How to beat the market with 'second-level thinking'

I write here last week about value investing. Do it right, I said, and over the long term, history tells you that you will outperform most other people. That brought mail.

If you believe that, a good few of you pointed out, surely you also believe in active investing over passive investing? The answer to that is yes, I do. I firmly believe in active investing. The problem is that, with a few significant exceptions, I don't really believe in active investors.

There are almost no fund managers who, over the long term, can outperform any given index after fees. That is not because good investing as discussed last week isn't based on a series of relatively simple concepts, it is just that our behavioural biases mean that following them isn't very easy.

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Investment guru Howard Marks neatly summed this up in a letter to his clients. The goal as an investor is to earn better than average returns. That means that a good manager's thinking "has to be better than that of others both more powerful and at a higher level".

A huge percentage of the people in finance are clever, well-informed and highly computerised, so to be better than them, you "must think of something they haven't thought of, see things they miss, or bring insight they don't possess".

You have to be a "second-level thinker", Mr Marks says. 'First level' investor thinking says "it's a good company, let's buy the stock". Second level thinking says, "everyone thinks it's a great company. That makes it overpriced sell."

First level thinking looks at a stock and says: "I think the company's earnings will fall sell". Second-level thinking says: " I think the company's earnings will fall far less than people expect, and the pleasant surprise will lift the stock buy."

The real money isn't made in buying what other people like. It's about buying what others underestimate. Buying that kind of thing can be a lonely business, and fund managers hate that. You get the idea: simple, but not easy.

There is of course the chance that active managers are getting better. I pointed last week to the Undiscovered Managers Behavioural Value Fund, which has delivered exceptional outperformance over the past decade (it is distributed by JPMorgan for those of you still looking for it).

And as Simon Evan-Cooke of Premier Multi Asset Investment points out, one of the developments that has "sneaked past most financial pages" in the last few months is just how badly the indices have performed compared to the average fund.

From 13 April to 24 August, for example, the index in the UK fell by 13.6%. But the average UK fund fell only 8.4%. In Europe, the index was down by 14.9%, but the average fund only 11.5%.

Globally, the difference between the two was 6.2%. This is not to take away from the fact that pretty much everyone has lost their investors' money, just to point out that passive investors have lost more than active ones.

Will that trend last? It would be nice to think so. And there may well be a day ahead in which every rubbish manager has been chased out of their once-lucrative market by cheap trackers, leaving the way clear for the good stock pickers to clean up.

For now, however, Evan-Cooke isn't convinced. He reckons that the trend has more to do with the way that the tracker funds and exchange-traded funds that mimic the indices have become "the playthings of large investors" attempting to dive in and out of the market.

When these "elephants are all on the same dancefloor dancing to the same tune" it makes sense to expect the indices to swing around more wildly than an active fund run by someone with even half an eye on the job.

Fund managers aren't getting better (yet). Indices are getting worse. With that in mind, I want to briefly revisit the topic of what makes a good fund manager.

In his letter, Marks points to several things that I have mentioned here before. There is being clever the ability to be a second level thinker is a precondition. There is the ability to control your emotions there is often little point in either selling or buying into sharp market moves. There is the strength of character to stick with a strategy (even when consumed by envy as other people's stocks rise and yours do not). There is lack of greed (you just can't charge too much). And there is inaction nothing kills returns faster than the costs of high turnover.

But there is something else I have noticed in good fund managers. This one's a bit more airy fairy so bear with me. It is a tendency to read a lot of history books. Two things here. First, if you are the kind of middle-aged man who likes to sit around thinking about the world in 500-year chunks, you tend to have less time to fiddle around the edges of your portfolio.

And second, a sense of the great cycles of the past surely prevents a manager falling prey to the great evil of short-termism. If I were a member of the super rich spending the next few weeks wandering around Mayfair looking for someone to relieve me of the burden of my many millions, I'd be checking their desks for reading material.

I'd back out of the offices of those absorbed in anything with a title such as Analysis for Financial Management. And I'd be keeping an eye out for anyone reading Peter Frankopan's The Silk Roads: A New History of the World.

At the end of August, a meeting between Chinese and Russian diplomats ended with a statement about the efforts they intend to put in to "connecting the construction of the Silk Road Economic Belt and the Eurasian Economic Union between China and Russia".

Read Frankopan on the stunning economic successes of the original Silk Road, and you will begin to think that during the past few months it will have been only first-level thinkers who have succumbed to Chinese stockmarket hysteria.

Second-level thinkers will have been looking for new ways to take part in what is clearly one of history's great power shifts one in which a vast region that looks to the uninitiated to contain nothing but failed or failing states is reconnecting.

Think about that, and you'll see just how short-termist it is to fuss too much about the 150% rise and then 40% fall in the Chinese stock market over the past year. In the charts of the market we will all be looking at in 20 years, you will barely see the blip.

This article was first published in the Financial Times.