Category: Derivatives

QUESTION: Active equities managers generally don’t seem to be able to consistently beat their benchmark, what is wrong with these people?

ANSWER: Hubris, and occasionally stupidity.

TSA believes that smart folks, by fundamental analysis, can rank stocks in an investment universe from outperform to underperform/bankruptcy, and generally get it mostly right over many years.  However, the reason it doesn’t often happen is hubris and/or the marketing imperative to get investor-clients.

So this is how it works (in a simplified form):

1. Active manager has had some early success picking stocks (about three years will do it), so investor-clients are now interested (flipping three  heads, or three tails, in a row is not an impossible challenge and neither is an active manger with poor fundamental skills fluking stock picking for three years);
2. Active manager does some great fundamental analysis and determines that stocks A, B, C, D, E and F are going to be best highest total expected return (“TER”).  The active manager knows nothing is certain in markets so it (my preferred pronoun) also calculates the risk for each TER.
3. Client say to active manager, stock F is expected to have a TER only slightly above the index, so why are have you got that in the portfolio?  Also, D and E’s return is a lot less. Why aren’t you backing yourself as an active manager?
4. Active manager says “you are right, you have come to me because I’m a great stock picker, so I will give you a three stock portfolio of A, B and C, and I will be fully invested, i.e. hold no cash, proving to you the first three years was not a fluke”.
5. Overtime, the stock picking active manager with the three stock portfolio generally underperforms.

The potential mistakes are:

• the manager is just bad at stock picking based on fundamentals (a few high profile managers have been in the media recently);
• concentrated portfolios inevitably have the wrong “bet size”; and,
• active mangers ignore bet size because it sends the wrong marketing message to potential investor-clients,

In a nutshell, active equities is about ranking stocks on fundamentals, but constructing portfolios using quantitative tools.

ACTION PLAN:

1. If you haven’t heard of “bet size” and understand the maths behind the  Kelly criterion,  you are just punting securities, derivatives, etc, rather than investing.  You should get a licensed investment manager.
2. The most significant means to increasing your wealth is getting the asset allocation correct.  For most people, that means knowing when to put money into equities, bonds, et al and when to take it out.  The first thing you need to ask your investment manager (or yourself if you take the DIY route) is what is the expected 10-year US Treasury yield and the percentage of a portfolio that should be equities, bonds, realty or cash (the other asset classes are so speculative, they should be only for the very brave).
3. Once you establish how much to allocate to each class, then it is a question of which security or property in each class to buy.  For the DIY folks, that will most likely be an index.  For professional investment managers, it will  be buying individual stocks, bonds, realty or leaving money in cash in a well constructed portfolio.
4. Contact TurnerStreet if you wish to buy our current asset allocation recommendation (we do cash and equity only allocations for our wholesale clients), and the list of the stocks TurnerStreet would buy for a typical wholesale client, or if you would like TurnerStreet to manage your equities and derivatives portfolio.

IMPORTANT: This Q&A is general product advice for wholesale or sophisticated investors, and NOT suitable for retail investors.  Retail investors should seek advice specific to their circumstances and not rely upon general product advice written for other types of investors.  Retail investors acting like wholesale/sophisticated investor are likely to experience inappropriate and/or excessive risk for their circumstances, and unacceptable losses.