Financial Lessons from “It’s a Wonderful Life”

We take a look at a few financial lessons from the Christmas classic It’s a Wonderful Life, including some that are timeless reminders, and one or two that may surprise you.

FIVE THINGS YOU SHOULD KNOW

Equity Markets – were higher this week with U.S. stocks (S&P 500) up 2.33% while international stocks (EAFE) rose 2.42%.
Fixed Income Markets – were mixed with investment grade bonds (AGG) down -0.26% while high yield bonds (JNK) rose 0.97%.
3. “Build Back Better” on Last Breath – This week saw President Biden’s $2 trillion stimulus package suffer a massive setback with Democratic Senator Joe Manchin rejecting the plan and assuring that in its current state it would not pass a Senate vote. With critical midterm elections only 10 months away, Democratic leaders held emergency conversations with Manchin as they hold out hope that a resolution can be made, with Manchin’s biggest concerns centering around increasing national debt while there are ongoing inflation concerns.
Omicron Study Results – Preliminary data from three separate studies have shown that while Omicron cases have spread rapidly, they are less likely to lead to hospitalization or severe symptoms. The Government announced their new strategy to send over 500 million at-home testing kits free-of-charge to Americans to combat the spread but did not announce any additional Federal restrictions or shutdowns.
Key Insight – [VIDEO] We take a look at a few financial lessons from the Christmas classic It’s a Wonderful Life, including some that are timeless reminders, and one or two that may surprise you. [ARTICLE] Playing off the theme of this week’s video, we use Potter’s greed, to look at some common mistakes investors make in their effort to rush the process that can have harsh consequences and includes two must-read articles to get in the right mindset heading into 2022.

INSIGHTS for INVESTORS

It’s a Wonderful Life is one of my favorite movies and one I have seen literally over a hundred times in my life. The lessons from that movie are endless, as is my need for reminders on how to be more like George Bailey. In past commentaries, I’ve cited such lessons as “not panicking” and quoted George’s encouragement to his community during the bank run to, a) “Just remember this thing isn’t as black as it appears” and, b) “Potter isn’t selling, Potter’s buying, and why? Because we’re panicky and he’s not.”

But there are many other lessons as well, some of which we discuss in the video above. Of course, one of the obvious “lessons” from the movie is to be more like George and less like Potter.

While Potter is an extreme example, the truth is, keeping a proper perspective around money is a challenge for most people and aspects of “greed” can creep into our thought process in some seemingly innocent ways.

Suppose you view your thriftiness as prudent saving and/or planning, but it may not be if it means depriving you and/or your family of some potential joy/memories today that could safely occur without bankrupting your future.

Or you see moving around your investments to what appears to be the “best” option as smart management, but such intentions can easily morph into performance chasing that has the exact opposite outcome as one would’ve hoped for.

For Potter, maybe such greed and misguided thought was in his DNA, but for the rest of us, how do we avoid letting good intentions lead to unhealthy mindsets and actions?

Perhaps above all else, is setting your purpose and plan accordingly. In the movie, George is offered the equivalent of 25 years of his pay over the next three years to shutter the Building and Loan and work for Potter. Initially, he is excited and appreciative, and you can see his mind racing with the possibilities of such money. However, VERY quickly he realizes that such a decision is not in alignment with his greater purpose, nor is it required for the life he NEEDS to lead, and he turns Potter down.

Time and time again, we see people who don’t feel the need to take the time to truly (and formally) define their goals and purposes and outline a plan to achieve them. When they don’t and are left to their own gut instincts, fears and/or greed, the results are very similar – they become overly fearful with respect to their spending and/or market volatility or they naively believe they can do some research in their spare time to find the next get-rich-quick investment (usually in the form of what happened to work last year).

