Rob Arnott on the Hard Part

Sure, everyone’s a “contrarian.”

Until it actually comes down to being a bit patient and uncomfortable in a position. Then they get squirmy or begin looking elsewhere for a more conformist approach, a warm sweater of a portfolio that makes them immediately “feel better” and back in the mainstream.

Now of course, in the modern era of iPhone apps that give us market updates 24/7, it is nearly impossible to step outside of the style box and ignore the indices. Investors pretend to want something non-correlated to the S&P but in an up-market what they really want is beta dressed up in a tuxedo. Managers are at once excoriated for hugging the benchmark and then ridiculed for “missing the move” should they stray too far.

Rob Arnott sat down with fellow quant Cliff Aness and a Morningstar reporter to talk about a wide range of topics in regard to portfolio management. My favorite bit is this one, in which Arnott explains why exploiting market irrationality and making contrarian bets is so difficult when running money for the modern investor:

I guess I’m saying that I’m a believer that the market is 90% efficient and 10% inefficient, and it’s the 10% inefficiency that creates marvelous opportunities to add just a little bit of value for our clients on a reasonably consistent basis for those who have a modicum of patience. Unfortunately, a lot of investors don’t even have a modicum of patience.

I love to use a concrete example to help people viscerally understand this point. Suppose I go to a client and say, “We’ve scanned your portfolio, and we found an investment that you’ve got that’s very popular and beloved. It has its finger on the pulse of the consumer like nobody else. No serious competitors. Lofty growth potential. It’s gotten to be so popular that it doesn’t have a risk premium, so we just dumped it. Apple is gone from your portfolio. We’ve searched the world high and low to find assets that are truly feared and loathed; lo and behold, we found a basket of Spanish and Greek banks. Yes, I know, some of them are going to go to zero, but the ones that don’t go to zero, they’re really cheap. So, we used the proceeds from Apple to buy a basket of Spanish and Greek banks.”

That’s not very comfortable. Do we viscerally believe that it has better than 50/50 odds of winning? I think most investors, if they sat back and thought about it, would say, “Yeah, I think it does have better than 50/50 odds of winning.” But most investors would also quickly say, “But if it doesn’t win in the first year, you’re fired.” And therein lies the challenge.

Now you’d think that with Rob’s track record and incredibly intricate study of global asset classes and portfolios, the investors would give him the benefit of the doubt. But for the most part investors are monkeys watching the moves of everyone else and imitating most of what they see lest they feel left out or too far from the status quo. They are far less comfortable allowing a manager’s longer-term view bear itself out while everyone else is doing something different and winning short-term. This is as much an attention deficit feature of our modern age as it is a primitive instinct to remain within the folds of the herd so as not to get caught out there alone. I’m not sure I have a solution for this, I confess that I have difficulty with this as well.

Serious students of investing ought to make time for this whole discussion, both of these guys are hall of famers.


Fitting Factors Into the Formula (Morningstar)

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