Last month we examined the effect of big data, smart algorithms and super-fast computers on share trading. The conclusion reached, based on a recent study, was that human traders are finding it very difficult if not impossible to beat the deadly trinity mentioned above. As far as share trading is concerned, computers seem to have won the day.
But what about share picking? Can computers do better than human fund managers when it comes to selecting shares to beat a sector index, or in selecting a share portfolio to beat a market index? Here the news is more promising: recent research in the UK showed that, of 426 active fund managers, 100 of them managed to beat the market over an average 18-year career. What’s more, their outperformance averaged an impressive 4.6% per year, adding huge value for investors.
True, 76% of active fund managers were defeated by computer-based tracker funds. But if you wanted to outperform the market and not simply match it, you had to turn to a human being. This raises two interesting questions: how did the humans do it, and why are computers, even the current generation of super-fast machines, not able to defeat the best human fund managers?
After all, way back in 1997, the IBM computer Deep Blue had done the unthinkable by defeating Gary Kasparov at chess. Kasparov, the top-ranked chess player in the world between 1986 and 2005, and generally regarded as the best ever, had never lost a chess match until his run-in with Deep Blue. Surely, with the advances in computing speed since the late nineties, computers should be able to outperform human fund managers by now?
How the humans do it
In the first instance, let’s look at how the best active UK fund managers achieved their success. It appears that these managers operate in areas of the market that are less-well researched. This includes smaller companies or mid-cap stocks, for example.
So 14 of the top 100 fund managers run UK smaller company portfolios, while 33 of them combine mid-cap and smaller company shares. Only one of the top 100 UK managers runs a portfolio of US shares, supporting the suggestion that highly-researched markets, such as those in the US, make it very difficult for fund managers to add value.
Giles Hargreave, the top UK fund manager, also runs a UK small company fund. He explains that he searches far and wide for suitable investments. He meets as many company management teams as possible, and is happy to invest in ’micro’ businesses, i.e. those with market caps below £75 million. Many fund managers avoid these companies, regarding them as too small.
Hargreave is also unusual in that he has holdings in over 200 companies. A company failure therefore inflicts minimal damage, as Hargreave limits his investment in any one company to a maximum of 2% of the overall portfolio value. His basic strategy then is to construct a large, diversified, low-volatility portfolio, consisting of small companies that deliver better than average performance.
Fifth-ranked UK fund manager Mark Slater takes a different approach. He considers the entire universe of shares, so that his portfolio is made up of certain large blue-chip stocks, alongside a selection of small and mid-cap shares. This suggests, perhaps, that in the final analysis it is stock-picking ability that separates the best managers from the rest. Whether the focus is on small, mid-cap or large blue-chip shares, winning fund managers are somehow able to spot shares that will outperform the market over long periods of time.
Why the computers can’t compete
Statistician and master-forecaster Nate Silver notes that computers are formidable machines. They make extremely quick calculations with 100% accuracy, and never get tired, emotional or irrational. However, computers are not perfect forecasters. The old ’GIGO’ rule still applies, so that ’garbage-in,’ in terms of bad data or faulty programming, will result in ’garbage-out,’ or invalid findings. More importantly, computers are not good at tasks that require creativity and imagination, something that humans (or at least some of them) excel at.
So what about Deep Blue and Gary Kasparov? Well, explains Silver, computers are very good at games like chess, which depend on relatively simple and well-understood laws. But where the understanding of root causes is less-well understood, computers are on much shakier ground. As experience reveals, only around one-in-four active fund managers has the magical ability to pick winning shares. What’s more, each one has a slightly different or even completely different strategy, so that the understanding of what makes a winning share is still shrouded in mystery. And computers don’t handle mystery too well!
Do successful fund managers understand their choices?
Some of you will have been surprised by my use of the word ’magical’ when referring to fund managers’ stock-picking ability. However, a study in late 2016 by the University of Cambridge suggests that more than intelligence and training may be involved when it comes to investment success.
Cambridge researchers tested hedge fund managers for their ability to read their own physical symptoms, or ’gut feelings,’ when it came to making buy and sell decisions. The researchers concluded that ’signals from the body, the gut feelings of financial lore, contribute to success in financial markets.’
Significantly, given the high levels of experience of the top ten active UK fund managers, the Cambridge researchers went on to say that: "Veteran traders did better still than their more junior colleagues. While junior traders, those with no more than four years of market experience, scored 68.7, only slightly above average for the control group, their mid-ranking colleagues scored 76.3, while senior traders, those who had traded for at least eight years, did better with a score of 85.3."
These findings, although based on a single study, suggest that successful stock pickers may depend on more than intelligence and qualifications for their success. Gut feelings may also play a part, and the accuracy of these feelings may be enhanced by experience. This may also suggest that successful investors are more likely to be foxes than hedgehogs!
Foxes and hedgehogs
Philip Tetlock, an American professor of psychology and political science, has studied the cognitive styles of so-called experts. Cognitive styles refer to the way in which people form beliefs about the world, and specifically about the way in which it works. Tetlock classified his experts along a spectrum which he called hedgehogs and foxes. He took these titles from a passage by the ancient Greek poet Archilocus, who noted that: “The fox knows many little things, but the hedgehog knows one big thing.” This is thought to refer to the fact that, when threatened, the hedgehog will always roll up into a ball. The fox, however, will make use of a variety of different methods to escape danger.
The characteristics of these two cognitive styles are as follows:
- Hedgehogs believe in Big Ideas - governing principles about the world that behave as though they were physical laws, underpinning virtually every interaction in society. An example might be Donald Trump, who sees his ’America First’ policy as the solution to all of the US’s problems.
- Foxes on the other hand take a multi-faceted view of reality. They appreciate that the world is a complicated and often unpredictable place, with many inter-related aspects. Foxes are more comfortable with uncertainty and complexity, and are generally more open-minded and less likely to jump to conclusions.
Tetlock found that Hedgehog experts would state their predictions boldly and with conviction, but were far more likely to be wrong. Foxes, on the other hand, were generally more cautious and circumspect in their predictions, but were also much better at forecasting the future.
Until computers can be taught to think, human fund managers are likely to have the upper hand when it comes to selecting winning shares. And even then, human gut feelings may give us the advantage. Fund managers should be judged on their long-term results, and beware of those Hedgehog managers with fixed ideas and firm convictions. A cautious Fox who considers the bigger picture and all of the underlying variables, and then trusts his gut, may turn out to be the best of all!
AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.