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Like a Pro
Skilled investment in a world of passive assets. Charles Ellis, John Maynard Keynes, Howard Marks and Tommy Armour on the practice of not being average.
If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different.
The chasm between professionals and amateurs is an often-misunderstood distinction. Pros aren’t simply better in their respective domains; they are consistently better, often uniquely better . Golf Digest recently ran an experiment to see how low a professional golfer could score on a normal public course versus the manicured perfection of Tour stops. Masters champion Bubba Watson agreed to play a public course, Starfire, a few days after the Masters wrapped up. Starfire is “is good but not great, the greens are mostly green but brown and bumpy in parts, and the practice range is expansive and stocked with balls that are desperately asking to be sent to the ICU. The green fee is $36. Players dressed in polos and well-trimmed shorts are paired with players in gym attire. In short, a normal public course.” As for Watson:
… he is not really a pro; there are thousands of those around the world. He is a two-time Masters champion, a feat only 17 men have accomplished. He has won 12 times on the PGA Tour and made six appearances on Ryder Cup and Presidents Cup teams. That is who you want in this arena—someone whose game underlines the expanse between them and us. With power and touch, a vision to see lines others don’t and the courage to take them, and a proclivity for shaping shots, Watson’s game is singular.
Prior to the round a golf analytics firm projected the pro would score 66.9, or ~3 under par. After 18, Watson notched a 62. It wasn’t an errorless round; he missed puts, hit sand traps and overshot a green. But what really exemplifies Waston’s pro status was his approach on the 18th:
…a 330-yard drive left Bubba 30 yards off the green. There were no bunkers in front of him, but he didn’t have much green to work with. The safe play would have been to throw it on just past the pin and hope to sink a seven-footer for birdie. Bubba saw something else. After a few practice swings, he beckoned for the phones and cameras to come out.
“This is going in,” he repeated, and just as we realized what was going on—Wait, is he calling his shot?—Bubba lofted the ball into the Scottsdale sky; it took two skips and hit the pin only to pop out, three inches from the cup.
This professional level of aggressiveness is an element of what Charles Ellis called “The Loser’s Game” in his 1975 article for Financial Analysts Journal. Ellis was writing about the unlikelihood of beating the market in light of the rapid growth of professional investors. To Ellis, the expanded population of pros had made price discovery in stocks a cutthroat, ruthless endeavor, one in which most amateurs couldn’t truly expect to have an edge. Ellis drew his main comparison from the work of Dr. Simon Ramo’s Extraordinary Tennis for the Ordinary Tennis Player.
Over a period of many years, he observed that tennis was not one game but two. One game of tennis is played by professionals and a very few gifted amateurs; the other is played by all the rest of us.
Pros win serves, hit aces and score points after long, exciting rallies; successful amateurs on the other hand simply return the ball to their opponent until they almost inevitably make an unforced error.
In other words, professional tennis is a Winner's Game--the final outcome is determined by the activities of the winner--and amateur tennis is a Loser's Game---the final outcome is determined by the activities of the loser. The two games are, in their fundamental characteristic, not at all the same. They are opposites.
Bubba Watson scores low by attacking the pin from 30 yards out, but the rest of us are well advised to just lay up and take our chances with a (hopefully) mid-range putt. When Ellis wrote Loser’s Game he argued that institutional (read: active) investing had risen to 70% of total market volume. Ellis’s description sounds practically provincial in the context of modern markets:
There are 150 major institutional investors and another 600 small and medium sized institutions operating in the market all day, every day, in the most intensely competitive way. And in the past decade, these institutions have become more active, have developed larger in-house research staffs, and have tapped into the central source of market information and fundamental research provided by institutional brokers. Ten years ago, many institutions were still far out of the mainstream of intensive management; today such an institution, if any exists, would be a rare collector's item.
Ellis’ overall suggestion is that in markets you are in a foursome with Bubba Watson and two other formidable pros and maybe you should consider playing best ball. This has been internalized for the investing public through passive investing in index funds.
Prices are a little bit like Schrodinger’s cat…
A year after The Loser’s Game was published Jack Bogel founded Vanguard and with it birthed passive investing. Today passive assets are 46.5% of managed assets and are on pace to grow larger than active funds by 2026. The alleged superiority of passive indexing has been virtually institutionalized and codified in law. Between the Department of Labor’s Fiduciary Rule language around fund expenses and qualified default investment alternatives in 401(k)’s, odds are that a new dollar coming into the market is, to some degree, an indiscriminate buyer of equities.
In a variety of ways, the very challenges Ellis was talking about have reversed course in dramatic fashion. Mike Green, of Simplify Asset Management, has been a long outspoken critic of the influence index funds hold over the market.
…there’s no alternative for many to invest in terms of their biweekly paychecks. The money goes into the market and then automatically is defaulting into these vehicles. That’s just a massive regulatory advantage and it’s driven a phenomenon that is much more demographic in nature than people really understand. Passive penetration in aggregate is closing in on about 40% of the total market cap.
