Archives for February 2012

When a mutual fund or hedge fund lists their historical returns, the industry standard is to use time-weighted returns that assume you buy at the beginning of the time period and hold until the end. However, what often happens is that a fund will start out small and have great returns for a while, gradually start attracting lots of investor money, and then the subsequent returns are not so hot. Whatever special inefficiency or investment idea the fund managers had initially is either wiped out by market forces over time or simply hindered by asset bloat. In such a case, the actual returns experienced by investors is less than what is listed under fund return data, even though things like 5-year trailing returns still look quite good.

Via Abnormal Returns, Ben Lorica of The Verisi Data Studio took an academic paper by Dichev and Yu [pdf] in the Journal of Financial Economics and made a nice visualization of the hunk of data presented about hedge funds:

click to enlarge

From the paper’s conclusions:

Using a comprehensive sample, the main finding is that dollar-weighted investor returns are about 3% to 7% lower than fund returns, depending on specification and time period examined. This difference is economically large, and it is enough to reverse the conclusions of existing studies which show outperformance in hedge fund returns. In addition, the estimated dollar-weighted returns are rather modest in absolute magnitude; for example, they are reliably lower than the returns of broad-based indexes like the S&P 500 and only marginally higher than risk-free rates of return.

Most of us can’t invest in hedge funds even if we wanted to, so this is best taken as a larger lesson to be careful when chasing hot returns by any money manager. You don’t want to be the last money in. Morningstar also tracks “investor returns” (dollar-weighted) separately from “total returns” (traditional, time-weighted) in their mutual fund listings.

While perusing this early retirement reading list for more books to read, I ran across an interesting fellow named Harry S. Dent, Jr. His primary theory is that age demographics are strongly correlated with the economy and thus stock market prices.

In particular, the number of households headed by 46-50 year-olds are the best indicator because they are shown to have the highest spending. This makes sense, as around age 50 is also when peak income occurs while you also have spending pressure from grown-up kids and college tuition. After that, the kids move out, things slow down, and average income drops. Here are some charts from the HS Dent Foundation website:

Source:HS Dent Foundation

By looking at birth rates and adjusting for immigration, you can basically predict how many 46-50 year-olds there will be well into the future. Here’s how the shifted birthrate data corresponds to the Dow Jones stock index adjusted for inflation:

Source:HS Dent Foundation

According to the birthrate data, we are looking at depressed prices for another 10-15 years or so, but things will pick back up after that. While I think there may be something to this concept on a long timescale, I would be careful with trying to profit with it in the short-term.

I’m actually look at Mr. Dent himself here – a quick look around shows that he is trying everything under the sun to make money from this simple theory – writing a new book every few years with mostly the same content (2011, 2009, 2006), selling $1,500 seminars to “Demographics School”, and even starting his own Dent Tactical ETF (ticker symbol: DENT) with poor performance since inception and a bloated 1.65% expense ratio. Potential investors should know that he already started a mutual fund previously that failed:

In 1999, the AIM Dent Demographics Trends Fund was launched, based on the demographic economic and lifestyle trends identified by Dent. Unfortunately, the fund’s results were miserable. From 2000 through 2004, the fund lost more than 11 percent per year and underperformed the S&P 500 Index by almost 9 percent per year. In 2005, its sponsor put investors out of their misery by merging it into the AIM Weingarten Fund.

Over the years, he has made many predictions. Some of them came true, more or less. For example, he predicted that the slowdown in Japan economy would coincide with the end of the end of their peak number of 46-50 year-olds in 1990-1994. Some of them did not, like in 2006 when he predicted the Dow Jones would reach 32,000-40,000 in the year 2010 (the highest ever close was 14,164 in 2007).

The last prediction I could find was Dow 4,000 to 6,800 somewhere around 2012. That’s over a 50% drop from today’s prices. I think I’ll add this demographics theory to my investing consciousness, but I’ll leave the bold predictions behind.