Sir Isaac Newton’s Revenge on Wall Street

Performance chasing can be tempting.

Those fund managers, stock pickers, and companies who seem to always outperform, always beat, and always return above their peers — well, it’s certainly tough to resist their siren song. Whose first impulse wouldn’t be to get on a train that’s moving quickly, up, and to the right?

But things are not always as they appear, and what comes up must, according to physics, come down.

Physics, and Isaac Newton himself, have even more to teach us about the market, as you’ll discover in today’s post.

Today’s guest post was authored and submitted by Ryan Kelly of RFK Capital Management, one of the few firms that made the cut to be on our short list of recommended financial advisors.

My clients are DIY investors who want to invest in a simple portfolio of index funds. They don’t want or need to pay an ongoing fee for financial advice but do want to make sure they are on a good path with their financial planning.  As such, they see value in paying a one-time fee for a financial plan or financial review.

I rarely spend time convincing my clients that index fund investing is the way to go. That’s because most of my clients find me through personal finance blogs and websites that promote indexing as the optimal way to invest for the long-term.

But while I don’t typically need to convince my clients to index, I do find it useful to spend some time discussing “why” indexing works. If they understand the why, I believe they are more likely to stay the course. This will lessen feelings of FOMO when investment fads are temporarily outperforming the overall stock market.

There are many reasons why indexing works well over the long run, but in my opinion the three main reasons are as follows:

1. Extremely low expenses. Today, a simple portfolio of broad-based index funds costs less than 0.05% per year in total fees (or $5/year for every $10,000 invested). Index fund investors receive their “fair share” of investment returns over the long run.
2. Broad diversification. A simple portfolio of two stock index funds, such as the Vanguard Total Stock Market ETF (VTI) and the Vanguard Total International Stock ETF (VXUS), allows an investor to own every publicly traded stock of significance in the world. Diversification is one of the only free lunches in investing. It not only minimizes the risk of permanent capital loss, but thanks to research from Dr. Hendrik Besseminder of Arizona State University, we know that broad diversification also can increase one’s expected long-term return compared to a more concentrated portfolio of stocks. Do Stocks Outperform Treasury Bills | ASU W. P. Carey
3. Reversion to the Mean. A successful and committed index fund investor is fully satisfied with the “market return” and will therefore avoid the mistakes and pitfalls that come from the human tendency to chase investment performance.

Sir Isaac Newton’s Revenge on Wall Street

The third concept, reversion to the mean, is less understood by index fund investors compared to the first two concepts. But it is critically important to understand. John Bogle writes about reversion to the mean in his book, The Clash of the Cultures. In chapter 9, he offers 10 simple rules for investing, and lists “Remember Reversion to the Mean” as rule number 1. He writes the following on page 301:

“Time and again, I have tried to drive home to investors the need to…rely heavily on low-cost market index funds as the core (or even 100 percent) of their portfolios. Yet too many investors believe that “it’s easy to find funds that have done better, and I know how to do it,” or, “it’s easy to beat the market, so why settle for boring mediocrity.” They don’t realize how much better off they would be with the boring mediocrity that index funds offer.

Sadly, when investors try to beat the market, they select funds that have done well in the past, with the expectation, or at least the hope, that the past will be prologue to the future. But in the world of investing, the past is rarely, if ever, prologue.”

Many investors incorrectly assume that if a mutual fund manager, hedge fund manager, or financial advisor has done well in the past, then the future is also bright for that manager or advisor.

In truth, reversion to the mean is an ever-present force in the financial markets. It acts as a “law of gravity” where the high-flying fund managers of yesterday fall back to earth and become the losing fund managers of tomorrow.

John Bogle has called this phenomenon “Sir Isaac Newton’s Revenge on Wall Street.” An investor who understands this concept is less impressed with high flying fund managers and is content in consistently earning market returns.

Here is a brief list of four mutual fund managers who had a long period of stellar performance followed by a humbling period of very poor performance. These managers, once praised by Wall Street, have become victims of Sir Isaac Newton’s Revenge on Wall Street.

