Discover more from Klement on Investing
It seems I am not special after all
I like to think of myself as unique and special (who doesn’t) and tend to look for evidence of why I am the way I am as an investor. So when I read a study by Mesiane Lasfer and her colleagues that claimed that fund managers who start their career in a recession have better performance, I was all over it. After all, I started my investment career in 2000.
The seminal work by Ulrike Malmendier and Stefan Nagel on ‘depression babies’ provided ample evidence that the economic environment we encounter during our childhood and our formative years (age 16 to 24) influences our financial decisions for the rest of our lives.
No wonder then that fund managers who start their career during a recession tend to manage their portfolios differently than fund managers who start during boom times. Adjusted for systematic differences in their portfolios like valuation, momentum, market risk, or size of companies, ‘recession managers’ outperform their non-recession peers by 2.3% per year.
That is a lot, but unfortunately, like so many factors that contribute to superior performance, it comes in lumps. Most of the time, equity markets are going up because recessions are - thankfully - rare. During non-recessionary times, the performance of a fund manager is mostly driven by her stock-picking abilities. And recession managers on average don’t have better stock-picking skills than their peers who launched their careers in non-recessionary times. So little to no advantage there.
But in a recession and during a bear market fund managers who launched their career during a recession shine. They generate substantial outperformance during market drawdowns and bear markets compared to their peers. And they do that mostly with two actions.
First, in the later stages of a bull market, they start to increase their holdings of defensive stocks and reduce cyclicals. And then, once a recession hits, they increase their holdings in defensive stocks even more, becoming far more defensive than their peers. Modern portfolio theory states that this more defensive stance should lead to lower returns for the recession manages since defensive stocks have lower systematic risk (that’s why they are called ‘defensive’), but in practice, defensive stocks tend to match or even beat the performance of cyclical stocks, something that is known as the low beta anomaly. And recession managers exploit this low beta anomaly to their advantage.
The second thing recession managers do is to increase their cash holdings in their portfolios during a recession. And they have a cunning ability to sell some of their holdings and move into cash shortly before a market drops so that they hold only 1% more cash in their portfolio during a recession than their peers, but they are able to time that so well that this makes a significant contribution to the long-term performance of the portfolio.
And when you read this description of recession managers as people with a preference for defensive stocks and a good ability to anticipate substantial market drops you know how I used to manage my portfolios. The key weakness I discovered by analysing years of entries in my investment diaries was that I sold just in time before a bear market hit but got back into the market too late, thus squandering my outperformance during the recovery. As I have described here, I have worked hard to improve my investment process to rid it of this bias and I think by now I am a much better stock picker and have better performance during bull markets, yet also do fine during a recession and a bear market.