Turning the tide from passive investment

Every investment management firm claims to be different from its competitors. They have a superior investment team, or an innovative investment strategy, or both. 

But all too often these claims fail to live up to expectations. The superior investment team and innovative strategy fail to deliver the kind of results that clients expect.

Over the past 15 years, 84% of large cap Australian equity active managers underperformed the ASX 200 benchmark. This shouldn’t be a surprise in an environment where herd behaviour is prevalent and where fund managers tend to hold similar positions. 

In some cases, the below-average performance results from being positioned very similarly to the market index while charging an active fee. If so, underperformance may be the most likely outcome – even over the longest time periods. Some investors may realise that this isn’t worth the fee and instead opt for a cheap, passive approach to investing. That seems fair enough. Why pay for something that isn’t offering you a sustainable advantage over passive investing? 

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How can an active fund manager address this situation? By offering an investment approach that separates it from the herd and offers clients something distinct. If it is not distinct from passive investing, it should be available very cheaply. The approach also needs to be transparent, so investors understand what the manager is doing and are then able to invest with both money, and trust. 

Lastly, if the approach is both distinct and transparent, it cannot have a sustainable advantage unless there is a barrier to entry. The investment approach must therefore be difficult to replicate in order to maintain its advantage. 

Many people are uncomfortable with stepping outside their investment comfort zone and truly being different, typically because of poorly-aligned incentives and investment psychology. This is precisely what allows a contrarian approach to be difficult to replicate and to maintain distinct advantages over more pedestrian strategies in a competitive market. 

Our research has found that four key principles can foster the kind of outside the box thinking that leads to innovative and contrarian investing and overcome any barriers and challenges fixed in the minds of investors.

ALIGNMENT OF INTERESTS

For investors, alignment of interest is critical when selecting a fund manager or adviser to work with. This alignment of interest between fund manager and client ensures that decision-making focuses on investment outcomes, rather than being driven by self-interest.

There has been plenty of discussion around fund manager career risk (the threat of being fired by a client or employer for underperformance versus peers). The risk is that the manager places their best interests – keeping their job – ahead of their clients’ best interests which revolve around long-term investment outcomes. The desire for job security limits the investment approach. 

This can lead to scenarios such as a fund manager failing to proceed with an unpopular but outstanding investment opportunity because it carries too great a risk of looking wrong and increases the likelihood of them losing their job or client. It encourages career-safe decisions ahead of the best investment decisions. 

But the irony is that while appeasing clients and limiting their career risk, managers ultimately deliver an average performance, destroy their value proposition and they may well get fired anyway.

Simple measures can create an alignment of interest. Employee ownership, co-investment and performance fees can play powerful roles. 

Employee ownership by portfolio managers should be specific to the strategy they are responsible for so that alignment is not diluted. Co-investment in the fund, or having ‘skin in the game’, can further reassure investors. Put simply, investors know that if the fund underperforms and loses money for them, the portfolio managers themselves also lose out.

Performance fees are another way of aligning interest. As long as they are structured fairly, performance fees can create a much stronger link between what investors pay and the performance they get in return. In turn, portfolio managers do better when their clients do better.

THINKING LIKE A LONG-TERM BUSINESS OWNER

The second principle is to think like a long-term business owner. It’s a simple concept but one that is often lost on investors who focus on short-term-profit seeking and who are susceptible to ’noise’. As a result, rigorous valuation and the risk of overpaying while investing don’t get appropriate attention.

Of the top 50 members on last year’s Financial Review Rich List, that included business owners like Anthony Pratt, Gina Rinehart, Harry Triguboff, Hui Wing Mau and Scott Farquhar, 70% of members held more than half their money in a single business. 

Their wealth was built by seeing a long-term business opportunity and by taking equity, or founding capital, in that business for a bargain price. Those people recognised the prospects of the business opportunity when the broader investment community didn’t. They bought their equity cheaply and saw it multiply many times over the long term.

