Businesses exist to solve problems, so what is the problem that Outdexing was created to solve?
Active managers of equities are losing market share to index funds because the active investment manager returns are inconsistent with the risks that the clients are taking.
Essentially, active managers want to “shoot the lights out” and are often trying to get +3% above the index, but are taking +6% of risk. The net result is that over the long-term active managers, if they survive, and this is a big if given the volatility of their results, they often fail to outperform the index. Why do they do that? It is easier to get clients and raise funds if you market the “return objective” of top-decile or even top-quartile performance: regularly beating the index by a little, after fees, is not as sexy.
Outdexing, or an Outdex portfolio, is about managing return and risk, so long-term second quartile performance is possible. Why not just invest in index funds instead of actively managing by picking stocks?
Index funds are called passive investments because you don’t pick stocks. The only decision an investor makes is to determine the asset allocation to equities. Within the equities component, there is no opportunity in an index fund to better balance between returns and risks for the individual investor’s risk preferences. The investor gets the “beta” return of the market, but there is no “alpha” return.
The reason we don’t like index funds is that you don’t have to be genius to identify a company that is going broke, or is seriously broken, so it doesn’t make sense to hold it by investing in an index fund and then watch the on-coming light in the tunnel run you over. Fundamental analysis (cashflow analysis, SWOT, etc) can be used simply to identify a company that is performing badly, or which is underperforming its peer group.
Additionally, if you want to put some overlays, such as not investing in tobacco stocks, you can’t do that with an index product.
So how do you improve the return and risks of an actively managed equities fund?
Outdexing focuses on the highest conviction ideas (in our case the stocks we dislike the most) based on a fundamental analysis of the company’s prospects. Then, we apply some basic mathematics to construct a portfolio where the expected return is higher than expected risk. To use the jargon, we want our information ratio to be above one (1).