Style Drifting and Portfolio Chasing Are Killing Investor Returns

Paul Winkler: And welcome. This is “The Investor Coaching Show,” Paul Winkler, talking about the world of money and investing.

The DALBAR research came back out again. Investors are still messing up. They’re still getting really bad returns, and investment advisors are still messing up. I mean, what’s new there?

Really, you get down to it, the average investor … what I’ve been looking at more and more these days is not necessarily equity fund investors, stock market fund investors. Those numbers came up a little bit; actually, investor returns in stock funds versus the market came up some.

And part of the reason for that really is the period of time that was shown in the study. Actually it’s a 20-year period.

And 20-year period is, really, you think, Wow, it’s a long period of time. No, it’s nothing, really.

Is 20 Years in the Stock Market a Long Time?

If you look at 20 years, you could have entire 20-year periods where there’s zero return in stocks, zero return in the S&P 500 after inflation, as you may have heard me say before. You have a couple of them in the last century alone, and then you have about 12–13 years, where there’s a negative return even before you account for inflation, just this century alone.

And one of the studies that … and I don’t know why they’re doing this, but they’re comparing the return of the S&P 500, just the 500 biggest companies, to what the average investor has gotten investing in stock mutual funds.

Well, if you had an inkling, an ounce of diversification the past 20 years, you did better than the S&P 500.

Why?

Because you had a dead decade, you had a dead 12-year period where nothing happened.

So I think it’s almost making it look like that the average investor has done better than they actually have done over the past 20 years. 

And it was funny because I was talking to a friend of mine, and we were talking about the S&P 500 in general. If you look at from when the vaccine was announced, November 9 until at the end of June.

Anyway, I know these numbers off the top of my head. He had like a 60% return in small value stocks, 20% return in the S&P 500. So it wasn’t that the S&P lost money or anything like that. It just didn’t do nearly as well.

And even up till today’s date, forget the end of June until right now in mid-August, you’re still seeing a significant higher return in small value, micro-cap stocks, small, large value stocks are just right behind as I recall.

And then if you look at international, international small, small value, and kind of heading up the rear is large international, which has been for a while. One these days, large international companies, they’re going to get their act in gear and actually do.

And I tend to under-invest in large international, I mean, I guess I’m lucky, because I kind of missed a lot of this junk. But the reason is because those big international companies—like the Nestlés, the Toyotas, and Nissans, and all those companies—they tend to be after the same customers that the big U.S. companies are after.

So there’s not a lot of correlation difference between them. You don’t have a lot of dissimilar price movement, and that’s really what we’re looking for when we invest.

We want things moving in dissimilar fashion to reduce the volatility. It gives us a lot more predictability too. 

Think about it. If I have an entire 20-year period where one area of the market could have no return whatsoever, and I’ve invested in that area, hoping that 20 years later I’m going to have a lot more money, and it doesn’t do what I thought it was going to do?

I’m sitting there going, “Oh, great, where do I work now? I’m 70 years old and I’d better just go find a job someplace because I put all my eggs in this one basket and the basket didn’t quite do what I expected it to do.”

So that’s why we diversify in other areas because, for example, you take the mid-’60s to the early ’80s and large U.S. stocks had no return after inflation.

Whereas British stocks, small companies were up 21% per year. It’s huge, huge returns. And you had other areas of the market that did quite well as well.

But the idea being that if I didn’t own any of those, and a lot of times that’s not what you think of as an American, is it? You don’t sit around and go, Oh, I think I’m going to go invest in a bunch of British companies.

It’s really not what crosses your mind until—when does it cross your mind? It crosses your mind when the media comes out 20 years later and says, “Hey, look at what has done the best over the past 10 to 15 years, 20 years.”

And then you go, Oh man, I need to get on this bandwagon.

Then all of a sudden it’s over. So it doesn’t cross your mind.

So diversification isn’t necessarily a natural thing that we have a tendency to do.

Well, if you look at the past 20 years, like I said, you’ve got this big, long period of time where large companies did nothing and small, international companies, those small values U.S. companies really, really did well. And that’s when people tend to jump on it.

