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On Being Contrarian

If you are a regular reader of mine, you will heard me refer to AlphaGlider as a contrarian investor. It’s a term thrown around quite a bit in the financial press, but you may not know exactly what it entails, why we consider it to be important and why it’s rare in practice. Hopefully by the end of this blog you will have a better appreciation of our thinking on the subject.

As you know, a contrarian rejects popular opinion and takes positions opposed by the field, in our case, the universe of investors. Although we don’t know who all of these investors are, we do know their collective investment preferences through the prices they set on each asset in the marketplace. The universe’s performance, in sum, equals that of the index of assets, less the friction of various fees, such as trading commissions, bid/ask spreads captured by the trading exchange, fund management fees, advisory fees, etc.

Like most active investors, AlphaGlider’s goal is to outperform the universe of investors. To beat this universe, we have to be positioned differently than the aggregate of the universe. This may seem obvious, but there is a surprisingly large industry of high cost mutual funds and investment advisors that “closet” index, collecting high fees for investing in the index. In most industries, commoditized offerings converge to a single, low cost that leaves little excess profits for its suppliers, but this is definitely not the case in the retail investment field.

But just being different from the pack doesn’t ensure outperformance over the long-term. Being different cuts both ways, causing some contrarians to underperform and some to outperform. Of course over the short-term, the random nature of asset price moves cause even the best contrarian investors to have periods of underperformance.

As it turns out, the average non-institutional investor (i.e. do-it-yourselfers and individuals using investment advisers) consistently trails the universe of investors, and by an amount substantially larger than can by explained by the friction of fees this average retail investor incurs. Dalbar, a financial services consulting firm, chalks this up to performance chasing – basically buying high and selling low. Dalbar publishes a report annually that looks at reams of mutual fund transaction data from multiple sources to estimate non-institutional investor returns. In the 20 years ending on December 31, 2013, Dalbar estimates that equity mutual fund investor returns were over 4% below the S&P 500 Index,1,2 annually.

 Source: Dalbar

Source: Dalbar

On the fixed income side, Dalbar estimates that mutual fund investors did even worse relative to their index, the Barclays Aggregate Bond Index.3 They were also unable to keep up with inflation, a painful result for these participants.

 Source: Dalbar

Source: Dalbar

Dalbar’s calculation methods have received some criticism, but no one advocates that the average investor has shown itself capable of beating the market over time, even before fees. Another organization that attempts to measure average investor performance is Morningstar, at the individual fund level. Under the "Performance" tab of each mutual fund page on Morningstar there is an "Investor Returns" link that takes you to their estimate of average investor returns in the fund (asset-weighted) versus the reported returns of the fund (time-weighted)—the difference coming from the timing of investor inflows and outflows. All of the large mutual funds that I checked showed the average investor failing to keep up with their fund’s long-term performance—all due to poor timing of their buys and sells. Or said another way, due to the propensity for the average investor to buy high and sell low.

I witnessed this detrimental performance-chasing firsthand during my time at Janus. A fund puts up strong numbers, the firm’s incentivized salespeople get behind it with advertising focused on the strong recent performance, and then individual investors and financial advisors alike rush into the fund. Then the fund underperforms, the investors and advisors get frustrated and pull out, only for the cycle to repeat. Looking up the investor returns on Morningstar for the Janus Overseas Fund (JAOSX),4 one of the main funds into which I fed investment ideas in my role as an analyst, the long-term numbers confirm this. Investors saw 6.36% annualized returns in the 10 years through September 30, 2014 while the fund itself generated 8.99% returns.

Vanguard summarized much of Morningstar’s investor return data in a recent study. Over the 10-year period ending December 31, 2013, actual investor returns lagged fund returns in all ten mutual fund categories that Vanguard examined:

Perhaps stating the obvious, the ‘average’ investor would be much better off buying and then forgetting about their investments until it was time to sell in retirement. This would at least allow them to close the performance gap observed by Dalbar and Morningstar.

