Weekend Reading #20
This is the twentieth edition of our weekly newsletter, Weekend Reading, sent out on Saturday 8th June 2019. To receive a copy each week directly into your inbox, you can sign up here.
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Death of the core position.
Just as companies have flagship products (Persil, Corn Flakes, Vaseline, iPhone, Hennessy VSOP, Chanel No. 7, Johnnie Walker Black – you name it), portfolio managers have flagship stocks that exemplify their style, thought process and market understanding.
These are typically long positions, although on occasion a core short (like Teslato David Einhorn, or everything to Crispin Odey) is highlighted, and it is very likely be the longest-held and largest-sized position in the book. It may not be the best performer, but it’s the one a manager is best known for.
This tendency has tended to denote conviction and discipline, in line with the broader narratives peddled by the asset management industry over the past few decades. These are stories the industry tells itself about itself:
“Buy and Hold is the way to go, trading is for cowboys.”
“Long-term performance is best achieved by dollar cost averaging.”
“We’re investing, not speculating.”
The aim is simple. Get investors into a fund and explain away any near-term drawdowns by blaming the market, while using the platitudes to convince investors to stay invested – or potentially double down. Whether a fund is actually managed according to those platitudes is a completely different matter.
The biggest proponent of this narrative is The Oracle of Omaha himself. We won’t attempt to subtract from Berkshire Hathaway’s incredible achievements, but we will make one clarification upfront: Warren Buffett doesn’t play by the rules. He’s earned that right over time. His portfolio faces no mark-to-market (until this year, but BRK dictates the rules on how its financials are read), and enjoys unparalleled access to private deals, management and permanently captive capital.
For every other manager, the convenient sales pitch is turning into a liability.
Moreover, as much as managers hate to admit it, the informational asymmetry between company management and fund managers is so immense that investment professionals never truly know what goes on in the businesses they are invested in. This applies to both public and private markets.
In the interests of their investors, managers must be ready to change their minds if new information presents itself – declaring allegiance to a “core” portfolio simply shackles managers to a view that is based on incomplete information, regardless of how much effort was taken to gather it. Especially if it’s a losing position.
A thought experiment.
As Nobel Laureate Daniel Kahneman presented in his work on Prospect Theory and elaborated on in his book "Thinking, Fast and Slow", consider these two scenarios:
Choose between winning $900 with 100% certainty, or winning $1000 with 90% certainty AND $0 with 10% certainty.
Choose between losing $900 with 100% certainty, or losing $1000 with 90% certainty AND $0 with 10% certainty.
Most "normal" humans (investment managers included) choose certainty in Scenario 1, and risk in Scenario 2 – suggesting that we are, as Kahneman concludes, Risk-Averse when it comes to locking in gains, but Risk-Loving when it comes to holding out on losses. The mantra becomes:
“Let’s hold it a little longer, we might be wrong, but maybe there’ll be a reversal.”
Ironically, the notion of a “core” gives managers license to hold on for longer. Some call it discipline, but often, the behavioural implications of Prospect Theory suggest that having an excuse to hold on to losing positions (Scenario 2) really betrays a lack of discipline.
One thing is clear: a buy and hold “core position” (and by extension a “core portfolio” strategy) is not wrong in and of itself. It is, however, one possible strategy of many for managing money. Investors should be open to alternatives. It works in certain market environments (low volatility bull market runs) but very quickly breaks down in others (high volatility, high correlation markets).
Of course, a temporary change in market conditions is still no case for labelling a decades-old strategy “dead”. However, it is looking increasingly possible that a profound change in conditions is coming.
A crisis of "undifferentiation".
Take any sample of large sized (US$500m AUM or bigger) funds and ask their managers what their core positions are – or, even better, take a peek into their holdings report. You will see what we mean.
For most Global/US funds, chances are that at least one of the FAANG stocks feature in their top 5 holdings; and in the emerging market world, the corresponding usual features list would likely include Alibaba, Tencent(Naspers if South African/EMEA mandated) or TSMC.
Unsurprisingly, they also happen to feature as the top weighted names in the MSCI EM index, just as FAANG feature at the top of the S&P 500/NASDAQ Composite.
And therein lies the paradox: if a “core” position or portfolio defines a manager’s individuality, and multiple managers have similar “core” portfolios, then where’s the differentiation? Where’s the choice for end investors?
To be fair to managers, this is a function of the rising correlations in the market. We have ETFs to thank for that. The Annual Review of Financial Economics in 2017 found that ETFs by the end of 2016 exceeded 10% of market capitalisation traded in the US, and represented more than 30% of trading volumes.
That article also discusses the risks that ETFs bring in terms of propagating liquidity shocks and inducing excessive correlations, and whilst the jury was out back in 2017 (the bull market was still in full swing), those risks are now clear to see now. Through their outsized share of market turnover, ETFs have become the marginal price maker in the market by default. As a result, under normalised conditions, they are the price maker, and everyone else choosing to pursue a buy and hold strategy (as an ETF does) is compelled to follow.
This self-perpetuating momentum strategy leads not only to everyone owning the same instruments, but also to many instruments starting to behave like other instruments, not so much in absolute performance, but directionally.
No wonder passive investing advocates have been gaining ground. When active managers claim to be active but end up holding “core positions” in exactly the same stocks and generating poorer cumulative net returns than the passive momentum strategy, all that fundamental research and trading goes to waste.
Goodby classical portfolio theory.
"Old Turkey would cock his head to one side, contemplate his fellow customer with a fatherly smile, and finally he would say very impressively, "You know, it's a bull market!"
