Wednesday, September 28, 2011

Investor Dollars Keep Chasing Poor Performance

By Larry Swedroe

Several studies have shown investing anomalies that can’t be rationally explained by the efficient market hypothesis. Behavioral finance attempts to fill the void by explaining behaviors that shouldn’t exist. I propose a new area for research for behavioralists.

There have been many studies demonstrating that money flows follow performance, meaning that investors put their money into funds and sectors that have performed well recently. It also means investors pull their money from poor performers. This unfortunate behavior has been one of the causes of the well-documented phenomenon of investor returns being well below their very own funds. There appears to be a major exception to this rule: Despite the poor and inconsistent performance of alternative investments, investors continue to pour cash into them.

According to Morningstar, investor flows into alternative investments reached $14.7 billion in 2010, up from $10.8 billion in 2009 and just $3.4 billion in 2008. And the flows as of mid-year show that they’re on pace to match 2010’s total this year. Clearly this is a big trend.

Given the flows, you would think that the returns have been spectacular, and you would be dead wrong. As you consider the data, keep in mind that this three-year period 2008 through 2010 includes the period from July 2008 through February 2009 when the S&P 500 Index lost 41.5 percent, the very period when “alternatives” are supposed to provide risk protection. The figures represent the total return for the three-year period.

* Represented by MSCI indexes

The following represents the total return for international indices for the same period:

  • MSCI EAFE Index — -3.8%
  • MSCI EAFE Value Index — -3.4%
  • MSCI EAFE Small Cap Index — 11.2%
  • MSCI Emerging Markets Index — 14.2%

Clearly, any well-diversified portfolio would have outperformed all of the alternative strategies.

As I discuss in The Quest for Alpha, the long-term evidence on alternatives such as hedge funds is no better. Thus, the only explanations I can think of for the continued rush by investors to pour money into alternatives are:

  • Investors are unaware of the evidence.
  • While their performance is awful, the marketing machines of Wall Street are so good that they can overcome even this powerful evidence.

But perhaps the behavioralists will provide us with some alternative explanations for this bizarre and self-destructive behavior. Before you consider becoming a member of the “alternative investments club,” remember Groucho Marx’s famous line: “I don’t want to belong to any club that would have me as a member.”

Friday, September 16, 2011

Reality Show for Investors "Survivor"

By Weston Wellington

Anyone studying the long-run history of American business cannot help but observe how many of the prominent firms of one era fail to make it to the next. Free-market economies are characterized not only by intense competition but also by disruptive change. Sometimes a company’s toughest competitor turns out to be a firm it has never heard of selling a product or service that didn’t exist until recently. The list of companies that once dominated their industry but have fallen on hard times is lengthy enough to give every thoughtful investor reason for sober reflection.

Among many possible examples, a number of firms come to mind that were once highly regarded but later encountered serious or even fatal problems.

  • Bethlehem Steel pioneered the steel I-beam, which launched a skyscraper boom in cities across the country. Its engineering expertise supplied the steel sections for the Golden Gate Bridge. But growing competition and a changing marketplace eventually took their toll, and the firm filed for bankruptcy in 2001.

  • In 1973, Eastman Kodak held a seemingly impregnable position in the lucrative market for photo film and chemicals, enjoyed a reputation for innovation and astute marketing, and boasted a market value even greater than oil giant Exxon. Kodak shareholders had been favored with an uninterrupted stream of dividends dating back to 1902. Today the company is struggling to reinvent itself as the film business shrivels, the dividend has been suspended, and the share price is limping along under $3.

  • A Fortune article profiling Pfizer in mid-1998 praised it for having “one of the richest product pipelines in the Fortune 500.” A Wall Street analyst enthused that “some of my clients refer to Pfizer as the best company in the S&P 500.” In early 1999, a Forbes cover story sounded a similar note, crowning Pfizer “Company of the Year” and observing that “the people who brought us Viagra have more blockbusters on the way.” Thirteen years later, the Viagra boom has subsided, patents are expiring on highly profitable products, and the gusher investors expected from the research pipeline has slowed to a trickle. The share price has slumped over 50% since year-end 1998 compared to a 3% loss for the S&P 500 Index.

Some companies almost single-handedly create new industries but still find it difficult to turn innovation into a permanent advantage. Pan Am (air travel), Kmart (discount retailing), Polaroid (instant photography), and Wang Laboratories (word processing) all had impressive initial success and provided handsome rewards for their investors. Alas, neither Pan Am nor Polaroid survives today, and Kmart shareholders were wiped out when the firm emerged from bankruptcy in 2003. (Kmart, Polaroid, and Wang Laboratories were all cited as examples of “excellent” companies in the 1982 bestseller In Search of Excellence.)

Evidence of this “creative destruction” appears all around us. For example, the Wall Street Journal reported that shares of Minnesota-based Best Buy Co. slumped Wednesday to their lowest level since 2008 after reporting a 30% drop in quarterly profits. For most of its life, Best Buy has been the toughest kid on the block, vanquishing rivals such as Highland Superstores and Circuit City on its way to becoming the nation's leading electronics retailer.

Will Best Buy fall victim to even tougher competitors such as or Walmart? Or is this current downturn just a speed bump on the road to even greater success? No one can say. For every riches-to-rags story, we can find another tale of decline followed by dramatic recovery. According to some accounts, for example, Apple was only a few months from bankruptcy when Steve Jobs returned to the company in 1997. Now it vies with ExxonMobil for the number one spot in a ranking by market cap. And who would have imagined that a floundering New England textile firm with a low-margin business that sells suit-lining fabric would one day become a financial colossus known as Berkshire Hathaway?

The thrill of owning a great growth company during its most lucrative phase is a powerful incentive to search for the Next Big Thing. But almost every company with a highly profitable position is under constant attack from competitors seeking to garner a portion of those hefty profits for themselves.

As a result, the search for firms destined to generate greater-than-expected profits for many years into the future is fraught with peril and likely to end in frustration. Most investors will be far better off harnessing the forces of competitive markets and putting them to work on their behalf by holding a diversified portfolio. As Nobel laureate Merton Miller once observed, “Above-normal profits always carry with them the seeds of their own decay.”

Miguel Bustillo and Matt Jarzemsky, “Best Buy Gets Squeezed” Wall Street Journal, September 14, 2011.

David Stipp, “Why Pfizer Is So Hot,” Fortune, May 11, 1998.

“Pfizer: Company of the Year,” Forbes, January 11, 1999.

Standard & Poor’s Stock Guide, 1974.

Thomas Peters and Robert Waterman, In Search of Excellence (HarperCollins, 1982).

Merton Miller, “Is American Corporate Governance Fatally Flawed?” Journal of Applied Corporate Finance, Vol. 6, No. 4, Winter 1994.