The same principle can apply to investing. One may acquire equity in existing businesses at a bargain price when they are out of favour with the majority of the investment community and therefore competition to buy the shares (and the share price itself) are very low. But investors often prefer the most popular shares, anticipating a near-term rise in price, without the mindset of a long-term business owner. Demonstrating this, the average holding period of shares listed on the Australian Securities Exchange (ASX) is typically only 12 to 15 months.

The constant flow of information on companies, markets and economies also creates confusion and ‘noise’, making it harder for investors to make rational decisions. A business owner shuts out the noise – investors should do the same. 

An investment represents investment in a business and the same diligence should apply as when purchasing a private business. The relationship between price and value, and the risk of overpaying, needs to be assessed and a business owner should never forget that. 

AVOIDING OVERCONFIDENCE AND ACCEPT UNCERTAINTY

Thirdly, it’s important to avoid overconfidence and to accept uncertainty. Commonly-held beliefs and intuitive assumptions about the art of investing can lead to overconfidence in interpreting information. A willingness to rely on accepted ‘truths’ is fraught with danger, while the level of uncertainty in investing is often underestimated.

A number of hypotheses have become embedded in investment thinking around expected returns, yet there is ample evidence to contradict them. A flawed bias in expected returns can lead to overpaying for investments and a permanent loss of capital. 

One example is that a reasonable expectation for real (after inflation) long-term average returns is 4% to 6% per annum. Many of the assumptions in finance are based on studying the past 100 years in the hope that it represents normality. The truth is that we simply do not know if this is the case.

Another hypothesis is that broad share markets always grow, in real terms, given time. This may not be true either. Between 1900 and 2000, the median real dividend growth rate across 16 developed markets was 0.7% – and this excludes Argentina and Russia that were excluded from the survey in ‘Triumph of the Optimists’ (Princeton University Press) because investors lost all their capital in these markets.

The belief that a 20-year perspective is enough when investing in the share market also doesn’t hold true. A look at the S&P 500 over time shows roughly three cycles over 95 years with the average cycle length being about 30 to 40 years. The 20-year perspective also doesn’t hold true for the US bond market. A 20-year perspective may be just enough to get one into trouble!

Similarly, there is no hard and fast evidence to support the popular hypotheses that it is better to invest in a country with high economic growth or that high growth in an industry is good for investments. 

In the words of Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” 

OPPOSING CONSENSUS

The final principle for contrarian investing focuses on opposing consensus. Doing the opposite of what everyone else is doing can be psychologically challenging and it can feel uncomfortable to many investors. 

It’s natural for humans to seek social validation to justify our decision making. We also take comfort in the perception of authority. But when it comes to investments, the influence of social validation and authority can lead investors into trouble. 

In October 1929, Irving Fisher was a respected economist, Yale professor and adviser to several investment trusts when he made a prediction that: “Stock prices have reached what looks like a permanently high plateau”.

Shortly after that insight, the US market began a collapse of about 90% and didn’t regain its 1929 peak until 1954.

An analysis by the International Monetary Fund of the accuracy of economic forecasters found they failed to predict 148 out of the past 150 recessions. Share market analysts are also good at explaining what has just happened and extrapolating that into the future but that often proves a poor predictor of the future. 

Close to home we can look at the fall from grace of Babcock and Brown (B&B) in 2008. From the middle of 2007 until April 2008, when the first cracks began to appear in B&B, nine analysts on record had the company as a ‘buy’. By the time the first analyst broke ranks and changed that recommendation the stock had already lost more than half its value.

In this case, shunning the consensus would have provided a distinct advantage.

In short, you cannot do the same as everybody else and expect a better-than-average result. 

Contrarian investing may appear unpopular, or uncomfortable. But, ironically, it is the unpopular and uncomfortable that can make contrarian investing such a rewarding and sustainable strategy. 

Julian Morrison is head of research relationships and national key accounts at Allan Gray Australia.