Un-natural advantage

Aadil Omar

Michael Phelps was built to swim fast. Based on nothing more than his physical attributes and his 23 gold Olympic medals, I would not be remiss in suggesting he was born with a natural advantage.

This sort of anatomical advantage is not unusual to observe in the domain of elite physical performance. A simple internet search will reveal all sorts of biometric data on elite athletes from which one can easily connect the dots to outstanding performance. But the further from physical competition one veers, the less apparent these explicit advantages and the trickier it becomes to rely on deductive reasoning to predict performance.

Take chess champions for instance. If you asked me what makes Gary Kasparov or Magnus Carlson the best chess players to have competed in the game, I’m not sure I could answer that question by succinctly identifying an explicit advantage.

We can appreciate that the more complex and multi-faceted the game, the more difficult it becomes to articulate the advantage. Both games, however, occur in a relatively static environment where outside variables or shocks play no role whatsoever -- i.e. there is no random variable. Competitors know exactly what is required to win and what variables are at play at any moment. Trying to determine the explicit advantage in a real world setting where random variables are present gets even trickier.

Non-explicit
I have always found the intuition around an advantage or “edge” in investing tricky. Any advantage a money manager might possess will not be explicit the way a Phelps advantage is. Competitive advantages in the money management industry tend to be rather opaque. Observations are tricky and description almost always must be analogous if not conceptual. A basic internet search seeking the sources of an edge in investing revolves around ideas such as discipline, patience, risk tolerance, analytical rigour and other generalisations. Very rarely can one find an explanation detailing an explicit advantage unless it is in some way related to the possession of material non-public information1. This is not to say that advantages in money management do not exist, but rather that any advantage is unlikely to be explicit in nature.

I’ve spent some time arguing against an explicit advantage in the money management industry, but I will re-iterate that this does not imply a manager cannot have an edge. Often, an edge is an emergent feature of a clear philosophy and a well-executed process. It only shows itself over time.

As much “what” as “how” we play
Unlike professional swimmers and chess players, investors have much greater degrees of freedom. Within the confines of a mandate, an investor can dial up risk or step back based on market dynamics. Coincidentally, this means an investor can narrow the “field” to the point where an advantage is more likely. In contrast with Kasparov, who cannot simply eliminate the rooks from the chess board just because he happens to prefer bishops, an investor can opt into the sort of investments they believe offer the best prospects. It is therefore not uncommon for investors to be labelled along the lines of their preferred “playbook”, such as value investor or activist trader. These diminutive labels are not that descriptive in detailing the source of an edge, but closer scrutiny of an investment philosophy and process can be illuminating. Warren Buffet famously pointed to three key elements that he attributes much of his investment success to: 1) stay within your circle of competence; 2) invest with a margin of safety; and 3) invest in companies that have a sustainable competitive advantage and are managed by capable stewards of capital.

At M&G, we have similarly been focussed on a few key tenets on which we consistently rely to inform our investment decisions:

- Focus on long-run anchors of value
- Minimise the short-term noise
- Construct portfolios in a risk-conscious manner

Whilst I maintain that explicit advantages are not apparent in the money management industry, looking back it appears that an emergent edge may well be prevalent among certain managers. As in any game, a demonstrable and consistent track record is the closest thing we have to proof of an edge.