To produce the performance charts, I have used historical adjusted share price data from Yahoo Finance. The adjusted share price data accounts for dividends and capital gains distributions. The performance charts show the growth of $1,000 over a given period of time.

Four Victims of Sir Isaac Newton’s Revenge on Wall Street

#1. Cathie Wood

Cathie Wood is the founder and CEO of Ark Invest and the portfolio manager of their flagship fund, the ARK Innovation ETF (ticker symbol: ARKK). The fund launched on October 31, 2014. After a bit of a slow start in 2015 and 2016, the fund experienced a meteoric rise from 2017 to 2020 and became the most talked about actively managed mutual fund in the world.

If you invested $1,000 in ARKK at the fund’s inception on October 31, 2014, your investment would have grown to nearly $6,800 by the end of 2020. Over this same period, an investment in the Vanguard 500 Index Fund would have grown to $2,090. ARKK massively outperformed the overall stock market over this 74-month period.

But it didn’t take long for Cathie Wood’s investment performance to turn not just cold, but icy cold. From December 31, 2020, to May 1, 2022, the fund fell 68% in value. Over this same period, the Vanguard 500 Index Fund increased by 12%. In just 17 months, nearly all of ARKK’s market beating performance vanished.

After a massive 68% loss over the 17-month period, ARKK must generate a 213% return just to get back to its year-end high on 12/31/2020.

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#2. Bill Miller

Bill Miller joined the mutual fund firm Legg Mason in 1981 as their director of research. Whereas most mutual fund managers receive an MBA from an Ivy League business school, Miller earned a PhD in philosophy. Miller was a fascinating figure and received a lot of press coverage in the Wall Street Journal and other financial publications for his unique approach to investing.

As the lead portfolio manager of the Legg Mason Value Trust, he attained Wall Street glory by beating the S&P 500 index for 15 consecutive years from 1990 to 2005. For a time, it seemed as though Miller was an exception to the reversion to the mean rule.

However, Newton’s revenge eventually struck Miller and his fund, and it struck quickly and with a vengeance. The fund experienced massive losses during the 2007 to 2009 financial crisis. His fund was heavily invested in financial stocks. The more these stocks went down during the financial crisis, the more he bought them up. He kept trying to catch falling knives and his fund’s investors got badly cut in the process.

The following chart shows the growth of $1,000 invested in the Legg Mason Value Trust for a 14-year period from January 1, 1995 to January 1, 2009. The fund has since been renamed and I had difficulty finding historical share prices back to 1985. But Yahoo Finance did provide the data going back to the beginning of 1995.

It’s fascinating to consider how such a long period of steady outperformance can be followed by such a short but severe period of market underperformance.

#3. Ken Heebner

On October 1, 1997, Ken Heebner launched the CGM Focus fund (CGMFX) and has been the portfolio manager of the fund ever since. Over the next 10 to 11 years, he achieved extraordinary success. A $1,000 investment at the fund’s inception in October 1997 grew to nearly $12,000 by the spring of 2008. Heebner was lauded as a genius stock picker and fund manager, and investors chased the hot returns by pouring nearly $3 billion of new contributions into the fund in 2007 and 2008. I remember a conversation with my dad in early 2008. He was fascinated by Heebner and his track record and was considering a modest investment in CGMFX. Fortunately, he concluded that it all sounded too good to be true, and that Heebner’s sky high returns were earned by taking big risks.

Newton’s revenge would hit Heebner’s CGM Focus Fund gradually and at four different times over the subsequent 11 years from 2008 to 2019. The first hit came during the financial crisis. In 2008, the fund fell 48% in value while the Vanguard 500 Index Fund fell 39% over the same period. Despite the poor year in 2008, the fund still managed to be the best-performing U.S. diversified stock mutual fund from 2000 to the end of 2009. Interestingly, over that period, the average investor in the fund actually lost money. How could this be? It’s because the great majority of investors chased performance and got in at its peak–right before the fund’s 2008 crash.

