Imagine an investment manager that is so good that they can double their money whenever they put money into the market. However, this manager is only able to do so once every five years and is smart enough to know when he is invested outside his “window of opportunity” he will dramatically underperform the market and thus will go to cash during the rest of the time. This investor would be in the top percentile of all investors by virtue of his ability to obtain a 15% compounded return, year over year (doubling your money every 5 years is very close to 15% compounded annually). However, just imagine if he had a hedge fund and investors piled on board after his first 100% year and reading his annual reports:
Year 1 letter to shareholders – We were fully invested in the market, but have now gone to 100% cash. Our performance on equities has resulted in a 100% increase in our net asset value since the beginning, a very good year. We will look for more opportunities in the future when they present themselves.
Year 2 letter to shareholders – Thank you to the new investors for joining hedge fund XYZ. We have been 100% invested in cash, earning 3% on cash. We have found nothing suitable to invest in.
Year 3 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We still have found nothing to invest in.
Year 4 letter to shareholders – We have been 100% invested in cash, earning 2.75% on cash. We have found nothing to invest in. Believe me, we are trying!
Year 5 letter to shareholders – We have been 100% invested in cash, earning 2.5% on cash. We’re really looking hard for investment candidates, some might be on the horizon soon, but we can’t tell at this moment.
By this time, most of the people invested in the hedge fund would have already exited. “Why bother investing with this guy when he isn’t going to be investing our money?” If the investment manager was working for a larger company, chances are the manager would have been removed, even though he was working in the long-term interest of the fund.
Of course, by the time clients have removed all of their money from the hedge fund, the manager on year 6 sees opportunity and has another year of a 100% return. People, attracted by the performance, come back to the fund in droves, only to witness their money being invested in money market instruments for another 4 years.
This is one of the big advantages that an individual investor has, assuming they are capable enough to hold high levels of cash during significant market downturns. An individual investor does not have to sacrifice their strategy for political reasons (i.e. fear that their clients will pull money out of their fund). This political advantage can be exploited by those with ironclad discipline to hold cash for lengthy periods of time.
It is usually very difficult to measure the performance of these individuals over a short time period – it would have to be measured over a lifetime. The Buffett/Munger partnership is the best example of people that were not afraid to hold onto their cash for opportunistic moments.
I’ve thought about pursuing a route that might lead to fund management, but I always end up coming to a similar conclusion. It’s unfortunate that access to the kind of capital that would allow one to making a living from fund management alone (provided you don’t already have a large enough pool of capital already) usually comes with these kinds of issues — as has been said before, managing a fund becomes more about placating your customers, detracting from the time that can be spent doing research for potential opportunities. The people who earn their living from fund management are incentivized to work towards relative outperformance rather than absolute outperformance; just as long as they do marginally better than certain benchmarks, they can happily collect a fee, even if by any measure they’re mediocre investors.