You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen — Clifford Asness, AQR Capital
This article is dedicated to a legend in the world of investing — John C. Bogle. John’s work help put a fresh pair of eyes on millions of people around the world as they looked at the markets and their investments. John was the founder of Vanguard — a firm that was based on a truism. A truism that — over the longer term, market indices will outperform active fund managers. Today, Vanguard has $5.1 trillion of Assets Under Management (AUM)- that’s more than the GDP of Germany, the U.K. or France (in nominal terms). John had his own unique way of deciphering a simple truth about markets in the long run. We also seek many different types of truths. Of course, all of us are ultimately chasing eternal truths-truths as old as time itself. This article outlines the pursuit of truth through the lens of the various investment strategies adopted by investors. It ends by explaining the ultimate alpha we all chase in our own unique and varied ways.
A strategy is a plan of action designed to achieve a long-term or overall aim. In business, a strategy is a way to gain an advantage over the competition using differentiation. In a simplistic way, there are two sources of differentiation — price and value. A strategy is a means to an end. In investment, a strategy allows you to generate ‘alpha’ — a return in excess of the market return (as measured by the market indices).
As a teenager, I was told a story of a man who had nothing but his clothes and torn sandals on his feet before he came to gaze upon the Mumbai stock exchange. He was not educated and had nothing to lose. This made him driven, dangerous and extremely ambitious. He went on to make millions sometimes using less than scrupulous means. At the end, the authorities caught up with him. I will not take names but this story taught me a valuable lesson — the means is as important as the end. There is no harm in being extremely ambitious and wanting the world just not at anybody’s expense.Markets are the perfect avenue to study human psychology just as science is. Barring illegal means, the participants in a market have to evolve their own investment strategy.
Most popular classification of investment strategies is as follows:
Active vs Passive: this is the classic trade off between time and money. If you have time to research, you actively seek alpha or spend a considerable amount of your time outperforming a passive strategy — a strategy to invest in index funds with a longer time horizon. Active investing typically attempts to find shorter term plays and make money quick.
Growth vs. Value investing :
Growth investing is investing in rapidly growing companies. These companies typically reinvest their profits to keep growing. Thus, they may have a high return on equity, high profits but low dividend payout. Value investing, which is Warren Buffett’s investment philosophy is to invest in underpriced companies with strong fundamentals in industries we understand. Hedge funds, on the other hand have a variety of other strategies.
Investors themselves may have different objectives ie to become owners of the business they invest in, to simply get a healthy return or to get a delayed but exponential return (private equity or venture capital).
A Philosophical Advantage
A strategic advantage that provides repeated success then becomes an investment philosophy- some truths that stay with you longer.
Data builds organizational memory. More data means an elephantine memory of the world and how it behaves. Now, once you add the compounding power of your investment philosophy which is nothing but your understanding of how the world works to your memory (data), you get a philosophical advantage. This advantage is time bound and doesn’t always apply. The father of the Index fund John C. Bogle firmly believed that an index fund will outperform even the savviest investor over the long term. Therefore, the index is a compass of where the herd is headed. The herd slowly reaches the truth. When it does, all those who were in the herd benefit. George Soros put forth a theory of reflexivity which says that the psychology of investors has an impact on the market fundamentals. So, if we believe in a recession, it ends up being a self fulfilling prophecy.
In 2008, Warren Buffet challenged all hedge fund managers to a game of highest returns vs the index. He asked them to assemble funds that would outperform the S&P 500 -a $1 million bet that they could not assemble funds that would outperform an S&P 500 index in ten years. Protege corporation rose to the challenge and picked up 5 funds.
Nine years later, the hedge funds returned an average of 22% just shy of 2.2% a year. The index fund that Buffet chose — Vanguard Admiral Shares S&P 500 fund returned an average of 7.1% every year and a whopping 85.4% after nine years.
Now, this is not a promotional advertisement for index funds and neither is this a disparaging comment on hedge funds. If you select a different period, hedge funds could have found the elusive alpha. However, over a 28 year horizon, the performance of hedge funds is very close to the index with the S&P 500 slightly ahead by 5.3%.
Cliff Asness of AQR capital admitted in an article In 2018: ‘I find the story that hedge funds as a whole are now much closer to regular old traditional active stock picking, and thus less special than before, quite plausible. Given traditional active stock picking is such a consistent long-term disappointment, this ain’t good’
However, Bridgewater Associates (a hedge fund with AUM of $160 billion$) not only outperformed all major indices in 2018 but all major asset classes as well. It returned 15% net of fees when most of the indices were in the red.
In fact, Ray Dalio of Bridgewater wanted to build an algorithm by combining the brains of its employees.
The debate rages on and it is a very philosophical one. Over a longer term horizon, the philosophies of hedge funds may lose to the index. However, over the short term, hedge funds and algorithmic trading may win.
The Search For The Biggest Alpha
Truths that are far more longer than any investment philosophy are called eternal truths. Truths that don’t change over generations are the most difficult to seek and to obtain.
A market is a herd of people consistently searching for the truth. The truth, in this case, is the search for the right value of the market. Granted, the right value is not a single number rather a range and a direction. The people closer to predicting where the herd is on that journey or the people closer to the truth are the ones usually closer to the alpha — a return in excess of the normal market return.
Take for example, people like Michael Burry who shorted the mortgage market ahead of the 2008 financial crisis. His search for truth led him to read countless tranches of Mortgage Backed Securities (MBS) documents. This search led him to discover loans made to subprime borrowers. Common sense, then, guided him to short the market when the rest of the market couldn’t see the truth. Let’s take another example. Warren Buffet spends an extraordinary amount of time reading financial statements in search of the true value of a company. His approach is to truly find the right value of the company and find companies that are undervalued. Again, add common sense when he says he invests only in businesses he understands. Likewise, hedge fund managers and great investors alike are searching for truth irrespective of what the market thinks. In lay mans terms, they are trying to search for evidence when others rely on less evidence and more on their beliefs. We just don’t do our homework with the same dedication as a Warren Buffett or a Michael Burry. It wouldn’t be hard to refine our beliefs and be closer to the truth if we ask the right questions and are dogged in our efforts to find answers. The reality is that we invest on the basis of what we believe more than on what we know to be true. Often, because we have our homes to run. Ray Dalio, manager of Bridgewater — the largest hedge fund in the world had a brutally honest way of searching for the truth. He applied his brutal honesty to everything from recruiting, judging presentations to understanding the world around him.
Jainism is a set of ideas. It has three fundamental tenets one of which is aparigraha (gathering only as many material possessions as needed and no more). This principle is very hard for most people to follow. As humans, we want more and more. Now, let us assume you have made more money than your next seven generations need. You also have the most powerful job in the world. What next? What will you strive for after all that?
At that point — ironically, the pursuit of a billionaire becomes the same as that of a common man. It is a pursuit of liberation or salvation of this soul. This pursuit is the most ambitious goal of mankind. The idea is to rise above material possessions and seek the ultimate goal. More importantly, humans are the only animals with the consciousness to do so. In other words, we may not have another chance for a long time. Gautam Buddha said “Work out your own salvation. Do not depend on others.” He meant that the pursuit of the ultimate truth is a lonely pursuit. Without doubt, it is an individualistic goal.