Active Management and Contrarian Thinking

"Be fearful when others are greedy and greedy when others are fearful."

 -Warren Buffett

I recently listened to an interview with Rob Arnott from Research Associates entitled "Rob Arnott on Why Active Managers Fail."  Despite its poorly worded title (Rob explains why some active managers do outperform, see below), it's definitely worth a six minute listen.  Here are four key takeaways, including some of Rob's quotes from the interview.

Stock performance is positively skewed

We tend to assume that stock returns follow a normal distribution:

Source: Wikimedia Commons

In actuality, stock returns have positive skewness, meaning there tends to be a small number of stocks that perform much better than expected from a normal distribution.  See the picture below, right:

Source: Wikimedia Commons

What does this mean for investors?  In a portfolio, you'll find a couple of names (Rob Arnott calls them the "1 in 10") that will be the key drivers in your performance.  This also suggests that without a good way of identifying the best names, you risk missing out on the stocks that would truly help you achieve significant outperformance.

It's also worth pointing out that we've often seen narrow leadership and it's not necessarily a bad thing.  In the last couple months, big tech names have been the key drivers for the market.  Here's the FANG stocks and the S&P 500 for the last couple months:


This is reminiscent of 2015, when those same four stocks provided the lion's share of positive returns for the index for the year.


Narrow leadership isn't necessarily a bad thing, but it does make it very important to identify stocks poised to or beginning to outperform, as missing those names will make it virtually impossible to outperform the market.

Small/mid cap stocks provide good opportunities to outperform

"Small stocks don't beat large stocks, but small stock portfolios beat large stock portfolios."  To rephrase- on average, small stocks don't tend to beat large stocks.  But there will be a number of "home run" small cap stocks that will generate solid outperformance.  This relates to the positive skewness of stock returns and the importance of focusing on potential outperformers.

One of the great values of technical analysis is the ability to screen for stocks displaying certain price characteristics.  Combining this with valuation metrics, earnings growth or other fundamental factors provides a great toolkit to identify future winners. 

Active managers can win, but not all of them

"It's not hard to beat the market.  I think it's hard for active managers collectively to win."  We love to debate active vs. passive as if all of the active managers are either outperforming or underperforming passive funds at any point.  In Arnott's opinion, it is impossible for active managers collectively to outperform passive funds, but it is very possible and in fact probable that certain funds will do quite well over time.  

A number of people I've read, including Josh Brown (The Reformed Broker) and Peter Tchir (Forbes), suggest the key is for active managers to move further away from their benchmarks, with more concentrated high conviction positions and higher tracking error.  As Peter puts it, "The necessity to perform is high- and I believe that necessity will actually increase risk taking and trading.  It will force managers to look even harder for that extra edge."

Think contrarian

Rob points out that the customers of active managers (that is, retail investors) tend to chase performance.  They tend to put money in funds that are working, and take money away from strategies that are not working.  This can provide a great opportunity for investors willing to take the other side of that trade!

I've focused on this phenomenon recently with energy stocks and real estate, both of which experienced oversold conditions (suggesting investors had pushed the price too low too quickly) before seeing a short-term rally.  

You'll also see this with stocks in longer-term uptrends.  For example, Advanced Energy Industries, Inc (AEIS) is a semiconductor name that has been in an uptrend for the last 16 months.


I've added green arrows that indicate when AEIS pulled back to its 50-day moving average.  The stock remained in a Dow Theory uptrend (higher highs and higher lows), and the pullbacks to the 50-day moving average indicate when investors were taking profits and pushing the stock down in the short-term before buyers continued to push the stock higher.

You can listen to the entire interview here.



Disclaimer: This blog is for educational purposes only, and should not be construed as financial advice.  Please see the Disclaimer page for full details.