The Obliquity Portfolio: an introduction

I’ve become bored of index trackers.

Trackers are still good for you

It’s now a well known thing that active managers as a group have a hard time beating the index, which makes sense given that to a large extent, the index is the average of active managers and their ilk. For active managers to beat the index, there would need to be a category of investors that systematically does less well. It could be argued that retail mutual funds are not a majority on the market, but the people who manage non-retail funds professionally basically come from the same pool as those who do retail and have no reason to perform differently. Direct retail investors could be that category, but they’re small (single digit percentage of the market at most I would guess) and they’re collectively random. Retail investors underperform via crap timing and transaction cost maximisation through excess churn, not by having consistently negative insight as stock pickers. These errors they can make with index trackers as well, which do not account for bad timing or churn.

So in a perfect world the return of active managers should be the same as the trackers less the excess management fee. Even if they turn out a bit better than the other categories, it is improbable that they could earn the typical 1% annual excess fee in the (compounded) long term.

There has been arguments that the success of index trackers will diminish their efficiency, which is at the limit is true (if 99.9% of the market was trackers, we’d have a problem) but with pricing at the margin and mainstream cap weighted trackers being mostly passive observers of prices — they do not trade in steady state — I doubt this effect could come to dominate. There will always be a sizeable contingent of market participants who think they can add value, regardless of actual ability, in addition to those who actively try to exploit and thus cancel any emerging “index effect”.

So basically index trackers are still probably the best choice for a non professional long term investor who wants exposure to the stock market.

An oblique approach to investing: the index less crap

Yet, I’m bored of them. Every time I go through a tracker’s holdings list, I start thinking, of about a third to a half of the names i recognise, “this is a shite business I don’t want to be invested in”. I have a suspicion that mediocre businesses do, on average and in the long term, less well than good businesses. I have no formal proof for that, beyond anecdotal evidence that famous buy-and-hold long term investors tend to be successful via investing in non-crap businesses, and that businesses that tend to last decades tend to be those that offer some valuable service or product to their customers.

John Kay has been arguing that complex objectives are best attained via indirect means. The idea of the Obliquity Portfolios is to start with the simple concept that shite companies probably underperform, and that it only takes a modicum of common sense to identify a bad company. Basically let’s take an index and strip it from “obviously” crap companies. This should be much easier than picking the very best positively. In addition, it is a narrow objective, that, critically, doesn’t require a pricing model — we just assume that crap companies are on average always a bit underpriced.

What if there was no mispricing? If investors priced in the mediocrity of a business accurately, and that this mediocrity indeed had adverse economic impact on the business itself, they would just be cheaper relative to their good peers, reflecting poorer prospects and accomplishing an efficient market, where basically every instrument returns the same in risk adjusted terms. Why should crap companies be mispriced? I think there’s a chance that similar biases to those that produce the low volatility anomaly are in effect when it comes to the valuation of crap businesses.

In any case, even if crap companies are not mispriced, it is still hard to underperform with a portfolio of good companies. Given broad enough diversification, any sampling technique based on a meaningless criteria will still get pretty close to the index. Filter out companies with an odd number of letters in their company name out of a large index, and you will end up with a random half on the index that will perform very close to the full index: the sample just needs to be big and unbiased enough to approximate the full set. So for a well diversified “good company” strategy to fail, an opposite mispricing would be required: persistent and sizeable overvaluation of good companies.

Large caps as sectoral investment trusts

Another reason to go stock picking is that it’s not in essence that different from asset picking. Investors in index trackers still usually want to mitigate methodology, asset class and tracking implementation risk, so are still left with making decisions on a portfolio of asset classes and indices. There are hundreds of indices to choose from. Nowadays large cap companies are largely sectoral indices, often widely diversified geographically and in business lines within a sector. IBM is like a closed ended fund specialising in IT, BHP Billiton similarly so for mining, etc. In building a full portfolio why not go direct to these and avoid an intermediate layer, with extra fees and implementation risks, however minimal in the case of trackers?

So the portfolio will have a large cap bias, though likely little different than the natural one in whole market cap weighted trackers, for the benefits of in-sector diversification a large company provides. Small business portfolios can only be done either with an edge in a particular industry, or as large samples to recreate diversification statistically, both of which are not realistic for what this is trying to achieve.

Check lists

The actual criteria used to identify a “good business” is basically common sense, but it can still be decomposed in a handful of sub-criteria, the details of which I will expand on in a future post. This seems a perfect fit for Atul Gawande’s checklist idea. This has already proven valuable in the preliminary work, as repetitive churning through lots of potential constituents makes it very easy to forget the boring details. Some companies I would have intuitively let through for passing my basic test failed a more thorough checking of the subcriteria, even for a fairly simple criteria set that any moderately competent person could assess, from public data, in an hour or two for a given stock.

Low maintenance

As this portfolio will be invested with real money, I have to take care about transaction costs, and also with being long term maintainable without requiring constant nursing. I don’t have any plans to spend most of my time on this. As it is biased towards “good” and large cap businesses with long term prospects, a classic passive “never sell” portfolio should do. A sale should happen only because a business has changed enough to fail the inclusion criteria, or has outperformed so much as to be overweight in the portfolio in which case it needs to be cut back to size. An annual review of each existing holding should be more than enough.

Open source

It’s quite common practice for the failed investor to realise that, rather than beating the market, it is actually easier to profit from the naivety of the next generation of hopeful investors and become part of the finance industry; by becoming a broker of some description, or getting commissions by channelling the naive to some dubious service or other, or selling subscriptions to a tip sheet packed with one’s random investment ideas. There are platforms to publish one’s portfolio and get followers to pay for the benefit of tracking it. Doing this is a clear sign of failure. Those who can’t invest talk about investment, and charge for it.

In so far as I keep running personal portfolios in the Obliquity style, I will publish the holdings and weights for free, here or on any convenient open platform. The finance industry could do with more open source spirit. It wouldn’t take many vaguely enlightened amateurs — I wish others more enlightened than me did it — to make fee-based active management a vintage niche product.

Disclosure: the Obliquity Portfolio is in design phase and thus 100% in cash.

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