On Topic
Circular
Reasoning In
Due Diligence
By Gabriel Potter, AIF®
“The archer missed the bull’s-eye
because he didn’t hit the target.”
T
his sentence, while true, doesn’t
explain anything substantive about
the situation’s cause and effect.
An improved sentence would be, “the
archer missed the bulls-eye because
his broken arm was impeding his aim.”
The improved sentence supplies a clear
cause to the effect.
Why are we discussing logical arguments
in an article about finance and investing?
The reason is because we have been
disappointed with active managers using
circular reasoning to defend their poor
performance relative to their indices.
When we conduct due diligence on our
18 | SPRING
24
SUMMER
2014
2013
mangers, we try very hard to understand
the causes of relative performance, both
positive and negative. This understanding is
blocked when active managers justify their
underperformance with this excuse, “the
market hasn’t favored active management.”
Let us consider that defense for a moment.
As long as individual security returns
vary at all, there will be positions which
outperform the index and positions which
underperform the index. Naturally, active
managers try to pick the winners—
those securities which outperform the
index. Conversely, an active manager
will underperform their index, if their
selections—in aggregate—underperform
their index. Active managers are not
required to buy or sell any particular
type of position. Therefore, there is no
market that inherently favors or disfavors
active management.
It is true that the opportunity set for
managers might be different depending on
the strength of the market’s direction and
the variance of returns among different
securities. For example, Manager
XYZ is a contrarian large cap value
stock manager. A contrarian investor
generally picks positions that have
fallen in price, and they won’t pick
stocks that have rallied recently. The
underlying investment philosophy for
contrarians suggests that stocks, once
they’ve appreciated in price, are less
likely to appreciate in the future. On
the other hand, there are “momentum”
market environments where they previous
winners continue to win. In a momentum
environment, a contrarian investor will
likely underperform.
So, it is entirely fair to say a particular
style of management was not favored.