by Jerry A. Miccolis, CFP®, CFA, FCAS, and Marina Goodman, CFP®
Jerry A. Miccolis, CFP®, CFA, FCAS, is a principal and the chief investment officer at Brinton Eaton, a wealth management firm in Madison, New Jersey, and a portfolio manager for The Giralda Fund. He is co-author of Asset Allocation For Dummies® (Wiley, 2009) and numerous works on enterprise risk management. (firstname.lastname@example.org)
Marina Goodman, CFP®, is an investment strategist at Brinton Eaton and a portfolio manager for The Giralda Fund. She has been working to bridge the gap between research and practice to improve the portfolio optimization process. (email@example.com)
A few months back, a client showed us some promotional material from a stock-picking service that seemed “too good to be true” and asked whether that was literally the case. We want to share that example—and our umbrage—with you. While we’re at it, we also want to share some other, perhaps less egregious but no less annoying, samples of sales pitches that prey on a gullible public and give our industry a bad name. We have this quixotic notion—if enough of us educate our clients and prospects about these deceptive practices, maybe someday they will stop.
Example 1: The Stupendous Stock Picker
Consider the following claims: “84 percent of our stock picks are winners … An equal investment in each of the holdings would have delivered a noteworthy return of more than 300 percent in a little more than eight years’ time … An investment of $100,000 in our portfolio recommendations would be worth $389,414 today. In comparison, the same investment in the S&P 500 Index would be worth only $149,970 today. In other words, our portfolio outperformed the S&P by 165 percent!”
Wow. Good stuff.
Here’s the rub. There is no portfolio. There are only stock picks. If you had invested $100,000 in this firm’s stock picks at the beginning of the eight-year period, where would you have gotten the extra funds to buy the picks they made over the next several years? There were a large number of these buy recommendations before they made their first sell recommendation; if you had sold off any of the original investments in time to make these buys, you would not have enjoyed anywhere near the aggregate results they claim. If, instead, you had not invested the full $100,000 at the outset, the amount of cash you would have needed to hold to accommodate the future net buys would have been so large—and the resultant cash drag would have been so punitive—that the actual return on your “portfolio” would have a been a mere fraction of what they claim.
Example 2: The Super (Surviving) Separate Account Managers
We once competed for two prospects against the same advisory firm. The other adviser explained they had used several dozen separate account managers over the years, and they had hand-selected the best of those managers for our prospects. The recent returns for those managers were impressively above average. The adviser, conveniently, did not show the results of the managers they had actually selected for their clients over that time, only the results for those retrospectively “hand-selected” managers. Now, the typical prospect is not familiar with survivorship bias, and even after we explained the fallacy (when previously used managers who have underperformed are retroactively removed from prior performance history), only one of those two prospects understood that they were being scammed.
The prospect who “got it” remains our loyal client.
Example 3: The Marvelous (Modeled) Mutual Fund Portfolio
A popular family of mutual funds fashions their promotional material around the scientific methods they use to exploit market inefficiencies. They will even help you design a portfolio of their products that you can implement across all your client accounts. If you try to get a track record from them on that portfolio, you will come up dry. Instead, you will get a modeled pro forma view of what the current allocation would have looked like if it were in place in retrospect.
Data mining anyone? In its essence, this sales practice is simply survivorship bias in less transparent clothing.
Example 4: The Cunning Cumulative Return Presentation
Cumulative return graphs are ubiquitous in investment performance presentations, yet they are intrinsically deceptive. To illustrate how these graphs can fool us, we’ll use market indexes to avoid picking on any specific products.
Have emerging market stocks outperformed U.S. equities in recent years? As Figure 1 shows, that depends on your starting point. Starting your index (at 100) in 1999 would show emerging markets leaving U.S. equity markets in the dust. Starting your index in 2008 would show emerging markets underperforming.
Consider the loss in 2008 for emerging markets versus U.S. equity based on the first graph. It appears that emerging markets really fell off a cliff while the S&P 500 suffered a far more modest decline. The second graph paints a less dramatic picture with the same data.
It is easy to see how cumulative return presentations can—without being inaccurate—be manipulated by the unscrupulous.
Example 4 Revisited: The Remedial Rolling-Return Presentation
To cut through the potential distortions presented by cumulative returns, it is useful to compare investments on a rolling-return basis. In Figure 2, we can clearly see the periods over which emerging markets outperformed and underperformed U.S. equities, and are thus no longer biased by the starting date. We also have a more accurate assessment of how volatile emerging markets are versus U.S. equities and the magnitude of their respective losses.
Rolling-return graphs are also useful tools when evaluating numerous investment options with different inception dates. Cumulative graphs require the same start date; however, rolling-return graphs can compare investments with any number of different start dates. Another benefit is that they provide a more detailed view of past gains and losses. For example, from the graph it is possible to discern how often emerging markets suffered a loss of 20 percent or more over a 12-month period.
The rolling-return calculations can be adapted to any period the adviser is concerned with—an adviser with a longer time horizon may want to calculate returns over a three-year rolling period, while one with a shorter time horizon may adopt a three-month rolling period. We’d like to see rolling-return presentations routinely accompany their cumulative-return counterparts.
Educate, Don’t Exaggerate
These are just a few instances of how investment performance can be masked, intentionally and unintentionally, to the detriment of a vulnerable public.
By exhibiting the highest level of professionalism in investment performance presentation, and by identifying and unmasking deceptive practices when we encounter them, we can help engender the trust our profession desires and deserves.