Here we go again!
Active portfolio managers, like Rodney Dangerfield, get no respect. This year they have outperformed the market, but commentators insist on spoiling their party by pointing to less impressive long-term results that show less than a quarter of mutual funds beat the index over a decade.
That is so – but the long-term numbers are averages for all funds and therefore should be approached with caution. In my experience, the average fund manager is more concerned with losing his job than doing the right thing. As a result, many managers don't really try to pick stocks. They become closet indexers, or they diversify indiscriminately to make sure they never stray too far away from the crowd.
That is a shame. I believe stock markets are likely to become increasingly volatile, given a slowdown in productivity growth, increases in taxes and declines in government spending, as well as the likely reappearance of inflation in years to come. In my opinion, to make money in this environment, a portfolio manager has to be an active, disciplined and patient stock picker.
But don't just take my word for it. Let's look at some of the evidence, as it relates to the case for my preferred approach to picking stocks – value investing.
Academic research often defines value investing as investing in stocks with low price-to-earnings (P/E) or low price-to-book (P/B) ratios. In two studies published in the Journal of Investment Management and in the Canadian Journal of Administrative Sciences, I found that such value stocks outperform growth stocks (those with high P/E or P/B ratios) by about 10 per cent a year in the U.S. and 12 per cent in Canada.
Similarly, in a piece published in Financial Analysts Journal, Louis Chan and Josef Lakonishok demonstrated that value beats growth in European and Asian markets by about 13 per cent.
Value stocks outperform when the markets go down and when they go up, and in good and bad times. And they do all this without having higher risk, as measured by beta or standard deviation or adverse states of the world.
More recent academic research, better focused on what value investors actually do, also demonstrate that value investing works.
Marcin Kacperczyk, Clemens Sialm and Lu Zheng published two articles in the Journal of Finance in 2005 and 2007 that examined whether skilled managers exist. The researchers studied about 1,700 actively managed U.S. funds from 1984-1999 and 1993-2002. They found that the more concentrated a fund was – in other words, the less diversified – the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing.
The notion that less is more when it comes to diversification is what value investing is all about. Investors who follow a value approach typically focus their holdings on only a few stocks they believe are truly undervalued.
Portfolio concentration flies in the face of much contemporary market theory, but it has the blessing of John Maynard Keynes, the famed economist, who in his own investing switched from being a top-down strategist to a bottom-up stock picker after 1929.
"The right method in investment is to put fairly large sums into enterprises which one thinks one knows something about," he wrote.
Martijn Cremers and Antii Petajisto, in a 2009 Review of Financial Studies paper, introduced a new measure of active portfolio management, referred to as Active Share. This is the share of portfolio holdings that differ from the benchmark index holdings. They found that, between 1968 and 2001, the U.S. funds that deviated significantly from the benchmark portfolio outperformed their benchmarks both before and after expenses.
Again, this comes as no surprise to value investors. As Sir John Templeton used to say, "it is impossible to produce a superior performance unless you do something different from the majority."
Finally, in a 2011 Journal of Investing paper, in the first direct study of the value investing process, I examined whether value investors add value over and above a simple rule that dictates they invest only in stocks with low P/E and low P/B ratios.
Using Canadian data, I found that value investors do add value, in the sense that their process of selecting truly undervalued stocks produced significantly positive excess returns over and above the naive approach of simply selecting stocks with low P/E and low P/B ratios. The average annual outperformance between 1985 and 1998 was 1.1 per cent; between 1999 and 2007 it was 13.2 per cent.
So there you have it. General statements about active portfolio managers' underperformance mask the true story; the devil is always in the details.