Mr. Graham’s insightful prose is supported by the evidence that in the U.S., index funds, the most common being the S&P 500 Index, have outperformed the majority of active investment managers in large part due to lower management fees and lower portfolio turnover.1 Dalbar Inc., a market research company, found that during the 20 years from 1984 to 2004, the average stock fund investor earned returns of only 3.7% per year, while the S&P 500 returned 13.2%. On an inflation adjusted return, the average equity fund investor earned $13,835 on a $100,000 investment made in 1985, while the inflation adjusted return of the S&P 500 would have been $591,337 or 43 times greater.2 An analysis of the equity funds returns of the 15 biggest asset management companies worldwide from 2004 to 2009 showed that about 80% of the actively managed funds for US, European and Asian equities have returned below their respective benchmarks.3
Jeremy Grantham, Partner of investment management firm, Grantham, Mayo, Van Otterloo & Co. Inc. stated, “Everything concerning markets and economies (and everything else for that matter) regresses from extremes toward normal, faster than people think. Indexing is hard to beat and relative passivity is not a vice. Equity investors overpay for comfort and usually rotate into previously strong investment performance styles, which regress, dooming most active clients to failure.”4 This is best illustrated most recently by the significant redemptions of equity mutual fund investors during the Financial Crisis of 2008-2009 in favor of owning bond and money market funds.
Although there is no single, magic formula for investment success, some active investment managers clearly do beat their benchmarks, even over long periods of time. A 2003 study titled, Investing: Profession or Business?: Thoughts on Beating the Market Index, focused on four specific attributes of investment managers that demonstrated the ability to outperform their equity mutual fund peers and benchmarks over the period 1992-2002: 5
1. Portfolio Turnover
2. Portfolio Concentration
3. Investment Style
4. Geographic Location
1. Portfolio Turnover
Portfolio turnover, a measure of how frequently assets within a fund are bought and sold by a manager, was approximately 30% for those managers that outperformed their benchmarks. This percentage amount stands in stark contrast to the average portfolio turnover of 110% demonstrated by all of the equity funds studied. Not surprisingly, the S&P 500 Index turnover was 7% during the same period.6 In other words, the managers that outperformed had an average holding period of approximately three years, versus less than one year for the average fund.6 In addition to transaction costs, portfolio turnover may result in higher taxes when fund shares are held in a taxable account. One of the fund managers cited in the study, Mason Hawkins, Founder of Southeastern Asset Management and Portfolio Manager for the Longleaf Partners Fund, states in their investment brochure, “We are long term owners, not traders or speculators. Our time horizon when purchasing a company is generally three to five years, which our historic portfolio turnover reflects.”
This attribute is also validated by an RS Investments/Morningstar study from 1999-2009 that reviewed the performance impact of both high and low turnover on a on a universe of actively managed funds segmented by market capitalization. Those funds with the lowest portfolio turnover within each of the Small, Mid and Large Cap groupings had the strongest investment performance relative to their peers.7
2. Portfolio Concentration
According to an article from the August 2012 issue of Morningstar ETF Investor Newsletter, the average mutual fund holds 134 stocks and maintains only 27% of its assets in its ten largest holdings. In contrast, investment managers that have outperformed their benchmarks over time tended to have higher portfolio concentration, or fewer holdings than the index, with 37% of assets in their Top 10 holding versus 24% for the benchmark index.
Bruce Berkowitz, Portfolio manager of the Fairholme Fund stated in an interview, "The history of success, those who have succeeded well... they are focused on few activities. Why would you possibly want to buy your 10th best idea, if you can buy more of your best idea?”8
Warren Buffett, Chairman of Berkshire Hathaway, has been a proponent of concentrated investing since he established an investment partnership in 1956. Warren believes that investment risk can be greatly reduced by concentrating in only a few holdings. Warren stated in 1994, “We believe that a policy of portfolio concentration may well decrease risk if it increases, as it should, both the intensity with which an investor thinks about a business and the comfort level he/she must feel with its economic characteristics.”9
A 2006 study compiled by the faculty at Emory University’s Goizueta Business School found that high conviction managers, with concentrated portfolios, outperformed more diversified funds by approximately 30 basis points per month or 4% annualized. Their results found that focused managers’ “big positions outperform the top holdings of more diversified funds.”10
3. Investment Style
The vast majority of investment managers that have outperformed their benchmarks over time espouse a value oriented investment philosophy of buying shares of common stock of a company whose price is substantially less than their estimate of the per share value of the business. By analyzing a business, using measurable data i.e. financial statements, industry data etc., value investors can determine its intrinsic value. When stocks sell for less than intrinsic value, profit potential is greater and risk is reduced by creating a margin of safety, or the difference between the price paid and the business value received.
