c.) Corporate level:
Two are better than one,
because they have a good return for their labour:
If either of them falls down,
one can help the other up.
But pity anyone who falls
and has no one to help them up.
Paradox lives in the crowds. On one hand, we have celebrity writers like James Surowiecki extolling the virtues of the wisdom of crowds, by highlighting how accurate the average of independent estimates was in guessing the weight of a bull, as noted by Sir Francis Galton in Plymouth, England. On the other hand, we have voluminous literature by esteemed authors like Charles Mackay, Kindleberger, and Edward Chancellor warning us about the manias and the madness of the crowds. Which school of thought is correct? Under what conditions? We can see that Politics is often the determinant.
The Congenial American
In an industry heavily populated with underperforming institutional asset gatherers, Capital Group is a welcome exception. It is one of the few investment management organizations remarkable for its longevity (earliest versions have been operating since the 1930s) and strong outperformance even as their Funds Under Management (FUM) scaled first into billions and now into trillions.
If one is a passionate investor, one is attracted to Superinvestors like Rare Earth magnets. Sometimes one learns directly from these Grandmasters, as one can observe their best ideas and understand their thought processes. Some other times, these aces seed ace ideas in the mind, a line of thought one never knew existed. But almost always one enjoys the presence of master investors, and this is a middle-aged investor’s primal pleasure, the very same pleasure once gotten from watching favourite movie stars from one’s younger days. Hence, the mind brimmed with excitement at the arrival of this stock wizard from the land of ‘the Angels’. What a chance to see (and pinch at) this love laced legend! Will we have some investment thrust and parry?
However, personal pride said it was time for payback with a capital P. Back in 2007, as a newly minted MBA, I would have crossed the continent sized distance from Raleigh Durham to Los Angeles in a heartbeat to build a career among these passionate stock pickers. But alas! it was not to be. I had to learn to my chagrin that Capital won’t even interview at my school, even though it was ranked a top ten business school. Here we are, a decade and a half later, the tables have turned, and the giant was crossing an ocean and a continent to meet and get grilled!
What is the secret of this Investment Samson? Could we improve the Samsonian secret and create Capital 2.0 to rival the world’s greatest investment firm in alpha generation? Even an attempt at this could be as seismic as seizing the last two lines of Kipling’s ‘IF’…
…Yours is the Earth and everything that’s in it,
And—which is more—you’ll be a Man, my son!
Mr. Marketing ‘feeler’ man!! As the investment team entered the meeting room, we saw a ‘blonde Schwarzenegger with a DiCaprio comb-over’ seated at the head of the table, welcoming us with a beaming Colgate smile. Alas!! this ‘American Stock Santa’ came without any gifts, the investing heavyweights. Giant is probably sizing us up at this first date, I speculated. Moreover, the postcard pretty Hunter region dotted by golden-skinned Semillon vineyards, lazy zaftig Bikini beaches, and prone to sudden ‘too-late-to-leave’ bushfires was probably the last place on the planet where the Hope Street headquarters would have hoped for an intellectual match.
Mr. Marketing then distributed two sets of ‘bound in black 50-pagers’ with a feast of charts and a famine in words. Then in his soft southern accent, he started to explain the hard outperformance. 330bps p.a. in the Global strategy! And going back to the time when most people in that room were not born (1973)!! With numbers this good, one must probe for risks whether this high-flying American is flying close to the fireball and would soon be christened as the ‘American Icarus’. The investing team scanned the numbers probing underperformances over the last twenty years.
2002, down 23.9% but still outperformed the benchmark.
2008, down 22% but still outperformed the benchmark.
But wait, in 2003 & 2009 only 2% and 6.2% returns respectively, outperformed but returns should have been much higher in an early bull market. The PMs are not exactly ‘antifragile robots’ and must have been traumatised by the prior year’s crashes, I hypothesized.
Finally, our spirit soared as we saw darkness at the end of this performance search tunnel – down 21% and underperformed by 860 bps. 2022 – Annus horribilis – The year the giant couldn’t perform!
