Modeling Regret

Below are the closing numbers from Monday for two momentum ETFs and SPY which tracks the S&P 500. Below that as you can see are how each of the three funds did in 2023 where momentum lagged behind.

We've been talking a lot lately about momentum, it has outperformed market cap weighting (MCW) more often than not it seems but nothing is infallible. These two momentum ETFs lagged by similar amounts in 2021. Picking one fund for modeling purposes in a blog post because over time it outperforms is one thing. It's not that picking one fund to serve as an equity proxy is invalid it's just at times that one fund will cause a tidal wave of regret like if everything seems like it's up 20% and your one fund is flat. 

As I play around with these portfolios I've seen funds that miss almost entirely for a short period. YTD, the Invesco Russell 1000 Dynamic Multi-Factor ETF (OMFL) is up 8.5 % as one example. The fund is not broken, that sort of lag happens occasionally. From it's inception until just a few months ago, OMFL had outperformed the S&P 500. This happens with any valid strategy. I don't think owning 10 broad based index ETFs is the answer but other than for blogging purposes, maybe a couple can be a solution.

Here's a simple expression of that idea with 75% in SPMO and 25% in PUTW. It has the identical return as MCW with noticeably lower standard deviation, smaller max drawdown and much better Calmar and Kurtosis numbers.

I listened to an incredible podcast interview of Bruce Berkowitz who manages the Fairholme Fund (FAIRX). This is a very unusual story and while I followed what he said, I don't necessarily follow the logic. Twenty and 25 years ago, Berkowitz was the epitome of a star manager. The fund did lights out good, he ran concentrated portfolios without much turnover. He was famous for owning names like Fannie Mae and Freddie Mac. Unfortunately, after making a ton on those names he rode them down to receivership in the financial crisis. 

You can see to the left of the chart, FAIRX pulled away from the S&P 500 with a similar volatility profile. Then in the Financial Crisis it did far worse and since then it has had much more volatility than the index on the way to a much lower growth rate over the last ten years per Portfoliovisualizer. You can see year by year, it very rarely resembles the index.

FAIRX has essentially morphed into a one stock mutual fund. According to the Fidelity page I linked to above. St Joe (JOE) which is a land company comprises 78.65% of the fund, Enterprise Products Partners takes up  6.42%, there's less than 1% in a mining company and the rest is cash. Berkowitz is the chairman of JOE's board. If I understood the podcast correctly, as fundholders got out due to performance, he sold other things and just kept JOE. He and "his affiliates" own 38% of the fund which is about $2 billion in AUM and JOE's market cap is about $2.8 billion. 

He expects remaining fundholders to sell, he doesn't expect anyone to buy the fund and he doesn't care. He is investing for his family, he views his holdings as being about generational wealth which speaks to his time horizon. That allows him to not be concerned about the periods he lags the market either. 

He had a great quote in the interview saying "you don't need to do much better than 8-9% as long as you don't lose." He places high priority on owning his time and continuing to learn. These points came up several times during the interview. The fund is quirky to be sure but the interview was fascinating.

A useful lesson from the podcast, was the understanding and matter of fact acceptance that there will be periods that he underperforms. His 8-9% quote is about independence from obsessing over looking like the stock market all the time. If you want to do that, put it all in a broad based, market cap weighted fund. You'll be pleased most of the time and miserable, full of regret every few years. The focus here is to strike a balance between capturing upside while not feeling all the regret that goes with holding onto MCW no matter what. 

Here's a short Substack from Joachim Klement about how profitable market making against retail traders is. The way to avoid being someone else's profit center is to trade less. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.