Even The Perfect Portfolio Might've Blown Up Your Firm

(Bloomberg) Would you do it all over, knowing what you know now? For a professional money manager looking back on the bull market at its 10th anniversary, it’s a hard question to answer.

Here’s a thought. Imagine you knew exactly which stocks to pick a decade ago, the ones that would do best during the rally -- like, literally. You knew Jazz Pharmaceuticals would soar 23,000 percent, that Abiomed and Netflix would rise more than 60 fold and Exact Sciences would go from 78 cents to $85. You were granted that knowledge, and you went out and bought those stocks. What would life have been like on the way to world-beating gains?

Worse than you think. From time to time, big losses are inescapable even in a portfolio chosen with 20-20 hindsight, with underperformance often dragging on long enough to put a money manager’s job in jeopardy.

The idea is a variation on an experiment tested three years ago by the research firm Alpha Architect, in a study designed to demonstrate how futile it is for professional investors to try always to outperform. The paper, “Even God Would Get Fired as an Active Manager,” showed that perfect stock-picking clairvoyance over long stretches wouldn’t spare a money manager from rough patches that would threaten his career.

Researchers looked at the period all the way back to 1927 but Alpha Architects’s founder, Wesley Gray, and quantitative researcher Tao Wang agreed to run the numbers on the bull market to see how the perfect portfolio fared in honor of its latest anniversary. And while the pain of owning only winners was a little less over the last decade, the results still cast a brutal light on life on Wall Street.

First the (somewhat obvious) good news. An equal-weight portfolio comprising the best 100 stocks in the Russell 1000 since the bottom of the financial crisis would have returned nearly 20 times the benchmark, according to data compiled by Alpha Architect. But while arriving at that destination felt great, the travel it took to get there was rough.

Take 2011, for example. Stocks that ended up trouncing the S&P 500 over the decade fell behind the benchmark by as much as 10 percent for part of that year, a dose of weakness that would’ve tested a client’s patience. The perfect portfolio plummeted more than 22 percent at one point -- six percentage points more than largest drawdown for the S&P 500. Just half a year later, the god group suffered a three-month stretch of trailing its benchmark again. (The firm calculated returns at monthly intervals, not daily.)

The goal of the original Alpha Architect experiment was to answer the question: “If God is omnipotent, could he create a long-term active investment strategy fund that was so good that he could never get fired?” The conclusion was no. While long-term returns were obviously astounding, shorter stretches -- the ones by which fund managers are often judged -- were “abysmal.”

“Investment managers typically have a set philosophy, and philosophies don’t always work,” said Jason Thomas, chief economist at AssetMark, which has around $45 billion on its platform. “Even determining what the right thing to do in terms of performance, 10 years is pretty long. Five years is longer than most portfolio managers would keep their job if they didn’t perform well.”

Just look at the hair-raising routes of the 10-year winners to see how gut-wrenching volatility can get even in sure-thing picks. On March 9, 2009, Jazz Pharmaceuticals traded for 58 cents a share. Ten years and 23,327 percent later, it’s worth $136. From 2015 to 2016, the company lost half its value. In 2014 and last year, it suffered two separate drops of about 30 percent or more.

The next five companies -- Exact Sciences, Ulta Beauty, Lululemon Athletica, Netflix, and Abiomed -- have all endured stretches over the last 10 years when their stock fell almost 40 percent or more.

Scott Davis, who is 62 years old and a portfolio manager for the Columbia Dividend Income Fund, started his career back in 1980. What’s helped him deal with the ups and downs and constant benchmark comparisons is something that only comes with time -- age.

“You worry about it a lot when you’re younger and you’re thinking about your career,” he said in an interview at Bloomberg’s New York headquarters. “There’s a temptation to say, ‘Oh, it’s not working, I’ve got to change what I do.”’

This weekend officially marks the 10th birthday of the bull market -- the longest ever. It’s come close to extinction twice, with intraday declines in the S&P 500 topping 20 percent in 2011 and again more recently in December. Each time, it was saved at the last minute.

“One of the most important attributes of any portfolio manager is having the fortitude to go through those periods,” said Eric Marshall, president and director of research for Hodges Capital Management in Dallas.

Back in March 2009 he bought shares of Texas Pacific Land Trust for $25 each, and his portfolio has held the stock in some capacity ever since. It’s now up more than 4,500 percent, although last year its value was cut in half. Marshall’s thought process when purchasing the stock back at the bottom hinged on a simple equation.

“For this investment to work, we need one thing to happen -- the world not come to an end,” he said in an interview at Bloomberg’s New York headquarters. “In March of ’09, it was like the world was coming to an end.”


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