Value investor Seth Klarman (Trades, Portfolio) doesn’t give many interviews, but investors can still learn a lot by scrutinizing the things he has written. He has taken many contrarian positions in his time, one of which has been that many professional investors really do no better than amateurs. In his book, "Margin of Safety," Klarman explores exactly why even smart and well-resourced institutions can still lose in the market.
Time is the most valuable commodity
Klarman believes that one big factor in the underperformance of large money management firms is a lack of time. There is just simply too much information out there, taking the form of company reports, regulatory filings, 10-Ks and market research, for even the most well-staffed office to read and process. Sure, high frequency traders can move on a headline at almost the speed of light, but that is not the same thing as synthesizing all the data available on the fundamentals of a company and distilling it down to what really matters. As far as I know, no one has built an algorithm that powerful, not even Jim Simons. Moreover, much of the information out there is either useless or actively misleading, which makes the job of the analyst even harder.
To make matters worse, there are other parts of the job that make it hard for the institutional investor to focus on the task at hand. Professional money managers have to keep up to date on the capital they have already invested, but they must also court new clients and look into new opportunities. This means that a lot of working time is spent in meetings with clients, which in the aggregate is not efficient for any of them. As Klarman puts it:
“It is ironic that all clients, present and potential, would probably be financially better off if none of them spent time with the money managers, but a free-rider problem exists in that every client feels justified in requesting periodic meetings. No single meeting places an intolerable burden on a money manager’s time; cumulatively, however, the hours diverted to marketing can take a toll on investment results.”
In addition to having to spend time placating clients, institutions suffer from a problem of bureaucracy and what Klarman describes as a tendency towards “conformity, inertia and excessive diversification that results from group decision making.” Simply put, individual managers within institutions risk their careers, reputation and bonuses by pursuing contrarian strategies, and so they have strong incentives to not do so. As a result, there tends to be a clustering towards the consensus: if you fail, it is comforting when those around you are in the same boat.
This isn’t to say that big money management firms can never be innovative or go out on a limb - far from it. But I think it can be useful for retail investors to remind themselves that the professionals on the other side of the market are ultimately just humans, with their own particular set of biases and incentives, not all of which are beneficial for their firms.
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