“What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money?”
That’s a question Howard Marks of Oaktree Capital likes to pose to other investors, quoted in a 2014 memo.
Marks is not talking about tracking the index, or mildly outperforming. He’s talking about shooting the lights out.
To have a chance of doing that – of being up there with the best in terms of investment performance – what do you need to do?
The answer, like many things in investment, is simple in theory and hard in practice: “You have to assemble a portfolio that’s different from those held by most other investors.”
In other words, to beat the crowd, you can’t be part of the crowd. You have to be contrarian.
And that’s a lot easier said than done…
Unconventional can mean brilliant – or awful
Marks’ point makes logical sense. If you want to beat the market average, you can’t own the average portfolio. You have to own a portfolio that is very different to the average. “Only if your behaviour is unconventional is your performance likely to be unconventional,” as he puts it.
There’s a problem here, which I’m pretty sure many of you have already spotted.
“Unconventional” cuts both ways.
You can deliver astounding outperformance, or you can deliver absolutely woeful underperformance. They’re both unconventional, but only one represents a desirable outcome.
This is the challenge that Ben Inker attempts to tackle in US wealth manager GMO’s latest letter.
Inker starts with the idea that you’re running a portfolio and the only outcome that will get you paid is if the portfolio massively outperforms the majority of the rest of the market. So a sensible asset allocation to index trackers is out. What do you do?
In line with Marks’ point, Inker notes that you’d have to hire fund managers who were willing to deliver results that were well out of line with the benchmark.
You’re looking for “high conviction” managers who have “concentrated” portfolios (ie, a lot fewer stocks and much bigger individual bets than your average closet index hugger).
And you’re looking for managers who have a “high tracking error”, as Inker puts it. In other words, their results are typically nowhere near the index – they either underperform badly or outperform satisfyingly, but they don’t get the return on the index.
What’s the big issue here? Well, there are two main problems. One lies with choosing the managers – how do you find the mavericks who beat the market, rather than chronically underperform it? And the other lies with managing the portfolio – how do you assess their performance over time?
The first problem sounds like the hardest. But in fact, argues Inker, it’s the second one that causes the most problems.
The problem with finding great fund managers
Using various statistical magic tricks and assumptions that I shall not even attempt to unravel here (you can easily access the paper yourself at the GMO website), Inker concludes that even if you’re not that great at finding half-decent fund managers, the truth is that as long as you can find one strong performer for every five you hire, you’ll still beat the market.
Impressive. Sounds like a no-brainer, as they say.
The problem, says Inker, is that you have to have nerves of steel. You see, your high conviction managers – even the good ones – are almost certain to have big periods of underperformance during that time.
He points to a study by Aaron Reynolds from 2011, that looked at 370 funds that had managed to beat their benchmark over ten years. In other words, these were funds that you would genuinely have wanted to own for the long run.
Almost all of these funds underperformed their benchmark by at least 5% for at least one year during the period. One in four had a year in which they underperformed by more than 15%.
Half had a three year period in which they lagged their benchmark by at least 3% a year. And again, a quarter of them lagged by more than 5% a year, for at least three years in a row.
Remember – these are all successful funds. They pan out over the long run. But imagine you’re hanging onto a fund that’s just coming to the end of the third year in a row where it has badly underperformed its benchmark.
What are you thinking? Give the manager yet another shot? Or get shot of them?
You’ve got to find good managers fallen on tough times
This does tie in with previous research that suggests that private investors have a bad tendency to buy funds when they’ve just had a great period of outperforming, just in time for the outperformance to end.
They then hold them for a few years, get disillusioned, and sell. Usually at the bottom. And as far as Inker is concerned, institutional investors – despite often presenting themselves as being smarter than mere “retail” investors – have the same problem.
Is there a solution?
Well, yes, but it does go against every instinct in your brain, which is never easy to challenge.
What you want to find is an independent-minded manager with a half-decent record (my colleague Merryn suggests quite a few in this piece).
Past performance is no guide to the future, as they say, but it’s the only one we’ve got, and if we’re arguing that skill in fund management exists at all, then you have to hope that evidence of that skill would crop up somewhere.
But what you also ideally want, is to find them when they’re at a low ebb. Because regardless of how good a manager is, sometimes they’re in tune with the broader market, and sometimes they’re not.
For example, most value investors – even the best ones – are crying into their pints right now, and losing clients left, right and centre. It’s not because they’re bad at their jobs. It’s because their particular style of investing is out of fashion.
And because you can’t be sure that you’ll pick the managers who can genuinely outperform, you realistically have to pick a spread of funds. And you need to strap in for the long run, and be capable of enduring a fair bit of volatility.
It’s easier than picking stocks yourself, but it’s still pretty demanding. If you don’t feel you can trust yourself to do it, then there’s no harm in sticking to a passive portfolio (or in keeping a big chunk of your money in a passive portfolio and only attempting to pick the active, contrarian funds with part of your portfolio).