On Portfolio Differentiation

The latest from Howard Marks of Oaktree is as good as always.  But I wanted to highlight something that I found particularly important – differentiation.  Marks says:

“Here’s a line from Dare to Be Great: “This just in: you can’t take the same actions as everyone else and expect to outperform.” Simple, but still appropriate.

For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile. What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money? No one has ever answered it right.

The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different.”

This is important to understand when analyzing portfolios and constructing your own for several reasons:

• First, be wary of people who refer to sweeping studies about portfolio manager “underperformance” when they compare all funds or managers with some broader index.  The vast majority of the studies I see are engaged in apples to oranges comparisons which take something like the S&P 500 and compare it to something like an actively managed multi-strategy hedge fund.  These are two totally different animals and if they’re not benchmarked appropriately (as most funds aren’t) then the comparison doesn’t really tell you much about anything.
• Second, be wary of those who aren’t differentiated, but sell you their services as though it is.  There are a huge number of portfolio managers and strategies out there that merely mimic a closely correlated index without actually doing anything that differentiates the fund or strategy from the index.  They usually go by fancy sounding names like the “So and So Global Value Fund” or something, but the reality is that many of these funds are simply their benchmark masquerading as something different with a huge fee attached.
• If you’re going to run a strategy that adds value relative to a benchmark then it needs to be differentiated.  This can be done in lots of different ways, but it’s not easy to construct a strategy like this that would outperform a closely correlated aggregate.

Differentiation is important.  But in addition to finding differentiation you have to ensure that you’re properly benchmarking it, properly evaluating it on a risk adjusted basis and ensuring that there’s more to this differentiation than a fancy sounding name and a high fee structure.