A Glimpse into the Mind of a $27 Billion Fund Manager
Individual investors have been challenged plenty by the current stock crisis, and this has been all the more painful for mutual fund managers, even though they may not feel it.
The current correction in stocks that we’ve been under over the last three weeks have been pretty painful for everyone who remained on the long side of stocks throughout this, as they have borne the full brunt of the move. Those who have remained substantially exposed to stock market risk during this time are all hoping that this comes back soon, and that’s likely to happen to a large degree, as we’ve sold off way too much due to the panic that so many people are feeling.
Panic and the stock market don’t go together if you only see things one way, where up is good and down is bad, and those who cannot shake free of this strong bias in their thinking are paying the price for this now. Anyone can look smart during a bull market, but when the bears take the wheel, this ends up exposing the weaknesses of the stay long strategy as it goes from being rewarded by the trend to being severely punished by it.
It is unreasonable to expect investors to be zigging and zagging with every little move that the market makes, and while there are people who do well at this, this requires greater abilities than investors have. Investors do not want to be sweating or even thinking very much about moves of just a few percent, and this is because the trend they are following is a longer one than traders use.
The moves with big enough risk to require the attention of investors always come with a story, and assessing the risk and determining if a reversal of the sort that they need to be worried about involves more than just looking at charts as a technical analyst would.
Traders don’t need to care about such things as they will play out on the charts, and being active in the charts will have them out during both large and small risk events and will seek to capitalize on the reversal rather than just standing there and taking the punches. Investors only need to avoid the big ones, and these ones do come with a real story behind them, like the financial crisis of 2008 or the coronavirus crisis of 2020.
People may choose to ignore the bigger things, but they do so at their own peril. They rely on rationalizations to get them through these tough times, and even though it might seem incredible to think anyone could justify sticking around in stocks through what we’re currently under, if you think that the fact that things returning more to normal later is a good reason to stay in, you can confuse yourself enough.
The key to understanding this big mistake is to realize that regardless of what happens once this all goes away, the amount that we choose to lose while it is going on is money that is lost forever and cannot ever be made up for. The 18% that these investors have lost so far, from the point where it became very obvious where we were headed, at a much higher level of confidence than we normally see with trying to predict stocks, is money that could have been saved provided we were smarter about this. When it comes back, it’s just better to save these losses than not.
18% of your stock portfolio is a lot of money indeed, and if this is as bad as it gets, when we get back to recovering this, those investors will just be even while the ones who took shelter will be up 18%. We should not have to deliberate very much when it comes to deciding which of these fates we would prefer, and this should be by far the easiest decision any investor would ever make. We might be fine with being out in a lightning storm, but after it strikes us, with more bolts on the way, we need to take action.
What throws us off so much is our bias to the long side. If we were told that the market will be going up and know this with great confidence, we would not hesitate in wanting to be long the market. Strangely though, when we have even more confidence that things will go down, we choose to not only not take advantage of the opportunity, we ignore a dangerous situation.
You have to at least get to the level where you are able to cast off your prejudices to fully appreciate the conundrum that mutual fund managers find themselves in. If you continue to want to pretend that the long side is the only side and you always want to be betting this way regardless, you won’t think anything about mutual fund managers being handcuffed to their long positions like they are. They are chained to a tree during lightning storms and are left completely helpless, so our choosing to chain ourselves alongside them is not such a good idea.
Fund managers have no choice but to take whatever beating the market decides to put on them, but this predicament is even worse than this. Mutual funds not only are committed to being close to fully invested on the long side at all times, they are also committed to particular types of assets to stay in line with their fund philosophy, regardless of how unsuitable they may have become.
If you are looking to buy the JPMorgan Equity Income Fund, you need to be able to count on it holding stocks only and particular types of stocks, ones that have enough of an income component to qualify. This particular fund limits themselves strategically to stocks that pay at least a 2% dividend, and are completely helpless against a move like we’re seeing now because they simply have nowhere to run or hide when these things happen, not even into other types of stocks losing less.
We might think it to be nice to have funds specialize like this, as certain investors may prefer to go with a fund like this, even though this particular strategy may doom them to both underperforming in bull markets and getting clobbered during bear markets. These particular stocks don’t do that well at the best of times, and those who don’t understand the rationale of a lot of investors would be rightly mystified at why anyone would ever choose such a fund, but having fund management and their investors both so confused about what we’re supposed to be seeking with our investments is plenty enough to sustain the relationship even during the worst of times.
