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Rekenthaler Report

Dear Active Manager: Can I Reinvest?

When scale becomes a problem, even the greatest fund isn’t all that great.

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Alpha Dog
There are two viable paths for money managers: 1) selling beta or 2) creating alpha. (For readers unaccustomed to investment jargon, that statement translates to "selling portfolios that move closely in line with the markets, or creating portfolios that perform both differently and well.")

Most successful active managers sell beta. This assertion defies convention, which places index funds in one group and actively run funds in the other, but the largest active funds are, in effect, cheap beta. They are bland, highly diversified offerings that act much like market portfolios, and are priced accordingly, carrying low expense ratios for their institutional shares. They can readily be substituted for index funds.

Finding alpha creators is much more difficult. To understand why, consider the case of Medallion Fund. Managed by a firm called Renaissance Technologies, Medallion has posted the highest gain of any fund, anywhere in the world, over the past 30 years. This includes Renaissance's other offerings, which haven't come close to matching its returns.

That last sentence, along with the follow-up that Medallion is held solely by Renaissance employees, while its (relatively) underperforming siblings are open to outside investors, indicates that Medallion is not a registered fund. Mutual fund (and exchange-traded fund) providers don't treat their customers like that. But Renaissance provides hedge funds, and the attitude of the leading hedge fund managers is, "We do what I like. If you don't like it, you are welcome to go elsewhere."

Does Not Compute
When you post numbers like Medallion's, customers don't fuss the niceties. Since the fund's 1988 inception, reports Greg Zuckerman in "The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution," Medallion has returned 39.1% annualized--after fees. And those fees are hefty indeed. Before costs, estimates Zuckerman, the fund's annualized gains were 66%.

Such numbers would freeze Spock's brain. For comparison's sake, the highest annualized mutual fund return (nope, not Vanguard 500 Index (VFINX)) since 1988 has been 16.2%, after fees. Compounding, of course, greatly expands the difference. Over three decades, a $1 million investment that gained 16.2% per year would have appreciated to $90 million, while a purchase that accumulated at 39.1% would have become $20 billion. One sum is not like the other.

As Medallion Fund frequently accepts large investments, one might wonder why it's not the largest fund in existence, rather than a reported $5 million-$10 billion. (Obtaining exact figures for hedge funds is difficult; the only reason that Medallion's reported returns can be stated with confidence is because Zuckerman did the footwork.) Good question: The answer is because at the end of every year, Medallion distributes pretty much all its profits, thereby maintaining its slender figure.

Unwanted Distributions
Which brings us to the point of this column: Highly active management can be wonderful. However, the circumstances under which it can thrive are distressingly limited. Trillions of dollars can invest in cheap beta without harming the product. With alpha creation, though, asset size is an ongoing problem. Even a few billions may slow the fund's performance. Perhaps even less, if the strategy is esoteric.

(Yes, only two weeks ago I praised the largest mutual funds, and now it looks like I am burying them. But not so. The major actively invested funds are useful vehicles for cheap beta. They are competitive with index funds, and they won't be disappearing anytime soon, because fund companies don't liquidate their biggest offerings. However, they aren't much good for alpha generation.)

That is a problem, practically speaking. Steep ongoing rates of return help fund marketers, as well as columnists who wish to demonstrate the almost-overwhelming power of compounding, but they don't make money for investors if those investors are no longer in the fund! When Medallion ejects shareholder assets, in the form of annual distributions, those monies must go somewhere. And whatever that somewhere was, it was far less profitable than Medallion.

Four Potential Investments
Morningstar's Thomas Furuseth took these thoughts one step further, by testing to see how various reinvestment strategies would have fared. He invested $1 million into Medallion upon its inception (He deeply regrets that this exercise is only hypothetical), assuming that he would receive each year's profits as a distribution. What do with those monies?

One approach would be to buy things--that is, to cash out. Writes Furuseth, "If you spend all the proceeds, then you would have spent $12 million." Add the $1 million that would have remained in the fund, after the final year, and the full amount for the cash-out strategy would be $13 million. A paltry return for owning the world's best fund! Then again, spending one's gains is effectively disinvesting.

For contrast, buying and holding the S&P 500 would have returned $20 million. The waiting time would have been much longer than with the previous approach, so when the time value of money is considered, buying the S&P 500 was the inferior strategy. Nonetheless, it's surprising--at least to me--that merely by reinvesting promptly, an ordinary investment could generate higher profits than did Medallion.

The next rung up consists of buying Medallion, then rolling each year's distribution into the S&P 500. Sadly, one can't buy more shares of Medallion. Happily, one can invest in the overall stock market, which performed very well over those three decades, all things considered. This approach, says Furuseth, would have produced $51 million in ending wealth.

Only $51 million? Not that I wouldn't mind owning that sum, but if I had been fortunate enough to own $1 million in 1988 (as opposed to my actual savings of $2,000), and brilliant enough to place that amount into Medallion, I certainly would want more than $51 million for my troubles. After all, buying and holding the top-performing mutual fund (Fidelity Select Software & IT Services (FSCSX)) would have returned $90 million. I found Medallion but still couldn't beat a mutual fund!

Finally comes the highly desired--but unpermitted--strategy of buying and holding Medallion, while reinvesting all its distributions. Furuseth calculates the final wealth at $20 billion, thereby matching my result. (It would have been distressing were that not so.)

In Conclusion
Two different ways of investing $1 million in Medallion, along with one of holding the S&P 500, led to final wealth amounts ranging from $13 million to $51 million. Our hypothetical investor can purchase a summer home with the former, and a ski lodge (or two) with the latter. The fourth investment approach, however, would have enabled him to buy New York's Knicks, Jets, and Rangers, with plenty of assets left for tropical islands.

The sole difference between being a multibillionaire and just another wealthy person owed to problems with scale. Unlike the cheap-beta providers, Medallion couldn't keep doing what it was doing while growing ever larger. To maintain its extremely high level of performance, it had to distribute its gains. Such actions don't typically show up in total-return calculations, which assume that investors can reinvest all profits, but they are critically important for real-life results.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.