Every investment management firm claims it is different from its competitors. Many focus on things like a superior investment team and an innovative investment strategy, so why do so many fund managers produce results that are anything but different?
Over the past 15 years, 84% of large cap Australian equity active managers underperformed the ASX 200 benchmark. It’s an outcome of herd behaviour; if fund managers hold similar positions to the benchmark and charge an active fee, they should be expected to underperform after fees. Active managers must therefore provide a service that has a sustainable advantage, otherwise investors may as well invest in a cheap passive fund for index-like returns.
At Allan Gray, we believe that to provide a sustainable advantage for their clients, an investment manager must be very different from the crowd. Being different is something that we are comfortable with, that’s why our investment approach includes a strategy and behaviour that is difficult to replicate. If it wasn’t difficult everybody would do it.
What are the principles of successful contrarian investing?
We believe there are four key principles that play an important role in investment outcomes. Although these principles sound simple, in practice they can be extremely hard to implement consistently, as we often have to fight against human instincts.
Alignment of interest
Alignment of interest between fund managers and clients is vital in ensuring that decision-making focuses on investment outcomes, rather than the self-interest of intermediaries. There has been plenty of discussion around fund manager career risk (or being fired for underperformance versus peers) and job security, which can limit an investment manager’s approach. Self-interest is inherent in human behaviour, it’s a survival mechanism, but there are simple measures that can be taken to prevent it. Employee ownership of the business, co-investment and performance fees can all play powerful roles in aligning the interests of the fund manager with the interests of investors and help to safeguard against closet indexation as a managed fund gathers more assets under management.
Thinking like a long-term business owner
Thinking like a business owner as opposed to a share trader is a simple concept, but one that is often lost to investors who are focused on short-term profit seeking and susceptibility to ‘market noise’. As a result, the practice of rigorous valuation and the risk of overpaying do not receive appropriate attention.
Avoiding overconfidence and accepting uncertainty
Commonly held beliefs and intuitive assumptions often lead to overconfidence and an underestimation of the level of uncertainty in investing. For example, it can be tempting to invest in sharemarkets in countries with high economic growth, but studies show that high GDP doesn’t always translate into strong sharemarket performance. Such behaviour can be difficult to avoid as it ‘feels right’, but ignoring emotions and sticking to the facts can lead to opportunity for investors who can embrace uncertainty.
Doing the opposite of what everyone else is doing can be psychologically challenging and feel uncomfortable to many investors. The fact that prospective returns can be inversely proportional to the popularity of an investment can be counterintuitive to investor psychology. Ironically, it is doing what is unpopular and uncomfortable that makes contrarian investing such a rewarding and sustainable strategy.
We have delved into these four principles in much greater depth in our white paper, Four Key Indicators for Manager Selection. Please click here to download our paper and learn more about what it takes to be a successful contrarian investor.