Better yet, the ‘average’ investor would rebalance5 annually to restore their initial asset allocation mix. This would not only maintain an appropriate risk-level for this investor, but it may very well result in performance that actually exceeds that of the underlying investments by forcing sales of assets that recently performed well (sell high) and forcing purchases of assets that recently performed poorly (buy low). The buy/hold/rebalance strategy is hardly an undiscovered secret and nor is it rocket science, but as the numbers bear out, overconfidence, panic and other human emotions all too often prevent the strategy from being executed.

In another recently published paper, Vanguard compared a “performance-chasing” strategy (entailed rotating out of underperforming funds into a top-20 performing funds) with that of a buy & hold strategy, across multiple style boxes over the 15-year period ending December 31, 2013. Not surprisingly, the performance-chasing strategy lagged the buy and hold strategy in all style boxes:

  Source: Vanguard, “ Principles for Investing Success ”

Source: Vanguard, “Principles for Investing Success

But let’s get back to the topic of contrarian investing. We’ve learned that the average non-institutional investor performs well below the index, the aggregate of the investor universe, mainly as a result of chasing performance. Mathematically, that means that there is another component of the investor universe, that performs well above the index, at least before fees are taken into account. As no surprise to you, this is the part of the universe in which AlphaGlider strives to be. By being contrarian, by zigging when the average non-institutional investor zags, we hope to not only outperform non-institutional investors, but also the index. We employ rebalancing to force ourselves to sell high and buy low, but we also employ rigorous fundamental analysis to identify overvalued assets to underweight and undervalued assets to overweight.

Beating the markets is easier said than done as it entails selling market darlings and buying the unloved and down and out. It entails a willingness to travel outside of the pack and to be painfully visible when we are wrong. It entails being contrarian.

True contrarian investors are rare. Part of it has to due with human nature – our predisposition to be overconfident when we are initially right and to panic when we are initially wrong. But part of it also has to do with the incentive systems in the financial industry (and perhaps in society). It is better to fail in a group than to fail individually. As a portfolio manager, you’re unlikely to be fired if you ride the market down with the rest of the pack – they can’t fire the whole pack, right? But if you stray from the pack, as a contrarian might do, and get it wrong in the short-term, you might not be around to prove you were right in the long-term. It’s these types of incentives and disincentives that combine with our human nature, to cause investment frenzies and asset bubbles.

Time will tell if AlphaGlider can be a successful contrarian investor. We feel that we have the right pieces in place, namely:

  • a faith and past experience in practicing fundamental analysis to drive emotions out of investment decision-making
  • having most of my investable net worth in AlphaGlider strategies, so my utmost priority is maximize the risk-adjusted long-term returns of AlphaGlider strategies
  • a distinct lack of career risk on my part as I’ve already locked in my family’s retirement savings, allowing me to walk away from my institutional investment career in order to manage my own money and that of like-minded individuals
  • one of the lowest cost active investment management cost structures (advisory fees, fund management fees, trading fees, etc.)
Be fearful when others are greedy, and be greedy when other are fearful.
— Warren Buffett

NOTES & DISCLOSURES

1Indices are unmanaged and investors cannot invest directly in an index. The performance of indices do not account for any fees, commissions or other expenses that would be incurred.
2The Standard & Poor's 500 (S&P 500) Index is a free float-adjusted market capitalization weighted index that is designed to measure large cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization in the US equity markets.
3The Barclays Capital US Aggregate Bond Index is a market capitalization weighted index that is designed to track most investment grade bonds traded in the United States. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds and a small amount of foreign bonds traded in the United States. Municipal bonds and Treasury Inflation-Protected Securities (TIPS) are excluded due to tax treatment issues.
4Mutual funds and exchange-traded funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
5Rebalancing can entail transaction costs and tax consequences that should be considered when determining a rebalancing strategy.