For all the talk about “smart” money and “dumb” money in investing, you would think that money had a mind of its own. A curious twist in the year-end results of some hedge fund tracking ETFs, however, shows just how strikingly random a year’s returns can be.
As Burton Malkiel points out, the relevance of a given year’s performance vs. the market is whether the return is statistically different from chance. As he illustrated so brilliantly in A Random Walk Down Wall Street, throwing darts at the financial pages is as effective a way as any to pick stocks.
A member of the Investment Committee of my own firm, Malkiel warns that the chance factor means market timing is a wildly risky way to invest for anyone, including the pros.
“When people try to do it, we have abundant evidence that it’s not simply that they get it wrong randomly,” Malkiel explains. “They do exactly the wrong thing. Don’t try to time the market. Nothing could be more dangerous.”
It also can be serendipitous, as Barron’s found. The investment weekly noted an echo of the dartboard effect in a recent review of exchange-traded funds that follow famous hedge fund managers.
The idea of such funds is attractive. By perusing the public filings of big-name traders, a cheaply run fund could replicate those portfolios while avoiding their crazy “2 and 20” fees — hedge funds charge their clients 2% of assets and 20% of profits to participate.
Hedge funds, on average, turned in an awful 2014. Barron’s reports average gains ranging from 2.9% to 4.6% for the first 11 months of the year, citing estimates from eVestment. The Standard & Poor’s 500 Index returned nearly 12% over the same period.
Yet one hedge tracking fund, AlphaClone Alternative Alpha actually beat the S&P 500 by nearly 1%. There were more such funds, with less dramatic results, but they still outpaced hedge funds as a whole, Barron’s reported.
How? By being late and making “mistakes,” it appears. The tracking funds don’t get to see what the gurus are doing until weeks and perhaps months down the road. The hedge funds took on tricky, questionable trades and lost money, then the tracking funds bought the same positions after they had fallen, Barron’s surmises, or vice versa in the case of short trades.
Darts at a dartboard. The tracking funds profited by chance. By failing to track their models accurately they came out ahead, but it was not a matter of timing or skill. Just luck.
Recognizing the difference between luck and ability is the mark of a mature investor, but there’s more to it than that. Increasingly, there’s no wiggle room in the market for investors of even extreme ability.
Market timing darts
That becomes clear when you consider that the Dow just notched its sixth consecutive year of gains, an outcome few professional managers predicted early in the year. Mostly, they worried about the end of Fed intervention and called a bond market top — over and over.
Stocks finished higher, bonds finished higher, and now index-fund providers such as Vanguard are seeing record inflows. December was a big month, as you might have guessed. As of Dec. 29, an amazing 74% of active managers were chasing their own benchmarks, Morningstar reports.
Yes, the indexes are starting to give back a bit now, but these kinds of retrenchments are incredibly normal in any given year. We saw several during 2014 and still closed the year higher. I have no predictions to make for 2015, of course, except that perhaps even more retirement investors will tire of tossing expensive darts.