In the last few blog posts, we discussed the danger of the “greed, hope, and fear cycle” (in which people tend to earn below average returns by buying high and selling low) and some ways to overcome it by diversifying and rebalancing your portfolio to earn the average return. But what if you were to actually buy low and sell high?  Could you actually earn the “holy grail” of higher returns and lower risk that way?

In theory, yes.  Academic studies show that over long periods of time, stocks that are priced low relative to standards of value like dividends, book value, and earnings, tend to have both higher returns and lower risk than those that are priced high relative to those standards.  This is what many investment managers who use a “value” style strive for.  In reality, few actually achieve it (Warren Buffett is a rare example).

One problem is that in some ways, value investing is even harder for investment managers than it is for regular investors.  Let’s say that technology companies are back in style and everyone is buying them.  In the short term, tech companies are likely to do very well.  If you’re a mutual fund manager who doesn’t buy tech companies because you think they’re overvalued and closer to the top than to the bottom, you’ll underperform your peers.  At best, the media will say that you’re out of touch with things like the “new economy” (that’s what happened to Warren Buffett in the late 90s) and investors will flee from your fund (as happened to my favorite investment manager in the same time period).  At worst, you’ll be fired.

On the other hand, if you go along with the crowd and buy tech companies, you won’t be punished when they eventually come down.  It won’t be considered your fault since you won’t be doing much worse than the peers that you’re compared against.  After all, they can’t fire everyone.

So while there are true value managers out there, they are hard to find.  The key is to look for those who stuck to their guns even when their style wasn’t very popular. You’re also more likely to find them in small, independent fund companies than the big-name brands that tend to be more driven by short-term performance.

There’s also another problem.  According to a lot of economic research, the main determining factor in a portfolio’s performance is the asset allocation (division between stocks, bonds, and cash) rather than the selection of individual securities.  Yet, we take the asset allocation out of the manager’s hands and force them to generate their outperformance just by selecting securities.

Let me use an analogy.  Let’s say that you’re picking a team for a relay triathlon race that consists of running, swimming, and cycling.  Normally, you’d look for the best runner, swimmer, and cycler available for your team.  Now imagine that you’re limited to only picking from a group of runners from a certain geographical area and of a certain size.  You certainly could pick the best runner, swimmer, and cycler from that group but it’s not going to be as good a team as it would be with a wider pool to choose from.

That’s what happens when we limit fund managers to manage something like a “U.S. large cap stock fund.”  The best values at the time may be in foreign bonds or small cap stocks but the manager’s hands are tied.  To make matters worse, they may have to buy almost every stock in their category just to stay broadly diversified.  In a sense, they become expensive index funds.  Then we blame them when U.S. large cap stocks are down.  (Of course, their fund’s performance could still be their fault but not always.)

I prefer to let a skilled manager pick from among the best (meaning undervalued) investment opportunities whatever and wherever they may be.  If that means moving out of stocks that have become too expensive, so be it. If I want “buy and hold,” I’ll buy a much cheaper index fund.

So here are the things I like to look for:

1) Managers with a long track record of outperforming by buying undervalued investments rather than following the herd.

2) A fund that offers the manager(s) as much flexibility as possible.  The fund should be global (both foreign and domestic) and include stocks, bonds, cash, and even alternative investments like real estate and gold or other commodities.

3) Below average expenses.  All things being equal, a fund with low expenses will beat one with higher expenses.

Unfortunately, there are only a handful of funds that meet these criteria.  Since they tend to be relatively small and obscure and don’t fit well into traditional asset allocation models, they’re also unlikely to be available in your 401(k) so you might have to buy them in an IRA or taxable account.  But you didn’t think that finding the “holy grail” would be easy, did you?