The global financial crisis is fading from the rear view mirror – good news for fund managers but potentially misleading for investors. The S&P 500 dived more than 57 per cent between September 2007 and March 2009, when stocks finally bottomed. The Euro Stoxx 600 index tumbled more than 60 per cent over the same period while Irish stocks fared even worse, with the Iseq losing more than 80 per cent of its value.
Stocks everywhere have soared since then but until recently, 10-year returns – a long-term metric habitually used by money management firms on their websites – continued to be weighed down by the brutality of the previous bear market. Now that 10 years have passed since the bottom, returns suddenly seem much better. Quantitative expert Michael Markov, co-founder of New Jersey-based Markov Processes International, points out that at the end of 2017, the S&P 500 had averaged annualised returns of 8.5 per cent over the previous 10 years – perfectly healthy, if undramatic, returns. By February 2019, however, 10-year annualised returns had almost doubled to 16.7 per cent. Casual investors who noticed the sudden jump in 10-year returns might think 2018 was a spectacularly good year for stock markets, but that's not the case at all, with indices actually slipping last year. The sole reason for the change is the global financial crisis has "been receding from equity funds' 10-year return windows", notes Markov, with 10-year results looking better and better with each passing month.
There are implications arising from this accident of the calendar. Investors might be delighted with the seeming upturn in their fund performance, even though there has been no change in managers’ underlying performance. Institutional investors, too, might be fooled.
Fund rating systems have been "in massive flux" over the last 16 months, says Markov. Influential fund research firms such as Morningstar give star ratings to managed funds based on their performance and the apparent level of risk being taken, with top-rated funds receiving five stars, bottom-rated funds receiving one star, and so on. Over the last year, there has been more than a seven-fold increase in the number of funds seeing a change of at least two stars in their 10-year rating, says Markov.
Unpleasant as bear markets can be, they serve a useful purpose in that they allow investors to see how a fund performs in different market cycles
Morningstar’s measure of 10-year risk-adjusted returns soared from 5.5 to 14.3 per cent in 2018, he notes, even though the year ended on a brutal note for stock markets. The freakishly sudden growth both in 10-year returns and in risk-adjusted returns is more than in any other year since at least 1988.
Many institutional investors and fund platforms use their own custom criteria to measure risk-adjusted returns but these dramatic shifts “likely also hold true” in such instances, he adds. The huge increase in risk-adjusted returns testifies to the inherent limitations of such metrics. Ironically, the funds being rewarded with improved rankings may well be the more aggressive funds that have shown little appreciation for risk management in recent years.
Investors have long been prone to performance chasing, moving their money into top-performing funds. Even cautious investors might assume that 10 years is a sufficiently long period to measure performance; as a result, riskier funds that have benefited from the bullish market environment are likely to attract increased investor inflows, suggests Markov. Markets usually experience at least one bear market over a 10-year period. Unpleasant as bear markets can be, they serve a useful purpose in that they allow investors to see how a fund performs in different market cycles. Warren Buffett famously said that it is only when the tide goes out, that you discover who's been swimming naked.
The tide went out in 2008, allowing investors to distinguish risky funds from their more cautious counterparts, but it’s now been more than 10 years since investors last witnessed a protracted, draining market decline. Distinguishing skill from luck is a tricky business. Performance during the global financial crisis was a “prime differentiator”, says Markov. “Substantial differences in skill or strategy may be masked by general buoyancy”, he cautions.
No doubt, funds will seek to take full advantage now they can point to such healthy 10-year returns. Fund managers know well most investors don’t heed the line about past performance being no guide to future returns and that they’re much more likely to invest after periods of healthy returns. That’s why, for example, US funds spent 18 times as much money in 2005, when stocks were in the middle of a bull market, than in 2009, when investors were unnerved by the market crash.
The problem is past performance may be an illusion, to borrow from the title of one study that examined fund advertising patterns. Improved fund performance, the authors noted, can be driven not only by strong recent returns but by an embarrassing period dropping out of the record. The study found funds were most likely to launch an advertising campaign 13, 37 or 61 months after a very bad month – the very time when the poor month would drop out of one-, three- and five-year return calculations.
European indices have bounced nicely from their lows a decade ago, but 20-year returns are dismal
Not only is this obvious evidence of “opportunistic behaviour”, funds tend to hike fees at the same time, taking advantage of “unsophisticated” investors. Increasing fees because you upped your research spending and managed to deliver strong recent returns is all very well, but charging investors extra money because poor performance has dropped out of the record is cynical, to say the least. Investors are being fooled in such instances; they’re not so much chasing performance (after all, recent performance might have been mediocre) but chasing “stale” performance due to a quirk of the calendar.
Investors today need to be especially wary of this fund trick, as what has happened in recent months is a particularly extreme example of how past returns can be distorted by a bad period dropping out of the investment record.
It’s a reminder, too, that 10 years is not really a long time in financial markets and that investors who think otherwise should think again. There can be a huge variation in 10-year returns. In 2009, following a lost decade where stock markets suffered heavy falls, commentators were busy proclaiming that buy and hold was dead.
In contrast, the buy-and-hold mantra looked decidedly wise on the 10th anniversary of the collapse of Lehman Brothers in September 2018 (by then, indices had enjoyed a healthy recovery and posted health double-digit annualised returns) and even more so today, now that all traces of the global financial crisis have been erased from the 10-year record. Tweaking time periods can make a huge difference. The S&P 500 may have averaged annualised returns of 16.7 per cent over the last 10 years, but that falls to just 9.3 per cent over the last 11 years and only 5.9 per cent (or 3.65 per cent after inflation) over the last 20 years. European indices have bounced nicely from their lows a decade ago, but 20-year returns are dismal. The Iseq has more than tripled over the last 10 years, but it has fallen if one looks back 11 years. How long should one look back? What qualifies as the long term? There's no standard answer to these questions, but one thing is clear – it's more than 10 years.