The Loser's Game

I wrote this essay about a month ago for my equity portfolio management class. I thought it addresses some key issues in this business so I thought I'd share it here.

“The Loser’s Game” by Charles Ellis, is a provoking explanation of the seemingly puzzling fact that active mutual funds on average have lower returns than market benchmarks. While Ellis is correct that the market has become more efficient over time to a point where fees on average outweigh alpha, this premise inaccurately implies fund mangers are failing and misses the real goal of fund mangers. Further, he is taking this unique situation to a specific investment strategy, long only large equity funds, and then applying it beyond its implications. So while the concept of a loser’s game and its implications for active investing performance are important, they are overstated and applied too broadly.

To justify the existence of investment management, it is always relative performance that matters. Thus while it may seem important for a manger to beat the S&P, he will really only fail if he underperforms his peer funds. The misconception is that measuring him against his competition is the same as measuring him against the S&P. However, this is not the case if this class of funds does not perform to the S&P in the first place. This is the root of the fallacy since in reality mutual funds can not under perform themselves. It is true that other forms of investment compete for the capital invested in simple equity funds. Yet this becomes irrelevant as well since the individuals and institutions that choose these investment vehicles that consistently under perform market benchmarks are willing to effectively pay the prices of the fees for reasons other than an attempt at outsized gains. Much of the rational for active equity management is the comfort and knowledge that the investments and risk are being actively monitored, even if over the long run this is not productive. Thus much of the capital in this investment universe is content with such “underperformance”, which therefore is really not underperformance because it is both expected and accepted.

Ellis’s argument also overemphasizes the extent of market efficiency. There are many parts of the market, such as small caps as well as new strategies that are by nature of the lack of attention paid to them less efficient. Thus, they are less subject to Ellis’s key point that investors and mangers can no longer succeed through their own positive accomplishments. It is particularly the big caps that are so dominated by large mutual funds that exhibit the over coverage and competition that creates a loser’s game. Therefore, while still significant, like everything about there market, the concept of the loser’s game is less applicable where market efficiency breaks down.

While it is very important to consider the possibility that investor actions in the market can only hurt returns, in the end it is only one part to consider. Nothing in the market is that simple or concrete. Therefore it is more accurate to consider the loser’s game as much harder than the consensus thinks to actually deliver outsized returns that are the result of the investor’s correct decisions. Under this more realistic but still humbling perspective, the concept of a loser’s game can help small investors better understand the dynamics they are up against. Yet such an understanding may matter less to the mutual fund mangers themselves since their goals are still very different then many more speculative smaller investors and hedge funds. In effect the loser’s game is a loser’s game because those mangers who specifically are playing it are trying more to not lose than to win as that is the nature of their incentives. Thus, the loser’s game is more of a subset of the investing world then an overarching principle.

"Goodwill"- A Tangible Asset in Investing

My hedge fund class teacher, Martin Gross, manager of the Sandalwood Securities (a FoF specializing in distressed debt), brings in hedge fund mangers every week to talk to us. Next week is going to be Rob Lowenstein, author of When Genius Failed.

This week Mike Offner, the manager of Greenlight Securities’ fund of funds (value long short equities) came to talk to us. A Swenson protégé, he was very interesting and had a lot of valuable insights on the qualities that make great portfolio managers. He taught me a valuable lesson as well as an interesting quote about Wall Street that both got me thinking.

The quote is simpler. It’s one of Keynes' famous quotes, “It is better for reputation to fail conventionally than to succeed unconventionally”. There are so many market and non-market applications for that. For example, it explains why mutual funds often are so lousy since as long as you stay within a band of the average a portfolio manager is unlike to get many redemptions. Being risk adverse, this will be his goal. It’s really too bad for retail investors, and I have an essay on this I am going to post later. The direct result is it leaves more money on the table for the unconventional hedge funds and savvy investors.

The lesson is one I hope to take to heart if I’m ever in the kind of shoes of the decision maker of any fund or entity. The topic he was discussing was about work environment, and how he evaluates the work environment of other funds and whether that effects what he’s doing. His stance to paraphrase was,

“At Greenlight we don’t tear people up for making mistakes and yell at everyone; we don’t see such an environment as productive. We prefer that the funds we invest in treat their workers with respect and we often hear from various sources what’s really going on at different firms as people certainly talk. We see the funds with very high turnover and the ones where people only leave to retire. This has actually been frustrating in the case of Steve Mendel’s fund because no one has ever left to start their own fund. What a fund chooses to do is their choice, but I do know this, ‘if whenever someone makes a mistake, they are ripped apart and people are throwing phones’ it can become a real problem. The reason is when that person finds out about some really bad news they can either report it and get their head ripped off. However they may not want to face that so they can do one of two things, either hope the bad news goes away or hope they have left the fund before it hits.”

I found this observation very interesting and once I heard it, it seems so obvious. There are two parts to be being a good “manager” since hedge funds are so entrepreneurial in nature. It's one thing to have success, it is an entirely other one when you can achieve great success while maintaining integrity and respect for others. It's foolish to think that having those qualities won't have a positive effect on returns.

Introduction

I intend to post investment ideas as well as other finance and trading related writings here. I hope it is informative and useful.