Your Slow Mover Advantage Over Bay Street - Part 1

As avid MoneySaver readers, you know that there are a million different investment strategies out there to follow. To each their own, but in our mind at the Motley Fool, we think a lot of people are investing with entirely the wrong mindset. Bad advice abounds and we’d like to share some of the reasons why we believe this is so and what we Fools think can be done about it.

Consider famed newsletter writer, Dennis Gartman. Though a touch dated, this anecdote serves as an excellent example of what we’re talking about.

Gartman is a frequent guest on CNBC and his advice on April 7, for those that still tune in to this channel, was that he’d “pared his equity exposure from an average of 100% to close to zero”.

Two weeks later, on April 21st, Gartman was back on CNBC indicating that he’d re-entered the market and had become “pleasantly long”. Quite the change of heart!

The best part of all was Gartman’s rationale for getting out of stocks in the first place. He explained that he did this because of a “market reversal” on the previous Friday (April 4th) – which he described by saying “I’m not sure what happened, but something happened between 11 and 11:15, that everything turned on a dime”.

From scared stiff to “pleasantly long” in just 2 weeks! In our mind, both of these pronouncements are 100% useless.

A Different Perspective

We Fools pay such noise no mind at all and really only know about these ridiculous prognostications because of, well, how ridiculous they are. They are merely examples of how the media and information machine that surrounds the world of investing feeds on the illusion of how important activity is and tries to project this image where the only way to succeed is by remaining in perpetual motion with your portfolio.

To the detriment of those who choose to pay attention to this machine – because of all of the noise, it has been demonstrated that short-term horizons are the new normal in the game of investing.

While it’s to the detriment of the masses, in our mind, this works to the advantage of those of us who can keep things in a long-term perspective. The rampant shorttermism that exists gives those of us who view things through a long-term lens an edge.

We whole-heartedly believe in these sage words from Nick Murray:

“Timing the market is a fool’s game, whereas time in the market will be your greatest natural advantage.”

The Root Of The Issue

One of the primary reasons for this rampant short-termism is how the investment industry is structured. You see, many in the institutional investing industry, and I’m talking portfolio managers at the big mutual fund companies and prominent hedge fund managers, actually talk like they are exclusively focused on long-term returns. The reality is, the nature of the industry doesn’t really allow them to actually invest this way. Largely, it’s been my experience that this apparent long-term focus is a marketing and sales oriented sham.

The reality is, institutional investors are evaluated against a benchmark and their performance relative to this benchmark is what makes or breaks their career. That’s all well and good, but the thing is, institutional investors are evaluated vs. their benchmark literally every 90-days. Every quarter, they’re forced to communicate to their clients whether they beat or lost to their benchmark over  the previous 90-days. It is virtually impossible to invest with a 5 or 10-year horizon in mind when one has this 90-day evaluation gun put to their head.

Rack up a few 90-day losses in a row and suddenly, clients become itchy. Rack up enough and they begin to leave. Assets under management suffer, revenues shrink, and before you know it, job security becomes an issue.

The solution for many in the money management business is to virtually copy the make-up of the benchmark that they’re being evaluated against – a practice known as “closet indexing”. For instance, if Royal Bank carries a 5% weight in the underlying benchmark, even if a fund manager hates the Royal Bank, it’s too risky for them to simply not own it – that is, take a 0% weight.

In this case, again, even if the professional investor hates it, they might still dedicate 3% or 4% of their fund’s holdings to the Royal Bank. They’re still underweight but this helps to ensure that if it does go up over the next 90-days, it doesn’t hurt the fund’s relative performance, that is, performance against the benchmark, too much.

This concept of RELATIVE PERFORMANCE is critical to grasp if you want to understand how institutional investors, aka “the smart money”, invest. Positioning relative to the benchmark tends to be more important than what they’re actually invested in and making money for clients is often times a secondary pursuit. After all, the market can fall by 25% in a year but if their fund is down a mere 20% it represents a massive win and probably a significant pay day for the manager.

Misaligned Interests

Industry wide, this pursuit of relative performance is a big contributor to the short term actions that go on. Not only does it hurt if you “lose” for a couple quarters in a row, but to lose and appear to be doing nothing about it? Not good.

For this reason, the pursuit of relative performance tends to lead to unnecessary activity.

If a portfolio manager is trailing their benchmark in a year, they may try to play catch up by picking up and overweighting riskier, momentum oriented stocks.

If they are leading, they may move positions around so that they resemble the benchmarks even more closely. This helps to ensure that performance after the repositioning is virtually identical – effectively “locking in” the lead and again, achieving that princely bonus that beating the benchmark procures.

Chasing relative performance makes investing into a very different pursuit than what it should be – which in our mind, as long-term investors, is the pursuit of and investment in great companies to buy and hold for very long periods of time. We figure, if you can stay focused on this mindset, and keep the long-term in perspective, beating the index and making a lot of money in the stock market will not be an issue.

Part 2 of this article will appear in the next issue.

Iain Butler, CFA, is the Chief Investment Adviser at Motley Fool Canada. He is also the lead adviser for Stock Advisor Canada. For more information please visit www.fool.ca or email Iain at IButler@fool.ca.

All material has been prepared by Iain Butler, Chief Investment Adviser at Motley Fool Canada. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Motley Fool Canada or its affiliates.