3 Paths to Outperformance

Roads to Success Earlier this month, the CFA Institute published an article ("Active vs. Passive Investing and the 'Suckers at the Poker Table' Fallacy") that consisted of thought experiments about alternative versions of the stock market. The author, Druce Vertes, ponders how profits would accrue under different structures. For example, what if the only stock owners were index funds plus one active manager? Would that active manager fare better than in a marketplace that consisted of indexers, a single insightful active manager, and several "dumb" managers?

I enjoyed the discussion, although being a second-rate abstract thinker, I am not qualified to judge the results. (That's not faux modesty; I have no idea if Vertes' conclusions are on track.) But the discussion did get me wondering about a more manageable question: What are the possible paths to stock market outperformance in the existing world?

1) Find Dumb Money This is the traditional approach. Most stockholders lack investment skill. They are not adept at security analysis; or they are adept, but do not put in the effort; or they are adept and work hard, but are not smart enough to see what others cannot; or they succeed on all three of those fronts but fail emotionally. Given those deficiencies, there seems to be plenty of opportunity for the gifted minority to relieve the dumb of the burden of the wealth.

But, of course, it hasn't worked like that. Most of the stock market's would-be wolves have instead been deceived sheep--dumb money that has fooled itself into thinking that it is smart money. (Although in the case of professional asset managers, who are paid for their efforts regardless of the outcome, the alleged dummies can laugh to the bank.) In poker, the stronger players can reliably fleece the suckers at the table. In the stock market, not so much.

The truth is, suckers at the table is a flawed analogy. In a poker game, a weak player has no support. He receives his cards on his own; reads the opponents on his own; and makes his bets on his own. In the stock market, on the other hand, every player has many thousands of partners. Others have already voted--and continue to vote--on the value of that hand. And conversely, the strong players don't have the advantage of being lone wolves. Many, many other predators have been there before them, scouring for weaklings to devour.

Beating the dumb money is not impossible. Warren Buffett has done it for decades, as has Yale's David Swensen. However, both advise that their readers do otherwise, by purchasing low-cost index funds. Their reason (which they will not acknowledge openly): They are extraordinary, and almost everybody else is not. True that, and the reason why beating the dumb money is a difficult path.

2) Find Different Money The stock market typically is thought of as being populated by smart investors, dumb investors, and indexers. The notion is that for every winner of a trade (the success owing either to superior insight, or to the squirrel stumbling on the nut), there is a "willing loser"--an investor who voluntarily agrees to take the losing end of the trade, because of a bad decision. That concept is incomplete. It may well be that the willing loser has erred. But it's also possible that the willing loser has made a sound, rational choice.

The reason being that investors have varying conceptions of risk, which can lead to varying--but equally rational--calculations of a security's worth. If one investor is immune to a potential danger from the stock, while a second is sensitive to that risk, then (all other things being equal) the two parties will value that stock differently. Stupidity is not required to induce trades.

To cite an example: time horizon. Consider a stock that has dicey near-term prospects, as its industry is deeply out of favor and looks to remain that way for the foreseeable future (say, energy pipelines), but which looks to profit handsomely over the next decade. A fund manager who is evaluated on rolling three-year periods will likely be less fond of that investment than will a buy-and-hold investor who answers to nobody but herself. The fund manager may thus sell that stock to the buy-and-holder owner. A willing loser, but not a dumb one; the decision was rational.

Such is the approach of strategic-beta funds. (Or, as they call themselves, smart beta.) Such funds expect to outgain the overall stock market not through outwitting dumb money, but rather by holding exposures to risks that bother others more than the holders of that particular strategic-beta fund. Sure, not all strategic-beta funds will achieve their goals. But they have an easier task than do those who hope to fleece the dumb money. Accepting higher returns in exchange for higher risk is a more reliable strategy than trying to get higher returns by wits alone.

3) Time the Market The final path to outperformance is by cash management. While the purest form of market-timing, moving into and out of stocks in a binary fashion, has a poor track record at best (and outright horrific at worst, for taxable accounts), there's much to be said for the more cautious versions. Raising a bit of cash during bull markets, to be put to work when and if stock prices slump, is a sensible way to beat the indexes without being either a great stock selection (path #1) or assuming additional risks (path #2).

The master of cash management, of course, is Warren Buffett. As he constantly reminds his readers,

Such actions lie outside some definitions of active management. Often, that task is regarded as occurring solely within a marketplace. That is, for the U.S. stock market, it is treated as the ability to make profitable trades of one stock for another. But, as Vertes reminds us, in real life the trade might instead be cash-for-stock (or stock-for-cash). He writes, "If you're planning to invest for an objective other than buying and holding forever, you have to make decisions about when and how much to invest and when and how much to withdraw. On a sufficiently long timeline, the probability of being a completely passive investor goes to zero."

Those are my three. If you have a fourth, drop me a line. Ditto if you read Vertes' article and think that you have resolved the issues that you raise. I won't be able to judge the accuracy of your claim, but I will be interested in your take on what, for me, is an intriguing subject.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.