There were many lessons to be learned in 2008. Throughout the year events such as hedge fund liquidations, bankruptcies, the oil price acceleration and subsequent decline, the Volkswagen share price rally, inflation fear, and towards the end of the year, a so-called Ponzi scheme by Bernard Madoff shocked the financial system. Subsequently, these events affected mutual fund investments. With such a year behind us, many investors are showing increasing risk awareness and feel a need to better understand their fund investments.
Early last year, we discussed ‘The Art of Portfolio Diversification’ and how the hunt for returns might affect diversification considerations. Madoff’s alleged Ponzi scheme has led many to revisit this topic and focus on six of the most common pitfalls in fund investing:
1. Failing to understand the product
2. Viewing past performance through the wrong lenses
3. Underestimating risks
4. Identifying unskilled managers as skilled
5. Too little or too much diversification
6. High trading frequency
PITFALL 1: FAILING TO UNDERSTAND THE PRODUCT
What can the investment do for you, should always be the paramount question on an investor’s mind. Yet, a common mistake investors make is failing to understand the product. As each investor has his own risk tolerance and investment horizon, not all products are suitable for all investors. Failing to understand the product could have severe consequences for a portfolio. Therefore, a fund manager’s investment philosophy is a good starting point in a qualitative selection process.
PITFALL II: VIEWING PAST PERFORMANCE THROUGH THE WRONG LENSES
“Past performance is no indication of future performance.” Most research reports and documents related to investments have this statement, be it in the small print or as a big disclaimer. Yet a basic mistake many investors make is focusing too much on past returns. Investors will miss a lot of information by simply looking at an investment fund’s past performance.
PITFALL III: UNDERESTIMATING RISKS
Risks in investing come in many forms. With actively managed funds, no return can be judged without understanding the risk taken to accomplish it. Until mid-2008, many investors were tempt- ed by the stellar outperformance without considering the risk a spe- cific product represents versus the broad market. A due diligence on the product would not eliminate that risk, but it would allow investors to take an informed risk. Risk metrics, such as volatility, drawdowns or tracking error are usually available on a fact sheet.
PITFALL IV: IDENTIFY UNSKILLED MANAGERS AS SKILLED
It is the task of fund researchers and institutional investors around the world to identify truly skilled managers using a mixture of quantitative and qualitative tools. Interviews with portfolio managers, reviews of the investment process and the internal risk management, and other processes, help to separate the skilled managers from the lucky ones. Two important terms in this context are alpha and beta drivers. Beta is a measure of the systematic risk of an investment compared to the overall market. In simpler terms, beta is the measure of an investment’s movements versus the market. Alpha refers to the out performance of an investment manager relative to a benchmark when corrected for the systematic risk effects of the manager. Alpha is therefore generally a measurement of the “skill” of an active manager to generate outperformance.
PITFALL V: TOO LITTLE OR TOO MUCH DIVERSIFICATION
Warren Buffet’s deep value investment approach is an example of an actively managed investment style with an alpha source. However, even if an investor has managed to identify a skilled man- ager, there will be times where any investment style fails, as mar- kets are not constant. Even the “Sage of Omaha” will not always outperform the market. A deep value investor like Buffet takes a long term approach. His investments may need years to pay off and his investors, if they understand his approach, will look past periods of underperformance. As an example, Warren Buffet’s Berkshire Hathaway had a period of underperformance at the height of the tech bubble as can be seen in the figure below.