If you like Cathie Wood, you’d have loved Bruce Berkowitz

I, like many other investors, have followed Cathie Wood’s incredible performance with a mix of awe and envy. Her flagship fund, Ark Innovation ETF, returned a stunning 150% in 2020 and the fund’s 5-year annualized return is an equally notable 44.9% per year. With the 0.75% expense ratio and almost $19.5 Billion in this fund alone, Ms. Wood is doing very well indeed.

What strikes me when I read articles about Wood and ARK funds, as well as when friends and associates discuss her funds, is that very few of her current admirers are aware of the history of star fund managers and how the story typically goes. Ms. Wood is the latest incarnation of the star money manager. There is a research literature dealing with the hot hand phenomenon among fund managers. A manager starts out with a specific approach to investing and very little money under management. The manager generates exceptional performance and lots of money flows into the fund. The manager’s fund builds enough track record that it is receives a Morningstar rating and the fund gets 5 stars because of the performance to date. The fund manager starts to get interviews and even more money flows to the fund. Eventually, however, the manager’s particular approach to investing no longer matches the current market trends, and performance wanes. Diehard fans stick with the fund for a while. Eventually, the the manager is no longer invited for interviews because there is some other hot fund manager who has been knocking it out of the park. The investors who chase fund performance inevitably under-perform, getting into a fund after it has generated big returns and then riding the fund as it reverts to the mean.

For people who are convinced that Cathie Wood is a genius, I suggest reading about Bruce Berkowitz. I have yet to meet a Cathie Wood fan who has ever heard of Berkowitz. In January 2010, Morningstar named Berkowitz the domestic equity fund manager of the decade for his remarkable performance from 2000-2009. Over the 10 years through 2009, Berkowitz’ Fairholme Fund (FAIRX) delivered 13.2% per year in annualized return vs. the average domestic equity fund which returned 0.01% per year (yes, 0.01% per year–not a typo). While most equity funds had seen their performance demolished by 2008, FAIRX had successfully navigated this extremely challenging period.

Jump forward to the present day. Over the past 10 years, FAIRX has annualized total return of 9.8% per year, as compared to 16.2% per year for a an S&P 500 index fund over the same period. FAIRX had around $18 Billion in assets at its peak, but now holds $1.4B.

In the same way that Cathie Wood has achieved her remarkable returns with a narrow portfolio strategy, Berkowitz was famous for making very concentrated bets. Lack of diversification enables high returns but also amplifies loss potential. This is not a criticism of either Berkowitz or Wood. My point is simply that investors need to be keenly aware of how this process can play out.

Will Cathie Wood be the next Bruce Berkowitz in terms of a run of under-performance following huge gains? Only time will tell. The hot hand fallacy suggests that many investors will be willing to give her the benefit of the doubt.