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What Index Funds Can't Do

Jack Bogle died yesterday... I hardly need to tell you about him. As Warren Buffett wrote in his 2017 annual letter: “If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.”


But today we ask, how to beat the monster he created? One answer lies in honing in on the one thing index funds can't do...


When I think about the future of money management, I still see index funds with a huge slug of the pie.


But what about the rest of it? What do the “survivors” look like?


Well, I think the survivors will offer something that is markedly different than what you get in an index fund. One species of survivor will be the concentrated investors.


For the sake of discussion, let’s say concentrated means portfolios with no more than 20 securities. The idea is you don’t bet much, but when you bet, you bet big. This is far from how most people manage money.


Anecdotally, there are many compelling case studies that say this is the way to go. I’d recommend Concentrated Investing: Strategies of the World’s Greatest Concentrated Investors by Allen Benello, Michael van Biema and Tobias Carlisle. There are some wonderful stories in there.


For example, Lou Simpson ran GEICO’s portfolio from 1979 to 2010. His record is extraordinary: 20% annually, compared to 13.5% for the market.


Simpson’s seemed to get more concentrated over time. In 1982, he had 33 stocks in a $280 million portfolio. He kept cutting back the number of stocks he owned, even as the size of his portfolio grew. By 1995, he had just ten stocks in a $1.1 billion portfolio.


A lesser-known example is Joe Rosenfeld at Grinnell College. The endowment had $11 million in assets when he took the helm in 1968. When he stepped down in 1999, it was up to $1 billion. Rosenfeld had delivered 15% annually – net of the 4.75% that went to the college every year. Astounding, really.


He did it by buying a handful of stocks and holding on. In 30 years, he made half a dozen major investments and sold even more rarely. Rosenfeld “considers selling to be indistinguishable from error.”


Of course, this approach led to some harrowing moments. In 1990, the endowment dropped a third, thanks to a giant position in Freddie Mac. But Rosenfeld held on. (I don’t know what this did to his insides.)


Okay, so there are lots of anecdotes. What about empirical research?


Here is a survey of some of that research by Lazard Asset Management. They say most research supports concentrated investing but “the empirical results… are not unanimous.”


I’m not sure there is a right answer. My gut says that your success with a concentrated portfolio probably depends more on temperament than anything else. Concentrated portfolios tend to be more volatile. And if you can’t stomach the ups and downs, it probably won’t work for you.


But it also begs another question…


How concentrated is concentrated?


Number of positions is one thing. But that’s not the only dimension here. How big do you let positions get? Because if you buy and hold and you nab a big winner, then you may well get a nutty looking portfolio after some years.


Say you took a 3% position in Intel in 1987 and never sold. Twenty years later, it would pretty much be your entire portfolio. Of course, almost nobody would allow this to happen.


Remember how last week I wrote about Stahl’s essays? In 2017 he wrote an essay titled “How Could Indexation Ever Be Invalidated?” (I took the Intel example from this, though I could’ve chosen lots of other examples). To answer his question, I pose another question:


What is one thing an index can’t do?


An index can’t take a 3% position in an Intel and let it become a bigger and bigger piece of the portfolio.


Aha. Maybe here, then, is a chink in the armor where an active manager can thrust his sword. An index must always rebalance. In essence, it must always sell its winners and add to its losers. But you do not.


Stahl concludes:


“If the only assertion about indexation is that the index will outperform the active managers, then the only way to invalidate indexation is to outperform the index. The index can be made to do anything except compound into heavy concentration. This is an approach that the active manager might do well to explore.” [Italics added].


I’ve been running concentrated portfolios my whole investing life. I’m sold.


But not everybody is. I spoke with one guy who told me letting a position get to 20% of the portfolio would be “financially irresponsible.”


Would it? What if it started out as a 3% position?


This is the conundrum of money management today. Everybody seems to be watching the S&P500 Index. They want you to beat that index. But to beat that index means you have to do things the index doesn't. One way to do that is to allow your portfolio to become… top heavy, chunky, unbalanced – choose your adjective.


But not many people want to do that, because it means suffering more volatility. And everybody seems to want low volatility. But for those who can do something at variance with the index, I believe there are big rewards.


