Joel Greenblatt (Trades, Portfolio) is the co-chief investment officer of Gotham Capital, a New York-based hedge fund. He is also the author of several books on value investing and an adjunct professor at the Columbia School of Business. He frequently gives interviews and lectures detailing his investment philosophy and his thoughts on the financial markets. Greenblatt gave a talk at Google on April 4th 2017, in which he explained why most active managers end up underperforming.
Difficult to know the thesis
Most people want to make money in the stock market, but donât want to do the actual work. Itâs one thing to understand the logic behind compounding returns. Itâs another thing entirely to actually spend hours every day digging deep into financial statements, industry reports and analyst commentary. Accordingly, some people may choose to give their money to someone else. How do you know who to give your money to? Who is good at this? Greenblatt explains why itâs so difficult for an investor to pick the correct active manager:
âWhat you should probably look for when youâre looking for that person is someone who has a good investment process that makes sense to you. The problem for most active managers is when theyâre picking an individual stock they must think that they have a variant hypothesis for why that stock is priced differently to the way it should be. I have been doing this for over 35 years, and itâs very rare, almost never, have I bottom-picked a stock. 99.9% of the time a stock is down after Iâve bought it. And there really are only two reasons why. One is I was wrong. The other is that I just need more time for my thesis to play out. Now, as an outside allocator you donât really know what the thesis for the stock wasâ.
So in other words, itâs very difficult to know whether your stock picker is right or wrong if you donât know their thesis. Now, some fund managers will disclose their thinking in quarterly reports and updates to shareholders, but these are exceptions to the rule. Few allocators want to give away too much about their process.
Past performance is no guarantee of future returns
The conventional way that investors assess fund managers is on their record over the last year, or three or five. Greenblatt referred to a passage in his book âThe Big Secret for the Small Investorâ in which he discusses the flaw in such a method:
âA study looked at the best-performing mutual fund of the decade 2000-2010. That fund was up 18% a year, 100% long US equities. The market was flat during those 10 years, so 18% up a year was pretty good. Unfortunately, the average investor in that fund, on a dollar-weighted basis, managed to lose 11% a year, because every time the market went up people piled in, when the market went down they piled out. When the fund outperformed they piled in, when the fund underperformed they piled out. And they took an 18% annual gain and turned it into an 11% annual dollar-weighted lossâ.
This doesnât mean that good managers cannot beat the market. They can. But investors in these funds are almost comically bad at choosing when to allocate capital. By chasing the best-performing funds they are consistently buying them at the very top and selling them at the very bottom. That is the opposite of value investing.
Disclosure: The author owns no stocks mentioned.
