Competitive Advantage and Long-Term Fund Performance

by Mike Holman

About the Author: Mike writes at The Oblivious Investor, where he regularly reminds readers to ignore the noise of the market. If you like this post, subscribe to his blog to read more. I’m a regular reader.

Imagine that you run a business making a physical product. For example, let’s imagine that you’re in the construction industry, and your business makes concrete.

And by some manner of genius, you invent a new formula that allows your concrete be just as strong as the best concrete on the market, while weighing significantly less per cubic foot. And the best part: your concrete even cost a bit less than that made by your competitors.

What would you do to protect your competitive advantage? Probably something like:

  • Get a patent for your new formula, and
  • Do everything in your power to prevent your competitors from getting their hands on the new formula.

How long do you think your competitive advantage will last? I’d guess it’s a few years at most before a competitor comes along with a new invention to make your formula obsolete.

Now, imagine instead that you aren’t allowed to file for a patent. Also, imagine that you aren’t even allowed to keep the formula secret. Instead, industry regulators require that every 6 months, you publish the precise formula for every product your company makes.

In that scenario, how long could your competitive advantage possibly last?

That’s what it’s like in the mutual fund industry.

If a fund manager is sure that a given stock is going to outperform over the next period, there’s nothing he can do to keep other fund managers from buying that same stock. The idea of patenting “owning shares of Coca Cola” is ludicrous.

Similarly, fund managers can’t keep their holdings a secret. They’re literally required to publish them on a regular basis.  (Quick note: I’m not saying this is a bad thing.) And with as much competition as there is in the mutual fund industry, you can bet that each of the major players is closely watching what the others are doing.

In that kind of environment, even if a fund manager does come up with a legitimate strategy for outperforming his peers, how long could he possibly hope to maintain his advantage before everybody else figures out what he’s doing?

Is it any surprise, then, that it’s so rare for managers to be able to consistently outperform for sustained periods of time?

Similarly, what does all this seem to indicate about the prospects of a fund manager who has just beaten the market for the past few years in a row?

About the Author: Mike writes at The Oblivious Investor, where he regularly reminds readers to ignore the noise of the market. If you like this post, subscribe to his blog to read more. I’m a regular reader.

Be Sociable, Share!

Want to learn more about RESPs? Buy The Book:

Resp-Book

The RESP Book: The Simple Guide to Registered Education Savings Plans

Everything you need to know about RESPs.

See it on Amazon now

{ 7 comments… read them below or add one }

1 Dividend Growth Investor

Buffett’s Berkshire Hathaway comes to mind whenever I hear about mimicking other investor’s portfolio. The main problem with mimicking other people’s strategies is that they might have different risk tollerances than you.
For example I am a buy and hold dividend growth investor, who likes to dollar cost average into stocks that offer dividend income growth potential. If a company does cut its dividend however I sell, even at a loss. If someone is not comfortable selling at a loss, then they would have a hard time replicating my results.

2 Charles in Vancouver

It could work the other way too, couldn’t it? Fund A makes a bet on (let’s say again) Coca-Cola 5 months before their portfolio disclosure, and bets against PepsiCo. At disclosure time, everyone decides Coca-Cola is a good bet too. So funds B-F also purchase some Coca-Cola, and sell or short-sell PepsiCo. Fund A has now benefited so much from their copycats (by driving market prices) that they can safely close their positions at a profit and pick a new bet.

3 ObliviousInvestor

Hi DGI.

I imagine that you’re right, as far as individual investors go: Replicating somebody’s portfolio just because they’ve had good returns lately isn’t exactly a wise strategy.

I was really only intending to make a statement about the mutual fund industry. And no, I don’t suspect that mutual fund managers simply go and copy other managers’ portfolios every 6 months.

What I do strongly suspect is that they put some serious time & money into analyzing the portfolios of the people who are putting up the best numbers. And it’s probably difficult to keep your strategies a secret when you have to disclose so much on such a regular basis.

4 Canadian Money

Can you define what you mean by “market noise”?

5 ObliviousInvestor

Sure. My definition of “noise” is pretty inclusive. The way I see it, anything that you can neither impact nor predict is simply noise and is best ignored.

In other words, day-to-day, month-to-month, or even year-to-year market fluctuations are simply noise for most long term investors. Most of us would be better off ignoring them completely, and focusing instead on things that truly are predictable: Long-term market returns, for instance.

6 Frank

I used to manage mutual funds and I never found the disclosures of my competitors funds that useful, nor did I worry about them seeing mine. They’re really pretty stale, at least 90 days old, by the time you get them. You might find out that another guy did well the quarter before last because he owned Coke, but so what? The fact that Coke did well wasn’t a secret and you don’t know what he owns now.

I think your analogy of the concrete company isn’t far off. Your competitors can see the concrete you made, but that only tells them a little about how you made it. Similarly, unless you know how and why a portfolio manager decided to buy Coke, you can’t effectively replicate what he does.

7 ObliviousInvestor

Hi Frank,

Thanks for the feedback. It’s great to get the viewpoint from somebody who’s actually been there before!

Leave a Comment

Previous post:

Next post: