Academic studies by and large assume that consistent outperformance is impossible. The naysayers point to legions of money managers who produce mediocre to poor results, jumping around the leaderboards in random fashion.
The laughable thing is, most of these studies take their samples from large money managers — the equivalent of elephants and aircraft carriers — who all do things the same way.
To preview the critique now unfolding, size and conventionality betray this group. Their gear-shifting ability is nil… and the ability to shift gears is crucial to dynamic performance.
Above a certain size and scale threshold, your mobility is severely restricted. This matters a lot, because flexibility and versatility are two of the trader’s key advantages. Also, if you restrict yourself to certain styles or behaviors, it is mobility restriction in another form, regardless of whether your capital base is large or small.
Take this conclusion from low-cost index guru Rick Ferri, largely based on a Morningstar Study showing all mutual funds are basically the same:
Past performance does not provide useful information about future performance. Wishing upon a star is a fine fantasy for children, but it doesn’t work for adults who are trying to earn a fair return from their mutual funds.
(Side note: This isn’t very PC, but if I had a world view like Ferri’s I might want to kill myself. Never mind the actual argument — it’s the philosophy, the inner voice of the thing. These guys with a table pounding message of “You are average… expect mediocrity… only fools hope for more…” So demoralizing. I’d rather clean out septic tanks or sell car insurance.)
But back to the studies “proving” outperformance doesn’t exist. Most of these criticisms, like Ferri’s, focuses on randomness within a control group. The manager at the top today will be at the bottom tomorrow.
But here is the thing no one ever asks. How much style differentiation exists within the control group itself?
These guys (the Morningstar approved managers) all by and large went to the same schools… wear the same brands of suit and tie… espouse the same plain vanilla philosophies like “growth at a reasonable price” or “low debt to equity”… and live under the same straitjackets like “always be fully invested;” “never put more than 3% into one position;” “always take the same size positions;” and so on.
The majority of plain-jane restrictive rulesets are performance killers, plain and simple. It’s like the old Apple criticism of IBM. How much can you really “think different” as an IBM salesman? How much are you even allowed to?
And when Morningstar (or whomever) bases their mediocrity-affirming money manager studies on samples drawn from an army of Brooks Brothers b-school clones with neither imagination nor balls, all running mild variations of the exact same playbook, what could they possibly have expected?
The real problem is that the average investor has no access to truly talented managers who are willing to do things differently than the thundering herd. This is just a fact of life — and from a supply / demand perspective, it makes logical sense.
In poker terms, most poker players are terrible, but a few are excellent. The ratio is most likely 95 / 5 at least, and quite possibly 98 / 2. (As with investing, the monolothic mediocre-to-bad group does not see itself as such.)
And so, for an “investor” seeking a “manager,” a serious supply / demand problem exists. If you find a truly excellent poker player with a high and consistent ROI and ask him to let you invest, e.g. buy a piece of his cash game or tournament action, he is likely to say, “Ah, let me think about that. No.”
Whereas the legion of poor quality poker players would happily say “yes” to investment requests — by all means, buy a piece of my action! — because they are constantly scraping to get their game out of the mud.
It’s the same on Wall Street… great traders, great investors and great money managers obviously do in fact exist. The fact they won’t take money from the hoi polloi doesn’t make them unicorns. They just don’t exist in large enough numbers for Morningstar studies to definitively confirm or deny their presence via sample studies drawn from armies of mediocrity clones.
The finance industry has thrown a weird sort of temper tantrum over the fact that true money management talent is generally not available to the undercapitalized masses. The general sour grapes response (from guys like Ferri, who also push index products) is to pretend that the talent doesn’t exist.
Perhaps Ferri et al do this in a spirit of paternal protectiveness, e.g. “Joe Sixpack investor has no chance of finding real talent, so I’m going to tell him real talent doesn’t exist. The truth is too complicated and the lie is for his own good.”
Whatever. To that we say, screw paternal protectiveness. The truth just is what it is. If the true high performers only make up an inaccessible 2 – 5% of the general money management population, so be it. When you think about it, isn’t it the same way in most every profession? Top performers always have an exclusive air. It’s just supply and demand.
But here’s the thing: There are certain things high performers do — aspects of their methodology and skill set — that separate them from the pack on a structural capability basis. It isn’t just mystical ineffable “talent.” It’s embedded habits and practices.
Which brings us back to the intended topic…
It has long been recognized the small trader (small meaning non-large, e.g. less than $100 million) has an edge in being able to act quickly.
Whereas the giant hidebound institutional fund might take a week to unravel a position — or months to adjust an allocation mix — the nimble trader can go from “flat” to “full boat” in the space of half a trading day.
And it is not just speed that’creates that edge… it’s flexibility too. In fact, flexibility — particularly in respect to inflection points — turns out to be much MORE important than speed.