– Reminiscences of a Stock Operator, Edwin Lefevre
Understanding that the reverse is also true is critical. When the market turns (when, not if, since we believe it always does), the equivalent answer to questions around why a “diversified portfolio” of core holdings, actively chosen or otherwise, is losing money will likewise be: “You know, it’s a bear market.”
To extend the animal metaphor, the tail is wagging the dog, and the dog – unaware of the change in circumstances and still believing itself in control – perpetuates the same behaviour that strengthens the tail, which wags the dog even more violently.
Ultimately we think these trends will continue to accelerate and render classical portfolio management styles increasingly redundant, as we laid out in our first thematic note on The Future of Asset Management.
A better way forward.
Classic portfolio performance attribution boils down to 3 key components:
2. Manager style
3. Active management (aka stock-picking)
While it’s true that the ends justify the means and performance is performance regardless, it’s time for managers to take a long hard look at where they're adding value.
Traditionally, most performance was driven by the market. But in terms of value-added by managers, that story’s over. As we’ve previously argued, our strong stance against charging any form of management fees is built on the principle that accessing market-based performance – beta – is eventually going to be free of charge. And as investment products cease to provide value in terms of access to beta, they also lose the right to charge ongoing management fees. We believe a performance-fee only model is the way forward.
Contrary to popular belief, not charging management fees can open up new avenues of freedom to outperform in style and active management. Free of the obligation to hold specific stocks (to match a benchmark), or to hold ANY stocks for that matter: a 100% cash position is unacceptable when a management fee is being charged, not so when no ongoing charges are incurred. Added to drastically lowered trading costs as a result of MiFID2, we are given much greater liberty to manage size, exposure and risk, with minimal costs.
Our intended strategies run much smaller core books, and only when appropriate, with much more trading being done in a small number of stocks. Quality over quantity – we’d rather know a few names very well and trade them actively, than try to own a large number of names that we will never understand in detail for the sake of “diversification”, increasingly negated by rising correlations.
Nothing will stop us from zeroing an entire position if markets go wrong, nor from crystallising profits and staying in cash to ride out volatility without the obligation to stay exposed. No minimum exposures or number of positions, no buying for the sake of buying, and certainly no buying for the sake of matching a benchmark. No position is important on its own, no matter its fundamental strengths: the only sacred cow is the portfolio’s net return.
A laughably simple aim.
Cap the downside risk, and the upside takes care of itself.
Our job is to deliver alpha and absolute dollar returns. To do that, there can be no single stock attachment, no ideologies, no soft spots, no “core” positions. A change in the investment case for this month’s top buy could make it next month’s top sell. After all, a manager’s success is defined not by a handful of superstar trades, but by consistent overall portfolio returns over time.
What will our investors pay us for? Not for “top pick” stock ideas (call a broker), not for interesting blog posts (call a journalist), certainly not to blindly invest their money and blame the market when things go wrong (call your local ETF provider). An investment management team has ultimate confidence in its process when it can happily say it doesn’t know for sure where the return will come from over the next period, but it knows that wherever opportunity presents itself, returns will come.
Investors will pay us to make them maximum upside for minimal downside risk. And that’s exactly what we intend to do.
What we're doing.
This week we attended the Edelweiss India Conference at Grosvenor House on London’s super posh Park Lane. It was great to see such a diverse range of Indian companies gathered in one place and, as we have come to expect, Edelweiss put on a seriously impressive event. The conference came on the heels of a landslide victory for Prime Minister Narendra Modi and a sharp rally in stocks, taking the market to all-time highs. India is a huge market with a reform-minded and business-friendly government and a bright future. Thank you Edelweiss for making us feel so welcome!
What we're reading.
“Money, like water, is non-linear.” These are the words of Ben Hunt, investor, farmer and creator of Epsilon Theory, a publication for those trying to make sense of markets that often don't make much sense. This blog post really resonated with us. Its thrust – that sometimes you can’t predict human behaviours around money based on a macro theory of monetarism – is something we buy into here at Three Body Capital. As we get older (and hopefully a little wiser) we have become more interested in behavioural explanations for markets. To succeed as active managers and gain an edge over the market we have to be more than financial analysts and economists regurgitating mechanistic theories and best practices from textbooks – we have to train ourselves to be psychologists and philosophers, too. We are the first to admit we don’t have a magic formula for performance. Rather, we seek to manage uncertainty. “Past performance is not reflective of future performance” isn’t a cut-and-paste compliance mantra, it's actually true. The past 10 years are the exception, not the rule. When we recognise this, our worldview changes and we are humbled by the uncertainty of markets – and the people who trade them.
What we're watching.
This week we delved deep into the Netflix archives to revisit Limitless, the ridiculously entertaining sci-fi flick starring Bradley Cooper as a penniless writer turned superstar day trader. It’s all thanks to a mysterious (and definitely illegal) pill that enables him to access 100% of his potential… but not without significant downside. This movie falls firmly in the "finance thriller" genre along with Margin Call, Wall Street, Rogue Trader and The Wolf of Wall Street (and a bunch of frankly terrible movies that we won't dignify by listing here). And, as is often the case with the sci-fi genre, reality ends up imitating art. The cult of productivity has already spawned a new pharmaceutical vertical (nootropics) that’s somewhat worryingly gaining traction in offices the world over. Although you don’t need to "hack" your body with smart drugs and cognitive enhancers when you have strong coffee, light mornings and a brilliant team around you! The ultimate lesson of this film is that there are no short cuts to success. Good things take time.