An overwhelming equity bias, and need to be “fully invested” cause all kinds of pricing discrepancies in various investment assets
I was reflecting on comments made by fund manager Bill Fleckenstein about
how it seems that investments with a sensible thesis and fundamentals at their back seem to test investors’ patience, and investments that defy logic seem to “levitate.”
No doubt that the type of investor who can see certain themes playing out and invests ahead of those themes often comes early to the party. Often, it seems, they’re so early that their investment goes against them for a time. If they can hang in there to see through that, then they have to navigate a transition period where their investments rise then fall (often hard) repeatedly. If they can make it through all of that without selling out (due to frustration or self doubt), then they eventually might see the gains they expected when they made the investment in the first place.
The bottom line oftentimes, for the thinking investor is that if they do not to buy right before a market upcycle, they may have to wait awhile to for the price to move up. This often leads to frustration – and selling out before money can be made.
On the other side, investments that shouldn’t possibly do well for economic, market, or industry reasons will steadily rise. I know a few times in the past 10 years, I have personally held my stock allocation very low as I expected a bad market correction. Only problem was, the markets continued to rise. And it was only after months have passed (and once over a year) that I was proven right. A few times clients asked me why we were in cash. Those were hard conversations at the time!
It is certainly easiest when the investments I have chosen rise when most other investments are falling. This occurrence can make one feel more intelligent than the average investor! And yes this is a feeling that is usually wrong. As they say, don’t mistake a bull market in a sector for genius.
However, this is rare and much more time is spent suffering through the “tumultuous” times waiting for a thesis to play out. Why does it take time for what should happen to happen and why do nonsensical investments float up until they crash hard?
Why Does This Happen?
I can’t say for sure why your investment thesis doesn’t play out right away. However, I tend to think blame for why some investments rise without reason lies in the fact that most investment managers have a somewhat religious equity bias and a mandate that their fund be “fully invested. Please understand, I love the stock market, love that I can invest in so many different companies without being a tycoon (I can “own” McDonalds!). I love that there’s a chance to share in the growth of a company that I didn’t have to spend the money to incorporate or run.
With that being said, it does not mean that stocks are always the best investment. There are plenty of times that stocks individually or the market as a whole are wildly overvalued. I won’t go too much into this point for now but let’s just say that stock investors often pay 20-30 times reported annual earnings for a company when buying stock whereas private companies often sell for 3-5 times cash flow.
The point I will make is that even if the market is overvalued, there are many fund managers who will still invest. They have cash and they must “put it to work” because they are not getting paid to “manage cash.” if you are still wondering why your mutual fund manager was fully invested in 2001 as your stocks swooned or in 2008, it was likely because of this “fully invested” requirement.
Yes – for most money managers, stocks are the best ways to play everything. Famed investor Jim Rogers (Quantum Fund partner with George Soros) has repeatedly said in interviews that investors who bought commodities did much better than investors who bought stocks of companies that produced those commodities. But still, even if fund managers want exposure to commodities they are likely to buy stocks of commodity producers, not the actual commodities.
Another example is gold. In many informal surveys, gold is severely under-owned. If a group of fund managers were asked in 2009 or 2010 if they owned gold in their funds or personally, maybe 5% would’ve said yes. Strange considering the 10 year return of US stocks was negative from 1999-2009 and the 10 year return of gold was over 400%. yet still they all stuck to stocks.
And this is still going on – with excess cash in the global economy due to money printing (The Fed crowds out investment in government bonds pushing asset managers into other assets), managers have to buy something. And that something has been stocks. Stocks were undervalued in early 2009 according to well-known money manager Jeremy Grantham, but they have since blown past fair value to overvaluation. Now we see highflying stocks of companies with poor business models or companies with no long term competitive edge floating up week after week. Floating = accumulation: these companies aren’t seeing massive short term buying just consistent accumulation by a group of fund managers with money on their hands. They have cash and they must buy stocks and be fully invested. (Interestingly, many of the busiest days on Wall Street have been down days…)
As mentioned above, managers don’t get paid to “manage cash,’ and that’s what they’ll tell you. Therefore, a fund will likely be 95-99% invested and only keep 1-5% in cash at any one time. Because they have a mandate (often) to be fully invested. This might cause fund managers to buy investments that are often relatively a good value but maybe not absolutely a good value. In my view, a fund manager needs the ability to park in cash and wait for the best opportunities. With the requirement that a manager be fully invested, a manager will not be able to wait for absolute values to show up and will be forced to invest in what may only be a relative value.
And this is why a significant amount of funds do not outperform an unmanaged index of stocks. By having to be fully invested, they in fact mimic the index and follow the market up and down as they have on the wild ride of the last 10 years.
We could analyze this forever but I hope I’ve given you some food for thought on this.
Agree? disagree? Share your comments please!