Below is correspondence between myself and two other value investors from India.
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Email 1 from Mayank Sharma
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I was thinking about the best way to beat an Index. This idea ( Wild one at that ) has been in my mind for a week now.
A certain part of the portfolio is invested in the index ( Let's say an equal number of shares of all the companies in the BSE 500 ) And a certain part in Value opportunities.
The ratio can be 1:1.
Upside -
a) You copy the index to some extent and thus dont perform too badly in relation to it. ( Depends on the ratio again )
b) You can best the index using value investing methods of stock selection ( you wont beat it my much overall, but you'll still beat it )
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Email 2 from myself
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The best way to beat the index is through value investing as you know.
It doesn't make sense to invest a portion of your money in the index. I'm sure you want to beat the index handsomely and not just tracking it.
As long as you are sufficiently diversified with at least 6-8 stocks, you will do well over the long-term. It is extremely hard to beat the index year in and year out, like Bill Miller. Super-investors like Charlie Munger, Tweedy Browne, Lou Simpson are great investors, but on average, lose to the index 1 in 3 years. But, their compound returns were much more superior than the index.
The most important thing is to outperform the index in the long-run and it doesn't matter to underperform once in a while.
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Email 3 from Koushik Sekhar
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What you suggest is being done rampantly by many mutual funds at least in India and I am sure in other parts of the world too ! It has got another name - "closet indexing" where they claim to be managing the money but in effect they are only closet indexing. Of course the ratio they use is perhaps 80% index and 20 % cheap shares !
I think this is a short cut for those who have severe short term performance pressures and those who dont really want to underperform the index in any period and in return are willing to give up large outperformances of the index in most periods.
By putting the entire fund in the same cheaper/value shares they will surely do better in the long term but they risk underperforming in some periods.
Why would any sane private value investor not accountable to the wrong type of committees or customers who want "action" want to become a closet indexer ? In effect, to the extent you track the index you will give up the advantage of being a value investor. Suppose you are 80% index and 20% value you are only a 20% value investor !
I am attaching a report by Tweedy which compared the performance of champion value investors who have beaten the market over 10 -15 years by a very large amount. See p 6-7 for the section titled as follows
Is Underperforming an Index 30% to 40% of the Time a Normal Part of Long-Run Investment Success? What we learned from an examination of the year-by-year results for nine value-oriented investment managers with index beating long-term records.
There is one striking feature - up to 33% of the time some of them have underperformed the index. Also when they underperform the margin of underperformance is low but when they outperform they really outperform. See Charlie Munger's record with his penchant for severe concentration.
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Email 4 from Mayank Sharma
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I am not departing from the value approach but was trying to figure out different techniques.
Now, I at least know what closet Indexing is. It's actually a very shrewd way of keeping very nifty customers. I guess, most of the closet indexing would be carried out by open ended mutual funds. This way they would make sure that they can claim that they beat the index for x number of years continuously and attract more funds.
And the document Superinvestors of grahamsville and doddsville by Warren buffett just proves your point.
This also has to do with the loss aversion principle. There is a paper on loss aversion by Nassim Taleb. I read it a long time back but I remember he talks about asymmetric payoffs and people's dislike for it. I love the way he makes money. He entire investing philosophy is based on taking small losses for periods whose duration is unknown and then getting a big payoff because of the occurence of one event ( maybe a change in the level of the index because of an unexpected event)
Happy learning,
Dah Hui Lau (David)
P.S. Send me an email of our thought on portfolio construction.
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