For myself, I like to start no bigger than 10%. I would not let a position grow to more than 20% of the portfolio. And it would have to be a very special position to get that big. Even those who like concentrated bets have limits. As well they should. You’re going to make mistakes. You don’t want to die from one mistake.


This reminds me of a Nick Murray quote, from his wise little book Simple Wealth, Inevitable Wealth: “The fewer ideas in your portfolio, the fewer bullets it will take to kill you. One idea: one bullet.” (Murray is not a fan of stock picking, by the way. He’s an asset allocation and index sort of guy. Well, nobody’s perfect).


I run a concentrated portfolio, but try to take a balance of risks. I own companies in different industries and that do business in different places all over the world. I’m mindful of that one bullet.


Of course, not every position starts at 10%, but I hesitate to keep anything less than a 3% position around for too long. Raise or fold, as they say in poker. Again, the precise numbers are more a personal choice. This is not a science. It is more an art.


Moreover, such positions must meet my CODE investment criteria. This means, among other things, a very strong balance sheet. Perhaps this goes without saying, but certain styles are better suited to concentrated portfolios than others. For example, those who invest in small biotech firms or junior miners probably should spread their bets.


The Secret to Success? Tennis Shoes!


I’ll end this bit on concentrated investing with a funny story Glenn Greenberg, founder of Brave Warrior, tells. This story is in Concentrated Investing. Greenberg worked for a family office. The money manager there was a guy named Arthur Ross:


“Nobody’s ever heard of him because he handled private money and he didn’t get written up in books or get quoted in the newspapers, but he was a really phenomenal investor.”


One of the family members came into Ross’s office one day and asked, “Arthur, what’s the secret of your success?”


Ross said, “Tennis shoes. Now get out of my office.”


And the guy leaves and thinks to himself, “Tennis shoes? I don’t get it.” So he goes down the hall to the office of one of Ross’s analysts, and said, “Arthur told me the secret to his success is tennis shoes.”


The analyst tells him that Ross meant ten issues. He owns ten issues. Just ten stocks.


Maybe people are starting to figure this out. An article from the Economist earlier this year cited data showing the average number of stocks in global portfolios halved over the past decade.


*** Mailbag


A reader writes:


“Maybe I misunderstand coffee can approach but a few concepts seem to have burrowed down into my mind and wont leave me alone when it comes to making investment decisions. One is courtesy of Danny Kahneman and his ‘base rate’. When asked a difficult question he says you need to ask yourself what the relevant base rate is before answering. So, in this case, buying a small number of stocks and holding for a very long time…is that a good idea? Tom Gaynor of Markel gives folksy stories about his granny not selling her husbands stocks and lo and behold they were worth a small lottery win when she died so the lesson is, never sell? But, for my sins I was a bond dealer for 20 years before retiring and so have become incredibly skeptical of all such easy tales of great wealth. JPM did a study that came out last year that shows since 1980s nearly all stocks outside the top handful have delivered as a group zero returns, e.g. the right tail accounted for nearly all market gains. Back to base rates, what are the odds you or me picking a few tuck aways are going to pick the (very) few that actually do deliver? Very low.”


Yes, this reminds me of a report I read four years ago, which said much the same thing: “The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position.” It’s a good read.


The key here is to think about the population used to get at a base rate. The odds from the population as you define it – or as these studies define it – seem poor.


But… by applying some basic principles to sift through these populations, the odds of putting a portfolio together that does very well over time turns more favorable. For example, the base rate for owner-operated firms is quite a bit better. There are many studies that show how companies with high insider ownership outperform their peers.


You can choose whatever factors you like, that's not the only one. You could use price-earnings ratios or some other valuation metric. You could use Joel Greenblatt’s Magic Formula, or Pabrai’s Cannibals or some other sensible screen. Then you pick from that sifted population.


The point is: within certain subsets, or mini-populations, the base rate turns favorable.


Nonetheless, you raise an excellent point. An investor needs a way to improve the odds. This is why good investors spend so much time on process.


Thank you for your thoughtful email.


Have any questions or thoughts you want to share? Send them to the mailbag: info [at] woodlockhousefamilycapital.com.


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Published: January 17, 2019

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