies (NYSE:IVV[2]) than is the reality in today’s markets.

Analysts get around this issue by increasing the multiples applied or lowering the discount rates used to more closely back into more familiar prices.  They justify it by comparing the backed into multiple with a stock’s historical multiple and/or its competitors’ multiples.  It’s kind of like defining a word by its definition.

Companies such as Amazon (NASDAQ:AMZN[3]) have a trailing earnings multiple of over 300x (this essentially equates to a discount rate/cost of capital/expected annual return below 1%, but the popular response to such accusations is that earnings will “grow” into that multiple bringing it down to 20x by the year 2030 or so).

Contrast this to Apple (NASDAQ:APPL[4]) that has a trailing P/E multiple of only 16x.  It is easy to get confused about “multiples”.

No doubt there is great disparity between P/E multiples, but what does this have to do with funds chasing returns?

Returns Chasing and Multiples

Research data validates that many fund managers are “closet indexers.”

A study in 2009 by Antti Petajisto, a former New York University economist, discovered almost a third of all the money invested in actively managed U.S. mutual funds was supervised by “closet indexers,” whose investments closely follow the behavior and performance of a benchmark index.

When funds buy stocks to keep up with benchmarks, there is zero fundamental explanation that can support such investment strategy beyond self-interest.  They don’t buy because of company financials or improving economic backdrop or better earnings.  They buy simply because they have to in order to keep up with a completely unrelated return figure.  They buy because “everyone else is doing it”.

This cannot be justified fundamentally by the analysts, but instead is captured by the “all inclusive of things not exactly explainable” multiple, which of course is based upon historical data.

Keeping up with the Joneses

It’s a known fact that over time most active mutual funds underperform their benchmarks, and investors are often warned not to chase hot fund returns, but they usually do it anyways, to their own detriment.

This is exactly the same as those same funds chasing stock returns in the above example.

Investors chase mutual fund returns to keep up with the Joneses and mutual fund managers chase stocks in order to keep up with their benchmark Joneses as well.

Buying a stock (or mutual fund) simply to meet return objectives is not justified fundamentally or as a rational investment strategy.  Doing so can result in buying an overvalued company and or fund and more often than not will lead to underperformance and/or losses.

Investors would be much better off listening to their parent’s life lesson:  Don’t jump off a bridge just because everyone else is doing it.

The Road Less Traveled

“Common sense and careful logic show that it is impossible to produce superior investment performance if you buy the same assets at the same time as others are buying,” said Sir John Templeton.

As such, we are not willing to buy this market (NYSE:SPY[5]) right now and I advised our subscribers in the Sunday night, 9/9, ETF Profit Strategy Technical Forecast[6], “I will not be chasing this rally, given most of the underlying issues we have called out the last month are still in place.”

The following chart published earlier in the week, on 9/5, pointed out two high probability long trade setups with a move beyond the trendlines at 1406 and 1410.  Prices closed on 9/6 at 1432.

 Should you Follow Fund Managers Chasing Returns?

 

Endnotes:
  1. JNK: http://studio-5.financialcontent.com/investplace/quote?Symbol=JNK
  2. IVV: http://studio-5.financialcontent.com/investplace/quote?Symbol=IVV
  3. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  4. APPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=APPL
  5. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  6. ETF Profit Strategy Technical Forecast: http://etfguide.com/nl_options.php

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