We could discard the idea that the markets are efficient allocators of capital. If you’re willing to do that, then it’s “not a problem.” But what we’re actually doing is, is we’re sending all the money to vehicles that allocate the capital on the basis of the current market cap or the current float-adjusted market cap. When you do that, one, you’re presuming that the market has actually done the work to say that that current level of price is the right price. The second is, is that you’re actually concluding that the price that it transacts at next is the price that it would have transacted at next had you not been involved. That’s kind of one of these weird things. Prices are a little bit like Schrodinger’s cat, they tell you where something was on the last transaction, but they don’t actually tell you what the price is, right? The price could be up, it could be down. We don’t know that until the next transaction occurs. Passive is assuming that they’re not having any influence on that next price but they have to be because they are transacting.
Ellis believed the influence of increasingly sophisticated active participants had shifted the market closer to efficiency.
Ironically, the reason institutional investing has become the Loser's Game is that in the complex problem each manager is trying to solve, his efforts to find a solution--and the efforts of his many urgent competitors---have become the dominant variables. And their efforts to beat the market are no longer the most important part of the solution; they are the most important part of the problem.
The irony today is that fewer and fewer participants are making an effort to beat the market. Happy with average, a greater share of investment flows to quantitative, albeit primitive, strategies that buy equities in a perfunctory manner, trusting that someone, somewhere has checked the scales.
The state of confidence
The belief of passive investors is broadly that the past will be prologue, that average performance going forward will be a continuation of long-term trends. But equity returns are a function of valuations and valuations are themselves a reflection of long-term expectations. In John Maynard Keynes’ General Theory of Employment, Interest and Money he foresaw what today plays out at a massive scale: That many invest with scant knowledge of the underlying enterprises and allocate capital largely based on a general view about the future which may or may not be correct or relevant.
A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady.
Whether it’s bond yields, geopolitics or the cacophony of “data” instantly accessible day-to-day, large swaths of the market are putting capital into or pulling it out of enterprises of which they have no intimate nor even passing knowledge.
Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and nonsignificant character, tend to have an altogether excessive, and even an absurd, influence on the market.
I do not need to recount some of the excesses of the previous two years to demonstrate the fundamental truth being conveyed here. Fewer and fewer market participants are “doing the math” and as a result, intrinsic value, true prices, are not being ferreted out. It is possible that active portfolio management may once again have an edge over the passive indexer, that the Loser’s Game of accepting average returns may paradoxically lead to below (historical) average results.
I may also posit here that the promotion of passive indexing has more to do with the career risk of a large industry of advisors than with investment risk or returns. As Keynes’ famously identified:
Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
Howard Marks makes the obvious, but profound point that “you can’t take the same actions as everyone else and expect to outperform.” I’ve discussed Gambler’s Odds before; that if you believe you have an edge, that edge can only be revealed in time. If average may not be good enough to win (however you define that), you will need to depart meaningfully from conventional wisdom. A paradox depending on your role will be that you need to nurture what David Swensen called “uninstitutional behavior” from within an institution. You will need to do so over a long enough timeline for your edge, for your unique view, to be proven out. Marks again:
I find it incredibly simple: If you wait at a bus stop long enough, you’re guaranteed to catch a bus, but if you run from bus stop to bus stop, you may never catch a bus.
My biggest issue with indexing is largely that the evidence in support of it assumes 100% adherence. While it is true that every trade you make in an active strategy may on average hurt your relative returns, any trade in a passive strategy is almost by definition ruinous to the goal of achieving average returns.
Playing Like a Pro
To labor our golf metaphor: Should you attack the pin or lay up? How do you play like a pro if you are uninterested in merely average results? Ellis quotes Tommy Armour,
Play the shot you've got the greatest chance of playing well…Simplicity, concentration, and economy of time and effort have been the distinguishing features of the great players' methods, while others lost their way to glory by wandering in a maze of details.
Your approach will be deeply personal and so naturally distinct from the average provided you are capable of honest introspection. Tobias Carlisle once said “the best strategy is whichever one gives you the confidence to buy when prices are going down.” Keynes offered this warning:
Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.
Neither blind confidence nor diligent study can guarantee success, but to do better than average one must start with the uncomfortable, the unpopular and the untested.
Consider subscribing and your welcome email will include a link to download a PDF 📃 of Warren Buffett’s How Inflation Swindles the Equity Investor from the May 1977 issue of FORTUNE
Passive investing almost surely won’t come to represent 100% of the equity market, in fact its ascension may already be slowing, but shifts in investment paradigms are challenging to predict. Something beyond the scope of this review (and perhaps the scope of my intelligence) is Michael Mauboussin’s Shift Happens which tackles the changing understanding of the market as a complex adaptive system, more akin to a natural science than a social one.
Also not to be missed is Byrne Hobart’s breakdown of Jane Street…