A couple of news stories today piqued my interest with unsourced statements
about financial markets which didn’t make a lot of sense to me. First of all
there was a column by Ed Dravo
in Slate, which said that
When an asset manager begins to beat his peers by a large margin, pension
trustees actually withdraw money from the hot-performing manager.
Individual investors, by contrast, pour their money into those same asset
managers. History shows today’s high-performing funds are tomorrow’s laggards,
so individual investors are choosing investments that are likely to disappoint.
I agree that individual investors tend to put their money into hot-performing
funds, but that’s about all I agree with. Is there any evidence at all that
if pension trustees are lucky or smart enough to find an asset manager who starts
doing really well, they then take their money away from him? I can just about
imagine a situation where no one manager is allowed more than a certain percentage
of total assets, and that if he’s doing really well, he might start exceeding
that percentage and triggering withdrawals. But I can’t imagine that trustees,
having found a successful manager, will then give up on him just as he starts
Furthermore, I really don’t think that "history shows today’s high-performing
funds are tomorrow’s laggards". When a rather obnoxious man at Citibank
tried to sell me some mutual funds once, based on their outperformance, I actually
spent quite a bit of time researching this issue. Companies like Morningstar
generally group funds into quintiles: the top 20%, the next 20%, and so on.
And there is in fact a certain amount of correlation between past performance
and future performance. Not a lot, but a little. Funds in the bottom quintile
will tend to underperform in the future, funds in the fourth quintile will underperform
but not quite as badly, and funds in the top three quintiles are all roughly
equally likely to outperform in the future.
This is actually the opposite of what Dravo is implying, which is that funds
in the top quintile are the most likely to underperform in future – and
I certainly found no evidence of that. I know there’s a lot of sleaziness among
financial advisors, but I don’t think that so many of them would push funds
based on their Morningstar ratings if past performance was actually negatively
correlated to future performance.
If you were to be charitable, you might say that financial markets are cyclical,
and if one asset class has done well for a while (technology stocks, say, or
emerging-market bonds, or small-cap manufacturers) then it stands to reason
that it might slow down in future and some other asset class – invested
in by some other mutual fund – will be the new place to be. But that’s
not what Dravo was saying, and in any case you’re just as likely to move from
today’s high-performing asset class to tomorrow’s low-performing asset class
as you are to make the perfect leap from outperformer to outperformer just as
the former has stopped rising and the latter has just started. Rather than try
to execute that kind of acrobatic act, better you just stick with what’s working,
I think – even Dravo, later on, points out that people who trade more,
Meanwhile, the BBC picks up on the
story of Google’s IPO:
Dutch auctions and other supposedly open IPO forms are blamed for the extraordinary
price swings seen in the early days after some high-profile flotations.
Some analysts say they also tend to underprice shares, leading to insufficient
returns for the issuer.
This is the point at which Jon Stewart, of The Daily Show, would rub his eyes
in a comical manner and do one of his patented "wha????" expressions.
Dutch auctions, of course, are designed precisely to avoid extraordinary
price swings in the aftermarket – people pay exactly what they want to
pay, without investment banks second-guessing them or trying to underprice the
shares so that there are lots of juicy immediate profits for their favoured
And while some Wall Street types do have an argument that Dutch auctions overprice
shares (see the quote from the FT on this
blog), I have yet to see any reason why they should underprice
them. After all, the stock market is essentially one big continuous Dutch auction:
sellers sell their stock to the person who will pay them the highest price.
And the stock market seems to work a lot more efficiently than IPOs normally
Think about it for a minute: if institutional investors are willing to pay
more than retail investors, then the institutions will end up owning most of
the shares, at a reasonable market price. If, on the other hand, retail investors
are willing to pay more than institutional investors, then most of the Google
shares will end up in individual hands, and when those people come to sell,
they might have to take a loss in the secondary market. In other words, the
IPO would have been overpriced, not underpriced. It really is hard to imagine
how a Dutch auction could underprice shares – or even to think of what
kind of "analyst" would ever say such a thing.
Now I’m willing to admit that I might be wrong here – would anybody like
to come to the defense either of Mr Dravo or of the BBC?