Iron Cage of Professional Finance

"Ever wonder why fund managers can't beat the S&P 500? Because they're sheep, and sheep get slaughtered."
--Gordon Gekko (Wall Street)

During last week's RISE conference, it was hard not to conclude that consistent outperformance by finance industry professionals is difficult if not impossible. In their quest for alpha, professional money managers must cope with standard industry practices (getting stronger with the CFA craze), regs and compliance, and career risk concerns--all of which drive behavior toward central tendency.

Subtract the fee structure, and principals who invest capital thru professional agents seem likely to under perform indexes over time.

Given the current industry context, seems to me there are three primary ways to outperform:

1) Concentrated positions. Among professionals, portfolios of less than 30 positions are rare. As such, professionals are unlikely to consistently beat benchmarks by significant margins. Yet, successful investors who do not employ professional money managers nearly always operate concentrated portfolios.

2) Bold changes to asset allocations. In the industry, asset allocation changes are considered radical when they are adjusted by 5%. Ten percent swings are almost unheard of. As we have seen, however, instability in the current macro environment has been rewarding swift and large adjustments in asset allocation. For example, those who have been able to move out of risk assets such as stocks during deflationary downdrafts have been able to sidestep steep draw downs.

3) Hedging. Pairing long positions with short positions ensures some variety in portfolio correlation. Hedging may also enable longer holding periods for positions as it tempers the urge to sell favored positions by mitigating drawdowns.

In the investment industry, the only firms capable of such freedoms are hedge funds. However, even hedgies are under increased pressure to comply with institutional rules. Professional money managers in other segments are destined for the Iron Cage that constrains performance via institutional norms.

This situation also spells opportunity for individual investors.

position in SPX