Creating an Actively Managed Portfolio That Outperforms

And today, we welcome back founder of NS Capital Lou Day to talk more about active management. Welcome, Lou.

Lou Day  00:40

I Doug, how are you? Thanks for having me.

Douglas Heikkinen  00:42

Good. Let's get right to it. What does it take to build a diversified active portfolio that outperforms?

Lou Day  00:50

First what I'm going to share is ns capital's philosophy and approach to building our actively managed portfolio which has delivered out performance over time. There are a lot of people that would take exception to our approach. So we are not saying what we do is for everyone.

Douglas Heikkinen  01:05

Lou, what is outperformance?

Lou Day  01:07

That's a great question, I will tell you what it means to us. And that is not beating some arbitrary benchmark or a risk adjusted return. Simply said it means making money for our clients and seeing it in their accounts. Another way of saying it is making sure that they're seeing value for the fees they pay us for the actively managed portion of their portfolios. And then this capital we run two gain seeking equity portfolios. One is a broadly diversified index strategy was seven ETFs that has over 13,000 securities globally. The other is a highly concentrated, actively managed global portfolio, which has seven money managers and currently has only 45 total securities. All of our clients generally have both strategies, usually around 5050. The ETF portfolio we see as ballast being a traditional and fundamental asset allocation approach. The actively managed portfolio is obviously dramatically different. And that is important. Everyone would like to have outstanding performance. The real question is whether or not you are willing to be different and willing to stay committed, you cannot look and act like everyone else and expect outperform. What we expect is that over time, and I don't mean all the time is that the active portfolio outperform the index portfolio. And that's exactly what has happened. Both portfolios have done very well. But the active portfolio has done somewhat better.

Douglas Heikkinen  02:38

Okay, would you share with us your approach to building your actively managed portfolio? It's the one you call the Alpha Ring?

Lou Day  02:46

Sure. Our approach has several components, recognizing the two sides to asset management, losing the science, embracing concentration and volatility. And then it comes down to manager selection and managing client expectations

Douglas Heikkinen  03:01

What do you mean by two sides of asset management?

Lou Day  03:04

Obviously, the asset management industry has changed dramatically over the last 20 years. And today, there's a very clear bifurcation. On the one side is the business of asset management. And the other side is the profession of asset management. And they are very different. The business side is dominant. It's made up of huge companies mostly public that control the vast majority of active assets under management. Today's business model is for these firms to gather as many assets as possible to collect fees and generate profits. The firm's really show a greater loyalty to their stockholders than they do toward optimizing returns for their clients. It's asset size that define success. When you look at the business side, it's pretty obvious that a brand okay is not a surrogate for value. The large brokerage firms insurance companies and banks for a long time have used the power of their brands to earn what we see is an unwanted price premium on products and services. These price premiums benefit the company's at the expense of the clients and economics This is referred to as an agency problem. The profession is very different. It is mainly smaller, privately owned firms with very focused strategies, not trying to be all things to all people. Success in the profession is totally dependent on one thing, client outcomes. What john Bogle said for years about public companies was prescient. You can't serve two masters clients and n stockholders. When it comes to active management, we do not do business with any public companies. We only do business with money managers that we deem to be in the profession.

Douglas Heikkinen  04:48

Lou, what do you mean by losing science?

Lou Day  04:52

What I mean is the industry has co opted academic science and repeatedly turned it into sales tools. Most often totally. From the actual science, Nobel laureate modeling the Princeton study being miscast that asset allocation is largely responsible for all returns, efficient frontier risk adjusted returns, volatility is risk, I could go on and on. Okay? Our take is if these things as they are sold, probably do more to dampen returns as opposed to enhancing returns. If you want to generate returns, you cannot let mindless diversification and theoretical precision overwhelm good judgment and common sense. Here's some facts about diversification that you'll never get from the business side of asset management. There is little difference between owning 20 stocks and 1000. The benefits of diversification and risk reduction are minimal beyond the 20th stock. So owning more stocks than necessary takes away the impact of large stock gains, and limit your upside.

