Current Myths About Fund Management & Rebounds

This weekend's Wall Street Journal profiled a Texas fund manager, Donald Hodges, amidst the recent ruin of his investment strategy. It highlights a common myth that several friends have expressed to me lately. Simply stated, the belief is,

'I know the market, and my funds, fell sharply last year. But, eventually, the funds I own will come back...won't they? The market will surely regain its losses in time, so my funds will, too. Right?'

Not necessarily.

The article begins,

"For many years, Donald Hodges ran one of the top-rated stock-focused mutual funds in the country. He also has lost money for his investors over the past decade.

A $10,000 investment in Hodges Fund made 10 years ago would be worth around $9,015 today, compared with $7,720 if it was invested in the Standard & Poor's 500-stock index. Years of stellar performance were wiped out by a 49.5% plunge in 2008, a much steeper fall than the S&P, and a 11% drop so far this year."

From various pieces of information in the piece, it's clear that Hodges is a qualitative, seat-of-the-pants type manager. He doesn't seem to employ any tools to assess whether he should be long, or short in regard to equities. The article continued,

"He has become more cautious in his new stock picks, leery about buying until he is sure they are unlikely to blow up.

The "go-anywhere" Hodges Fund -- Donald Hodges invests in both value and growth issues, and ranges from small- to large-market capitalizations -- was founded in 1992 and rose to $750 million in assets by early last year. But now it is one-third that size, thanks to the brutal decline and outflows of around $31 million for the first two months of this year.

In the first half of 2008, even as the broad market fell, Hodges Fund held up relatively better because it had few financials. In the summer, Mr. Hodges took time off for an investors' cruise to Asia. He received a daily update on the fund portfolios via faxes and emails.

But after the collapse of Lehman Brothers Holdings Inc. in September, several of his fund holdings were hit hard. Mr. Hodges figured it was a buying opportunity -- a strategy that had worked well for him coming out of the 1982 and 1987 market slumps."

I found this to be just amazing. And very indicative of subjective equity managers. Without well-reasoned, defensible metrics, Hodges just felt that the fall of last year looked a lot like prior equity markets, so he started buying.

"He bought some cheap shares that he thought would hold up. One was Cal-Maine Foods Inc., a large producer and distributor of eggs. Wrong move. That stock has dropped 42% since September.

"You have to be somewhat forgiving of yourself, and realize that over a period of time you've done well," Mr. Hodges says. "And that day will return again." "

That last statement is so desperate. How can Hodges possibly know if his subjective approach will ever work again?

I have friends who, from the other side of the table, fervently want to believe the same thing. They have holdings in a disparate collection of equity mutual funds which have just been crushed in the past twelve months. They want to believe that, in concert with a hoped-for return to an S&P of 1400, their own funds will also rise.

They just don't realize how unrealistic such a hope is. Like Hodges, many of these other qualitative managers are now at sea in a very different market. We are experiencing the largest deleveraging of the past several decades, if not since the 1930s, as well as a serious recession. How anyone with a purely subjective method for selecting equities would know what to do in these conditions is beyond me.

But, as my business partner constantly reminds me, people like stories. Stories with happy endings, no matter how fictive they may be.

So investors cling to shares of mutual funds they have held for years, despite the fact that while, in an average year, 25% of mutual funds can beat the S&P, it is typically a different 25% each year. Public mutual fund managers are notoriously inconsistent in their results.

Will Hodges ever return to his prior portfolio returns? Who knows? Frankly, it's doubtful. As it is, the Journal piece notes that Hodges' fund was Lipper's best 5-year fund in that category for three years. That's a pretty narrow timeframe of outperformance, isn't it?

Multiply the Hodges story a few thousand times, and you have a pretty good picture of the equity management sector right now.

That is, failed managers, taken by surprise, desperately clinging to hope that they can reproduce whatever short period of market outperformance they once exhibited during the last few decades' largely up market on the back of expanding private leverage.