Practical analysis for investment professionals
22 January 2015

Beating the Market: Four Mistakes to Avoid

Active management is a tough gig. Asset owners and individual investors expect their investment managers to do more than make money for them, or “generate absolute return.” The popularity of index funds has put the onus on active managers to prove that they can beat the market.

There are few hard and fast rules for beating the market or generating “active return.” Knowing what does not work, however, at least gets investors a step closer to finding active managers that are fit for purpose. Below are some thoughts and anecdotes about certain dubious approaches some active managers pursue.

1. Add to — and Trim — Stocks in the Portfolio at Predetermined Target Buy/Sell Prices

Plenty of investors estimate the fair value of their portfolio holdings and there is nothing wrong with that. Taking it one step further to have both buy and sell targets around the fair value adds less value in my opinion. Relying religiously on these buy and sell targets to add to or trim portfolio holdings is highly questionable. In spirit, it is not that different from market timing.

Valuation is an art as much as a science. Given the number of parameters that go into valuation models as well as the fundamental and behavioral factors that affect these parameters, anyone who thinks they can pinpoint the entry and exit point is simply fooling themselves. Frequent trading in this fashion also exacerbates the problem of selling your winners too soon and holding on to your losers for too long.

Recommended Action: Avoid managers who engage in excessive trading.

2. Hold on to Practically All Stock Holdings over the Long Term

Contrary to active managers who churn their portfolios, some active managers prefer to hold on to everything.

Low turnover is not a sin. Far from it. But religiously not selling most likely is — for the simple reason that we mortals make mistakes.

In the most extreme case that I have come across, a manager told me the reason that his portfolio had a single digit turnover was that “[his] worst performers from the year before often turn into [his] best performers the following year.” Were that indeed true, one wonders why he did not simply adopt a strategy of buying last year’s losers in his portfolio? Sounds to me more like someone giving up the fight.

Recommended Action: If a manager’s portfolio has been stuck in a slow gear for a few years and the manager is still holding on to all the losing stocks, look elsewhere.

3. Farm the Portfolio out to Too Many Active Managers

There is nothing fundamentally wrong with engaging multiple active managers. Actually, most asset owners, such as pension funds and insurance companies, often develop fund-of-funds programs and allocate their investments to a number of active managers who focus on a certain discipline.

Where it gets tricky is when one keeps adding active managers to a program. The more managers you have in your portfolio, the more it will look like an index fund. So you are paying active management fees for a market portfolio.

Ideally the active managers added to an existing portfolio should bring complementary skills such that they will add value rather than offset the existing managers’ value added.

Recommended Action: Make sure you look under the hood before you invest in one of these fund-of-funds programs.

4. Invest in Too Few Stocks

Theoretically, the more confident an investor is about his investments, the fewer stocks he needs to invest in. The logic is simple: if you have high confidence in the outcome of investing in various stocks, you really should concentrate your investments on your best ideas.

Where this logic breaks down in reality is that too many of us think of ourselves as superstars. We are human and humans tend to be overconfident. When I explain to people how little edge even the best investment managers have, most find it hard to believe and think they can beat those odds. Time and time again, they eventually fail to meet their own expectations and sometimes cause serious damage to their own portfolios in the process.

If you are still not convinced, check out how many stocks Peter Lynch had in the Magellan Fund.

Recommended Action: Avoid managers who have not experienced a full market cycle, or for those who have, have failed to deliver but remain convinced that they will in the next cycle.

There are many investors out there who may have figured out a way to beat the market. But if your active manager has committed one or more of the four “sins” above, he or she is probably not one of them.

What do you think? Feel free to share your experiences in the comments section below.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockPhoto.com/erhui1979

About the Author(s)
Larry Cao, CFA

Larry Cao, CFA, is director of content at CFA Institute, where he serves as a thought leader for Asia-focused content, events, and conferences. Previously, he served as senior client education and product communications manager for the Asia-Pacific region at HSBC. Cao also served as a fixed-income portfolio manager at the People’s Bank of China. He also worked at Munder Capital Management, where he managed US and international equity portfolios, and at Morningstar, where he developed financial planning solutions and managed asset allocation strategies for a global financial institution clientele. Cao was a visiting scholar at the MIT Sloan School of Management and holds an MBA from the University of Notre Dame.

8 thoughts on “Beating the Market: Four Mistakes to Avoid”

  1. Bob Sefcik says:

    Good points – All managers are not created equal – and Active Investment Management is both and Art and a Science – takes a JAZZ musician to add color/value – unfortunately, there are a lot of garage bands out there…

    1. Larry Cao, CFA says:

      Bob,

      Interesting analogy! Thanks for visiting our blog and I hope you have found your favorite musicians.

      Warm regards,
      Larry

  2. Joseph says:

    Just avoid active management altogether, which loses to passive investing the vast majority of the time. Explore using the Permanent Portfolio investment strategy: simple, safe, stable with decent returns.

    1. Larry Cao, CFA says:

      Joseph,

      Your are exactly right about indexing – if you do not feel that you have an edge in picking active managers, it is the natural solution for you.

      As for the specific product, each investor should take into consideration his own situation. More importantly, make sure you understand the risks before investing, no matter how safe and stable the product may sound.

      Warm regards,
      Larry

  3. Patrick says:

    I think one of the most important things to look for (behind low fees) is fund size. A small value manager for example, might be able to hold a 5% position in a small-cap stock without moving the price too much. A huge fund with many billions under management is more restricted as to what companies they can take a sizeable position in.

    Another easy one to check, which you alluded to in point 3, is looking for closet index-huggers. If your fund managers top 10 holdings matches the top 10 of the index it is benchmarked against, it’s unlikely to acheive alpha. This kind of thing is particularly prevalent in my home country, Australia, where the big 4 banks, 2 miners and 1 telco make up over 50% of the index weighting.

    1. Larry Cao, CFA says:

      Thank you for visiting our blog and share your thoughts with us, Patrick.

  4. MarketFox says:

    Hi Larry,

    I couldn’t agree more with you comments regarding multi-manager portfolios that contain too many managers.

    They simply don’t work, but everyone still invests this way. Here’s a blog that I wrote explaining why:

    http://marketfox.org/2015/01/05/the-parable-of-the-seven-fund-managers/

    1. Larry Cao, CFA says:

      Thank you for visiting Enterprising Investor and share your thoughts with us. I’m glad the idea resonated with you.

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