Douglas Heikkinen  05:59

So what does ns capital do that's different, what's special?

Lou Day  06:04

First, its concentration, we get a small number of stocks from each of the seven money managers that we use in the alpha ring. And second, we don't see volatility is a proxy for risk. You know, as I said, our beta core or ETF portfolio with 13,000 securities, you know serves as ballast, or alpha ring is about shoot for the fences stock picking. Each of the seven managers implement a highly concentrated portfolio. On average, we get somewhere between four and seven stocks per manager. If the listeners want to learn more about why this strategy makes sense, there's a great article in the Journal of portfolio management called conviction in equity investing. Some of the key points are these conviction is defined as money managers willingness to take risk and express beliefs through a bowl course of action in pursuit of long term goals, or high conviction strategy consists of taking fun risk with highly active strategies that represent the absolute best ideas of the manager. High conviction strategies require long term focus and patience with short term volatility. And investor who seeks to achieve excess returns from active management can only do so by proactively identifying the best managers.

Douglas Heikkinen  07:24

So how do you do that? How do you identify the best managers?

Lou Day  07:28

Well, first we have staffed it Okay, Todd Peters. Okay, the chair of our investment committee comes from the institutional consulting world. With over 20 years experience Todd has conducted due diligence research on over 4000 managers and Todd is mainly responsible for the identification, selection and monitoring of the money managers that we work with in the offering. Speaking for Todd, who will be doing a deeper dive on this subject in some future podcasts, we do not believe a winning strategy is simply built on rigid tactics, mathematical formulas, or risk reducing rules. And its capital is always looking for money managers that have the intellectual skill, and the emotional courage to stray from the crowd. We believe that market beating managers express their insights with portfolios that differ dramatically from a benchmark. Ultimately, we're looking for specific characteristics. Small focus firms, their employee owned the skill to build concentrated portfolios, side by side commitment of their own funds, a willingness to negotiate fees and identifying capacity limits for their strategy, and then a willingness to close in the face of diminished opportunity. And capacity is critical because opportunities can be exhausted by size. Let me share a capacity story about Peter Lynch, one of the most famous mutual fund managers of all time, in his time as a portfolio manager for for fidelity's Magellan fund. We all know that during his tenure as Portfolio Manager Peter Lynch trounced the market overall. But there are some interesting facts laid out by William Bernstein in his books, the four pillars of investing. What most people don't know is the Magellan fund got it started as a private investment vehicle for fidelity founding family. The Johnsons Peter Lynch was handed the fund in 1977. And even then it still stayed private until 1981, which is when it was actually opened up to the public from 1981 to 1990. The fund reported returns of 22.5% versus 16.5% for the s&p excellent returns to be sure, but nothing close to Buffett's returns during the same period. And as a matter of fact, there were there are more than a dozen other funds that also beat the s&p by the same percentages at Lynch. Now, it's not commonly realized that the investing public only had access to Peter Lynch for only for nine years. And the fact is, he started with a real relatively small 100 million dollar fund. Pretty much all of this outperformance came when Lynch was managing an amount of assets that allowed him to be nimble while executing his strategy. In the last four years of his tenure, the fund had grown to billions of dollars, a point at which Lynch had to exert enormous effort against expenses to maintain a razor thin margin of victory. Then in 1991, Lynch was out the door, he realized that Mogens ballooning acid base, which was now 16 billion, would make it very difficult for him to sustain the performance of his famous built on. He wisely knew that the front is exceeded the capacity for his strategy, and he was smart enough to get out on top. Now, I did work out for clients. Well, maybe okay for the lunch area, but I kind of doubt it, because Magellan bled a huge amount of assets during the 87 crash. I think it was published somewhere the average investor return during Lynch's reign was about 7%. And what about after Lynch left? Off Lynch's track record, fidelity grew the Magellan fund to $125 billion. And overall, it performed poorly on that march up. Now that bad performance eventually caught up and today the Magellan fund has totally round tripped and jettisoned over $100 billion. I call this story the tyranny of performance numbers for actively managed mutual funds. And Magellan is in no way an isolated case. The large asset gathering mutual fund companies all too often publish performance numbers that have more to do with marketing than investor reality. You know, as I said, capacity is critical, because opportunities can be exhausted by size.

