The secret of Absurdistan’s incredible fund managers
Here is the solution!
What an amazing story. All the fund managers of Absurdistan beat the market. And they are the market.
But let’s take it one step at a time: Absurdistan is a completely isolated country. The same 57 companies have been listed on its stock exchange for over 10 years.
Only residents of Absurdistan are allowed to buy shares and only through equity funds.
For over 10 years, the same 7 equity funds have been available for selection. No fund was newly launched, merged or ceased to exist in the market.
Over the last 10 years, all 7 equity funds have outperformed the Absurdistan Total Return Equity Index. All of them, without exception.
How is this possible?
It’ s as simple as this:
Let’s assume for simplicity that there are not 7 but only 2 equity funds in Absurdistan. The entire market is worth 200 million, each fund starts year 1 with 100 million.
At the end of year 1, fund A has achieved a performance of +25%, its assets thus rise to 125 million. Fund B, on the other hand, has a miserable year and loses 25%, its assets thus fall to 75 million.
So how do investors react? Studies show that investors buy the winners of the past, those funds that top the charts, which are accordingly actively marketed with advertising and road shows.
Accordingly, one third of the investors switch from looser B to winner A. The fund assets of B fall by 25 million to 50 million, the fund assets of A rise by 25 million to 150 million.
In year 2, however, everything is different. Looser B becomes the winner – perhaps because his preference for commodity stocks during the economic recovery is successful. Winner A now becomes a looser, perhaps because his fundamentally defensive orientation does not pay off in an economic recovery.
In year 2, fund B had achieved a performance of +48%, its assets thus rising from 50 to 74 million. Fund A, on the other hand, lost 16%, its assets thus falling from 150 to 126 million.
Over two years, the market performance of the Absurdistan Total Return Equity Index is therefore 0%. Fund A has achieved a performance of 5%, Fund B of 11% (1.25*0.84-1=0.05 and 0.75*1.48-1=0.11 respectively).
Both and hence all have beaten the market.
How? Fund performance does not take into account how much money was employed to achieve the performance in the different time periods – it is only a time-weighted return.
Fund A lost 24 million in year 2, fund B gained 24 million. So it’s a zero sum game for the overall market. But for fund A, the 24 million on 150 million in fund assets is only a 16% loss. In the case of fund B, on the other hand, 24 million on 50 million fund assets make up a profit of 48%.
In reality, it works the same way. Many funds start with limited assets. A few achieve a very good performance over several years, whether with luck or skill is left open. These funds are hyped up by the media, investors and sales people. They record large inflows. Then comes disillusionment. The results lag behind the market. The majority of investors in the fund are dissatisfied because it has disappointed since they started holding it.
The fund manager, on the other hand, points to his very good long-term track record. He may even have beaten the market since the fund was launched. However, this is only because he initially gained a lead with little money and later – with a lot of money – only squandered part of the lead. Most likely because he risked a lot at the beginning, got lucky and then managed the lead by positioning the fund close to the index.
Conclusion: When fund managers point with pride to their strong performance, it doesn’t mean their clients are happy. Most have probably missed the good times.
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