A great number of investors think that mutual fund managers must know what they are doing, and will maintain this view even in the face of clear data to the contrary. If you know little or nothing about investing, and especially if you buy into the broken reasoning that the majority of mutual funds employ, you just aren’t going to know the difference and won’t know a good fund manager from a poor one, and most are in the poor category pretty clearly.
There are so many assumptions that investors take for granted without any thought, and will cling to these beliefs without ever considering that they may not be valid. We see fund managers tell us that they won’t own anything with a dividend below 2% or similar strategies and may consider this to be quite reasonable as long as they don’t really think about it in any objective way.
There isn’t anything all that wrong with funds segregating to cater to particular interests such as this, but the real problem happens when investors hear the song of these harpies and become enchanted, and then watch in horror as their ships are lured toward the rocks. A fund can do as terribly as it chooses, but when we also choose to go along with the ride, this is where the pain of this hits home.
Someone Needs to Examine How These Funds Think, Because They Don’t
If we wish to really learn about where this all goes wrong, why the majority of mutual fund managers fail at even beating a random selection of stocks, we need to take a closer look at how these managers think, and especially how they choose their stocks.
First though, we need some sort of benchmark, not the one that compares their results with the broader market and has so many of these funds come out behind that, an outcome that is completely unacceptable in itself, we also need some sort of strategic benchmark, to be able to compare what these funds should be doing if they actually do wish to succeed.
It turns out that, in the end, they really don’t want to succeed, as the follow a different prime directive, as they have placed their strategies above the success of making money. They will pick a certain stock picking strategy and just stick with it dogmatically, like the one that drives the JPMorgan Equity Income Fund.
Since the goal here is to make money, or is supposed to be, and needs to be, how well a strategy does ultimately will always come down to this measure, and it therefore has to be the primary goal and cannot be supplanted with ideas that do not promote this goal very well. These are active strategies, so we cannot rightly console ourselves with being carried under by a strong market undertow like this instead of choosing to save ourselves.
It’s not that this fund has done all that badly lately, and returned 21% in 2019 for instance, which was off of the broad market by 8% but at least beat most of its competing funds in the same class. That doesn’t mean anything though when the class itself fails, and choosing a fund that is structured to fail to keep up with a random basket of stocks should not be seen as so attractive or attractive at all.
Lead fund manager Clare Hart is quick to boast about the fund’s performance, citing the fact that she beats the Russell 1000 as well as 90% of her peers in the equity income category. Why this should matter given that the fund lags the overall market so much isn’t made clear, but why would she given that part of her job is to try to put positive spin on her fund. The fact that this spin works so well and fools so many people is what should really concern us.
The lure of the income harpies is so strong that even in the face of their ships crashing violently upon the rocks from being allured with this song, the champions of this idea are telling people that since bond yields are so low, people have to get their income from somewhere, so buying and holding tanking stocks is now the way to go. Gaining single digit payouts while losing double digit capital losses and getting excited about such a prospect is beyond crazy. The fact that this view is insane does not bother them because insane people don’t know that they are insane.
We may rightly wonder how these people have fallen off of their rockers and hit their head on the cement like this, but all it takes is just keeping your eyes on the income payments and ignoring all the blood that gets spilled, and things like gaining an extra 3% while losing an extra 30% can seem sensible if you just pretend that these losses don’t exist. Far too many people are very good at this. Enron might have used fraudulent accounting practices, but they knew it was fraudulent. It’s more dangerous when you mess up the numbers this badly and have no idea of how fraudulent your thinking is.
It is not that this shooting for poorer performance than the market is offset by the fund providing more protection in down cycles. This fund is currently down 18% year to date versus the 16% that the S&P 500 is. When you are selecting your stocks based upon the size of a stock’s dividend, this so-called income strategy does not provide any defensive measures and is actually less defensive than average.
This is nothing like the SPDR Utilities ETF which went toe to toe with the S&P 500 last year but is only down 5% this year so far. This is nothing like Coca-Cola, which we featured as a defensive stock a few months ago, which is only down 4% year to date. This is nothing like CME, which we also featured recently, and in spite of this stock getting hammered lately, is still only down 4% year to date.
It’s been pretty tough to stay in stocks and not take a big hit so far in 2020 given how the year has gone so far. Going with more defensive plays is only a good idea if you do plan on staying in regardless, and the best way to manage these crises is to just step away when they happen. Many investors do choose to stay the course, and if you do, it is definitely important to protect yourself. This fund does not offer any real protection from this as we see.
If we give up so much on the upside but receive no benefits on the downside, we have to stop and wonder what the heck we are doing with a fund like this. The sad answer ends up being that performance has been thrown to the back of the bus and this dividend strategy is driving it instead.