Two articles below are fantastic reads for a couple reasons:

a) Perspective – How do you keep a proper mindset without proper perspective? The first article helps clear up how markets and their long-term performance work to address the common misunderstandings which lead many people to unnecessarily hit the panic button and switch strategies mid-stream, costing themselves the returns they hope to see over time. It also includes great charts/facts to show how scary markets are not as common or fatal as many presume.

b) Patience – The second article uses the headline making ARKK (an ETF of high-flying tech) stocks to highlight investors penchant for chasing performance and how it results in anything but great returns for them.

As George states in the movie, “Now we can get through this thing alright, we’ve got to stick together though.” And part of “getting through” is regularly reminding ourselves of our purpose, and the person we need to aspire to be to realize that purpose. I hope the team here at TEN, this year, these articles, as well as a good viewing of It’s a Wonderful Life will be a help to you and yours. You all certainly are an inspiration to us.

Merry Christmas!!

Tim and the team at TEN Capital

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The Average Outcome (Almost) Never Happens

by Aneet Chachra, CFA Portfolio Manager at Janus Henderson

’Tis the season for decorations, gifts, parties and stock market forecasts. And just like holiday displays, it feels like prediction season starts earlier every year. This year, I received the first 2022 outlook report on November 7, with 15% of 2021 still remaining. A steady pace of thick publications has continued since. By now, most strategists have announced what they expect to happen next year. Here are all the 2022 forecasts I could find.

Exhibit 1: S&P 500 Strategist Estimates for the End of 2022

Source: Bloomberg, Research Reports, as of 5 December 2021. Industry estimates are hypothetical in nature, do not reflect actual investments, and are not guarantees of future results.

The average forecast calls for the S&P 500® Index to close next year at 4,909 – a 8.2% price increase from its current level. This matches the average annual historical rise of 8% for the index. However, although the S&P 500’s price return has averaged 8%, it has rarely gone up by about the average amount in any given year. Remarkably, in only six out of the last ninety-four years has the annual S&P 500 gain actually been between 5% and 10%.¹

Exhibit 2 shows the past distribution of annual price returns for the S&P 500. The most frequent annual return range was 10% to 20% (occurring in nearly one-quarter of years) followed by the 20% to 30% range. Importantly, both the -10% to 0% and the 0% to 10% ranges were less common than others despite being closer to the average return.

You can visually see that outcomes are not normally distributed – instead both larger positive and larger negative returns happened more often than central ones.

Exhibit 2: Frequency of S&P 500 Annual Price Returns

Source: Bloomberg, Research Reports, as of 5 December 2021. Industry estimates are hypothetical in nature, do not reflect actual investments, and are not guarantees of future results.

Strategist estimates for next year are also rather clustered. The standard deviation of the 2022 market forecasts shown in Exhibit 1 is 240 S&P 500 points, or 5%. But the realized standard deviation of annual S&P 500 price returns is 19%, more than triple the dispersion that strategist estimates imply.²

This is because equity market outcomes are somewhat bimodal in nature. Using a single average number to describe historical or forecast returns is insufficient. The S&P 500 has increased in about two-thirds of years with an average gain of 18%. However, the S&P 500 has also declined in about one-third of years with an average drop of -14%.³

Stated simply, in up years, equities tend to be very good. In down years, they can be quite bad. A well-structured portfolio typically has an equity allocation that is often the primary return driver in up years, but also allocates to uncorrelated strategies and assets to help diversify or hedge the portfolio particularly in down years.

The pile of 2022 market outlook reports I have received are well-written, full of interesting charts, and very convincing. Strategist-provided average forecasts of 5%-10% annual total return for equities seem reasonably supported by estimated equity risk premia, dividends, growth, inflation and historical evidence.

But return outcomes over a one-year horizon tend to be much more volatile in both directions than the average. As the quote variously attributed to Niels Bohr, Yogi Berra, Mark Twain, Samuel Goldwyn and many others reminds us:

“Prediction is hard. Especially about the future.”

¹Bloomberg, S&P 500 Index price series from January 1928 to November 2021.
²Ibid.
³Ibid.

