This week in Outside the Box we take a gander at the always-insightful research of good friend James Montier, who poignantly addresses the pertinent topic of portfolio diversification and the pitfalls that ensue on account of benchmarking, wherein investors obsess over relative performance and their respective tracking error. James asks the question, why does the average US mutual fund hold 160 stocks, when diversification could be achieved with around 30-40 stocks. The answer in word, benchmarking.
James Montier posits that the average portfolio manager is focused upon short-term relative performance, paying scant attention to total portfolio risk, rather, the inclination of the average PM is to be primarily concerned with tracking error, that being stock specific or idiosyncratic risk. This misguided focus Montier suggests, leads the PM to manage very large portfolios in their attempt to control stock specific risk, holding nearly 4 times the number of stocks needed to meet diversification targets.
The solution you may ask? Montier suggests the utilization of Monte Carlo simulation to construct a universe of potential portfolios subject to construction rules that define your respective investing universe, thus permitting the measurement of skill to a comparable universe and impelling the manager to focus on absolute return performance.
This week's report is about some research finding from a group in Bellevue, Washington called Evergreen Capital Management, LLC. They have built a proprietary model that is used to predict when mutual fund styles (large-mid-small capitalization, value-growth) are being overbought or oversold. They believe that their model is quite good at predicting returns relative to the overall market over the subsequent two years.
This report does an excellent job of weaving together many of the themes from my past letters and book, Bull's Eye Investing. We find behavioral finance, herd mentality, why investors fail, how Wall Street works, contrarian investing and more. I think you will find the results of their research along with their other comments very valuable the next time you find yourself scanning the top performing funds of the recent past and that is why I chose it as this week's Outside The Box.