Warren Buffet is easily everyone’s favorite long-term investor. He is a legend, growing a defunct textile manufacturer into a wildly successful diversified organization through careful analysis and savvy buying. He has become one of the wealthiest individuals in the world through a keen business sense, carefully timed purchases (and probably some luck).
However, his legendary outperformance didn’t come without temporary setbacks. Like any other “active manager,” Buffet experienced his own periods of underperformance.
In 2009, the stock gained only 2.7%, compared to a 23.5% return for the S&P 500. In fact, single-year underperformance relative to the S&P 500 is not uncommon for BRK.A. The stock missed the benchmark’s return in 2003, 2004, 2005, and those are just years from the past decade. Buffet was long lamented in the tech boom of the late ’90s when stodgy and value-oriented BRK.A did not participate in the full runup of the markets.
Despite these periods of underperformance, Bershire Hathaway has grown tremendously, giving Buffet his legendary status as an investor.
But what if Warren Buffet ran a mutual fund? How would his investors have faired? What we need to do is explore the behavior of investors when presented with a pattern of outperformance and underperformance. Thankfully, a good deal of examples are available to us.
Since roughly 2006 Morningstar has calculated “Investor Return” for public mutual funds, a calculation that incorporates the buying and selling activity of investors and how the timing of their activity affects the actual return earned by investors. In this published article (and related study), Morningstar demonstrated that from 2000 – 2009 the average investor underperformed the actual average fund return by -1.50%. annually.
These figures are the result of poor investor behavior and timing. In addition to the Morningstar study, other studies have quantified that investors have a poor record of buying mutual funds after periods of strong performance and selling funds after periods of poor performance. One key study, “The Selection and Termination of Investment Management Firms by Plan Sponsors” demonstrates that even professional retirement plan sponsors hire investment managers after they have outperformed and subsequently firing them after a period of underperformance. The study finds that before hiring, an investment manager may have excess returns from 1% – 3.5% in the three years prior to the hiring decision. However, after a manager has been hired by the plan sponsor, there is no statistical outperformance. This can simply be attributed to mean regression – over time, outperformance cannot be consistent. The subsequent costs of firing and hiring managers end up with the plan assets underperforming on a net basis.
The final and perhaps most widely recognized source of investor performance is the DALBAR “Quantitative Analysis of Investor Behavior”, or QAIB. This study, updated annually, uses data tracking investor cash flows into and out of stock mutual funds to determine the average performance of investors. The study regularly shows a tremendous gap between market (S&P 500) returns and actual investor returns. The most recent gap over the 20 year period ending December 2011 was 4.32% annually, showing that investors gave up over half of the annualized returns of the S&P 500 for 20 years.
How would these investors have behaved in a fund run by Warren Buffet? How many investors would have stayed the course in 1999 when Berkshire Hathaway lost nearly -20% and the S&P 500 gained over 20%? And this coming just a few years after 1996, when Berkshire Hathaway underperformed the S&P 500 by over 16%. Based on typical investor behavior, it seems evident that many investors would have given up on Warren Buffet’s imaginary mutual fund in the late 1990’s, only to miss out on an extended period of outperformance beginning in the year 2000, and then consider getting back in shortly before another stint of underperformance from 2003 – 2005.
Mutual funds with more consistent performance records have been shown to have a smaller gap between reported fund performance and actual fund performance. The most volatile funds demonstrated the largest gap between reported and investor performance, with investors only capturing 62% of long-term returns. Investors in less-volatile balanced funds that own a mix of stocks and bonds have been much more successful, typically capturing 100% of the stated return.
Of course, investors utilizing index funds will be dramatically less exposed to the behavioral challenges presented by the short-term underperformance of an active manager. Perhaps this is why Warren Buffet himself frequently advises investors to NOT pursue actively managed strategies but instead diversify with low-cost and tax-efficient index funds?