The evidence is that the average active fund has produced disappointing results for investors.
This means that to be an active fund manager you either need to believe that you are better
than average or brazenly ignore reality. Not being one to put my head in the sand, I spend a
lot of time thinking about our sources of “edge” that I think make us better than average.
For us to deliver outperformance, this edge needs to be big enough to cover the fees that we
charge, as it is the combination of edge and fees that determines if a fund has “alpha”. The
fact that the average active fund has historically underperformed passive equivalents, is as
much a reflection of fees being too high as it is managers struggling to “beat the market” with
their investment decisions. It is this thinking that informed our decision to cap the fees that
the fund charges.
The disappointing record of active management is rationalised in the academic community
with the “efficient market hypothesis”. This is the idea that all available information is rapidly
assimilated into market prices, such that beating the market isn’t just hard, but is impossible.
The theory relies on lots of information wonks diligently reading annual reports, and the like,
such that share prices immediately reflect their collective wisdom.
Whilst I don’t believe the efficient market hypothesis to be true, it is a good approximation.
Where the argument for markets being efficient gets interesting, is that as more money flows
to be invested passively, there will be fewer people crunching the numbers. This then means
that prices should be less representative of “all available information”, making it is easier to
have an edge.
The famed “quant” Cliff Asness recently penned an opinion piece1 where he makes the case
that markets have become less efficient. Asness specifically states the case for there being
more opportunity to profit from value investing, based on evidence of market prices being
more disconnected from underlying corporate results. He puts forward three possible reasons
why this might be so:
1) The rise of passive investing.
2) Very low interest rates.
3) The negative impact of technology (or “gamification” of markets).
His view is that it is actually the third of these that is driving a reduction in market efficiency,
and the quotes I provide below are my attempt to give you a succinct summary of what he
wrote (the emphasis is my own).
“Imagine some fraction of the market passively hold the index and the rest are active traders/investors trying to outperform. Now divide this active group in two (this is the obnoxious part). One group are sharks, the other minnows. Minnows make bad decisions based on emotion, story, tastes that are not relevant for risk and return, and behavioral biases. Sharks outperform by taking the other side of the minnows’ misguided positions. Well, if indexing has grown, whether this has made markets more or less efficient comes down to whether more sharks or more minnows moved to indexing. If more sharks have moved, the remaining sharks should have an easier time making money over the long term as there is less competition in betting against the minnows, but the minnows have more influence than they used to at the short to medium term. Prices are a dollar-weighted average of opinions, and if a larger fraction of this is misguided, so will be prices.”
“I think the rise of indexing and the super low interest rates of the last 10-15 years may have had exactly this effect (more crazy, and crazier, minnows, fewer rational G&D [Graham & Dodd[1] / value] disciples), but I conjecture that’s a relatively small part of the story. I’m far more certain that social media, the overconfidence that come when people think all the world’s data is at their fingertips, and gamified, fake-free, instant, 24/7 trading has done so in a significant way.
“Put simply, it should be more lucrative for those who can stick with it [value investing] over the long-term, but also harder to stick with. More lucrative seems obvious. If the rational active investor makes money from the minnows making errors, then they should make more if those errors are generally bigger. But, it also seems obvious that it’s harder to actually do. The periods of underperformance will be more severe and last longer.”
Whilst this story clearly “suits my book”, it also resonates with what we observe. After six years of running the fund, I am more convinced than ever that “time horizon” is one of our major sources of edge. This is as much about focusing on the likely long-term earnings power of a business, as it is about owning them for extended periods.
I believe that many corners of the market are increasingly short-term, and not driven by a rational appraisal of fundamentals. This creates opportunity, but as Asness says, trying to capture it makes for an uncomfortable ride. In order to stay the course, you have to have done enough homework, otherwise the first bump in the road will leave you wanting to capitulate.
By way of example, one of our holdings went up 54% during the last quarter, only to fall back by 26% in the final week. Without getting into the weeds, it is hard to see that this level of volatility was justified by the news coming out of the company, with management reaffirming their guidance for full year profits. It is however a company with a relatively high level of retail ownership, and we believe that this price action has been driven by these folk more than the professionals who own it.
Although I give an extreme case, we often see a level of stock price volatility that appears disconnected from any reasonable interpretation of the facts. I believe that this is because of the dominance of people who aren’t acting based on long-term fundamentals.
Clearly my views, and those of Cliff Asness, argue in favour of fundamentals driven value investing having at least some weight in your portfolio. I increasingly view it as a “time horizon arbitrage”, but this means that you need to be willing to judge the results based on years and not months.
[1] Ben Graham and David Dodd wrote the definitive value investing book Security Analysis in the 1930s.