This idea was captured in a very cool NYT piece, Cheetah’s Secret Weapon: A Tight Turning Radius.
Anyone who has watched a cheetah run down an antelope knows that these cats are impressively fast. But it turns out that speed is not the secret to their prodigious hunting skills: a novel study of how cheetahs chase prey in the wild shows that it is their agility — their skill at leaping sideways, changing directions abruptly and slowing down quickly — that gives those antelope such bad odds.
“Cheetahs don’t actually go very fast when they’re hunting,” said Alan M. Wilson, a professor at the Royal Veterinary College at the University of London who studied cheetahs in Botswana and published a paper about them on Wednesday in the journal Nature. “The hunt is much more about maneuvering, about acceleration, about ducking and diving to capture the prey.”
…High-speed runs accounted for only a small portion of the total distance covered by the cheetahs each day, the researchers found.
They also found that a cheetah can slow down by as much as 9 m.p.h. in a single stride — a feat that proves more helpful in hunting than the ability to break highway speed records. A cheetah often decelerates before turning, the data showed, and this enables it to make the tight turns that give it an advantage over its fast and nimble prey.
“Its muscles are very powerful,” Dr. Wilson said. “They’re arranged in a way that gives it the ability to accelerate very quickly.”
Along with those leg muscles, cheetahs have a flexible spine and big claws that give them a great deal of grip — “more grip than even a motorbike,” as Dr. Wilson put it. This anatomy helps the cats get their feet in the right positions to turn and maneuver.
In poker and trading terms, cheetah-like versatility is described as “shifting gears.” A seasoned professional can go from first to fifth (or sixth) and back again extremely quickly, i.e. accelerate or decelerate dramatically at just the right time. Lesser practitioners are often marked for having “one gear” — either stuck in second all the time, or always red-lining with no ability to slow down, and so on.
Gear-shifting capability is as important for risk control as it is for profit exploitation. In fact the two concepts are inexorably intertwined. Superior risk control enables aggressive profit exploitation, in the same manner that brakes on a sports car let the car go faster.
Consider, too, the virtues of being able to accelerate quickly from a dead stop, or otherwise turn on a dime:
Less time in the market. Large investors and slow-moving money managers are often forced to build large anticipatory positions. Their size (and slowness) dictates that they be early — sometimes very early — which in turn increases their general exposure risks. An ability to accelerate quickly off the line, in contrast, means the trader can wait for the last possible moment to enter a position — the optimal moment when an inflection point has crystallized but the real move is just beginning.
Less exposure to adverse price action. Simple risk control systems are robust risk control systems, as Richard Bookstaber so well articulated. The champion risk control system for trading and investing is refusing to tolerate adverse price action beyond a certain threshold. An ability to put on large positions and take off large positions in very narrow timeframes means the vast majority of market exposure comes with price action working in one’s favor (otherwise one would not be in, but out).
Larger size on winning positions. Another advantage of the small (or rather non-huge) trader is the ability to take positions that really “move the needle.” If a Fidelity manager finds a small-cap stock he thinks could be a home run, he will be lucky to allocate 0.5% of capital to the position without running the price up on himself. And as for exploiting macro inflection points, forget about it. The nimble and aggressive trader, in contrast, can have two or three massively sized trades or investments (or both) make the entire year.
Greater Adherence to 90/10. As risk manager Ken Grant observed, the best traders in the world tend to overwhelmingly display a 90/10 profit distribution, where 90% of profits come from 10% of trades. (Go here for full excerpt.) The 90/10 concept — which reflects a deeper truth in terms of how the market distributes profits — synchs up beautifully with the shifting gears principle, in terms of moving quickly, and in large size, when the time is right — while being just as quick to cut adverse price exposure.
Again to emphasize, as it can hardly be emphasized enough: Flexibility (ability to shift gears) is a core component of risk control. Whereas the cheetah uses its “tight turning radius” primarily for offense — out-juking the antelope — the trader (or poker player) uses related gear-shifting ability as a means of preserving capital, not just accumulating more of it.
“Reversals of fortune” happen all the time in markets and at the poker table. Inflection points can change a landscape dramatically, in the blink of an eye. A few off-the-cuff examples:
~ In September of 2012, Mario Draghi (the head of the European Central Bank) gives his “whatever it takes” speech. The psychology of markets shifts instantly, from pessimism to euphoria. Short positions are at immediate risk of being flambeed. The bulls surge forth with a vengeance.
~ Markets are trending strongly up (or down, doesn’t matter). A jobs report hits the tape with numbers far stronger than expected (or weaker than expected – again, doesn’t matter). The previous trend is extended enough that a boatload of long PMs are caught vulnerable — or a boatload of cash-heavy PMs are caught flat-footed. Either way, the environment has powerfully and aggressively shifted.
