John Rogers Ponders Buffett Quote in April Commentary
In recent years, investors have yanked assets away from surging equities and pushed them toward fixed-income securities that, in our view, were becoming increasingly unattractive. When examining the most recent data from Morningstar, we noticed that there were two categories of funds among investors' top five favorites over the past three-, five- and 10-year periods and two corresponding disliked groups. That is, the Intermediate-Term Bond and Diversified Emerging Markets (Equities) categories have ranked in the top five funds by inflows over all three periods while the Large Growth and Mid-Cap Growth cohorts have among the top-five outflows. For most investors, mid growth funds and emerging markets funds serve as supporting players whose flows might occur for a range of good reasons and be incidental to the portfolio overall. For that reason, we will focus on large growth and intermediate bond funds.
The table below shows the year-by-year flow history of intermediate bond (I.T.B.) and large growth (L.G.) funds as well as an overall tally on the right.
If we assume that investors are building their portfolios rather than winding them down, the bond inflows do not appear terribly out of whack. The spikes in 2009 and 2012 stand out, but otherwise you see incremental investments. Not so for large growth. There you see a gradual move from nearly flat investments to outflows to big outflows—clearly not a normal part of a growing portfolio.
When you see the calendar-year returns alongside the large growth flows, the picture becomes more clear.
Assuming investors had an asset allocation policy and were not systematically overinvested in large growth equity, you should see inflows most years—heavier after down years and lighter (or even negative) after big gains. On that basis, the 2002 to 2007 period flows are reasonable. Then it changes. During and after the massive downdraft in 2008, investors pulled away money in substantial amounts. And despite the varying returns in 2010 to 2012, they slashed large growth exposure in similar increments. Generally, the explanation for this behavior involves risk—stocks' losses are too sharp and sudden—or that the risk/return tradeoff is somehow not good enough.
We're not buying it. Below we have listed the three-, five-, and 10-year annualized returns and standard deviations for the two categories, along with the cumulative 10-year return figures and flow totals.
As you can see, intermediate-term bonds have been in the 5%-6% return realm over these time periods and in the 3% to 5% standard deviation range. Large growth funds have been in the 4%-11% return range and the 16% to 20% standard deviation area. On an annualized basis over the period in question, large growth funds have had 53% better annualized returns which have translated to 64% better cumulative returns, a much bigger gap than Buffett points to in his quip. Admittedly the large growth funds held nearly four times the volatility. At the end of the day, however, stuffing the lower-performing asset class with a half-trillion dollars while pulling $167 billion from the higher-performing one has cost investors tens of billions in potential gains.
Taken altogether, it seems clear to us that recent investor behavior has not helped maximize returns while keeping risk in check. Rather, it has embodied a recent quotation from Ned Davis Research that has been getting the rounds lately: "Investors are not risk averse, they are pain averse. They fear the pain of losing money and the pain of not making money when others are." They sold large growth because it delivered heavy, short-term pain. And if, as early data suggests, they are creeping back in, it is not because the risk/reward tradeoff has improved or even that they see it differently or more correctly. Rather, they tired of seeing large growth stocks go up while they missed out on the gains. Clearly we are not a growth asset manager, but the lesson we draw from this history applies to us and to our investors. Adopt a long-term view, create an asset allocation policy with it in mind and stick to the plan, while looking past short-term pain toward long-term gains.
The opinions expressed are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
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