Not long ago, hedge fund manager John Paulson was hailed as a master of the universe. He was in a class by himself, generating returns of up to 600 percent by betting against mortgages in 2008. However, 2011 wasn't as kind to Paulson. Bloomberg reported that for the period December 28, 2010 through December 20, 2011 the Paulson Advantage Fund, which seeks to profit from corporate events such as takeovers and bankruptcies, fell about 35 percent. And his gold fund lost 10.5 percent even as the metal headed for its 11th straight annual gain.
Such a tale should serve as warning that a great track record doesn't guarantee great returns in the future. 2011 certainly provided us with reminders of that. In addition to Paulson, consider the fates of these other legendary managers.
Bill Miller and the Legg Mason Value Trust (LMVTX) provide our next example. After beating the S&P 500 Index for 15 straight years through 2005, Morningstar ranked the fund in the bottom 1 percent of all funds in its category (mid-cap blend) for three straight years (2006-08). LMVTX underperformed its benchmark by 8.3 percent, 12.8 percent and 17.3 percent, respectively.
However, after turning in a stellar performance in 2009, returning 40.6 percent and ranking in the 8th percentile, the media was reporting that Miller's "still got game." Unfortunately, in 2010, the fund's performance fell back down to the 98th percentile, underperforming its benchmark by 7.3 percent. 2011 was not much better. The fund lost 4 percent and finished in the 76th percentile.
Our third example is legendary investor Bruce Berkowitz, manager of the Fairholme Fund (FAIRX). Morningstar once named Berkowitz the manager of the decade -- as it did with Bill Miller. He is known for "beating the pack by breaking from it." Of course, that is the only way to beat the pack -- and it's also the road to underperformance.
From 2004 through 2010, the fund never once ranked below the 23rd percentile in performance. Five times during that period, it finished in the top 10 percent relative to its benchmark. However, FAIRX lost 32.4 percent in 2011, underperforming its benchmark by 31.7 percent, with a percentile ranking of 99. The question for investors is: Was 2011 just a bad year for Berkowitz (even Warren Buffett has bad years), or is he the next Bill Miller?
Unfortunately, there's no way to know the answer to that question today. And since the evidence from research on the persistence of performance of active managers has demonstrated that even long streaks don't have predictive value (as Miller's case demonstrates), prudent investors have learned not to bet on the answer either.
The above examples are just a few in a long list of what happens when investors chase returns. It also explains why so many investors end up singing this lament: I own last year's top performing funds. Unfortunately, I bought them this year.