Hagstrom Demonstrates the Extaordinary Gap Between Investment Theory and Practice

In March, MoneyWatch featured an interview with Legg Mason's Robert Hagstrom, manager of Legg Mason Growth Trust. In the interview, Hagstrom summarized a recent Market Commentary he wrote, which found that from 1975 through 1982 -- during which the overall stock market was flat -- an average of 38 percent of all stocks in the S&P 500 index rose more than 100 percent.

From this finding, Hagstrom reaches a couple of different conclusions.

First, he says that in order to reap the rewards of stocks providing such returns, managers have to adopt a longer view. "What we've seen in money management today is that our turnover ratios are way too high," Hagstrom says. "People are trading stocks not investing in stocks."

Amen. Fund managers -- and fund investors -- would do well to adopt a longer-term view.

And what if a similar sideways market lies ahead of us? Hagstrom reaches the following conclusion in his commentary:

Who should not be afraid of sideways markets? Stock pickers! Whether the approach is to select stocks that pay higher dividends or companies that are growing shareholder value at an above-average rate, I believe the game is now in the hands of those investors who can identify mispriced stocks.

Of course, such a strategy sounds great; they always sound great. They're explained clearly, backed up with historical data, and communicated by a well educated manager who looks and sounds like he or she knows exactly what they're talking about.

But as I listened to Hagstrom's analysis, I was curious why his study focused on the flat market of 1975 - 1982. After all, over the past ten years, the S&P 500 provided an average annual return of -1.1 percent -- surely fitting anyone's definition of a long-term sideways market.

After checking the record, I wondered no more. It turns out that Hagstrom's fund didn't fare terribly well in this long-term "stock picker's market." Over the past ten years, Legg Mason Growth Trust has earned an average annual return of -2.8 percent, lagging the S&P 500 by 1.7 percent per year. And in the 15 years since his fund's inception in 1995, Hagstrom's fund has earned 4.8 percent annually, lagging the S&P 500's 6.8 percent return by two full percentage points. (Not coincidently, his fund's largest share class carries an expense ratio of 1.88 percent, which accounts for the lion's share of his fund's losing margin in both periods.)

It's easy to develop theories about what sort of investment strategies should work, and to write books and articles describing how to put those theories into practice. And it's easy to speculate about how the wise implementation of those strategies will prevent investors from having to settle for the distressingly "average" returns that index funds are consigned to providing.

But as Hagstrom's record makes clear, profiting on those theories over the long-term is something else altogether. In many ways, it's a fool's errand. Do yourself a favor and remember that the next time you find yourself captivated by an intelligent-sounding portfolio manager with a sound approach to outperforming the market.