Last month we launched our inaugural Institutional Perspectives piece, entitled “Winning the Game”. Since publication, there have been some timely updates made to the research cited, impacting a number of the key points presented in the article, while also making us look rather prescient in our views and in our approach to investment management. After which, writing a follow-up became imperative, as we believe the paradigm in terms of what is working in the markets and what is not to be shifting, and we are likely only in the first inning of this game.

In order to win, one must remain objective and maintain a 30,000 foot view of the markets, while at the same time blocking out the noise that so often leads investors astray (if not exploit it for increased opportunities to generate meaningful outperformance). This is obviously easier said than done, but in this educational series our intent is to equip our readers with critical insights that have continued to help us achieve long-term success and provides the foundation for winning a game at which the vast majority have repeatedly failed.

In order to win, one must remain objective and maintain a 30,000 foot view of the markets, while at the same time blocking out the noise.

Matthew Erickson | Senior Portfolio Manager Tweet
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Key Points Made in Winning the Game: Part 1

In order to provide appropriate follow-up from our initial article, it is first necessary that we reiterate some key points:

Generally speaking, there are two basic approaches to investment management – active and passive. Over the past decade, the vast majority of industry practitioners have favored a passive approach; by which, net of fees, there is essentially no chance to outperform a mirrored benchmark. 

In this sense, they have given up and accepted defeat. Fund flows have clearly reiterated this fact.

Cumulative Flows for Active Vs. Passive Equity Funds

“Two roads diverged in a wood, and I – I took the one less traveled by, and that has made all the difference. ”

– Robert Frost

The dramatic flow of investable dollars into passive strategies has directly mirrored those out of actively managed strategies. After more than a decade of this phenomenon, ownership of the U.S. equity markets by indexed based products has gone from roughly 25% to nearly 50%. The unintended consequences of such a move is that this has created massive divergences and inefficiencies in the market. As monies pile into passive indices, they continue to disproportionately reward the largest stocks (as the majority of index based products are capitalization weighted), driving them up in price; not based on fundamentals or more highly attractive corporate developments, but simply because they are bigger.

The markets are rarely appropriately priced, and neither are individual securities. The state of prices is continually in flux, akin to that of a swinging pendulum. The secret therein, is in determining in which direction that pendulum is swinging – either in favor of something being oversold or overbought. The philosophical premise behind active management is to buy low and sell high. In theory, this may sound easy, but the problem is the vast majority of those who attempt to do so have failed. They took the proverbial road less traveled, and then they took a wrong turn.

Achieving sustainable success through active management may begin with this philosophical premise, but that alone is not enough if all of your actions thereafter are predicated on looking like your passive counterpart. Money managers commonly base their investments to a large degree on the index itself, taking incremental under or overweight positions in sectors based on benchmark weightings. They also often own larger weightings in the largest stocks in the index. Remarkably, many due diligence practices actually reward this approach, highlighting statistical measures such as tracking error or r-squared as being more favorable when a strategy moves more like their benchmark. Seems silly, right? Of course, but that is what the herd is doing. It is also the principle reason why they fail. 

In order to stand the chance of consistently generating meaningful, risk-adjusted outperformance, we believe there are three critical elements a manager must possess that dramatically improves their chances of having success*:

  1. Adhere to a tactical approach – Underlying holdings should reflect prevailing market conditions; this can
    be applied with respect to portfolio risk attributes, sector weightings, and/or factors.

  2. Remain sector weighting agnostic with respect to the benchmark – Active management is not just about picking the right stocks, equally important is being in the right place at the right time. If there is no fundamental or technical reason to own a sector, then regardless of that sector’s weighting in the index, it need not be owned.

  3. Invest with a relative degree of concentration – Many investors falsely believe that the more stocks that you own in a portfolio, the less risk (due to a perceived increase in diversification). Yet studies have proven that a portfolio of more than 20-30 stocks does nothing to further reduce risk, but it does exponentially reduce your odds of outperforming.
*In Winning the Game: Part 1 we provided additional support for these points. For further detail one may refer to that article, but in an effort to reduce unnecessary redundancy this general summary will suffice.

