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Want to touch on passive investing versus higher conviction investing

I watched the Big Short last weekend – many people asked me if I had seen it and were surprised when I hadn’t – don’t watch many finance movies or documentaries – find them to be liberal with the facts or only cover the rudimentary factors – so I watched it – good movie – did touch on some of the deeper points of the legislation and had some nods to the root causes – like when Michael Burry had the Fannie Mae/Freddie Mack prospectus on his desk – Those were the Government controlled lending institutions – that were mandated to give out at minimum 30% to lenders who couldn’t afford the loans – Most interesting character was Dr Michael Burry –

  1. Michael Burry – Christian Bale’s character – interested in the real-life man – Did some reading –
    1. Started his Hedge fund in 2000 – Quickly made large profits from shorting the overvalued shares in the DotCom bubble – Market fell buy about 12% while he made about 55%
    2. Also called the subprime housing crash in 2005- profited in 2008 then shut his fund down
    3. Since then – Burry has started to focus much of his attention on investing in water, gold, and farmland – quoted “Fresh, clean water cannot be taken for granted. And it is not—water is political, and litigious.”
    4. But in August, 2019 – Bloomberg News quoted an email from Burry stating his belief that there was a bubble in large US shares due to the popularity of passive investing – which “has orphaned smaller value-type securities globally”
    5. He is a traditional Value Investor – Uses Benjamin Graham’s value theories in making a decision –
      1. What is value investing? Looking at a share and if it is overvalued you sell – if it is undervalued – you buy = Got to have a good justification as to why it is over or undervalued – not easy to get right – needs a bit of foresight and the timing will always be off – can’t predict to the exact day – may be able to predict the span of years –
    6. Seeking to work out what something is worth is price discovery – the market betting against the other –
  2. Bloomberg says that Burry’s view is that Passive investments are inflating stock and bond prices in a similar way that collateralised debt obligations did for subprime mortgages more than 10 years ago – Bloomberg made this seem like he was comparing CDOs and ETFs in their function – he was talking about the same effects – which is an inflated value of something
  3. Great quote that summarises the issue with ETFs –thought: “Like most bubbles, the longer it goes on, the worse the crash will be,” and “The theatre keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally,”
    1. That is where he sees the issue – in the shares held in the index which will have no liquidity – i.e. nobody wanting to buy or sell them – hence loss based around larger bids to sells

How did this start?

– Spike in passive ETFs – Active V Passive – between the types of active – high conviction

What caused this rise in passive investing? Technology and cost – people can easily access at low costs

  1. Been a debate over the pros and cons of active versus passive investing – rightly fully so – as it brings into question the Merits of the different types of active investing
  2. Active funds select the shares to hold in the portfolio – whilst the index decides what shares to hold in an index fund portfolio – with this comes high versus low cost – so if an active manager pretty much holds the shares in the index but with slightly varying percentage allocations – is it worth paying the fees – not for active managers who hug a benchmark – or are closet indexers –
    1. Active managers have a rough job – have to justify the fees through outperformance – hard over the past decade – as the flow of money into index funds boosted their performances (flows of capital into the index – mostly the large-cap) –
    2. If I am looking for active managers – way to do this is to back their convictions and construct an index-unaware portfolio. As such, a subset of active funds has developed known as high conviction funds
  3. Issue – Used to be most active funds – all had different shares – but when in indexes – all the same share – granted there are different indexes – but if you buy any ASX index based on market cap – CBA will always be the number one share – same in any index –
    1. You might be able to sell an index still – but liquidity may be an issue – and liquidity is just how many buyers and sellers there are – may be a lot in most large-cap sectors – but when you get down into the bottom – slippage may be larger – and even though the bottom 250 companies only make up 25% of the ASX300 – the losses through spreads will likely be larger than the top 50 – and further losses to exit
  4. Brings me back to Michael Burry – obviously high conviction – Based around the latest reporting – he only has 7 shares in Scion capital $100m portfolio –
    1. Western Digital Corp. (WDC), Cleveland Cliffs, Inc. (CLF), Tailored Brands (TLRD), FedEx Corp. (FDX), Alphabet Inc. (GOOGL), Cardinal Health (CAH), Alibaba Group Holding (BABA)
    2. Diversified industries – tech, steel, clothing, IT, health, online commerce and supply chain – some are very low PE and may be bought out – beyond the individual shares – this shows he is a high conviction investor
  5. High conviction is a school of active managers – The ability of an active manager to outperform the index is a function of their skill, conviction and the opportunity.
    1. The broader the universe of stocks they can choose from, the more opportunity they have to find stocks outside the index. Their skill enables them to choose the right stocks and then, their conviction allows them to build positions in those stocks that may be very different to the index weighting, if they are in the index at all.
    2. High conviction equity funds generally have a smaller number of stocks. This narrow focus allows the managers to attempt to drive an information edge, through deep research of those select businesses
    3. There is no universally-accepted way to define high conviction funds. Generally, high conviction funds will be expected to contain a small number of stocks however that could vary from as little as 10 to as many as 40.

