Six Myths of Portfolio Construction, Part I

This is reprinted in two parts from my blog post on Hedgeconnection.com

All portfolios have at least one weakness. Many portfolio managers think they have their weaknesses covered, but as Nassim Taleb points out in his book, Fooled by Randomness, most managers build beautifully detailed models based on bad assumptions and make the mistake of thinking that their models reflect our complex world. Here are six common myths about portfolios and investor alpha that every family office and institutional investor should understand …

Myth #1: The Track-Record Bias
Would you put a portfolio together consisting of the highest-performing mutual funds of the last five years? You probably wouldn’t, because you know that these funds have more downside than upside. You know that the environment that powered these funds to success may not continue. The same goes for most hedge-fund managers. There are about 10,000 hedge funds investing around $2 trillion worldwide. Let’s suppose that 200 hedge funds have fantastic track records simply by being lucky, and perhaps 20 of those are actually good at investing. If you’re running a family office or making large investments, the only funds you will see are those with good track records. All of these funds will have a story – a story of cause and effect, showing with powerpoint slides and data that they know what they are doing. Managers with less than excellent track records won’t make it to your desk.

We know that hedge funds as an asset class do not outperform the broader markets. Assuming a few hedge fund managers actually have skill and can pick the winners, can you tell, going forward, who the winners will be? Almost all the research to date says you can’t tell skill from luck by looking at track records. Statistically, there simply have to be a fairly large number of funds with great track records and a good story – there always have been, and there always will be. Investors and hedge-fund marketers are fooled by this bias and are surprised when, sooner or later, the “absolute returns” stop returning.

Many track records are compared against a straw-man benchmark, like the S&P 500. The problem with many of the big indexes is that they are cap weighted, so companies with high valuations are over-represented. Equal-weight indexes tend to outperform cap-weighted indexes, and many mid- and small-cap indexes do even better. So if a fund has outperformed the S&P, better to ask whether it has outperformed a better index, after taxes.

Myth #2: The Smart Guys Can Pick the Winners
Buying public equities is like betting on horses. No one has been shown to be a consistently good stock picker, not even Warren Buffett. Sometimes he doessometimes he doesn’t. It depends on the measuring stick and time frame you use. A portfolio of carefully selected public stocks is either going to go up or down. If it goes up, it gives you false confidence that you know what you’re doing. If it goes down, you blame external factors. Now that we’re coming to the end of an unprecedented period of government injection of cash into public markets, do you really think the strategies that have been successful in the past four years will outperform in the future? Is Warren Buffet a member of an elite group of superinvestors who know value when they see it, or has he just been lucky? Has Ray Dalio really built a cause-and-effect machine, or has he gotten lucky? In Dalio’s case, my guess is about half of each, yet he tends to take full credit for the good years. Long/short funds with active managers must get lucky to outperform the markets. And some do.

Myth #3: Successful People Know How the World Works
We learn much more from failure than we do from success. Success is a poor teacher. Anyone who has had success also has a story about how he earned it. We hear it all the time, from Ashton Kutcher to Donald Trump. Their message is: work hard, play fair, and watch for good opportunities. They don’t have any idea how many people out there follow the same advice and the opportunities don’t come their way, or they just don’t get as lucky. Luck plays a huge role in success. Few billionaires are willing to admit that if things had gone just slightly differently, they would not have 90% of their fame and wealth.

Let’s take a statistical look at wealth and luck. This article claims that 45% of billionaires are in the top 1% of cognitive ability, showing that billionaires are more than hardworking people who got lucky. They are also incredibly smart. Let’s break that down.

First, the other 55% of billionaires may be smart, but they aren’t in the top 1% – how did they get their money? By being almost super smart? Are these people ranked lower in total assets than the 45% who are said to be smarter? Seriously, you can imagine this correlation if you want to, but it’s more likely that there is tremendous variance here, and that, as Michael Mauboussin points out, you need both skill and luck to be above-average successful.

Let’s go back to the 45% of billionaires who got good grades and performed well on standardized tests. In the developed world, where the best schools are, there are about a billion people, so the top 1% pool represents ten million people. Accounting for children and non-business people, let’s take it way down to 100,000 – the top 1% of the top 1%. This must be a group of very smart people. There are about 1,600 billionaires in the world. 45% of that would be about 700. So, out of about 100,000 super-smart people on earth, 700 have become billionaires and 99,000 haven’t. Where is the cause-and-effect in that? Did all those other people end up doing very well for themselves but made under $1 billion, or is this authorforgetting the base rate and measuring the wrong things?

One of my favorite examples is Richard Branson, who quite simply has gotten very lucky several times. Someone has to, and he’s the poster child. A great and fun guy, to be sure, and smart enough to hire people who execute well, but the vast amount of his wealth can be attributed to timing. He sold his retail empire to raise money for his airline at exactly the time when retail music was falling off a cliff and air travel increasing exponentially. There’s really no such thing as a timing genius. Timing is essentially doing what other forward-thinking people are doing and being the lucky one. Out of millions of struggling entrepreneurs, a handful come out with a few back-to-back trades that land them on the Forbes list. Richard Branson is one of them. If he were really good at timing, he could have made a hell of a lot more money than he has. Richard Branson has been the fortunate victim of a few positive black-swan events. Whoops – I should have said Sir Richard. How many hard-working people have been knighted for simply being in the right place at the right time?

It has been said that George Soros has been skillful in timing the markets, because he has made so many individual trades. But a power law applies – a small number of very big bets went his way and generated most of his cash. The vast majority of his trades could have gone either way without significant impact on the portfolio. Not surprisingly, in the few hugely successful trades, he had a systemic advantage. There is skill involved, but there is also a lot of luck.

Tomorrow: Three more myths