Mutual Fund Managers Should Listen to Their Mothers

There will be a pullback sooner or later. But at this point investors can no longer wait for what the market will do, they have to follow what the money is doing now.
– WSJ, "Money Flowing into Top Stocks For 2011 is Form of Reverse Capitulation"

When I was 13 years old, there was nothing in the world I wanted more than a skateboard. For a seventh grader in the late '80s, skateboarding was the epitome of "cool."

My folks were having none of it. They were convinced I would bash my brains out on a curb or some such thing. (It probably didn't help that I was an exceptionally clumsy 13-year-old, having grown to my full 6'1" height before my 14th birthday.)

I couldn't believe how cruel and inflexible they were being. Couldn't they see? Didn't they understand that all the "cool kids" had skateboards?

I made this argument with all the passion I could muster. In return I got the classic response:

"If all your friends were jumping off a cliff, would you do it too?"

Within a year or so, my skateboard fever passed. (A friend of mine knocking three of his front teeth out helped cool the ardor too.) But I never forgot the lesson.

How did Mark Twain put it? "When I was a boy of fourteen my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much the old man had learned in seven years."

Reverse Capitulation?

I was reminded of the above this week upon stumbling across the phrase, "Reverse Capitulation."

Normal capitulation is what happens when investors give up the ghost… cry for uncle… throw in the towel… or otherwise give up and sell the losing positions they can no longer stand to hold.

Reverse capitulation, apparently, is when sidelined investors feel they can no longer stay in cash. As the WSJ explains,

Money is moving into hot stocks for 2011 because they are going up. The new highs in all three indexes means there is no longer a recent reference point for managers of that money to base their buying decisions. Those that have been skeptical, or underweight relative to their proxy indexes, no longer have a choice but to, at the very least, get back to neutral or risk falling further and further behind.

This seems the height of lunacy. Unfortunately, it also sheds light on how Wall Street works.

Mutual Fund Managers Haven't Learned

Those that have been skeptical "no longer have a choice," the WSJ reports. They have to get into hot stocks for 2011 "because they are going up."

In other words: Because everyone else is jumping off the cliff, these managers have to as well.

The WSJ piece further notes, "Investors like to have a good reason to justify buying." To which your editor replies, "No, really? You don't say!"

Think for a moment how silly this is. We now have mutual fund managers buying top stocks for 2011 not out of conviction, not out of good reason, but because Tom, Dick and Harry are buying. And, well, if those guys are buying, it must be the thing to do…

The Market Is Not a Popularity Contest

Now your editor is going to risk sounding like someone's mother in saying the following: The market is not a popularity contest. Buying top stocks for 2011 just because "everyone else is doing it" is a STUPID thing to do.

You may have other reasons for buying top stocks for 2011, of course.

• It may be that, while the broad market is overextended and overbought, there are individual names on your radar screen which you feel to be of good value.

• Or, if you are a trader, you may be buying breakouts in a carefully selected group of stocks with good reward-to-risk ratios on the individual names.

• Or, if you have a long-term capital allocation plan, you may have a habit of putting $X dollars in every month or quarter, with short-term fluctuations meaning nothing to you.

Can you see the similarity in the three courses of actions listed above? They are all based on having a logical plan. None is based on getting jerked around by the whims of the crowd.

The Peril of Benchmarks

This is why your editor remains skeptical of the professional money management business, or at least very large swathes of it.

The practice of mutual fund managers buying just because everyone else is buying is very widespread. In fact it's baked into the cake based on how the typical manager is measured. The great fear of these men and women is not making bad investments or losing money for their clients, but failing to keep up with their "benchmark."

This means that, when the benchmark moves, the managers have to move too – convictions be damned.

Not all money is managed this way, of course. The better managers (a lot of them hedge fund managers) refuse to buy at valuations they consider unreasonable. They will go heavy cash, or even all cash or net short, when they feel it is appropriate. They are not driven by a blind, slave-like devotion to what the herd is doing.

The risk of not tightly tracking the herd, of course, is that you wind up underperforming for occasional stretches of time. When you march to the beat of a different drummer, there will be times where the market appears to be ahead of you – especially when the market is flying headlong on vapors and rumors.

The risk of underperformance is too great for the average mutual fund manager. As Keynes once put it, it is better for them to "fail conventionally than succeed unconventionally." Safety in numbers means the average manager would rather risk your money foolishly under cover of the crowd, then do something wise and take a chance at being left behind.

The Performance Conundrum

One of the great mutual fund managers of all time, Robert Rodriguez of FPA Capital, likes to further hammer home an interesting point.

To be a great investor over the long term – to "beat the market" over, say, a period of a decade or more – almost requires you to have years where you underperform.

What is this statement based on? Simple empirical observation.

Rodriguez points out that, if you look at the track records of the great investors who earned X percent in excess of the S&P over many, many years, those returns are not distributed evenly every year. On the contrary, they tend to be very, very lumpy. Years of gigantic outperformance tend to be interspersed with years of humdrum and quiet. And in nine cases out of 10, there are always at least some years where the market itself did better.

This makes sense when you think about it. To outperform the crowd, one cannot be doing the same things as the crowd. This means different risk levels and different exposures. It means zigging when others zag… being greedy when others are fearful, as Warren Buffett famously once said, and fearful when others are greedy.

It is the exact opposite mentality, in other words, of the one that drives much of Wall Street. When the average mutual fund manager is in a buying frenzy for fear of getting "left behind," that is more than likely an excellent time not to buy. Unless you have reasons your mother would approve of.