This post originally appeared on February 27, 2023
I was fortunate enough to be one of the speakers at last week’s Strategic Investment Symposium at the College of Charleston. Mark Pyles is running a fantastic program there and the students I met are being well-prepared.
My segment was called “Products vs Ingredients” and was intended to be a discussion on the merits of active vs passive investing and the market circumstances that would favor one over the other. The discussion turned into a spirited debate. Here’s our cast of characters:
Kyle Ginty was our moderator, and as he works at Vanguard, he tended to support the passive side of the discussion. He made great points, but also ensured the active guys had a chance to speak as well.
Jeff Chang of Cboe Vest has some interesting ETF products and also made some excellent arguments in favor of passive (or set it and forget it) investing.
Vince Lorusso of Changebridge Capital manages a couple of active funds and was a strong voice on the active side.
As someone who’s spent a career as a stockpicker and an alpha generator, I backed Vince and the active investing side of the discussion.
What follows are an outline of my remarks. This is not a transcript, but will give you a sense of how I approached the topic. The session wasn’t recorded, and out of respect for my fellow panelists, I will not try to summarize or categorize their comments as they can do so if they want their views made public.
I will note that even though we had an animated discussion, the points made on the “other side” were excellent, and there are good reasons to consider the ETF products by the other panelists.
- People love to make pronouncements. Everyone in this room has heard the old sayings that markets are efficient, that you can’t beat the market, and that it’s impossible to time the market. These marketing slogans are so ingrained in our industry that to suggest otherwise can make you a subject of ridicule. My experience is that people tend to project a lot, and that when they say it’s impossible to do something, it really means they can’t do it.
Is It Possible to Beat the Market?:
- There are plenty of people who have succeeded in posting market-beating performance over long periods of time especially when you adjust for the lower risk profile of having short positions that reduce net exposure:
- Julian Robertson trained entire teams of outperformers at Tiger using fundamental analysis.
- Renaissance Technologies has done the same using technical analysis and mathematical correlation.
- At Silver Arrow, Raji Khabbaz and I put up a long return on invested capital that beat the S&P 500 by almost 100% over 8 years. We did that without using leverage.
- In 3 years of running Deep Knowledge Investing, we’ve done the following:
- $HMHC – Up 324% in under 13 months.
- $HCA – Up 116% in 10 months.
- $ENVA – Up 53% in under 2 years (in a down market – huge alpha generation).
- $LVS – Up 23% in under 2 months (first time).
- $LVS – Up 27%. This is our second recommendation. We bought it on the way down so the actual gains are much higher. 27% is the worst case scenario.
- S&P 500 – Shorted in February of ’20 just ahead of the Covid lockdowns. Made 33% in 1 month.
- S&P 500 and NASDAQ – Shorted both in the 1st week of January 2022 just ahead of Federal Reserve rate hikes. Both positions are very profitable in a down market.
- Bitcoin – Up 60% in just over 2 years.
- Inflation and Energy – Helped subscribers prepare for coming inflation in November of 2021 which included buying energy stocks just ahead of a historic year for performance in that sector.
- We’ve had one losing position in 3 years. One. (It’s Coursera.)
- I want to acknowledge that this kind of performance is difficult and requires not only talent, but an enormous amount of effort.
Is It Possible to Time the Market?:
- For those who claim that “you can’t time the market”, that’s probably true, but also misleading. With the exception of a few chart-reading savants like Steve Cohen, most people can’t time the market on a daily basis. Most day traders lose money over time. But it’s a mistake to think that you can’t and shouldn’t react at specific inflection points.
- We told subscribers to short the market in late February of 2020 just ahead of the Covid lockdowns. You could see entire economies shutting down from east to west. Best case scenario was two quarters of supply chain disruption. We got much worse.
- We told subscribers to prepare for inflation and buy energy stocks in November of 2021. It was clear the Federal Reserve had lost control of the situation and that their claims that inflation was transitory were unsupported.
- We told subscribers to short the market the first week of January of 2022 ahead of the Federal Reserve rate hikes. We had the highest inflation and misery index the US has seen in 40 years.