ARKK: An Object Lesson in How Not To Invest

There's a massive gap between reported total returns and investors’ actual results.

Amy C. Arnott, CFA Dec 13, 2021

As my colleague Katherine Lynch recently reported, ARK Innovation ETF’s (ARKK) downward trend over the past few months, in the wake of its spectacular rise in 2020, has taken shareholders on a wild ride. Because the actively managed exchange-traded fund didn’t attract widespread popularity until late 2020, the returns most of its shareholders have actually experienced have likely been far lower than its reported total returns.

In this article, I’ll dig into more detail on how big the difference has been between the fund’s reported total returns and the results shareholders have actually experienced, as well as why poorly timed asset flows are the major culprit.

Why Investor Returns Often Lag Total Returns

As I’ve covered in previous articles, a fund’s investor returns (also known as dollar-weighted returns or internal rates of return) often differ from its reported total returns because of the timing of cash inflows and outflows. Reported total returns (aka time-weighted total returns) assume a lump-sum investment made at the beginning of the period, with no purchases or sales made during the interim. But because investors often buy and sell funds for various reasons, their actual results can vary significantly if, for example, they buy more shares right before a major downturn or sell shares and then miss out on subsequent gains.

In our annual “Mind the Gap” study, we estimate the gap between investors’ dollar-weighted returns and funds’ total returns. For the most recent 10-year period ended Dec. 31, 2020, we found that in aggregate, investors earned about 1.7 percentage points less per year compared with reported total returns because of mistimed purchases and sales. We also found that this gap seems to persist over time, although it varies for different types of funds.

But while investor return gaps aren’t unusual, ARK Innovation’s results are on a completely different scale.

How Wide Is the Gap?

To estimate how ARKK’s shareholders have fared, I looked at monthly asset flows since inception, as well as asset totals at the beginning and end of each period. I then used these monthly cash flows to calculate an internal rate of return, which measures performance for the average dollar invested in the fund. It’s important to note that various complicating factors make it difficult to pin down exact investor-return numbers for ETFs,[1] but the numbers below should be directionally accurate.

Note: Data as of Nov. 30, 2021. Investor returns are based on estimated monthly net asset flows and total assets as of the beginning and end of each period. Returns for periods greater than one year are annualized.

As the chart above illustrates, investors’ actual results lagged reported total returns over all four trailing periods--by large margins. Over the past five years, for example, the fund’s 41.3% annualized return places it among the top five best-performing U.S. equity funds and ETFs, and it trounced the S&P 500 (the benchmark listed in its prospectus) by more than 15 percentage points per year. After the adjusting for the timing of cash inflows and outflows, though, we estimate that investors earned less than a fourth of that return. ARKK’s estimated 9.9% investor return over the past five years lagged its benchmark by about 8 percentage points per year.

The investor-return gap hasn’t been quite as large over the past 12 months, but absolute performance has been considerably worse. We estimate that shareholders suffered a 12% dollar-weighted average loss, which is almost 3 times deeper than the fund’s 4.3% reported loss over that span. What’s more, ARKK has experienced breakneck volatility, making any risk-adjusted measure of its dollar-weighted returns even worse.

What Went Wrong

The difference between ARKK’s time- and dollar-weighted returns comes down to a simple reason: Most of its returns came when fewer shareholders were around to benefit from them. Even during 2017, when it posted an impressive gain of 87.4% (partly driven by a 1,300% runup in then-top holding Grayscale Bitcoin Trust (GBTC)), it averaged only about $116 million in assets. By the time assets peaked around $25.5 billion in June 2021, performance was just about to drop off. Previously high-flying holdings such as Teladoc Health (TDOC), Roku (ROKU), and Zoom Video Communications (ZM) have crashed back to earth in recent months, and the fund shed about 24.9% of its value for the year-to-date period through Nov. 30, 2021.

