How to construct an evidence-based portfolio
Introduction
Active fund managers have long struggled to beat the index – in most cases, an investor would’ve been better off investing in a low-cost index fund. However, by analysing data and reviewing past experiences, we gain insight into why the active funds management industry has failed to create value, and our objective is to construct portfolios that are likely to outperform for our clients. The three key areas active fund managers and investors should focus on are:
Overcoming short-term loss aversion for long-term return potential
Investing in a concentrated portfolio of best ideas
Focusing on the the changing risk profile of investments
Overcoming short-term loss aversion for long-term return potential
The equity market provides a great opportunity for long-term investors, despite the significant short-term risks. We find that while investors are likely to suffer bigger daily and monthly losses than gains, the equity market delivers strong returns for long-term investors. The findings from our analysis are supported by findings from a study conducted by behavioural economists Shlomo Benartzi of UCLA, and Richard Thaler of University of Chicago. They concluded that the strong historical returns of the equity market was a symptom of investors’ short-term loss aversion rather than a reflection of fundamental risk. Our investment experience along with numerous academic studies support this view, and we aim to capture as much of the equity market return by focusing on the long term, and constructing a portfolio that affords us the best opportunity for outperformance.
Investing in a concentrated portfolio of best ideas
In a comprehensive study of equity markets, Arizona State University researcher Hendrik Bessembinder found that the ‘top-performing 1.3% of firms account for the $US 44.7 trillion in global stock market wealth creation from 1990 to 2018. Outside the US, less than one percent of firms account for the $US 16.0 trillion in net wealth creation.’ Our focus is therefore on identifying and investing in the few companies that are likely to outperform over the long term.
A separate study by Panchekha and the CFA Institute found that although active managers under-perform after fees on average (which is well known), their highest conviction ideas outperform. This could either be due to mandate flaws, self-inflicted by the investor, or a short-term volatility mitigation strategy by the portfolio manager, guaranteeing long-term under-performance. The findings of these studies support our investment approach: we strive to identify and invest in a small number of exceptional companies. Although we have a detailed process, we are ultimately looking for companies that can deliver a superior product or service to their customer base, with a sufficient and sustainable profit margin when compared to the capital required. Furthermore, a company with a large and growing revenue opportunity at an attractive price is preferred.
Focusing on the the changing risk profile of investments
Economist John H Cochrane of University of Chicago Booth School of Business argues that it is the variation in equity market risk premium / risk appetite that explains much of the equity market returns. We take Cochrane's approach but apply it to individual stocks, and actively look for companies whose risk profile is improving. The lag between the improvement in risk profile and the appreciation of it by the market, is where there is the potential to generate excess returns.
‘Bulls get rich’
There are many well-known finance anecdotes and quotes from legendary investors that summarise these studies:
'Selling your winners and holding your losers is like cutting the flowers and watering the weeds' – Peter Lynch
Based on Bessembinder’s discovery that only 1.3% of companies accounted for the US$44.7 trillion in wealth created, if you do identify one of the few exceptional companies that does in fact outperform, hang onto it.
'Bears sound clever, bulls get rich,' is a well-known Wall Street saying. Bears (market participants that are pessimistic) do in fact sound clever and are often right in the short-term, as the losses incurred over the short-term outweigh the gains. However, over the long-term, it is the bulls (those that are more optimistic and invested in equity markets) who are rewarded through small daily gains and compounding returns.
'Be fearful when others are greedy and greedy when others are fearful.' – Warren Buffett
Cochrane argues that it is the prevailing 'risk appetite' that explains equity market returns, and Buffett uses the market’s 'fear and greed' levels as a proxy for 'risk appetite.'
We utilise our investment experience and key findings from major academic studies to capture as much of the equity market return by focusing on the long term, and constructing a portfolio that has the best potential of long term capital growth for our clients.
This note has been prepared by ELM Responsible Investments (‘ELMRI’) ABN 70 607 177 711 AFSL 520428, for Australian wholesale clients for the purposes of section 761G of the Corporations Act 2001 (Cth).
The information is not intended for general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of ELMRI and its investment activities; its use is restricted accordingly.
This note is for general informational purposes only and does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of preparation and presenting and all forecasts, assumptions, opinions, data and other information are not warranted as to accuracy or completeness and are subject to change without notice. This is not an offer document and does not constitute an offer or invitation of investment recommendation to distribute or purchase securities, shares, units or other interests to enter into an investment agreement. No person should rely on the content and/or act on the basis of any material contained in this note. Any potential investor should consider their own circumstances and seek professional advice.
ELMRI funds, its directors, employees, representatives and associates may have an interest in the named securities.
Past performance is for illustrative purposes only and is not indicative of future performance.