Well, if you look at the data, you go, “So what’s happening?” Now, if you look at longer-term data, it’s a little bit less enticing when you look at the rate of return that investors have gotten versus the stock market.

Asset Allocation

But one of the things I like to look at is this: More and more, I look at how asset allocation investors have done. Now, asset allocation is the division of your portfolio between various areas because you know what I just said, that diversification is a good idea.

So if you look at asset allocation funds, there are funds that do exactly that. They mix between large companies and small companies and value companies and international and U.S., and those asset categories and bonds and short-term bonds and intermediate bonds and whatever. And they allocate it.

And what happens is now you’re choosing an asset manager. They are supposed to be used in this manner, that you just buy that one fund and you are done.

But I see people buy asset allocation funds and they’ll have four different ones. And no, that wasn’t the idea because they own the same stocks, and you’re just duplicating efforts.

And why do they do it? Because they perceive that they’re diversified. They perceive I’m diversifying more because I own eight different asset allocation funds.

So if you look at asset allocation investors, and think about how when you hire an investment manager, what do you typically think about when you’re hiring somebody?

You may go talk to your friends, right? You may go talk to maybe your uncle who was a CPA, or you talk to somebody you think knows something about investing.

And the reality of it is, a lot of times the people we talk to don’t know a whole lot about investing because that’s not their business. And even if it is their business, sometimes they don’t know. 

But that’s a story for another time. I can’t help myself. So I’ll stop now.

So if we look at asset allocation, we will look at funds and we’ll go through and we will try to find some funds that have done well in recent history. And we will find the ones that seem to have the most skill.

Well, that’s exactly what they did in one of the magazines I was looking at this morning.

They have ThinkAdvisor. And what they do is they have the best robo-advisors in seven categories. And they went through, and they said, “Who are the best robo-advisors robots?”

So, robotic portfolios. The idea is that the management fees are fairly low. And they said, “Best overall robo-advisor.”

I’m not going to tell you who it is because it doesn’t really matter. It’s a crapshoot because the best one today will not necessarily be the best one next year, or year from now or two years from now.

How do we know that? Because of mutual funds. I’ve been managing in an asset-allocation style and using asset allocation.

We got 30 years of data from DALBAR. And what do we find out from the DALBAR data?

We found out that the average investor in asset allocation funds … now mind you over this 33-, 34-year period, the market, large U.S. stocks, S&P 500 averaged about 10–11% per year. Money doubled about every seven years, right?

Guess what the asset allocation investors did? Less than inflation. Less than inflation.

That’s investors in asset allocation funds. Why? Because they watch stuff like this.

Which is put out by who? None other than the financial planning community.

Beware of Style Drifting

And you go to these conferences all over the place. This is what we used to do.

I would go to the conferences, and, man, you’d walk up and down the aisles.

And all these people would be pulling at me and going, “Hey, you need to sell our stuff.” “Oh, you need to do ours.” “Hey, here’s what we’re doing.”

The funniest one I ever saw was this one.

So I’m walking through, it’s like going to this huge conference, you know how they set up booths in these places.

And this guy comes up to me and he says, “You need to take a look at what we’re doing over here.”

I say, “Oh, okay.”

And I had been doing some research in academics and investing and knew that asset allocation, what areas of the market you are exposed to. How much do I have in large growth companies? How much do I have in small growth and in international large?

I knew that was responsible for anywhere from 91–94% of your performance, right? So 91–94% of your performance. That’s pretty much it.

When they actually looked at stock picking and market timing, tactical asset allocation, and tactical asset allocation market timing, it was 2%. Two percent of differences in returns were claimed by that. Not much.

Four percent with stock selection. You’d think that would be the thing, right?

Because, wow, what people do is look at which companies they want to invest in—which companies they think are better than others—and that’s how they invest. 

And they think that’s what investment advice is.

I mean, watch the commercials on TV. Watch the things where they have charts and things like that and things that you need to be looking at.

Well, what they did is they studied pension plans and they said, “Why did their returns differ?” And that was it.

They found that the allocation was the big deal. Now, stock selection, market timing, not a big deal.

So I’m walking up through this aisle and this guy goes, “Hey, you’ve probably heard of the Brinson, Hood, and Beebower study.”

