Most investors now realise their portfolio can, and probably should, be made up of a diversified set of investments that balance lower-cost and usually lower-return passive funds with those that are actively managed with a higher fee but usually higher returns in the long-term.
However, that is easier said than done. For passive options there are many things to consider, but the key question remains price. Meanwhile, with active managers, the dilemma for investors is in identifying skilled managers for the long-term. And when data suggests the majority (around 75%) of active fund managers underperform their benchmarks, that may raise the question whether it’s worth it at all.
That statistic, however, shouldn’t come as a surprise. Like a seesaw or a set of balancing scales, in the investment markets there is always a buyer and a seller and if one makes a profit, the other has to make a loss.
Therefore, not everyone can outperform the market – it’s just simple maths!
Making the right choice
Of course, that doesn’t mean that investors should give up and just stuff their money under the mattress. It’s just that instead of striving for the impossible – perfect – performance they should understand that even a modest outperformance can make a big difference to their portfolios over the longer term.
But to do that, investors need to identify managers that have a particular set of skills - they should be unique, transparent and have a sustainable long-term advantage that is difficult to replicate.
We believe there are four principles that can be helpful in narrowing down the field, that are typically overlooked by investors in general.
1. Understand the incentives
This is another way of asking whether their interests are aligned with yours, as incentives are strong drivers of human behaviour.
One example of this in the investment world is often described as ‘herding’ or ‘momentum’ where investors tend to follow the crowd. This can sometimes be driven by fears of career risk, where fund managers might prefer to play it safe and stay in line with their peers to protect their job, rather than take a different position and potentially risk underperformance and standing out from the crowd.
Key things to look for that show a manager is more aligned with their clients’ interests:
The ownership structure – Is fund management a key focus for the business, or a side hustle? Is it privately owned, or are there thousands of external shareholders driving behaviour and requesting shorter-term results rather than thinking long-term?
Co-investment – According to Morningstar, only half of all US mutual fund managers invest their own money in their funds. Does your manager put their money where their mouth is?
Performance fees – Do they benefit the manager no matter whether they under or outperform or are they dependent on actual results?
Activism – Does the manager make use of opportunities to potentially influence companies towards shareholder best interests. This could include things like engaging on remuneration, and corporate governance.
2. Focus on the long-term
Investors should remind themselves that when buying shares, they are investing in a business. This is sometimes ignored, as is evident by the fact that the average holding period for shares listed on the New York Stock Exchange is about 5.5 months. Is your manager making decisions based on the long-term fundamentals, or on short-term noise? Or a combination of both?
3. Be sceptical of overconfidence – especially about the future
The future is more uncertain than people believe, and many investors are prone to overconfidence in their assumptions and their ability to interpret information.
Though it is tempting to think that we can accurately predict the future, history tells us a different story. The key is to accept no-one can predict the future, but even modest outperformance compounded over time can make a big difference.
4. Embrace creativity
This is not opposing consensus for the sake of it, but rather being independent thinkers and looking at the counter view to the more popular one. As mentioned above, humans like to stick with the herd and look at what other people have done and say that’s probably the right thing to do. But there are exceptions, and investing is one of them.
This is because share prices don’t move based on the outcome of some event. They move based on the difference between the outcome and what people expected the outcome to be. So, for contrarian investors it comes down to finding opportunities where the outcomes are likely to be better than the expectations.
Thinking differently
The more successful investors over the years are those that look at the wider picture, and many active managers have evolved to do just that.
We try to only invest in a company once we have a strong view of what it’s worth (its intrinsic value) and aim to buy its shares at a price that is below that. But you have to understand the reasons why the seller is selling at a lower value.
We also tend to try and let other people take it off our hands once the share goes past our estimate of fair value. We can then invest those proceeds into something that we think is unfairly priced.
Sometimes people say that contrarian investing, opposing the consensus, comes with more risk. But our view is that it’s actually a risk averse approach as you’re seeking to avoid overpaying for shares that are very overpriced.
While we may not get it right all the time, as we’ve discussed, no-one can do that, but to create modest outperformance consistently over the long-term is a goal that we are proud to pursue.
Shane Woldendorp, Investment Specialist, Orbis Investments, a sponsor of Firstlinks. This article contains general information at a point in time and not personal financial or investment advice. It should not be used as a guide to invest or trade and does not take into account the specific investment objectives or financial situation of any particular person. The Orbis Funds may take a different view depending on facts and circumstances. For more articles and papers from Orbis, please click here.