The fund did have a good year in 2010, but Newton’s revenge came back again, and with greater vengeance, in 2011. In a year when the Vanguard 500 Index Fund appreciated 2%, the CGM Focus Fund declined by 26%. In 2012 and 2013, the fund bounced back again, but then had horrible returns in 2014 and 2015. It recovered somewhat in 2016 and 2017, but then went into an absolute freefall in 2018 and 2019.

By early 2008, the fund since inception had turned $1,000 into nearly $12,000. By comparison, the Vanguard 500 Index Fund had turned $1,000 into only $1,800. In other words, the CGM Focus Fund had generated nearly 14 times more wealth than the Vanguard 500 Index Fund over that period. By late 2019, the CGM Focus Fund, since inception, had only generated 1.5 times more wealth than the Vanguard 500 Index Fund. Most of the excess wealth it had previously generated had vanished. For those that invested in the CGM Focus Fund at its peak in early 2008, they were still down 40% on their investment more than 11 years later despite that period being a very strong bull market for the S&P 500.

#4. Bruce Berkowitz

Bruce Berkowitz launched the Fairholme Fund (FAIRX) at the beginning of the new millennium on January 1, 2000. Berkowitz is a value investor that seeks to invest in undervalued companies with strong and reliable cash flows. Over the next 10 years after his fund’s launch, he experienced phenomenal success and was named Morningstar’s “Mutual Fund Manager of the Decade” in the domestic stock category. Whereas the Vanguard 500 Index Fund experienced a lost decade with a slightly negative return, the Fairholme Fund appreciated more than 250% from 2000 to 2010.

Newton’s revenge first hit Berkowitz in 2011. That year, the Fairholme Fund declined 32% while the Vanguard 500 Index Fund increased by 2%. In his letter to shareholders that year, Berkowitz began by writing “What a horrible year for performance!”

The fund recovered and had very good years in 2012 and 2013. However, over the remaining six years of the decade, the fund’s performance was abysmal relative to the Vanguard 500 Index Fund.

The story of the Fairholme fund from 2000 to 2020 is really a tale of two decades. Whereas the fund massively outperformed the Vanguard 500 Index Fund in the first decade, it subsequently grossly underperformed the Vanguard 500 Index Fund in the second decade. I break out the 20 year performance into two charts to show the difference between the two decades in terms of performance.

Other Examples

There are countless other examples of reversion to the mean in the financial markets. This force not only impacts mutual fund managers, it can also impact hedge fund managers. One infamous example is told in the classic book ”When Genius Failed” by Roger Lowenstein about the rise and fall of Long-Term Capital Management. Reversion to the mean has been a force in precious metals and mining stocks, meme stocks, cryptocurrencies, and ETFs that invest in specific sectors of the stock market.

Incorrectly Applying the RTM Concept

As a caution, I need to be careful that the nature of my message does not lead myself or my readers to the same downfall it warns against. It’s important to not let overconfidence lead to incorrectly applying the reversion to the mean concept.

For example, it is true that international stocks have underperformed U.S. stocks over the past 10 years, and that international stocks are trading at much cheaper valuations compared to U.S. stocks. But it would be unwise to suddenly switch one’s portfolio entirely to international stocks because of a belief that international stocks will experience “mean reversion” and therefore outperform U.S. stocks in the future. Even if that view turns out to be correct, it’s extremely difficult to get the timing right and therefore profit from such a strategy.

Reversion to the mean should make investors more agnostic with investing, and less dogmatic with investing. The better approach is to have a balanced mix of U.S. stocks and international stocks and stick with that through thick and thin. We don’t know when or how reversion to the mean will play out. It’s essential to stay humble and stick with a broadly diversified and balanced portfolio.

By remembering reversion to the mean, I believe index fund investors can minimize mistakes, stay disciplined, and greatly improve their odds of long-term investing success.

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