Are you ‘go-go growth’? we pressed. The congenial American suddenly morphed into an unnerved American with a shrunk face and swung back in his chair with a sigh. “Oof! We are still analysing that performance….”, and then with a knowing smile cleverly hedged, “…Anyways, rolling three- and five-year returns are our primary focus”.
Then the probing-for-pitfalls eye landed on something absurd… This global fund has 287 stocks in the portfolio!! 287, that must be a joke, a farce, a 420 straight from the Bollywood Movie Shree 420. Is this a disguised Disney troupe from Anaheim? How could PMs even remember 287 names, let alone become stock sleuths and pick and mix into a winning portfolio recipe.
The Multi-Manager System
As more work was done, I was delighted to know that one of the world’s greatest investment Authors’ Charles D. Ellis, has analysed them in-depth in his ‘Capital – The Story of Long-Term Investment Excellence’. The secret behind the 287 was finally laid bare – it is their multi-manager system where multiple PMs and analysts could independently add stocks to the portfolio. The strength is that it combines independent thought and accountability, and can progressively morph into a Darwinian selection, where Analysts/PMs with the best investment ideas are flagged and advanced, and the poor ones are found out and weeded out. Hence, over time, this would increase the fitness of the organization, and offset the effects of the inevitable entropy that comes with the scaling of FUM, people, and the passage of time. Moreover, this ‘increased fitness’ is persistent, as the system is not the hostage of any ‘key man’ who could simply walk out with the performance key.
The multi-manager system also supports FUM growth without large compromises in performance. Imagine a $10bn fund wanting to build a 5% position. For many stocks, one would quickly run into liquidity issues (weeks or months to build a position, and ‘good luck’ if you are wrong and must sell). However, if there are 10 sleeves of allocation for the same $10bn fund, the need to build a 5% position in one stock could often be substituted by the need to build 0.5% in 10 stocks or even 1% in 5 stocks. This significantly improves the liquidity needs, and so the scalability of the investment product itself.
Statistics tell us that the sample size of 287 stocks is fundamentally superior to 30 stocks in terms of risk management. However, the challenge with having a 287-stock portfolio is all about alpha. One PM, unless he is a sad soul who never sleeps, can know only about 40-50 stocks thoroughly. The multimanager is one solution that reduces the drag on alpha with the increase in the number of stocks, thanks to the sheer number of heads and hands contributing to the portfolio independently.
Question: How could you outwrestle Atlas, the Greek god?
Answer: Trick Atlas into carrying planet Earth, and then wrestle.
While the multi-manager is a positive, Capital with US$136bn plus to manage in the global strategy is like Atlas balancing the Earth on his shoulders with one arm and wrestling Mr. Market with the other. These limitations could be seen in their stock picking – the lifeblood that nourishes this trillion-dollar giant. The stock pickers have largely said sayonara to Mother India, Mainland China, and Oceania in the top 20. As someone who has harvested alpha from the Emerging Markets, and extensively written about the opportunities in those markets, I find this exclusion a glaring weakness precipitated by the large FUMs and ‘Sweet Home Americana Bias’. Given that Capital didn’t bother to tap for talent at my alma mater, which is in the American South, it is safe to assume that the sourcing of the investment pros could still be improved (on country, racial, domain, gender mix).
Why are the Value stocks hiding in the top 20? If the multi-manager were functioning at close to 100% efficiency, one wouldn’t expect the top 20 to be so heavy with Growth stocks. A similar argument could be made for the relative paucity of alpha laden small-cap stocks. With high concentration in some countries and sectors, the multi-manager won’t fully protect against positive correlation in those sectors and countries. If investment ideas are positively correlated like Siamese twins, a 287-stock portfolio offers little advantage over a traditional 30-stock portfolio. As Alpha is a hard and highly prestigious zero-sum game, and as humans are social creatures prone to mimicry, the challenge is to master the Divided we stand and united we fall motto and still work together as a learning team, especially with the large number of investment cooks in the portfolio kitchen.
While ‘Positive Politics’ through the multi-manager system added shareholder value at Capital, in the next instalment we shall see how negative politics destroys shareholder value at many asset managers.
Written by George Kurian, CFA
Australian Equities Portolio Manager
Oracle Investment Management