This isn’t personal advice – but what are the Strength of high conviction funds over other active funds or indexes

  1. If you are a conviction manager – you should be specialising and focusing on your strengths and therefore produce better results than the market
    1. Why specialising helps – the sheer volume of information available makes it impossible for even the best quant machines to sort through and analyse it all
    2. But putting all of your attention into a limited amount of stocks may enable an information advantage – Think about Dr. Burry – he was always looking for long positions – but some of his biggest gains came from shorts – he was focused on finding value and found overvaluation in a number of assets
  2. What about diversification? – I talk about diversification all the time – and it is important – why an ASX index isn’t the best way to diversify either – 10 companies make up 40% of index – 5 of those – over 21% of index is in financials – next 10 companies (top 20) – make up just over 50% – but the bottom 250 only make up 25% – on average 0.1% – the price movement of a handful of share if they are outside of the top 20 won’t impact much at all
    1. Diversification may not always reduce your risks – i.e. buying 7 banking shares compared to Burry’s portfolio – but diversification is a necessary component of investing because it reduces risk when done properly- which doesn’t solely rely on the number of individual shares held
    2. This hypothesis – study – The authors did a backtest study comparing randomly constructed portfolios with varying numbers of holdings of S&P 500 stocks compared with an equal-weighted portfolio of all S&P 500 stocks. Using data from 1999 to 2014 they found that:
      1. A 10-stock portfolio had a 35% chance of outperforming the market by 1% p.a. and a 22% chance of outperforming by 2%.
      2. a 250-stock portfolio had a 0.2% chance of outperforming the market by 1% p.a. and no chance of outperforming by 2%. (Benello, 2016).
    3. These are the results for random portfolios and do not take into account the skill of the investor. A skilled investor should be able to improve on those odds – also – take this with a grain of salt – since 2014 to 2020 – I’d say the numbers may look in the index’s favour – due to the inflows and also large corporate buybacks – go into further Friday

How to find out if it is high conviction?

– one method through looking at statistical measures that indicate divergence from the index – BMO Global Asset Management did a study where they compiled a universe of high conviction active strategies to compare them against index funds or other large cap active strategies – Finding – and what measures can be used:

  1. Tracking error – 3-year tracking error in the top 20% more than 50% of the time
    1. By taking the volatility of Excess Returns – or the Tracking Error – this measures the relative risk, known as a tracking risk of a portfolio against a benchmark –
    2. For benchmark-aware strategies – a moderate amount of Tracking Error is necessary – if the tracking error is too low, the manager is less likely to generate Excess Returns – remember – the error here is not being in line with the benchmark based around the level of risk to return – so a high Tracking Error indicates that the manager seeks Alpha at the expense of higher relative risk – almost no tracking error for index-like investments
    3. The normal expectation is that high conviction funds will be higher risk. The variation in returns would be likely to be higher as they are less diversified. Large position sizes would result in a bigger impact if a stock meets with disaster. Of course, the hope is that these higher risks are rewarded with higher returns.
    4. When reviewing the risk-return trade-off using both one-year and three-year rolling data, they found that the high conviction universe had both higher returns and lower risk than the benchmark, as well as the full universe, when risk is measured as standard deviation of returns. 
    5. The study also found that downside risk was lower for high conviction strategies, with high conviction strategies in the bottom quartile of returns less frequently than non-high conviction strategies. The maximum drawdowns were also significantly lower. These findings challenge the assumption that high conviction funds are higher risk.
    6. Can also look at Beta – 3-year beta in the top and bottom 10% more than 50% of the time
  2. R2 – Coefficient of determination –
    1. In investing, R-squared is generally interpreted as the percentage of a fund or security’s movements that can be explained by movements in a benchmark index.
    2. An R-squared of 100% means that all movements of a security (or other dependent variable) are completely explained by movements in the index – quick way to tell a benchmark hugger
    3. 3-year R-squared in the bottom 25% more than 50% of the time
  3. Upside/Downside capture – Returns consistency – when the market goes up – does it outperform, or and when it goes down, does it also perform
    1. It also found high conviction funds had a higher likelihood of improving performance (i.e. strong performance after a period of underperformance) and a lower probability of declining performance (i.e. bottom quartile performance after three years of top quartile performance).
    2. 3-year upside/downside capture in the top/bottom 20% more than 50% of the time
    3. Downside capture can be more important –

Is this right for you? – again – not investment advice 

  1. But high conviction funds are probably best suited to patient investors – Whilst the high conviction funds were sometimes in the bottom performance quartile this did not hurt their long-term performance. They found that the probability of top quartile performance in the three years following bottom quartile performance was 55% for high conviction strategies versus 24% for non-high conviction strategies for developed markets.
    1. Investors who did not panic and sell out when the performance was low, were duly rewarded.
  2. Due to performance – can gain large inflows – which there may not be the shares to use the cash
  3. What is clear is that it works far better for patient investors who have the temperament and the time to ride out downturns. Used as a tool to add alpha to a well-diversified portfolio, it is likely to add to the efficiency of the portfolio. 
  4. When selecting a high conviction fund, investors need to understand the specialised skills of the managers, their processes and approach to portfolio construction and risk management, as well as the costs they will be incurring.

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