When Your Fund is All-Around Bad, but You Think It’s Doing Well, That Spells Real Trouble
The JPMorgan Equity Income Fund has been around for a long time, and they do pay out a little higher dividend percentages than stocks in the S&P 500, but this doesn’t add up to all that much and ends up getting the crap beat out of them on all time frames by the bigger index.
If we look back 20 years, the value of the JPMorgan Income Equity Fund has declined by 37%, happily so it would seem, while the S&P 500 is up by 95%. This is a difference of 132%, and an extra percentage and a half a year in dividends still leaves us with over a 100% difference. This means that after two decades, you will be left with less than half of the money you would have had if you had invested in the S&P 500 instead. That’s worse than just terrible.
If you just insist on ignoring this reality though, you can somehow come out of this with a smile on your face, and maybe even a big one. We might think this as very hard to believe, but as long as you confine yourself to just comparing with funds that are similarly deluded, that can work pretty well it seems.
Hart sums up her stock picking strategy by telling us that “we look for quality companies with a reasonable valuation that pay a dividend.” There’s quite a bit contained just in this statement, starting with her ideas of what a quality company is.
Regardless of how we may want to measure this, a quality stock is clearly one that at least provides an above-average return, because that’s why we invest in them, to make money, or presumably at least. She may think her picks are of an above average quality by some measure, but the reality is that they are well below average, and the only way that anyone could cling to this belief is to completely ignore performance and stick with your ideas that measure it another way, and continuing to ignore the issue of relevancy. Somehow, these other factors are deemed to be more important, and it doesn’t matter what they are if they are not attuned to stock performance.
She also reveals her preference for “reasonable valuation,” and this one mistake is responsible for funds failing to perform like no other, as it attempts to see strong stocks as weak and weak stocks as strong. The stronger stocks have higher valuations because they derive more of their value from future expectations, with the reverse being the case with weaker stocks with lower valuations.
This value speaks to the potential of a stock, and if we shy away from stocks that have more potential and are happy to embrace those which have less potential, that’s not too bright, but being bright isn’t a goal here, as the goal is to put these strategic concerns ahead of performance and then you don’t get disappointed when they fail because you are not paying attention to what actually matters.
She also shares her preference for dividends, and as it turns out, weaker stocks pay higher dividends generally because their price hasn’t kept up with their earnings growth as much. This is not something we ever want if we’re looking for a stock’s price to outperform rather than underperform, and all three of these criteria seek underperformance by nature. When the results come in and we see these funds continue to underperform, we should not be surprised because this is actually by design, whether fund managers realize it or not.
This would actually be scarier if they did, because this would turn things from just being stupid to being evil, seeking out bad ideas when you know they are bad and then sticking with them and costing their investors lots of money. The actual disease they suffer from is ignorance, which we may want to forgive, but we shouldn’t wish to join then in it intentionally.
Hart automatically excludes stocks that do not pay at least a 2% dividend, and clearly has no idea how ludicrous this is. Once again, we need to be paying attention to performance, and if there are better performing stocks that fall outside of this arbitrary and irrelevant condition, they are being excluded merely by way of an arbitrary choice that is disconnected with the overall goal.
These three conditions sum up the bane of investing quite well, and these are the real reasons most fund managers are so mired in underperformance. If you consistently fall below random performance, it can’t be luck, as the underperformance has to be intentional to be so enduring.
This may seem to be an overly harsh indictment of this fund, but it’s hard to be kind when you are doing the same things year after year and achieving bad results year after year and you don’t even have the sense to question your strategy.
As out of touch as Hart’s three primary goals are, they are very deeply entrenched, and these ideas have infected the way fund managers think to such a degree that there may not even be a cure. We don’t reveal much if we don’t even look though, and as long as so many choose not to and just keep assuming that these strategies are good ones without even any real examination, there not only isn’t a cure on the way, there isn’t even the possibility of a treatment out there.
This is no time to be long stocks anyway, to say the least, and given that we do at least have the capacity to think about what we are doing, we can at least try to use this power to not just keep up with the market, but to actually beat it, as these funds are allegedly supposed to be trying to do. Keeping up with the market’s 16% decline so far this year should certainly not be the goal, especially in situations like this where it is so easy to beat it that all you have to do is get out when panic is in the streets like this.
Funds can’t do this, which means that these are things that we want to steer clear of during more bearish times, and want to steer well clear of the JPMorgan Equity Income fund at the best of times. This fund thinks that they are doing such a great job, but we need more than their telling us this to make it so.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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