Dare to Be Different

Topic: Pearls of Wisdom

John C.A. Stevenson, CFA

August 11, 2017

Image used with permission: iStock/masterzphotois


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Dare to Be Different

The financial media love to write stories about how improbable it is that a firm like Nexus might be able to do better than the stock market.

In October 2016, The Financial Times ran a headline that exclaimed that “99% of Active U.S. Equity Funds Underperform.”1 As shocking as that sounds, perhaps it should be no surprise since academics traditionally have told us that the stock market is efficient as all information is quickly and completely discounted in stock prices. The implication is that “alpha” – the amount by which a manager beats the market – can only be the result of luck, not the result of sustainable and repeatable skill. Even Warren Buffett, one of the greatest generators of “alpha” of all time, recommends that the average investor avoid active management and use low-cost index funds.

All of this is frustrating to those of us at Nexus as it is clearly at odds with our experience. Not only have we beaten the market in the past, we are confident that our investment approach will allow us to do it in the future. Not every quarter or every year – we know we’ll have bad patches – but we are confident we will be successful over time. Are we kidding ourselves?

We recently came across an investment piece that tackled this issue head-on.2 To start, the data reviewed in the paper simply don’t support the contention that it is hopeless to think you can beat the market. An analysis of 2,933 equity mutual funds tracked by Morningstar in the U.S. show that a meaningful number of funds do beat the market. Anywhere between 30% and 43% of these funds beat their respective benchmarks over every measured period between 1 year and 15 years.3 Moreover, the author then linked this data to a paper written in 2009 by two Yale School of Management professors in which they first described a now-popular concept called Active Share.

We’ve discussed Active Share in the past – it is the fraction of a portfolio that is different from the relevant stock market index. Active Share of 0% means that a portfolio is a perfect mirror image of the index; 100% means it shares nothing in common with the index. What Cremers and Petajisto discovered was that nearly a third of all US equity funds had very low Active Share – they were little different from the index, or “closet indexers”.4 More significantly, they discovered that Active Share significantly predicts performance relative to the relevant benchmark. Low Active Share funds often underperform, which makes sense as how would one expect to outperform if there is little difference from the index and a fee is charged for the service? Conversely, high Active Share funds typically do outperform, and the higher the Active Share, the greater the chance of outperformance. This makes us feel better. Nexus makes no attempt to follow an index and our portfolios have high Active Share. So maybe our confidence about the future isn’t so crazy after all.

1 The Financial Times, October 24, 2016.
2 Jim Atkinson, “The Pursuit of Average”, Guinness Atkinson Investment Management, July 2017.
3 The analysis looks at 1, 3, 5, 10 and 15 year periods ended June 30, 2017.
4 Martijn Cremers and Antti Petajisto, “How Active is Your Fund Manager”, Yale School of Management, March 31, 2009.

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