Patience is a virtue for investors

It is better to have the ability and the freedom to ignore the short run if you want superior returns, writes Jason Blumberg.

A recent newspaper article reported that industry superannuation funds had outdone traditional retail super funds in terms of investment performance by what amounted to an extra $75 billion in retirement savings.

This is an interesting outcome.

While there are many talented industry fund managers there are also many skilled retail fund managers, so it is difficult to believe manager ability or a lower standard of stewardship is the only cause of this underperformance.

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Instead I would like to suggest that this result was instead due to the nature of industry fund investors who tend to be more "sticky" with their investment capital.

Taking a step back, the efficient markets hypothesis tells us that there is no possibility of consistently outperforming the market through the buying of mispriced assets because the price of an asset incorporates all available information and any deviations are merely random.

There is a lot of debate around the extent to which the hypothesis holds, but a cursory look at the performance of the actively managed fund universe suggests that many managers fail to consistently outperform the market.

There are a number of exceptions to this phenomenon, and two in particular do a good job of demonstrating how having the advantage of a long term investment horizon can overcome the constraints of an efficient market.

The first example is legendary investor Warren Buffett. In 1984, Buffett gave a speech at Columbia University titled "The Superinvestors of Graham-and-Doddsville".

In this speech Buffett uses the examples of himself and a group of colleagues, all trained in value investing and using the principles of Ben Graham and David Dodd, to demonstrate that it is possible to consistently achieve better results than the markets. 

The foundation of Buffett's approach to investments is that stocks should be viewed as partial ownership of a business, with an intrinsic value based on the cash flows the operation is able to generate, rather than as an esoteric piece of paper with a value attributed to it by the market.

Rather than being efficient, market prices are driven by human emotions and behaviour, which can at times be irrational and offer up good companies at prices far below their intrinsic value.

The job of a good analyst is to determine, to the best of his or her ability, the intrinsic value of a particular company and look for the opportunity to buy shares at a price well below this value in order to ensure a margin of safety for errors in their valuation assumptions.

Once they have made their purchase, a good investor is one who is able to ignore market movements in the share price until such time as it reaches its fair value, knowing along the way that it is impossible for the underlying value of the business to change as frequently as the market price would suggest.

Intuitively this approach makes perfect sense: regardless of whether the market is recognising the intrinsic value of the company today, it will continue to generate cash and accrue earnings, increasing its value and proving its true worth.

However, in order to be successful in this approach one would need to have a long-term investment horizon, with the patience and ability to wait for an investment to reach its potential value.

Buffett appears to practice what he preaches.

A recent quantitative analysis of his track record by AQR Capital concludes that his outperformance can be attributed to buying low-risk, high quality, cheap stocks.

However, I believe this quote from the same paper does an even better job in summing up Buffett's success: "he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift".

The second super-investor who has used long-term capital to achieve results far in excess of market returns is Yale Endowment manager David Swensen.

Swensen is widely known as the person who changed the way endowments manage their portfolios and in the more than 26 years he has managed Yale's fund he has achieved double-digit annualised returns.

Swensen believes that the way to get around efficient markets is to move lower down on the liquidity spectrum where less liquid markets are poorly understood and therefore less efficient.

He believes that in general investors pay too high a premium for liquidity; therefore these relatively illiquid assets offer the best opportunity to outperform the market. 

Again, this is a fairly simple philosophy that makes a lot of sense intuitively, but is also one that most savers and investors have difficulty implementing due to the constraints of time and human behavioural traits.

By nature, people desire immediate payoffs and dread the prospect of being wrong and not being able to change their minds immediately.

Swensen understands this and gains an edge over his competition by accepting circumstances others are unwilling to.

To be fair, Swensen admits that it would be almost impossible for the average individual investor to fully pursue his investment philosophy; as an endowment fund he has an almost infinite time horizon and a captive pool of investments funds with the critical mass to invest in any asset class or with any manager he wants.

However, his example does illustrate some of the opportunities available to gain an edge on the market by extending your time horizon.

So why do so many retail fund managers seem to get it wrong, offering at best index-like returns? A large part of this is due to the short-term nature, not necessarily of a strategy, but of performance measurement.

Most fund performance is tracked quarterly, monthly or even daily and a single period of underperformance can have devastating effects on a fund's assets under management as well as the rewards which flow to managers.

This continual measurement against benchmarks and peers makes all but the most high conviction managers hesitant to go against consensus and results in a continual chasing of the latest trend, often buying assets high and selling them low, permanently locking in losses.

The question investors should be asking themselves is: is this really the best way to be managing savings?

This continual evaluation of performance on shorter and shorter time scales means many decisions are made on nothing other than noise in the data which has no fundamental bearing on the long-term outlook of a particular investment.

It also forces even good managers to limit the investment decisions they are willing to take, leading to a substandard performance for the end investor.

Finally, this continual movement to the latest outperforming funds means that investors themselves end up chasing the latest trend, buying high and selling low. 

Industry super funds are in a fortunate position. Clients in these funds generally tend to be less active with their investments than typical retail investors, giving managers of these funds a much larger scope in their investment decision-making.

To paraphrase another great value investor, Seth Klarman, the individual investor has a distinct advantage over the broader market due to the fact that his or her performance does not need to be measured on a short-term basis.

An individual can implement sound investment practices and wait for the benefits to be realised over the long term.

For those of this mindset, that philosophy should apply to the selection of fund managers as well.

Longer-term investors should look for a manager who shares their long-term perspective and give that manager the time to reap the rewards of that strategy without worrying about the day-to-day movements of the markets. 

There are many different ways to approach the market - and the hundreds of fund strategies out there bear testament to this.

My own investment philosophy is that buying a dollar's worth of assets for 40 cents and riding out the bumps along the way is the best way to gain an edge when investing my savings, but this does not appeal to everyone.

In fact, Warren Buffett believes that this is a concept you either get the first time you hear it or you never get it at all.

However, regardless of whether or not you believe this is the best strategy to reach your investment goals, if you decide to pursue an active investment strategy you must ensure it is truly active and offers an edge over the efficient market.

The simplest, most reliable way to do this is by changing your investment time horizon.

Jason Blumberg is a senior investment analyst at van Eyk Research.