Friday, December 12, 2008

Excess Returns

Investors often report performance that beats the market. Successful investors are treated as superstars who prove that markets are not really efficient. While such cases are possible there are often other explanations. Today, the superstar investor Bernard Madoff was arrested for essentially running a Ponzi scheme, as reported in the here and here. Madoff reported very high, and very stable, returns for a very long time, and rich people invested in his funds. Now he reports that he paid the returns out of new investments, a classic Ponzi scheme.

Just the other day we learned that William Miller, "the era's greatest mutual-fund manager" has seen all of his superior returns wiped away in the last year. According to this article in the WSJ:
A year ago, his Value Trust fund had $16.5 billion under management. Now, after losses and redemptions, it has assets of $4.3 billion, according to Morningstar Inc. Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index.
What these, and many other cases illustrate, is that one cannot tell from observing a string of good years (or of merely reports in the Madoff case) that excess returns are really being earned. This is another case of excess risk masquerading as high "alpha." The problem for investors is that reports of past performance are no guide to future risks, as the disclosure statements always repeat, and as most investors usually ignore.

An important economic point is that prior to the crash the superstar investor is treated as a true Master of the Universe. And those who question this based on efficient markets reasoning are treated as ostrich-like academics, or worse. The investors on a hot streak earn more than those who are more cautious, so over time the latter get replaced. The market is filled with superstar investors and those who aspire to be them. They are encouraged by their management contracts to take on excessive risk and are rewarded. The big problem is that the losses tend to be more broadly felt. They get socialized.

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