A look at the fund’s estimated net inflows year by year sheds more light on why shareholders’ results have lagged reported total returns by such a wide margin. As shown below, the lion’s share of ARKK’s net inflows took place during 2020 and 2021. Combined flows for those two years represent about 90% of all cumulative net inflows since inception.

What’s more, the spigot of 2020 net inflows didn’t really open up until late in the year; as a result, most shareholders who bought in during 2020 didn’t fully benefit from the fund’s triple-digit calendar-year gains. As shown below, more than half of all net inflows for 2020 came in during the last three months of the year. In fact, the fund’s $3 billion of net inflows in December 2020 made up about one fifth of all cumulative inflows since inception.

Glimmers of Light

To their credit, ARKK’s shareholders have not bailed out in droves as of this writing. ARK founder and portfolio manager Cathie Wood often emphasizes that she looks for stocks that can outperform over a five-year period, and some shareholders might have adopted a similar long-term perspective. We estimate that net outflows have totaled about $2.2 billion over the trailing six-month period ended Nov. 30, 2021. That’s a big number, but the majority of the fund’s shareholders have not abandoned ship. It’s also worth noting that even after adjusting for the impact of cash flow timing, investor returns are still in positive territory over most longer periods, albeit significantly lower than reported total returns.

In addition, we’ve previously written about potential liquidity issues related to the fund’s concentrated ownership positions in numerous portfolio holdings. Because the fund owns a significant percentage of the daily trading volume in many of its underlying holdings, this concentrated ownership could create a downward spiral of increased redemptions causing more selling pressure on key holdings, which in turn would worsen returns and lead to more redemptions. That’s still a potential issue, but the portfolio now has more exposure to larger, more liquid stocks than in the past, which should mitigate liquidity risk to some extent.

Lessons From the Flood

While ARKK’s story isn’t over, its latest chapter contains some lessons for investors.

Triple-digit returns don’t repeat. As we’ve pointed out in the past, it’s highly unlikely for any fund to continue posting chart-topping returns year after year. Funds can typically rack up gains of 100% or more only by making concentrated bets on individual stocks in the market’s hottest sectors, which usually means taking on nosebleed levels of valuation risk. That often leads to sharp losses when market trends reverse course and valuations drop to more realistic levels.
Risk matters. On a related note, it’s impossible to generate high returns without taking on high levels of risk. As I wrote in a previous article, ARKK’s portfolio courts extreme levels of risk on almost every type of fundamental metric, including concentration, momentum, liquidity, valuation, and financial health. This high level of risk makes it imperative for shareholders to fully understand what they’re getting into before climbing on board.
Consider dollar-cost averaging. Dollar-cost averaging often gets a bad rap because it typically leads to lower total returns. That’s because equity market returns are positive more often than not, so keeping any money on the sidelines is generally detrimental. But we’ve found that in practice, dollar-cost averaging can help improve investors’ results because it helps enforce discipline and avoid the pitfalls of bad timing--namely, buying in after a huge runup and selling after a decline. That’s especially true when it comes to highly volatile asset classes and funds, such as ARKK.

Overall, the gap between shareholders’ actual returns and reported total returns underscores the perils of getting caught up in the hype of funds with high-flying returns, which usually leads to disappointing results.

[1]There are various factors that make it difficult to calculate precise investor-return numbers for ETFs. For one, investors who establish short sales positions engage in create-to-lend transactions, and demand from these short sales registers as net inflows (at least initially) in the same way as demand from long buyers. Depending on the timing of purchases and sales, some of these short-sellers may actually experience positive investor returns.

Long demand from market makers who purchase ETF shares and/or associated options for the purpose of building inventory and/or hedging existing exposures can also have an impact on estimated net inflows and total assets.

Finally, many ETF trades are made on the secondary market. Because these secondary-market trades typically don’t prompt new share issuance, they’re not reflected in estimated net inflow figures.