The solution is changing the process of active management of equities.

To better appreciate the Outdexing process it is worth looking at how equities are actively selected and managed most most investment managers, today.

The iconic scene in the Australian movie, The Castle, is not dissimilar to how a small, but not insignificant, number of investment managers, financial advisors and stockbrokers pick stocks for their client’s portfolios.

The common process that traditional active equities manager use to creates portfolios is as follows:

  1. decide they want to be a top decile performer, because that what they think clients want, and it is easier to get funds from investors with that objective;
  2. the portfolio starts with a clean slate;
  3. filter their benchmark stocks using some form of quantitative screening;
  4. do some fundamental analysis on the most likely “buy” candidates;
  5. add their highest conviction “buy” ideas to the portfolio from their benchmark universe;
  6. look at their portfolio and realise it is really concentrated and not appropriate for +99% of investors even if the manager has promised top decile performance;
  7. add increasingly lower conviction buy ideas until they have a non-concentrated, and more diversified, portfolio which they can still market to investors with an aggressive performance target;
  8. tell investors that they expect to beat the market, say, index+3%; and,
  9. eventually, report index+0% returns, not top-decile, but with 6% of risk over a 10 year period, if the manager survives.

Little wonder that few active equities managers outperform their benchmarks because the returns of the lower conviction ideas usually wipes out the gains of the highest conviction stock ideas.

Outdexing works differently:

  1. we set the objective to be second-quartile manager (index+1.5%), as believe it is more realistic target;
  2. portfolio construction starts with the all the stocks in the benchmark in the portfolio;
  3. filter the benchmark stocks for the usual characteristics of companies going broke, or needing to raise capital;
  4. do some fundamental analysis on the most likely “sell” candidates;
  5. the Outdexing portfolio manager then removes the stocks in which he has the highest conviction will under perform the market;.
  6. the Outdexing portfolio manager then tells investors they expect to beat the market by 1.5% and with a risk of 1.5% (tracking error); and,
  7. after fees the Outdexing investor-client should be better off than having their money in a traditional active manager, or an index fund (somewhere in 2nd quartile consistently).

After +30 years in financial markets, it is apparent to us that it is easier to select stocks that are going to underperform than those whose stock price will grow faster than the market.  The Global Financial Crisis of 2007-2009 demonstrated that differentiating between the best and worst stocks in a benchmark can be more profitable for investors than trying to differentiate amongst the better stock investments, because it is more obvious to the fund manager.

While some may look at the resulting portfolio and say it is almost an index fund, that does not appreciate that only our highest conviction ideas based on fundamental research have been implemented in the portfolio.  Unlike the index managers of the last few decades we don’t have to own, and watch the train-smashes of Enron, Worldcom, Kodak, Refco, Texaco, Pacific Gas and Electric, Chrysler, MF Global, Lehman Bros, Bearn Sterns, Babcock & Brown, Alco, etc….