Portfolio Purity

Investment success requires both a valid philosophy and rigorous execution—Portfolios are “pure” when their securities fit their philosophy—Pure portfolios are needed to outperform.

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PORTFOLIO PURITY

Investment success requires both a valid philosophy and rigorous execution. No special skills are needed to satisfy either requirement, yet only a small subset of active managers have proven investment success over the long-term. Achieving and maintaining this combination is the challenge of investment management.

A Scientific Approach

This two-step approach to investing reflects Karl Popper’s method in the “The Logic of Scientific Discovery.” Popper shows how predictions can be made by combining universal and singular statements. In investing, the universal statement is the overarching investment philosophy and the singular statement applies to individual securities selected for a portfolio.

“We have thus two different kinds of statement, both of which are necessary ingredients of a complete causal explanation. They are (1) universal statements, i.e. hypotheses of the character of natural laws, and (2) singular statements, which apply to the specific event in question and which I shall call ‘initial conditions.’ It is from universal statements in conjunction with initial conditions that we deduce the singular statement...We call this statement a specific or singular prediction.”1

What Are We Looking For?

An investment philosophy is the universal statement that guides a firm or strategy. These are hypotheses of the “natural laws” of investing. Investment philosophies should be precise and logically valid, allowing the investor to search for concrete, knowable data that will support an investment decision.

Much has been written about investment philosophies and we have empirical evidence supporting many logically valid approaches. In fact, most active managers pursue similar philosophies and attempt to differentiate primarily in their execution.

Importantly, these universal investment philosophies should be static. They are the bedrock of an investment strategy and must be immutable. All investors will agree that style drift, another name for a fluid investment philosophy, invalidates an investment strategy regardless of execution.

By having a concrete investment philosophy, great investors know exactly what they are looking for. If their crystal clear viewpoint is adopted by all team members they have successfully satisfied the first part of Popper’s criteria.

Portfolio Purity

Once an investment team is aligned to a proper philosophy the focus shifts to execution. In the investment world, the same “singular statement” is asked over and over again: does this specific business fit our universal investment philosophy?

The purpose of investment due diligence is to create a fact base that allows a team to objectively answer this question. Securities should be added to the portfolio only when their fit is rigorously supported.

By satisfying Popper’s second criteria, portfolio additions are logically deduced. Each individual holding, according to Popper, is a “prediction.” In investment parlance, this prediction is that the holding fits perfectly with the investment philosophy. Therefore, if the investment philosophy is valid, a positive return will be expected from the investment itself.

Only The Purest Perform

Investors with outstanding track records are often individual iconoclasts with concentrated portfolios. The reason for this is twofold. First, as iconoclasts, they deeply believe in their universal investment philosophies and steadfastly hold to their approach. Second, via portfolio concentration, they understand that few securities truly fit their philosophies. They limit their “singular statements” to ensure portfolio purity.

Pure portfolios deliver alpha due to their persistency. Any portfolio can randomly deliver alpha over short time horizons. But long-term, for an investment philosophy to truly shine through, portfolios must be pure. All trading decisions can be calibrated on this principle: will this trade make my portfolio more or less pure, as defined by my investment philosophy?

Unfortunately, much of investment management is designed to oppose Popper’s recommendations.

Muddy Portfolios

Allocators often take comfort in large investment teams capable of covering thousands of securities. This diffusion of research dilutes the universal investment philosophy. The probability of multiple team members completely internalizing and agreeing upon an investment philosophy is low.

Incentives are also an issue with investment teams. The entire purpose of the team is to prove singular statements, ensuring securities are added that fit a philosophy. But titles and annual bonuses are rarely conferred based on investment philosophy fit. Team members have far more incentive to simply get a security into a portfolio than to ensure it reflects the philosophy.

Avoiding key man risk creates a similar issue. Having multiple decision makers creates muddy portfolios. Even with alignment on an investment philosophy, committees will evaluate singular statements differently, reducing portfolio purity. It is no surprise that the most successful investment firms are often led by their founders, for decades, steadfastly adhering to their philosophies and ensuring a seamless fit between philosophy and portfolio.

The Investment Management Challenge

The recipe is clear for investment success: a valid philosophy and pure execution. Regardless of style, successful managers deliver pure portfolios to their clients. While a familiarity with Popper is not required for investment success, this two-pronged approach is a key theme that can be explored when evaluating investment managers.