One of the eternal truths about trading is that it is conducted by humans and humans are flawed. This is simply the nature of the universe. However, what this means is that all humans irrespective of culture, background, or education are prone to making the same errors. There is a great myth in markets that people who manage vast sums of other people’s money must be immune to the failings of ordinary investors – they must in some way demonstrate superhuman abilities. This is far from the truth a quick look at hedge fund filings will note two very important things. Large numbers of hedge funds fail every year and of those that survive very few beat their competing benchmark.
A glance at the chart below shows the comparative performance between hedge funds and the S&P500.
This lack of performance is not simply limited to hedge funds it is seemingly a feature of all managed funds including local superannuation funds. This does raise the question as to why managed funds of all types generally do so poorly and the answer is simple. They are largely run by people who don’t know what they are doing as evidenced by their poor performance. A somewhat circular argument but true. The people who run very large funds suffer from exactly the same behavioral and tactical issues that bedevil amateur traders. My experience is that they have two structural main issues. They cannot use stops and they use dollar cost averaging or averaging down as a technique.
I have spoken at length before about dollar cost averaging and how there seems to be no evidence that it works at all but despite this is it still widely practiced in the investment industry and there is no better example of this at present than the disaster that is engulfing the once vaunted ARK Innovation ETF (ARKK). For the briefest of times, ARKK was touted as the darling of Wall Street, and its founder Cathie Wood was simultaneously hailed as the greatest investor of her generation and on the receiving end of some brutal criticism – much of it simply driven by sexism. A chart of ARKK’s performance can be seen below. It can be summed as being of two distinct parts – the early years were phenomenal the latter years disasterous.
As can be seen, ARKK is in the middle of an appalling drawdown and the reason for this has become apparent in recent months. The people who run ARKK simply don’t know what they are doing and it is evident that the early outperformance was down to simple luck. Anyone who bought the fund post 2020 is most likely suffering badly. The reason I say that the people who run the fund have no idea is based upon their public filings and desperate attempts to shore up the fund via dollar cost averaging driven by ego.
The chart below shows the difference between the current price of ARKK and the current average price of their 35 largest holdings – apart from TSLA and SHOP all the holdings are substantially underwater even with aggressive dollar cost averaging. You can click on the image to download a larger version
However, this sort of chart hides a nasty sting in its tail and it is a point that those who average down fail to understand. A 10% loss on a share cannot be made up by a 10% gain on the remaining capital – it requires 11.1% to get back to where you started and it only gets worse from here.
The chart below looks at the percentage gain required on the dollar cost average price of the losing shares to get them back to the current last quote price I used.
As you can see some shares are so far underwater it is doubtful that they will ever recover. It would certainly be a remarkable feat to see CGEN put on a gain of 6960% to get back to the current market price. You can see the full extent of these losses in the table below.
What is most interesting about this is the disastrous recent performance of the fund could have been avoided simply by placing a stop loss under the shares as they went up and letting them be culled from the portfolio as they fell. A recent although not perfect example of this would be Pershing Squares’ decision to jettison Netflix and take a $400M hit – which also could have been avoided if they had decided not to buy a share that was in a downtrend. Despite this poor execution Bill Ackman Pershing Square will live to fight another day – it is doubtful whether Cathie Wood and ARKK will enjoy the same fate.