“Oh yes, absolutely have.”

And he says, “Well, here’s what we’re basically doing because we know that research is really, really robust and great. We have set up an investment management firm. What we do is we have a bunch of mutual funds in our portfolios, right? And then what we do is we watch them like a hawk on your behalf. You, the advisor, we watched them like a hawk.”

And I go, “What do you guys watch for?”

And he says, “Well, we look for style drift.”

So, in English you got a mutual fund that’s investing in large growth stocks, for example. So large growth companies, historically, the rate of return, would be the lowest returning area of all markets.

Why? Because large growth companies are companies that have grown. They’re really solid. They’re stable. They’re strong. They don’t have to pay much to use your money, historically, comparatively.

If you look at large growth companies versus the S&P 500, you might be losing about a 1–2% return per year, just to give you an idea. It would be even lower than the S&P 500.

And that’s the lowest of all the asset categories that I would hold in a portfolio, just to give you some kind of an inkling. 

So we look at them, and then let’s say if the fund drifts and they drift into medium-sized companies. And why would they drift into medium-sized companies?

Well, because they think medium-sized companies are going to do better than large companies. So they drift into it. Now, they don’t go all the way into it. They drift into it.

So that tells you they’re not terribly confident in what they’re doing because if they really knew it was going to do better, they would put all their money in there, right? That would be it. Put every dime of your money in there and be done with it.

But they drift into it.

So what ends up happening is you have to style drift, and what we do as an asset manager, let’s say that you’re supposed to have 10% of your money in large growth stocks, and they drift and put 30% of the portfolio into medium-sized companies.

What we’ll do is we go, “Oh, wait, wait. They’re drifting into another area of the market. What we’re going to do is we’ve got this medium-sized company portfolio over here, and since they drifted into mid-cap stocks in this fund over here, we’re going to go and reduce our holdings of this fund over here that holds medium-sized companies to make up for the fact that these guys drifted.”

And I said, “So wait a minute. Let me get this straight. The fund manager …”

This is crazy. Then this happens.

It’s like 70% of mutual funds do style drift. And I saw this study … it’s in my book “Confident Investing,” so this is not like the exception, guys. This is the rule.

So I said, “So let me get this straight. The fund manager thinks … now why would the fund manager drift into medium-sized companies if they … ?”

Because they are still called the large-cap fund, but if they’re right, that medium-sized companies do better in the next period of time, they will beat their peers and you will invest money in their fund, right? This is great stuff.

So what happens is this fund manager thinks that maybe this area of the market’s going to do better and they drift, and you undo what basically they have done, right? That’s pretty much it.

And I said, “Isn’t that like hiring a maid or somebody to clean up your house, and then you run around behind them and throw stuff on the floor?”

And well, I hadn’t really thought about it that way, but that’s literally what passes as investment advice.

Avoid Portfolio Chasing

So in essence, they’re saying, “Hey, here’s the best overall robo-advisor and here’s the best one for first-time investors. This is the best one for first …”

Well, don’t first-time investors want the same thing that longtime investors do? Which is maybe like good returns?

The best one for digital planning—they’ve got one for digital planning. Now, most of the time, when it comes to software, I’m telling you, financial planning software, you kind of have to know a lot about the financial planning industry to run the doggone stuff.

So if they’ve got digital software, digital planning software, you’re missing out on a lot of things because maybe you don’t have training in taxes. So I just thought that was kind of funny as well.

And another one’s the best one for complex planning. And that’s one that’s actually sold to financial advisors, which I wouldn’t have any problem with that one.

There are lots of programs out there, and I’ve looked at a lot of them, and they’re ones that I think are really, really good. And that’s fine, but I don’t know. I guess that’s helpful for somebody to have looked at that.

But the next one here was a top-performing digital advisor for the first half. Oh, wait a minute. The first half of this year.

You can get lucky easily for six months and get into that list, and all of a sudden, when people will hire you for a 30- to 40-year job based on six months of performance, it’s absolutely absurd.

I hope you are getting how absurd this is, that the investment industry does this kind of thing.