Douglas Heikkinen  11:47

Okay, Lou, we get what NS Capital believes and does. What about advisory firms that don't have the resources to staff the way you did?

Lou Day  11:56

My advice would be to get a subscription to the mutual fund observer, other than the fact that they use mutual funds and we don't their thinking is closely aligned with ours. They do a great job of identifying asset managers in the mutual fund industry that are relatively small, independent, and have aligned interests with their shareholders. They also focus on funds with an active share that demonstrates if their holdings do not mimic a benchmark index, so no closet indexes. If you want to find a mutual fund that has a shot, I would trust them a lot more than morning store.

Douglas Heikkinen  12:27

Let's go back to volatility. Tell us more about how you deal with it.

Lou Day  12:33

Actually, we don't we come from the buffet camp. Only with full market volatility will you get full market returns. For our alpha ring our one year number as of June 30 is plus 79%. Our five year number is over 20%. Now those numbers never would have been possible if we hadn't jumped on the opportunities presented in the cielos in December of 2018 and march of 2020. As I said, for us volatility is not a proxy for risk. We define risk two ways. One for selling in a down market which can lock in permanent losses, and two, having an unfunded future goal. In the decades since the financial crisis, volatility has created nothing but opportunity. Look at what continues to happen. The rapidity of information causes investors to shorten their time horizons at a time when they should be lengthened. What is most newsworthy, there's no necessary relation to what is most investment worthy. And over and over again. The reason dramatic swings go well beyond what the fundamentals suggest. since the financial crisis and the.com crisis as well, those are the second and third worst sell off since the Great Depression. Fear has become the most dominant functioning cog in the investment machine. equity investors get paid handsomely for facing those fears, because they can take advantage of the behavior of others who won't.

Douglas Heikkinen  14:04

Last but certainly not least, let's talk about managing client expectations.

Lou Day  14:10

Yes, this may well be the most important aspect of delivering outsized returns for clients. We spent a lot of effort educating clients that no significant returns will ever be made by clients asking for certainty. We tell them you can't expect consistent results if you wish to seek higher returns. Because even the most skilled managers will underperform for periods of time. It all comes down to portfolio construction. The key to protecting investors has nothing to do with individual securities. It has everything to do with an approach to total portfolio construction that delivers the proper balance between offense and defense, a portfolio that strives for safety and certainty alongside the pursuit of gain seeking. That is what ns capital strives for. This approach enables clients to emotionally absorb the why Short term price movements. And that is a critical component of maximizing long term returns, you have to be able to ride out the inevitable downturns without being a forced seller. The thing we stress is that no one should invest in equities without a longer term horizon period. We go as far as to say to a prospect if they're not willing to give us equity money for five years, and we're really not interested in managing their money. You know, to wrap up, okay, these represent the beliefs and a philosophy that we stick by. So far, it's worked for us and it's worked very well for our clients.

Douglas Heikkinen  15:36

Lou, this is just great stuff. Thank you so much for joining us,

Lou Day  15:45

Doug. Thanks for having me.

Douglas Heikkinen  15:50

For everyone at ns capital and the conviction creates alpha podcast team, we wish you will take care.

This podcast is for educational purposes only and should not be construed as investment advice. And as capital performance mentioned during this podcast has been calculated netta fees represents an average return over several periods unless otherwise specified, and it's not a guarantee or indication of future performance. The views expressed reflect the current views of ns capital as of the original recording date, and may change without notice to the viewer. There is no guarantee that any projection forecast or opinion in this material will be realized. All investments involve risk including risk of total loss, and you should consult with your financial advisor before implementing any investment strategy. All information is believed to be from reliable sources. However, ns capital makes no representations as to its completeness or accuracy. And as capital does not provide tax or legal advice, and urges you to consult with your tax advisor or attorney for those specific matters.