As stated in the prospectus of the Sequoia Fund, managed by Ruane, Cunniff and Goldfarb Inc., “In pursuing the objective of long term growth of capital, the Sequoia Fund focuses principally on common stocks that it believes are undervalued at the time of purchase and have the potential for growth. A guiding principle is the consideration of common stocks as units of ownership of a business and the purchase of them when the price appears low in relation to the value of the total enterprise.”11
Numerous academic studies have provided supporting evidence that value investment strategies work because they are inherently contrarian or the flip side of naïve strategies implemented by a majority of investors. Investors may face extra volatility if they hold value shares for just one year before selling, but not if they hold the shares over longer periods. The founders of LSV Asset Management, Josef Lakonishok, Andrei Shleifer and Robert Vishny, determined that value strategies outperformed growth strategies during recessions and the 25 worst months for America’s stock markets during the period 1963-1990.12
An alternative study in 1999 by Jim Brown, CFA, of Brandes Investment Partners, L.P. wrote, “value strategies work because most investors are captive to judgmental errors or biases that influence their decisions. When the facts of reality contradict their biased view of the world, investors often over-react, causing market prices to swing to extreme highs or lows. Successful value investors can exploit these over-reactions by adhering to investment policies and procedures that circumvent bias and over-reaction.”13
Sir John Templeton, Founder of the Templeton Mutual Funds, wrote, “Too many investors focus on outlook and trend. More profit is made by focusing on value. To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest potential reward.”14
4. Geographic Location
Interestingly enough, the attribution study indicated that only a small group of the managers that outperformed their benchmarks were from East coast financial centers, New York and Boston. Many of the alpha generators were located in cities like Arlington, VA (RE Advisors Corp.), Chicago, (LSV Asset Management), San Francisco (Dodge & Cox), Lake Oswego, Oregon (Auxier Asset Management). In other words, it was not necessary for an investment manager to be immersed in the frenetic activity of Wall Street to provide value for shareholders and investment clients. More importantly, having distance from U.S. financial centers can provide managers with the objectivity to think about and analyze investment opportunities with independence from the herd mentality and “group think” mindset.
In conclusion, the extensive and readily available data confirm that over periods of 10 years or longer the proportion of investment managers who underperform their benchmarks rises to approximately 70%.15 We can presume that if a manager has views which reflect the consensus of the crowd he or she are unlikely to outperform a market since a market by definition reflects the consensus view. Being different is necessary but not always sufficient for investment success. Investment managers can enhance performance by identifying opportunities that have been mispriced by the crowd or exploiting the gap between expected value and market price. After review of all this information, it should come as no surprise that the Fairholme Fund, which outperformed the S&P 500 Index by almost 50% total return over the last ten years through May of 2013, currently owns two holdings, (Bank of America and AIG) which account for 62% of the fund assets. It reported an annual portfolio turnover of 1.57%. The slogan on the cover of the Fairholme Fund prospectus reads, “Ignore the Crowd.”16
Written by Arthur Q. Johnson, CFA, President of A.Q. Johnson & Co., Inc., a Registered Investment Adviser in La Jolla, CA
1. Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996
2. John Y. Campbell, Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. Invited address to the American Economic Association and American Finance Association. Atlanta, Georgia, January 4, 2002. Retrieved May 20, 2010
3. Wessels, Daniel R (January 2010). "In Pursuit of Alpha: The outperformance characteristics of actively-managed equity funds".
4. “Everything I Know About the Stock Market in 30 Minutes” Jeremy Grantham, Collins Associates Client Conference.
5. Michael Mauboussin & Kristen Bartholdson, “Investing: Profession or Business? Thoughts on Beating the Market Index.” Credit Suisse, First Boston, Volume 2, Issue 14, July 15, 2003.
6. Vanguard Bogle Financial Markets Research Center, The Mutual Fund Industry in 2003: Back to the Future, January 14, 2003
7. RS Investments White Paper Series, Summer 2010, The Case for High Conviction Investing
9. Fortune, April 4, 1994, pg.33
10. Baks, Busse, Green; “Fund Managers Who Take Big Bets,” March, 2006
11. Sequoia Fund, Prospectus, 2013 pg. 1
12. Contrarian Investment, Extrapolation and Risk, Josef Lakonishok, Andrei Shleifer and Robert Vishny, Journal of Finance, Vol. XLIX, No. 5, December 1994
13. Why Does Value Investing Work? Jim Brown, CFA, March 5, 1999
14. Templeton Investment Principles, Franklin-Templeton Mutual Funds brochure, 1995.
15. Charles D. Ellis, CFA, Murder on the Orient Express: The Mystery of Underperformance, Financial Analysts Journal, Vol. 68, No. 4 pg.13.
16. Fairholme Funds, Portfolio Manager’s Report, May 2013