Readers of In Brief know that we’re big fans of using frameworks. For example, previous editions have featured a simple four-variable framework that we use to evaluate the relative attractiveness of equity markets.
We use frameworks to help us with all sorts of decisions, including how to identify opportunities where active management can add value.
One of the key parts to our active management framework is the concept of a competitive edge. We’ve written about this before (see the section on “weak games”). Active investors need to be able to identify the reason(s) why they feel that they have a realistic shot at beating the market.
We believe that there are four kinds of edges. They are:
Experience has shown us that the first two competitive edges are the hardest to sustain. Most investors have access to the same information and their ability to access and use that information has never been faster. Maintaining an analytical edge is difficult in a business such as asset management, which attracts a steady stream of MBAs, CFAs, CAs and PhDs.
There’s always someone bigger, smarter, faster. We know we can’t win that game, so we don’t even try. But it’s OK because there are other games where size, speed and complexity make investing difficult. The years that we spent as institutional investors working with hundreds of fund managers from around the world have made this very clear.
Information and analysis were big competitive advantages when the stock market was dominated by individual investors. Most individuals simply don’t have a lot of time or the energy to devote to investing. It’s logical to expect that smart and highly-motivated professionals could make money by trading against a bunch of amateurs.
This was the case back in the 1960s. One blog recently noted that “According to the Bogle Financial Markets Research Center, only 17% of investment dollars were professionally managed in the 1960s.”
What’s the situation today? According to Pension and Investments Online: “Institutions own about 78% of the market value of the U.S. broad-market Russell 3000 index, and 80% of the large-cap S&P 500 index.”
While the shift from individuals to institutions is bad news for the first two edges, its fantastic news for the behavioural and structural edge.
Institutions are subject to many factors that get in the way of an effective investment strategy. They include:
- Conflicts of interest
- Inertia or status quo bias
- Constraints imposed by size, regulation, contractual obligations, etc.
- Competition and the focus on short-term results that comes with it
- Constructing portfolios that are liquid
What does it all mean? The game has changed. Beating the market now has less to do with being smarter or faster. It’s now about managing your behaviour and identifying opportunities in areas where institutions are unable or have difficulty investing.
- Microcap equities. In Australia, specialist small cap investment managers struggle to purchase shares outside of the top 300 stocks. That’s almost 2000 stocks where fewer investors are competing for opportunities.
- Portfolio construction techniques that don’t rely on market benchmarks. Large institutions often use market benchmarks as a starting point when constructing portfolios. This allows them to maximise the amount of money that they can manage. It also reduces the risk that they will underperform the market. Unfortunately, it also reduces the chance that they’ll out-perform too.
- Active asset allocation. Most institutions stick fairly closely to a strategic asset allocation (for example 70% growth, 30% defensive). These allocations are largely based on historical returns and what competitors are doing (i.e. not wanting to stray too far from the herd). They try to add value though fund manager selection instead of seeking to managing risk and out-perform through active asset allocation.
There’s an important lesson here. Competitive edges are dynamic. What works well in one environment may not work well under different circumstances. This is why having a framework to identify your source of competitive edge is so important.
Legendary hedge fund investor Julian Robertson summed it up when he observed:
In baseball, you can hit 40 home runs on a single-A-league team and never get paid a thing. But in a hedge fund, you get paid on your batting average. So, you go to the worst league you can find, where there’s the least competition.
Investors trying to out-perform the market would do well to follow Robertson’s advice and look for areas where they can find a competitive edge. The flip side of this is that they should also opt for simple, diversified, liquid, transparent and low-cost investments where they don’t have a competitive edge.
Grioli & Co. is an Authorised Representative (001258470) of Heuristic Investment Systems (AFSL: 276762).
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