How much of what you do in your life is the result of what others expect of you?
I’ve been trying to remove small talk from my life and replace it with what Larry David calls “medium talk.” If you want to try medium talk, I’d steer clear of the above question. I’ve tried it, and it bombs. It bombs hard because most people’s answer is “a lot of what I do is the result of what others expect of me,” and this is a disheartening realization.
But for investors in general, and active managers in particular, this is a very important question. The extent to which you care what everyone else thinks or is doing determines the extent to which you should dabble in truly active management (that is, own something other than a simple market index). Emerson had it nailed when he wrote:
It is easy in the world to live after the world’s opinion; it is easy in solitude to live after our own; but the great man is he who in the midst of the crowd keeps with perfect sweetness the independence of solitude… the voices which we hear in solitude [grow] faint and inaudible as we enter into the world.
Greatness in active management—an elusive quality—requires two traits: the manager must be different and they must be right (on average). Both traits require a confidence—or even arrogance—that is rare.
The ability to select unpopular (and undervalued) stocks, and the patience to stick with those stocks may be a genetic advantage, as Seth Klarman has suggested:
“I actually think there is a gene for this stuff. Whether it is a value investing gene or a contrarian gene, I think that everybody appreciates a bargain, but when the market is going down most people overreact and get scared…for me it’s natural, but for a lot of people it’s fighting human nature.”
But whether the right independent psychology is determined by nature or nurture, it is essential; caring what others think about your portfolio will cause issues when times get tough. So, how different should you be?
The best way to measure how different a manger is from the benchmark is to measure their “active share.” This statistic roughly represents the percentage of the portfolio (1-100) which is different from the benchmark. An active share of zero indicates an index fund, an active share of 95 means there is almost no overlap between the portfolio in question and the overall market.
Active managers have a cost hurdle to overcome. They are handicapped by higher fees, transaction costs, and taxes. To overcome this hurdle, active managers should be different—but the opposite has been happening. Here is the industry trend: away from very unique, differentiated portfolios (active shares >80) and towards more similar, market-like portfolios (active shares < 60).
But as this chart from a great Fidelity paper on active share makes clear, the more different, the more unique the returns, both good and bad. As active share for the observed mutual funds go up, so do excess returns (both good and bad).
Holdings which are very similar to a benchmark may not underperform by much, but they won’t outperform by much, either.
Active share has probably been a bit overblown by its supporters. It is not some silver bullet that identifies managers who will outperform. Instead it is just one statistic that can be helpful alongside several others. Read these two papers (here and here) for a balanced opinion on the merits of active share.
Being different is merely the first step towards the potential for lasting outperformance. Equally important is being right. How to be right is, of course, the holy grail of investing and is the broader subject of this Field Guide.
Should Investors Hire Active Managers?
I was with Jason Zweig last week for a CFA Institute event called “Putting Investors First.” I agreed with Jason that the best way to put investors first was not to quibble over basis point fee differentials but instead to focus on several percentage points being left on the table by terrible investor behavior.
The answer to whether you should use active strategies is not a binary yes or no. The answer to the question is unique to each individual and it is dependent on that investor’s temperament. To use active strategies, you must truly be willing to be different and (often) wrong for extended periods of time. If you can’t do that, you should probably own an index-like portfolio (which is completely fine!).
Therefore, finding a strategy that each investor can stick with is the most valuable thing any advisor can do for their client.
I love robo-advisors, and send a lot of young people their way. But there are not 8 or 9 strategies that fit all. Emerson again:
No law can be sacred to me but that of my nature. Good and bad are but names very readily transferable to that or this; the only right is what is after my constitution; the only wrong what is against it…What I must do is all that concerns me, not what the people think. This rule, equally arduous in actual and in intellectual life, may serve for the whole distinction between greatness and meanness.
It is very hard to have a different portfolio when the S&P 500 is rocking and rolling, but a good advisor can help the investor keep their eye on the prize. One thing a good advisor can do is assess how each investor may react in difficult market environments. The more independent the spirit, the more appropriate truly active strategies may be.
It is so easy to dole out the advice “do what is right for you,” but much harder to follow through on that advice. We are social creatures, and most people (myself included) DO care what others think or expect of them. Sadly, this tendency is an obstacle to investing success. Emerson for the trifecta:
Insist on yourself; never imitate. Your own gift you can present every moment with the cumulative force of a whole life’s cultivation; but of the adopted talent of another you have only an extemporaneous half possession.
I generally believe that the hierarchy of equity strategies looks like this: Stock picking < index funds < titled index funds (smart beta) done right < higher conviction factor investing (say, a portfolio of 50-100 stocks based on factors like value, momentum, and shareholder yield).
While the latter category has provided the most impressive results, it has more extreme short term results (above and below the market). Accordingly it is only the best strategy if the investor in question can withstand those shorter term periods of pain.
I’ll leave you with passage from Jiddu Krisnamurti, which rephrases the question that we began with and challenges you to be creative and self-reliant.
[External] authority prevents the understanding of oneself, does it not? Under the shelter of an authority, a guide, you may have temporarily a sense of security, a sense of well-being, but that is not the understanding of the total process of oneself. Authority in its very nature prevents the full awareness of oneself and therefore ultimately destroys freedom; in freedom alone can there be creativeness. There can be creativeness only through self-knowledge. Most of us are not creative; we are repetitive machines, mere gramophone records playing over and over again certain songs of experience, certain conclusions and memories, either our own or those of another.
Knowing oneself, and investing accordingly, is the biggest advantage you can have.