The S&P 500 index just ended the best 1st quarter since 1998, up 12%. Is this a foreshadowing of more good things to come or is this too far too fast? We shall see. Regardless, the age old question and quest continues. Can an investor outperform, and do attributes exist among certain investors that give them the opportunity to add value over a long period of time.
As the performance of various managers comes in over the next few weeks, many investors who strive to outperform the market (active managers) will probably have helped to make the case for those who believe that a passive index approach is a more appropriate way to invest. It is easy to find articles about the virtues of an index versus an active management approach. Many suggest that performance persistence is not achievable and that, especially after fees and taxes, investing with active managers to try to outperform is a losing game.
I do not dispute the statistics that make the passive index investment case. I believe, however, that certain characteristics do give specific types of investors long-term advantages over just buying the market (index investing).
Before I go much further, please keep in mind that I just said long-term. Quarter to quarter or even year to year is not a good time frame to make decisions about investing. I feel that many have become overly relative performance-oriented on time frames that are too short.
Also, percent outperformance or underperformance does not necessarily tell the whole story, nor is it necessarily the appropriate question depending on what you are trying to achieve. As an example, is an equity manager that outperforms on a return performance basis over time the best manager if that manager has such large swings month to month or quarter to quarter that it makes clients nervous and they then move out of equities altogether at maybe the wrong time? Or is the best manager, in certain cases, the manager that does underperform the market slightly from time to time, but creates a smoother, more comforting ride, which allows clients to stay invested through the good and bad to acheive long-term goals? A discussion of these questions is another Blog altogether, but I wanted to at least get it out there before I talk about ways that I think some investors / managers might be able consistently to add value.
Three things made me start to write this Blog today.
First, we are finally experiencing the normal New England Spring. Kinda gray, a little cold and maybe even some snow flurries in the forecast (not much outside play with my SJM).
Second, the market performance I mentioned above. With the market up 12% in just one quarter, many managers probably will have underperformed.
Third, there is a good piece in the Wall Street Journal weekend edition by Jason Zweig in his Intelligent Investor column. It talks about Maynard Keynes who, regardless of how you feel about his economic thoughts, was, according this article, an exceptional investor during a very difficult period.
Zweig bases much of his piece on a recent published study that David Chambers and Elroy Dimson from the University of Cambridge and the London School of Business did on Keynes’s investment track record when he ran the endowment fund of King’s College Cambridge from 1924-1946. Is it true that many investors cannot outperform the market, but Keynes was not one of them. According to the WSJ article, during an era that included the Great Depression and WW II, Keynes outperformed the market by an average of 8% annually. Other successful investors such as our local Boston star, Peter Lynch, and the oracle of Omaha, Warren Buffett, are also mentioned by Zweig.
When I hear stories of exceptional performance in any field, I always strive to find out if it is repeatable. In the case of investing, I think certain characteristics of successful long term investors do exist and that if more investors followed them, more would outperform over time.
Beyond the Zweig mention of Keynes and others, a study on the SJM Idea Flow page titled How Active Is Your Fund Manager? – New Measure That Predicts Performance? is a piece of solid research from Yale, which suggests that past performance might be indicative of future returns for some types of long-only stock pickers. I am not suggesting that past performance warning disclosures are not appropriate, but the abstract and conclusion of this research suggests that they may need to be revised for some types of managers.
I recommend a read of Zweig’s WSJ article and a scan of the conclusion in the Yale research piece to get more of the full story but, in summary, they both share common themes. Many of these ideas are also in some of the published pieces by successful investors such as Lynch and Buffet. They all suggest that some outside the box, individual stock picking, concentrated managers consistently can add value. It is interesting to note that in Zweig’s article, he suggests that Keynes only started to outperform significantly when he changed his investment approach to be more focused on individual stock picking versus a more macro style.
As I briefly mentioned at the start of this Blog, all of the authors above also suggest that investors should remain anchored on an important point: long-term investing. Zweig includes one of my favorite quotes from Keynes that makes this point better than most and in a colorful way. “It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Following this theme, I find that investors who outperform tend to be unconventional. They do not follow the herd, are quite contrarian from time to time, and are patient to let an investment idea play out over years versus just months or quarters.
As the Zweig article suggests and the Yale study highlights, if an investor is looking to outperform an index, he or she needs to be non-index like. This means that portfolios will be constructed one stock / security at a time based on independent fundamental research, and that the portfolios will show conviction by being prudently diversified, but concentrated by what has become conventional practice (20-30 securities).
So, if you want to strive to outperform the market, how do you find the current or next Keynes or Lynch?
Finding these managers is not easy and it requires a long evaluation timeframe.
As Zweig mentions in the WSJ, many managers focus on staying close to the herd by constructing portfolios based on marco / sector themes that fit into “style boxes” (large cap growth, small cap value, etc.), holding large numbers of securities (50-100+) that have commonality to an index, and on constructing portfolios designed to have a tight tracking error (i.e., performance that relatively closely tracks an index, monthly or quarterly). It is hard not to see why a manager might follow this approach, which often is called a top down style. If a manager stays close to an index every quarter and inside his or her peer group box, he or she will not be an outlier from the herd at the wrong time. He or she might not have to experience the short-term lack of mercy shown to the zebra who finds itself outside the herd when the lions are roaming. Unfortunately, studies such as the one from Yale suggest that these top down, style box oriented approaches have a very difficult time showing performance persistence / consistency of outperformance.
Alternatively, the Yale study, the Zweig article, and comments in books by Lynch and Buffet all seem to suggest that if you look for bottom up individual stock / security picking managers that are not afraid to be unconventional and can resist short-term criticism, you can find managers that can outperform over reasonable periods of time.
The Yale study goes on to stay that if you find bottom up managers that are still relatively small, and hence can stay under the pressure-to-conform radar screen, those who add value through individual stock / security picking seem to be able to show performance persistence in the future / consistently outperform.
Looking at this another way, in today’s WSJ, Zweig writes that “it is worth hiring an active money manger only if you have the confidence that he or she is a free spirit who will have a completely free hand. Otherwise… you might as well buy an index fund.”
More important than outperfoming an index though, make sure you are working to perform according to your plan. At SJM, we feel we can help clients indentify some bottom up stock picking firms that have the ability to outperform an index. We feel it is much more important, however, to make sure that you feel good about your plan and results, which hopefully allow you to feel comfortable enough during the good and bad to stick to your plan.
Beyond how a manager manages a portfolio, if you do not feel comfortable getting a quarterly or even annual report that shows large deviations from an index or a peer group from time to time, then consider using index strategies to implement your plan and rebalanced your asset allocation back to your plan often.
Regardless of plan implementation with index funds or active managers, we strongly feel that too many people are too focused on short term performance relative to a benchmark / index or peer group (industry / manager category or friends at the club).
To outperform, try to find an advisor (professional firm or private fiduciary) who is transparent, is as unconflicted as possible, freely discloses and discusses conflicts, is not afraid to bring up and suggest unconventional and contrarian ideas, and helps you craft a plan that you feel comfortable sticking with.
Ok…. Back to my plan to spend time with my personal SJM (Susan, Jack and Meghan).
Enjoy the weekend and week to come!