~ In a high stakes cash game, you flop the nut flush. You have the best hand possible on the flop, and better yet it is well concealed (flopped nut flushes are rare). Your immediate focus is on extracting as much as possible from your opponent’s deep stack. But then the turn pairs the board, and your opponent is acting with suspicious casualness. You switch to high alert risk control mode, given the possibility he is slow-playing a full house. Good thing too — the turn actually gave him quads! You lost the minimum possible, given the turn card that could have doomed you, whereas a less risk-conscious player would have lost thousands in your exact spot. (This exact scenario unfolded just the other day by the way — to follow the tweeted exploits of Jack’s poker alter ego, go here.)
In some ways the equation can be simplified:
- To make meaningful gains, you have to selectively trade with size.
- To trade with size, you have to act quickly at inflection points…
- Which means establishing new positions quickly…
- And more so cutting exposure quickly in dangerous spots.
- A “tight turning radius,” i.e. ability to shift gears, enables this.
Again, with all those Morningstar guys in those authoritative studies of how nobody can generate consistent ouyperformance… what percentage of mutual fund managers have the capability and flexibility as described above?
Zero. Or so close to zero as to make it a statistical rounding effort…
So much of it is straight up marketing. You hear over and over about the get-rich-quick schemes designed to fleece the gullible or greedy.
But you don’t hear about how the Wall Street industrial complex has its own perverse incentives to sell mass-market mutual funds, for one, and low-cost index funds, for two.
The low-cost index evangelists are a different breed of cat, but their table pounding is a form of incentivized product peddling too. They need a worldview to sell — a perspective to evangelize — if they want to keep writing books and going on radio and TV shows.
So their thing becomes enthusiastically reminding you that you are a sheep, and they are the shepherd. (Or maybe Jack Bogle is the shepherd. Same difference.)
Can the individual investor or trader really do better on their own? The battle lines were drawn long ago. It almost becomes a philosophical question. You either believe in access to greatness or you don’t. You either believe that, with enough motivation and persistence, a lone individual can do extraordinary things or they can’t. Some people fall on one side of the ledger (motivation produces extraordinary results). Others fall the other way (mediocrity is inevitable). Maybe it’s genetic.
Ah, but the average investor or neophyte trader has no hope of hunting like a cheetah, some of you say. He doesn’t have the chops. If he tries to make those tight turns you are talking about, he won’t catch any antelope. He will simply make an ass of himself.
Yep, true. But with barely concealed sarcasm, we ask in return: Is there any money-making discipline or endeavor worth pursuing, that does not require deep training, practice and study to execute upon consistently and correctly?
Plainly speaking: For skill sets that are worth it, you often have to look dumb for a while before you can look good. (Ever try snowboarding?)
And as for full on professional endeavors, like trading, the average joe can’t become a doctor or a dentist in the course of six months to a year, let alone a few weekends. It’s really ridiculous what some people expect: You can’t even become a great shoe salesman for the amount of time and effort most arm-chair traders put in before they start demanding results. (No offense to shoe salesmen.)
Learning to shift gears properly — at the right inflection points, with the right amount of acceleration, torque, force etc — is a skill that takes time and effort to develop. Period.
The cheetah is born with such capability ingrained in its muscle structure and DNA. But then again, why do baby cheetahs grow up running and tumbling around all the time? Because they are practicing…
As a small (or rather non-large) trader, you are possessed with a set of inherent disadvantages. You do not have access to high-powered supercomputers, or the Goldman Sachs book of client order flow, or a pipeline of juicy information to trade against, or what have you.
But you also have real structural advantages too: Like the ability to trade in large size, at key inflection points, when the time is right. (The big boys can’t dial up or down anywhere near as fast as you.) Your ability to use a “tight turning radius” as a form of risk control is a great asset — and again one the bigs do not possess. Highly concentrated positions can make you a ton of money — something very few Morningstar managers can say. You are blessedly free of conventional restrictions that weigh like a boat anchor on potential returns: Forced allocation mixes, mindless benchmark tracking, position size restrictions, asset class restrictions, and so on.
You can skip all that and, like the cheetah, go out and hunt for the optimal kill, while using your gear-shifting ability and inflection point responsiveness to deliver max results.
Which is why, in terms of performance, a nimble trader who has truly learned his or her craft can absolutely gorilla-stomp the Morningstar crowd, no matter what the index gurus say.
It’s just not something the “average” investor will ever be able to do, because “average” by definition means not having the guts and gumption to step up to a demanding and immersive challenge, for as long as it takes for real skill to crystallize. One rises above “average” simply in pursuing such a noble goal.
(If you want to jump-start your own pursuit, sign up for the Driver’s Manual if you haven’t already.)