I am the wisest man alive, for I know one thing, and that is that I know nothing - Plato
Some of the most important truths in life are contradictory on the surface. They seem like impossibilities, yet experience proves them to be obvious over and over again. It isn’t until you look a bit deeper, beneath the surface of contradictions, that the real grains of wisdom emerge.
Think about this one: “The more choices you have, the less satisfied you are with each one” - the old paradox of choice. It might seem counter intuitive, but research shows that when we are presented with more options, we become less satisfied with the one we pick. The theory is that when we have so many options, we have greater opportunity costs to selecting each one; therefore, we are less happy with our decision. For me, some of the greatest paradoxes are simple ones such as “I know one thing that I know nothing” (the more I learn the more I realise how much I didn’t know), “the only certainty is that nothing is ever certain” and “the only constant is change”.
Paradoxes in investments
Coming back to our world of investing, there are plenty of paradoxes. Right at the core of it is that the empirical proof that markets are inefficient, yet active managers can’t outperform the market. This sounds as non sensical and paradoxical as Yogi Berra’s famous restaurant comment “nobody goes there anymore, it’s too crowded”! I will get back to this later, but first let’s ponder the following question: in what other field does someone with no education, no relevant experience, no resources, and no connections vastly outperform someone with the best education, the most relevant experiences, the best resources and the best connections? There will never be a story of Joe Bloggs or Jane Doe performing heart surgery better than a highly experienced heart surgeon. Or building a longer lasting phone battery than Apple’s engineers! (well, this one might be possible!) Unthinkable. But these stories happen in investing. Why? Because luck plays a huge role in short-term investment results. This, on one hand, leads to inefficiencies (good for active management) when market players take their luck too far, but it can also lead to increased survival risk for active management when only judged by short-term performance comparisons. This leads me to the most pervasive of all paradoxes in investing: the paradox of hindsight.
Here is a thought: Imagine you knew exactly which stocks/sectors to pick a decade ago, the ones that would do best during the post-global financial crisis bull market – you would know that US internet retail stocks would rise by 2700 per cent, that healthcare stocks would soar by 2200 per cent, and that Netflix would rise by more than 60 times. You were given that knowledge and you went out and invested in a portfolio of those best-performing stocks. How would you have felt on the way to world-beating results? Answer: A lot worse than you think.
The God portfolio and performance
From time to time, big losses and underperformance are inescapable even in a world-beating portfolio chosen with 20-20 hindsight. This was the subject of an experiment tested three years ago by the research firm Alpha Architects designed to demonstrate how ineffective it is for professional investors to always try to outperform. The paper, Even God would get fired as an active manager, showed perfect clairvoyance over long stretches wouldn’t spare rough patches in results. The research covers the period all the way back to 1927, but the study was recently updated on the 10-year anniversary of the post-GFC bull market to see how the perfect portfolio would have fared over the past 10 years.
First the obvious good news: an equal weighted portfolio of the best 100 stocks (God portfolio) since the GFC bottom would have returned nearly 20 times the market. Bad news though: the perfect portfolio might not have stood the chance to survive. While the end result here is what every investor would die for, the travel it took to get there wasn’t so much to die for! In 2011, for example, the perfect portfolio underperformed the market by 10 per cent and fell by more than 22 per cent at one point (or six per cent more than the largest drawdown by the S&P500). Just six months later, the God portfolio suffered a three month stretch of lagging the market again.
The ultimate objective of the experiment by Alpha Architect was to answer the following question (in their words): “If God is omnipotent, could he create a long-term active investment strategy fund that was so good that he could never get fired?” And, to the surprise of the researchers, and many others, the answer was: “God would get fired”.
So, why do so many active strategies fail to add value? Maybe markets are becoming more efficient? Highly unlikely. Even knowing the future doesn’t seem to help as demonstrated by Alpha Architect’s experiment. Besides, the root cause of market inefficiency is not information asymmetry. Market inefficiencies are the result of human involvement (despite all the structural changes, human nature remains a constant). Here are my three reasons why active management appears to disappoint:
- Active managers get fired (as per Alpha Architect’s experiment);
- Active managers ditch their investment philosophy and chase short-term performance; and
- The strategy is not backed by a sound, time-tested investment philosophy or the strategy relies too much on mathematical modelling and back-testing (As far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.” — Albert Einstein).