And this is why, when we look at asset allocation investors, the returns are so low, because at any given year, somebody is the best.

And then all of a sudden, you hire them and then they don’t do well. And then you get upset and you fire them, and you hire the best from the next year. And you do that time and time and time again.

And if you’re not doing it, the financial advisor’s doing it, and you don’t even know that they’re doing it.

So one of the things I tell people is how to look for this stuff. Go in—you got to watch what’s going on. Unless the advisor’s really educated the daylights out of you and shows you how to actually track your investments.

Basically, what we do is actually show people how to keep up on us. But let’s say that they don’t because most don’t.

What you do is this. Go pull up your funds that you own, the investments that you hold, and look at, number one, look at the turnover inside of the funds on a year-to-year basis. That’s one thing you can look at.

Turnover ratio is something you can look at. So pull up a fund and then look at turnover ratio.

Now, if you own ETFs, a lot of times you’re not going to see a lot of turnover ratio in there, but what you got to do is this. Gets a little bit trickier.

Go back and look at your statement two, three, four years ago and compare it to your current one, and be really, really careful to look to see if the same percentage is in each asset category.

Now, you shouldn’t have radical changes. There might be slight changes.

For example, if I started out with 7% of my money in large U.S. stocks, it’s not the end of the world if now it’s down to 6.5% or 6% or something like … it needs to be a minor change. But if I see that I started out five years ago, and I had 6% of my portfolio in large U.S. stocks, and all of a sudden now it’s up to 20% of my portfolio, there you have a problem.

So this is something that I look at when I’m examining a portfolio and all of our people. That’s what I teach our guys to look at as well.

And the reason being is it shows you, definitively, what we’ve got going on is tactical asset allocation. It is market timing in disguise that changed from 6% to 20% in one area of the market. Shows that the investment manager or the advisor is believing that area’s going to do better going forward.

What they are in essence telling you is this … think about it this way. They’re telling you that those companies, those big U.S. companies, are really, really dumb, and they want to pay you way more to use your money here out into the future.

Think of it that way, because it is a tug of war between you and whoever’s using your money. They want to pay as little as they possibly can to use your money. You want to get paid as much as you possibly can for the use of your money. And that’s literally what’s going on.

Now, if I look at it, what should I be doing? I should be holding these fairly proportionally.

So let’s say I might have a certain amount and I don’t have a lot, but I’ll have some money in large U.S. stocks, maybe 7%. I might have 2% or 3% in international large. (Remember I said, I de-emphasize that.)

I might have 20% of my portfolio in small value international. Why?

Because that is an area of the market that has a higher expected return than any other area of the market in international markets. One of the highest expected returns. And it is a great diversifier.

But I don’t go and change it all the time because it’s a constant. I don’t know when it’s going to take off and when it’s not going to take off.

Because here’s the deal: when markets take off, it’s so fast, you can’t get in or get out in time. Markets digest new information. There’s a bond market study that showed that bond markets actually digest new information in less than 30 seconds.

You’re not that quick. You’re just not that quick when it gets down to it. So you need to own these areas of the market before they do what they’re going to do. 

So remember, when you look at these studies and you hear these studies from the asset allocation investors, what mistake are people making? Making changes based on predictions or forecasts about the future, which is by definition, market timing.

You will hear me pound on this, and I may pound on it 18 different ways, because if I’m going to help you become a successful investor, I’ve got to get you to get this. It is the hardest thing to break investors up.

It is the hardest thing because it feels so right. It feels so right to find funds that have done well in the past. So right. It feels so right that that’s what the investment industry is marketing to their advisors constantly.

And I have been railing against it for 20-something years on this radio show. And I thought, Man, if I get out there and get really public about what I have to say about this, the investment industry is going to straighten out, and then, not because they listen to me but because the information becomes more ubiquitous and people know it more. And then they’re going to straighten out their act.

No they’re worse than they ever have been. They are worse than they ever have been.

And it seems to be an industry that is just bent on destruction of the investor. And the whole point of this show, that you listen to, is to offset the bad messages out there.

Want to talk with us directly?

Schedule a call here.

Ready to meet with us virtually or in person? Schedule a meeting here.

*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.