Beating The Market

According to Merrill Lynch, only one-third of mutual fund managers outperformed the S&P 500 in the 12 months ending April 30, 2012.

This is actually good news, in a way.  Active managers struggled even more last year.

For example, through the end of June 30, 2012, only 14% of managers had outperformed the S&P for the prior 12 months.

Trying to explain this phenomena has been the subject of numerous articles and publications.

Some, like Vanguard founder John Bogle, believe that active managers are doomed by their fees and transaction costs.  Others believe that manager skill has declined in recent years, as successful investors have migrated to the more lucrative field of hedge fund management.

However, Saturday's Wall Street Journal carried a column authored by Mark Hulbert that suggested another culprit:  computers.

Here's an excerpt from what Hulbert wrote:
 

One major reason why machines are winning is our inability to process lots of financial data, which is getting more complex and voluminous every year.
Terrance Odean, a finance professor at the University of California, Berkeley, has extensively studied the behavior and performance of individual traders. He points out that there used to be another human being on the other side of the trade when an individual bought or sold a stock. "Now it's a supercomputer you're competing with," says Mr. Odean.

"Individuals are no longer playing against Grandmasters; they're playing against Deep Blue," he says, referring to the famous battle in the 1990s between chess Grandmasters and International Business Machines' IBM +0.60% supercomputer. Individual investors "will almost certainly lose."

Another reason traders are losing out to machines is their general inability to assess complex data. They look at the same set of facts on different occasions and reach different conclusions, and they unwittingly let their emotions dominate their intellect. 

http://online.wsj.com/article/SB10001424127887324059704578471154109438438.html

I would offer another reason.

In my opinion, investors today have become hyper-focused on performance versus a benchmark.  Returns are posted daily, and monthly returns vs. a wide variety of indices are distributed and scrutinized closely.

In such an environment, it is only rational that managers have become less willing to take large contrarian bets.  Managing a diversified portfolio of stocks with representations in every sector may lead to sub-par results, but also probably means a longer career.

Warren Buffett once said:

“Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press”

Years ago I had a client named Dick Rosenbloom. Dick was a professor at the Harvard Business School, and was one of the smartest persons I knew.

Dick hated diversified portfolios.  He told me in his gentle way that it was highly unlikely that any manager had 35 to 40 good ideas, yet that was how most institutional money managers ran their portfolios.

Dick told me that he wanted me to only put my 10 best ideas in his account.  Ideally, he said, I would have less than that.  He was willing to accept the higher volatility that such a concentrated portfolio would entail, but he strongly believed that it was the only way to go.

As was so often the case, Dick was absolutely right.

By forcing me to put all of my energies - and his money - into my best ideas, the returns on his account soared.

It wasn't a straight line - there were some quarters when his account badly lagged the broader market averages.

But over longer periods, his account became easily my top performing portfolio, outpacing the S&P in some years by more than 1,000 basis points.

Yet the only reason this strategy worked was Dick's ability to look longer term, and not worry too much about the shorter term results.

So I wonder how many investors, or investment committees, would be willing to go Dick's route?