As active professional investment managers (see track record and GIPS disclosures for Taylor Frigon Capital Management located here), we are sometimes asked why good managers ever experience any periods of relative underperformance?
To put it another way, why do managers who outperform over longer periods frequently experience shorter periods in which they lag the market -- as research has shown that well over 90% of long-term outperforming managers actually do for periods of as long as three years? For data supporting this assertion, see this previous blog post and this study entitled "Investor's Paradox -- All High-Performing Managers Underperform."
We believe that the reason for this paradox lies in the fact that in order to perform better than the overall market, an investor must own companies that are better than the overall market (see here and here for our views on the topic). However, while an investor is owning those companies and waiting for them to realize their business potential, short-term market players are often stampeding from one part of the market to another, and back again. In the process the prices of companies in the "popular" sector will go up faster when the herd is focused on them, only to drop again later when the herd stampedes somewhere else.
We have written about this phenomenon as well, such as in this post explaining why we do not follow the typical Wall Street practice of "sector rotation." Big investment firms will often rush from one sector to another in response to various signals that they perceive as favoring one sector over another. Whatever the "flavor of the month" happens to be, where the herd is rushing at that particular moment, those stocks will go up for a short period, and often more swiftly, than the sectors that the herd is currently rushing out of.
To illustrate this point, have a look at the data collected from an extensive survey of investment managers shown in the table above. The data is from the period between August 2005 and August 2006, but it illustrates behavior that is very typical for almost any one-year period on Wall Street. The first column shows the months, and the next column over shows the percentage overweight or underweight that the US portfolio managers surveyed were at that period in time with regards to one sector, technology.
For the month of December 2005, the managers were net 38% overweight in the technology sector. By February 2006, they had reduced their exposure to a net 32% overweight, then by April 2006 had reduced their exposure to a net 27% overweight. Then, very suddenly, they went to 0% net overweight in tech during the month of May 2006, followed by net underweight 5% in June 2006 and then underweight 15% in July and underweight 22% in August.
In other words, in six months, the managers surveyed swung from being 32% overweight in technology to being 22% underweight in the same sector! That's an enormous amount of investment dollars sloshing out of one sector in a very short period of time. Portfolio managers who tend to hold companies for longer periods of time (such as ourselves) would have seen their technology companies suffer as prices dropped in the vacuum of all those other investors stampeding somewhere else.
A logical question that might come to mind at this point is, "Why would you stay in a tech company if you realized that all the money on Wall Street was moving out of technology stocks that month? Why wouldn't you chase the herd, so that your technology names didn't underperform during those months?"
The answer to that very practical-sounding question is, "because nobody can do that effectively." It turns out that trying to chase the erratic stampeding of the market herd is a surefire recipe for long-term underperformance. The fact is that the herd will inevitably come thundering right back in some future time period, and that nobody is good enough to predict its endless motion year-in and year-out for very long periods of time (such as the thirty-year, forty-year, or even longer periods of time that an actual investor typically should be thinking about for his investing lifetime).
In fact, we would go even further and make an even more shocking argument. We believe that because trying to chase one sector or another on a month-to-month basis is such a losing proposition, that disciplined investors who own better-than-average companies over long periods of time will very possibly do better than the herd! That's right: it may turn out in the long run that not only is it possible to beat the market using active management (and we certainly believe that it is possible, as we argue here and here) but that over the long run it would be difficult not to!
We don't have empirical evidence that this is so, but we may think of a way to prove it in the future. In the meantime, we would advise investors to think about this information very carefully, and to avoid the common practice of sector rotation -- or as we might call it based on the data above, "sector sloshing."
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