- Even though money managers claim to have market-beating investment strategies, data shows that the odds of beating the S&P 500 are very low.
- Today, Nicholas Vardy shares the simple recipe that can actually lead to market outperformance.
After I left the world of corporate law in the 1990s, I dedicated myself to the task of learning all I could about investing.
Part of that process was mastering the ins and outs of what business school professors called “modern finance.”
Another part was apprenticing myself to one of the leading portfolio managers in the U.K. This fellow had an outstanding reputation among portfolio managers in the City of London – England’s equivalent of Wall Street.
And over the prior decade, he had established a reputation for market-trouncing, if volatile, returns.
Here was the living, breathing incarnation of a money manager who my finance textbooks argued could not exist: one who consistently beat the market.
He was a rare bird indeed.
The Paradox of Active Money Management
You’d think that if you were a highly paid professional whose job it was to live and breathe the markets, you’d have better than a snowball’s chance in hell of outperforming an index.
But you’d be wrong.
The track record of active managers beating the market year in and year out is shockingly bad.
A 2016 study by S&P Dow Jones found that 99% of actively managed U.S. equity funds failed to beat the S&P 500 over the prior decade.
The comparable figures for global and emerging markets funds were 98% and 97%, respectively.
The implications of this are astonishing. You could put yourself in the top 1% of all professional portfolio managers by merely buying an S&P 500 index fund!
So, the odds of beating the S&P 500 Index are very, very low. Still, as my newfound mentor’s track record confirmed, the odds aren’t zero.
And I was determined to learn the secret behind his success.
What It Takes to Beat the Market
In his book More Than You Know: Finding Financial Wisdom in Unconventional Places, Michael Mauboussin conducted a study on equity fund managers who consistently beat the S&P 500 Index.
Mauboussin examined equity funds that beat the S&P 500 over the past 10 years. Each fund was managed by an individual and had assets of at least $1 billion. He identified four attributes that set these market-beating portfolio managers apart.
No. 1: Portfolio Turnover
Market-beating portfolio managers had a far lower turnover of stocks than the average stock mutual fund.
These top-performing managers averaged a 27% annual turnover, compared with a whopping 112% annual turnover for all equity funds.
(The S&P 500 index fund had a turnover of less than 5%.)
Market-beating portfolio managers had an average holding period of three years for each stock. That compared with less than one year for the average equity fund.
No. 2: Portfolio Concentration
Portfolios that beat the market over the previous 10 years were also more concentrated than the S&P 500. They had an average of 29% of their assets in their top 10 holdings. The comparable figure for the S&P 500 is 22%.
No. 3: Investment Style
The vast majority of the market-beating performers focused on a stock’s fundamental valuations. Ignoring factors like momentum or volatility, top managers calculated an intrinsic value for each of their holdings.
And they then invested only in stocks that they deemed cheap.
This approach also meant that top managers ignored the latest financial headlines. They spent no time on forecasting interest rates or the outlook for the economy.
No. 4: Geographic Location
Only a small fraction of high-performing investors hailed from East Coast financial centers like New York or Boston.
The top equity funds were based in cities like Chicago, Salt Lake City, Memphis, Omaha and Baltimore.
Sir John Templeton came to the same conclusion. This global investing pioneer claimed his investment returns improved after he left Wall Street for the Bahamas.
As I look back, the U.K. fund manager I sat next to had three out of these four characteristics.
Once he bought a stock, he held it for years. When he did buy, he bet big. And he had zero interest in the views of the endless stream of market strategists who vied for his attention.
His only “disadvantage” was that he was working out of a global financial center like London.
So the recipe for successful investing is surprisingly simple: Bet big, hold on for the long term, and ignore the news.
P.S. Mauboussin’s More Than You Know: Finding Financial Wisdom in Unconventional Places is an insightful collection of essays on applying mental models from various disciplines to markets.
Interested in hearing more from Nicholas? Follow @NickVardy on Twitter.