Active vs Passive:
- People market as a virtue non-discretionary index investing and being 100% long all the time. But let’s look at what that entails:
- Index investing – the more overvalued a stock is, the more weight it has in the index and the more buying pressure there is on that stock. Index investing causes people to buy more of the most overvalued stocks.
- Index investing – with 25% of the value of the S&P 500 in just 5 stocks in the same sector, you’re not getting the diversification advertised.
- Timing the market – People are encouraged to be 100% long all the time. To me, that seems like crossing a busy highway while blindfolded. It might work out ok, but it’s not the best long-term strategy. There are times when it makes sense to step aside, reduce exposure, or control that exposure using short positions.
- Timing the market – At DKI, we work with a lot of great RIAs. Last year, I spoke with dozens of RIAs who don’t do business with us. They told me they spent most of last year on the phone calming clients who were concerned. I asked the RIAs if they made any adjustments to the client portfolios, and they all said “no”. Of course, the clients were concerned-they were down around 20% – 30% in equities and 30% or more in their bond portfolios. Risk on and risk off both lost money. The 60/40 allocation protected no one. Had any of those RIAs read our research, and simply reduced client exposure by 20% – I’m not talking about going net short – just put 20% in cash, they would have outperformed their competition by 600 basis points. For the RIAs in the audience, I’m betting that would have made you heroes in the eyes of your clients, led to increased client loyalty and significant referral business. Being 100% long every day isn’t always the best approach.
Teagan Shaughnessy Asks About the Conditions Where We’d Favor One Strategy vs Another:
- My response to Teagan’s question:
- There’s no question that “free money”, helicopter money, and funds sloshing into index funds benefitted passive vs active for much of the last decade.
- Last year, we did see better relative performance from active, but much of that was due to the ability of active managers to reduce exposure.
- 2022 was the most macro-driven year I’ve ever seen. At DKI, we got the two big trades of the year right. We had a huge position short the S&P 500 and the NASDAQ, and we had enormous positions in energy.
- My personal preference is for a market where deep dive research, and fundamental stock picking are what matter. We’ll get there at some point, but until then, the Federal Reserve and expectations for what they’ll do are what are driving the market.
- Our motto on this is “Roll With the Changes”. Whether I like what’s happening in the market or not, what we’ve successfully done is make adjustments to our strategy to help investors earn better returns regardless of conditions. That flexibility is one of the best strengths of active management, and we’ve used it to help our people. Passive can’t adapt.
Ethan Epstein Asks When We’d Rely on Individual Stock Picking vs Sector Funds:
- My response to Ethan’s question: I think there’s a place for both and it depends on your specific expertise. It’s probably easiest to go through a couple of examples:
- Years ago, at Silver Arrow, we thought the hospital space might be interesting and Tenant came up as a company to research. After a while, I realized that Tenant was a mess, but that HCA was extremely well-run and cheap. We made huge profits in HCA while THC went straight down.
- A couple of years ago, I thought the educational publishing space was interesting. Houghton Mifflin, a small-cap company turned out to be a fantastic investment. We made more than 4x our money in 13 months. In that time, much larger competitor, Pearson lost value.
- We recently looked at the alternative consumer finance space. We invested in Enova which is up more than 40%. We avoided CURO due to small but meaningful differences in their business model. That stock is down 80%.
- So, when you have the expertise to do the research yourself, I’d much rather do the deep dive, and the stock picking.
- But there are times that you want exposure to a theme, and it’s out of your area of expertise. Right now, I’m bullish on nuclear energy and that’s a positive for uranium. That’s a tough market to trade with a lot of near-term capacity already purchased years ago. I don’t have any edge on figuring out how to buy uranium better than the regular market participants. In that situation, we bought an ETF and it’s been a profitable investment for us.
- In the end, there’s room for both approaches, but wherever I can use my own research, I’m going to do that.
DKI will always look for the best way to help our subscribers earn higher risk-adjusted returns. We tend to focus on individual stock-picking, but there are situations where we just want broad sector exposure, sometimes as a long position and sometimes as a hedge. I thank the College of Charleston, Mark Pyles, students Ethan and Teagan, and my fellow panelists for a fascinating and enjoyable debate.
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