What’s Your Edge? (1)

By Logan Ingalls from South Boston, MA, USA (11g poker chips) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

Sleep per Day: (Target) 7h30m / day (Actual) 7h17m  / day (55 day average)

What’s Your Edge series – Part 1 Part 2 Part 3

I read a beautiful article on Seeking Alpha called “The Sustainable Active Investing Framework: Simple, But Not Easy” that made me re-think about what my edge is in this market and how I can maximize that to beat the market.

The article used an analogy of poker when it came to evaluating where one can have the biggest edge to win, namely:

  1. Know the fish at the table (opportunity is high)
  2. Know the sharks at the table (competition is low)
  3. Find a table with a lot of fish and few sharks (sectors of market and overall market conditions)

I’d like to delve even deeper into each aspect, and I’d like to start with sharks (competition) first.

The author mentioned that the sharks you want to avoid are the hedge funds or institutional titans. Not only are they to be avoided because of the intense competition they will bring, but also the fact that according to the SEC, institutional investors own 73% of the whole US stock market, so what they do and what impact to the market it will subsequently bring needs to be taken into account of.

Among these investors, the different investment philosophies indicate where these investors play in, how their actions affect the market, which will then reveal the path to where a retail investor like me should play in to maximize fishes (opportunity) and minimize sharks.

So what investment philosophies are there in play for these hedge funds or institutional titans? In “Investment Philosophies” by Aswath Damodaran, he has the following categories:

  • Market Timing
  • Charting and Technical Analysis (Technical)
  • Small Cap and Growth Investing (Growth)
  • Value Investing (Value)
  • Information Trading (Information)
  • Arbitrage
  • Passive Investing (Passive)
  • Non-Equity [This is an additional category I’ve added]

I can’t find the specific breakdown of how many of these hedge funds or institutional titans adopt the aforementioned investment styles, but I will use the breakdown of the top 25 mutual funds in the US as a proxy of investment philosophy preference of the sharks [1].

The investment philosophy is also further summarized into four camps, namely Growth, Value, Passive and Non-Equity since one of the better ways to categorize the following funds’ investment philosophy is to follow a third party’s classification instead of relying on my personal qualitative assessment. For this exercise, I will rely on namely Morningstar’s judgment.

The top 25 mutual funds in the US currently as of Aug 19th 2015 [2]:

Rank Fund Name Investment Philosophy [3] NAV ($Billion) [4] % of Population
1 SPDR S&P 500 ETF  Passive  176.92  6.34%
2 Vanguard 500 Index;Adm  Passive  215.39  7.71%
3 Vanguard TSM Idx;Adm [5]  Passive  404.32  14.48%
5
Fidelity Cash Reserves
 Non-Equity  111.67  4.00%
6
Vanguard Instl Indx;Inst [6]
 Passive  199.53  7.15%
7
Vanguard Prime MM;Inv
  Non-Equity  105.16  3.77%
9 Fidelity Contrafund  Growth  113.32  4.06%
10 American Funds Gro;A  Growth  149.47  5.35%
11 American Funds Inc;A  Value  96.99  3.47%
12 American Funds CIB;A  Value  99.18  3.55%
13
Vanguard Tot I Stk;Inv
 Passive 180.79  6.47%
14
iShares:Core S&P 500
 Passive  70.28  2.52%
15 Vanguard Wellington;Adm  Value  90.23  6.74%
16 Dodge & Cox Intl Stock  Growth / Value  68.60  3.23%
17 JPMorgan:Prime MM;Cap   Non-Equity  67.97  2.43%
18 PIMCO:Tot Rtn;Inst   Non-Equity  100.99  3.62%
20 iShares:MSCI EAFE ETF  Passive  61.43  2.20%
21 Dodge & Cox Stock  Growth / Value  60.64  2.17%
22 Vanguard Tot Bd;Adm  Non-Equity  144.98  5.19%
23 American Funds ICA;A  Growth / Value  76.58  2.74%
24 Vanguard TSM Idx;ETF  Passive  108.50  3.89%
25 American Funds CWGI;A  Growth / Value  89.51  3.21%

In summary [6]:

  • Passive is 50.75% of the sample
  • Value is 15.54% of the sample
  • Growth is 14.70% of the sample
  • Non-Equity is 9.82% of the sample

I will talk more about the implications of this findings to retail investors such as me in the next article.

[Notes]

[1] The reason why mutual funds is because for the other sharks (hedge funds and companies that run large investment portfolios) it will take a lot of work to find out the NAV of each specific fund or large investment portfolio run by the hedge funds or companies before I can compare the sizes of these funds / portfolios to the mutual funds (where the information is publicly available and easily accessible). The reason why US only is because US’s market cap is 52% of the world, which is a good proxy for the world.

[2] My classification of Investment Philosophy will be highly controversial as some funds aren’t as clear cut. The best I can do is give a rough qualitative categorization.

Eg. American Funds Growth Fund of America invests in “classical growth stocks, cyclical stocks and turnaround stocks“, where classical growth stocks can be treated as growth investing, but cyclical stocks and turnaround stocks could be value / growth depending on the stocks selected.

[3] Based on Morningstar’s Ownership Zone rating. “Blend” is classified as Growth / Value

[3] Based on data from Yahoo Finance on Aug 19th 2015

[4] Includes Vanguard TSM Idx;Inv and Vanguard TSM Idx;Inst+ due to duplication

[5] Includes Vanguard Instl Indx;InsP due to duplication

[6] For funds classified as “Blend” by Morningstar’s Ownership Zone rating, the allocation would be 50/50 to the % of Population calculation.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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