Real-life version of Alpha Architect’s experiment - the evolution of the post-GFC bull market:
Phase 1: Given the pain and shock of the financial crisis, a large part of the investment community who retreated into a state of panic and fear had no time for risk-seeking active managers. The bearish stories of never-ending bad times were so convincing that asset owners, investors and the broader investment advice community sought active funds that carried a bearish flag. Active managers (especially hedge funds) with a bullish stance were deemed too risky and were sacked (especially if they bought in too early into 2008 falls and lost money initially). The surviving funds spent years chasing shadows and looking for the next big short. Having failed to protect against the 2008 crisis (most likely because those who survived all the way up to 2007 were those that chose to manage career risk and pursued the US housing-related bull market right to the end!!) and then failed again by not capturing much of a decade-long bull market in asset prices, active management lost credibility. At the same time, if cheap money didn’t bring much in terms of capital expenditure, it sure provided a fertile ground for technological innovation. This led to the advent of big data, machine learning and systematic investing (amongst other things). At the same time, technology allowed the proliferation of exchanged-traded fund securities allowing ordinary investors to gain market exposure with a touch of button on mobile devices (even as ETFs grew more sophisticated in terms of product, users and uses, ordinary retail investors still account for more than half of the assets).
Phase 2: Human investors did a poor job in protecting us in 2008 and continued to disappoint on the way up. We now have super smart computers. So why don’t we replace humans with algorithms and machines for cheap active management. Quantitative funds came up with fantastic back testing results showing how computers can do a much better job than humans. We save money and perform better.
And for the mum and dad investor: I don’t need someone else to lose my money. I can do a much better job myself by buying ETFs. US economic growth is going from strength to strength and I all need to do is to buy US equities. It can’t get much more obvious than that.
Hard to disagree (in hindsight!) … hedge funds have disappointed, algorithms have performed better (until Q4 last year), private (unlisted) investments have been an investors’ dream with strong returns and minimal volatility since the crisis. And if you owned US tech ETFs over the past 10 years you would have outperformed pretty much all active equity managers in the word. This is the kind of logic often used in the investment industry; one which has significant shortcomings. It demonstrates how emotions often pollute our judgment and how we continue to mix hindsight with foresight. The twist here is a real-life version of the Alpha Architects experiment which has got us to where we are now.
Still, it will be ignorant to suggest cycles and drawdowns should be disregarded for many with shorter investment time horizons. We launched the dynamic markets strategy in March 2011 with some key objectives:
- Flexibility in asset allocation to move away from overvalued, overhyped markets and into undervalued, underappreciated markets. The most recent significant global bear markets of recent times (2000-2003 and 2007-2008) were all led down by the most crowded and most expensive (US and tech sector from 2000 and US housing and global financials from 2007). US equities and tech stocks this cycle perhaps? (charts below).
- The ability to move away from market-weighted global benchmarks. History has shown over and over again that the most expensive, most crowded and most vulnerable markets, sectors and stocks end up with the highest benchmark allocation after prolonged bull markets.
- The ability to defend the portfolio and limit draw-downs against broad and deep global bear markets which are invariably pre-empted by broad-based market excess (overvaluation and euphoria) and economic excess (corporate spending excess, overheating, rising interest rates and broad-based tightening of monetary policy).
The bottom line
Markets are highly inefficient... the dot com boom and bust followed by the subprime/US housing boom and bust and so many other boom/bust cycles of the past are clear evidence of market inefficiency. That's because despite all structural changes and innovations, one thing is always a constant and that is human nature. No matter how much money is managed by computers, it is humans that are responsible for the profit and loss and at some point, managing career risk takes precedence over managing investment risk. This will continue unless the investment community stops moving the goal posts and until investment philosophy and process play a bigger role in active manager selection than peer or relative performance.
Lastly, anything worthwhile involving money comes with high stakes because of the possibility of losing your investment. Losing money is emotional. And the desire to avoid being wrong is best offset by surrounding ourselves with people who agree with us.
The problem with viewing crowds as evidence of accuracy when dealing with money is that opportunity is almost always inversely correlated with popularity. What really drives outsized returns over time is an increase in valuation multiples; and increasing valuation multiples relies on an investment getting more popular in the future – something that is always anchored by current popularity.
What we need to acknowledge is that the market is packed with different agents playing different games. And if we start taking cues from people playing a different game than we are, we are bound to be fooled and eventually become lost, since different games have different rules and different goals. Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviours of people playing different games. A stable strategy designed to endure change is almost always superior to one that attempts to guard against whatever just happened happening again. If there’s a common denominator in these, it’s a preference for humility, adaptability, time horizon, and scepticism of popularity around anything involving money…which can be summed up as being prepared to roll with the punches.
As the poem goes, taking the road less travelled can make all the difference!
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