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Best Ideas Research


merkhet
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A research paper that finally talks about what we in the CoBaFF community have known all along. Some highlights include:

 

The paper also has strong implications for the optimal behavior of investors in managed funds. Our findings suggest that while the typical manager has a small number of good investment ideas that provide positive alpha in expectation, the remaining ideas in the typical managed portfolio add no alpha at all. Managers have understandable incentives to include these zero-alpha positions. Without them, the portfolio would contain only a few names, leading to increased volatility, price impact, illiquidity, and regulatory/litgation risk. Adding additional stocks to the portfolio can not only reduce volatility but also increase portfolio Sharpe ratio. Perhaps most important, adding names enables the manager to take in more assets, and thus draw greater management fees. But while the manager gains from diversifying the portfolio, it is likely that typical investors are made worse off. We suggest that investors who put only a modest fraction of their assets into each managed fund can have substantial gains if managers choose less-diversified portfolios.

 

It's the Kleig-light syndrome -- you get the behavior you incentivize, so when you incentivize volatility and Sharpe ratios, you get crappy portfolio returns. Noted again here:

 

Second, the very nature of fund evaluation may cause managers to hold some or even many stocks on which they have neutral views concerning future performance. In particular, since managers may be penalized for exposing investors to idiosyncratic risk, diversification may cause managers to hold some stocks not because they increase the mean return on the portfolio but simply because these stocks reduce overall portfolio volatility.

 

Enjoy my fellow concentrated investors. :)

 

[Note: I didn't see that this was published all the way back in 2009 -- so others may already have seen this]

Best_Ideas_Research_Paper.pdf

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Charles Ellis has written a great history of active performance management and has observed that smart managers have arbitraged away most of the excess return of the largest 300 US stocks.  I for the most part agree.  What we may see after the alternatives mania is a movement to index funds for most institutional money combined with opportunistic managers that provide concentrated exposure to mispriced securities.  Fairholme is the only manager that provides this type of offering today. 

 

Packer

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Charles Ellis has written a great history of active performance management and has observed that smart managers have arbitraged away most of the excess return of the largest 300 US stocks.  I for the most part agree.  What we may see after the alternatives mania is a movement to index funds for most institutional money combined with opportunistic managers that provide concentrated exposure to mispriced securities.  Fairholme is the only manager that provides this type of offering today. 

 

Packer

 

Is there a paper or article that you would recommend for Ellis?

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Charles Ellis has written a great history of active performance management and has observed that smart managers have arbitraged away most of the excess return of the largest 300 US stocks.  I for the most part agree.  What we may see after the alternatives mania is a movement to index funds for most institutional money combined with opportunistic managers that provide concentrated exposure to mispriced securities.  Fairholme is the only manager that provides this type of offering today. 

 

Packer

 

Do you mean the he's the only manager offering this in a mutual fund product?

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You are correct in the mutual fund format.  There are others including some here that provide that type of product in a partnership format.  I think a benchmark of these types of products would be returning money when few bargains are available and allowing more investment when the bargains are plentiful. 

 

Packer

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The problem with these is that although they have good value strategies, they have either closely matched or underperfromed in some cases significantly (Longleaf) versus the S&P 500 over the past 10 years.  This is why I think the large stocks that make up Longleaf's and Sequoia's portfolios are pretty efficient. 

 

Ellis' article will be published in the CFA Journal next month.  Those that are CFAs can get access to the article on the CFA site.

 

Packer

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Very interesting insight!

Which alternatives mania are we talking about?

btw: I think Fairholme got its alpha mainly from large cap if I remember it correctly

but I agree they got it in a concentrated fashion

 

Charles Ellis has written a great history of active performance management and has observed that smart managers have arbitraged away most of the excess return of the largest 300 US stocks.  I for the most part agree.  What we may see after the alternatives mania is a movement to index funds for most institutional money combined with opportunistic managers that provide concentrated exposure to mispriced securities.  Fairholme is the only manager that provides this type of offering today. 

 

Packer

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The 45% allocation to alternatives that pension funds/endowments currently have.  This is in my opinion is an expensive way to get returns that you can get from other asset classes for less than 5 bp (indexed stocks and bonds) or focused funds with a little more in fees.

 

Packer

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Charles Ellis has written a great history of active performance management and has observed that smart managers have arbitraged away most of the excess return of the largest 300 US stocks.  I for the most part agree.  What we may see after the alternatives mania is a movement to index funds for most institutional money combined with opportunistic managers that provide concentrated exposure to mispriced securities.  Fairholme is the only manager that provides this type of offering today. 

 

Packer

Packer, can you elaborate? What do you mean "abitraged away most of teh excess return of the largest 300 stocks"

 

 

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I don't mean to speak for Packer, but I think he's saying that there are so many people following all the big names that it is very rare to see any significant mis-pricing.  If you're looking for mis-priced opportunities the S&P500 generally isn't the best pond to be fishing in. 

 

I'm in the the financial services business and I absolutely agree that there has been a huge push towards "alternatives."  This all came out of 08-09.  Basically both institutional and retail investors were looking for a new mouse-trap and the financial services industry has cooked-up a number of products that they claim fit the bill.  The other huge push I've personally seen, from a marketing standpoint, is to "tactical" management.  It's basically another way of saying market timing which is of-course non-sense.  I kind of chuckle when looking at the numbers for all of these strategies because, as you might guess, the S&P has killed them. 

 

A few other funds that I think fit the bill (regarding excellent managers who will concentrate and hold cash) include Steven Romick's FPA Crescent and Donald Yacktman's Yacktman Fund. 

 

The biggest problem with most mutual funds is they are far too diversified.  I think the vast majority have over 100 holdings.  At that point, the simple rules of math say you're not going to be much different from average.  Fairholme is one of the most concentrated funds you'll find.  Bruce seems to like holding 10-20 positions.  But I think his top 5 right now comprise 60-70% of the fund.

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