So Whats New?

It is undeniable that the vast majority of active managers have historically underperformed their respective benchmark. As cited in our prior article, Standard & Poor’s publishes a bi-annual report providing an update on the performance of active managers versus passive indices (S&P Indices Versus Active – aka The SPIVA Report). As of the end of 2019, across all capitalizations and investment styles, whether looking at the trailing 1, 3, 5, 10 or even 15 years – the vast majority of active managers failed to outperform their benchmarks.
Chart of U.S. Equity Funds Outperformed by Benchmarks

However, our contention has been and continues to be that with a number of divergences as large as they are, this market has priced in extreme conditions, and much sooner rather than later the pendulum is poised to swing in the opposite direction. Fund flows between passive and active investments over the past 10 years are the most extreme they have ever been. This has dramatically impacted the performance differences between the largest stocks and the average stock in the S&P 500. And the performance\ differences between growth and value styles over the past several years is also at historical extremes. When divergences are this wide, it opens up tremendous opportunities for active managers to exploit. At a certain point, the markets must revert to the mean, and we believe we are just now starting to see that.

S&P recently published their mid-year SPIVA report, and while only taking into account the first six months of 2020, the trailing 1-year percentage of U.S. equity funds outperformed by their benchmarks has dipped considerably from where they were at year-end. Polaris Wealth

Percentage of U.S. Equity Funds Outperformed by Benchmarks- Polaris Wealth Chart

At the end 2019, S&P cited that 97.23% of U.S. Large-Cap Value funds had been outperformed by their passive benchmark. Just six months later, that number has now dropped to 72.98% – almost a 25% drop! And when you look at the U.S. Large-Cap growth category, only 25.66% of funds were outperformed by their benchmark over the trailing 1-year period. These are considerable moves made over a very short period of time, and starkly different than the long-term averages of 80-90% of active managers underperforming.

Taking things one step further, a recent research note published by Kailash Concepts highlights just how extreme conditions have become by illustrating the percentage of stocks that have beaten the S&P 500 over the trailing 12-month period. Currently, the number of individual stocks in the S&P 500 that have outperformed the index is at its lowest point since the Internet Bubble and the Nifty Fifty mania of the early 1970’s. Historically, after these extreme conditions have presented themselves, the opportunity to outperform the index through active management swings dramatically in your favor.

As of the end of September, the five largest stocks in the S&P 500 had generated a total return of 61.80% over the trailing 1-year period and made up nearly 25% of the index. Comparatively, the S&P 500 Total Return Index was up 15.15% and the S&P 500 Equal Weighted Total Return Index returned only 2.50%. The proliferation of indexing in our industry has led to these severe dislocations, and surely the herd will continue to chase, but going forward, for those attuned to the changing paradigms, this opens up a tremendous opportunity to generate meaningful outperformance through active management.

The Bottom Line

Today, industry practitioners find themselves standing at a fork in the road. They can either choose to follow the herd and continue down the passive path, or elect to take the one less traveled. Their decision may ultimately make all the difference for their clients.

It should likely go without saying that not all active managers are created equal. For those whom continue to masquerade as active, while lacking the wherewithal to make moves dissimilar than their benchmark – they are very likely to soon be exposed. In choosing to follow an active path, one stands the chance to generate meaningful outperformance and achieve the holy grail of investing, the ever-elusive alpha. But in doing so, one also stands the chance of buying an active strategy at precisely the wrong time, and locking in greater underperformance than they may have had by simply following a passive approach. This presents a conundrum for investors, but rest assured we can help. In our next educational piece in this series, we will be discussing performance persistency and provide critical steps one can follow in their efforts to vet for appropriate managers and strategies. Stay tuned!

Additionally, for those looking for context to justify our approach and the investment philosophies we are opining, the following table depicts the trailing 3-year performance of our US Large Cap Value strategy, Polaris Focused Value:

Chart of 3-year performance of our US Large Cap Value strategy, Polaris Focused Value

For further insights, please refer to our most recent rolling 3-year period analysis.

Until next time, if you have any questions or comments, please feel free to reach out.