In the ever-evolving world of finance, the adage “the more you know, the more you realize you don’t know” rings particularly true. After nearly two decades of running quant models, one of the most profound lessons learned is the importance of focusing on what remains unknown. Despite the wealth of knowledge accumulated over the years, the vastness of what’s yet to be understood in this field continues to humble even the most seasoned professionals.
Reflecting on this journey, it’s reassuring to note that many core principles have stood the test of time. Strategies such as following factor-based approaches with strong historical track records, maintaining a long-term focus, and striving to eliminate emotion from the investing process have proven their worth. However, the application of these principles is far from straightforward, and the introduction of investor behavior adds layers of complexity to the equation.
While it’s impossible to encapsulate all the insights gained over two decades in a single post, here are three key lessons that stand out:
Lesson #1: Market Outperformance is Possible, But Rare
The aggregate performance of active management trailing the market is a well-established fact. Academic research has consistently shown that, collectively, active managers’ portfolios mirror the market, resulting in similar returns but with higher fees and trading costs. Over the long run, when compared to index funds, the underperformance of active managers tends to roughly equal their excess fees and trading costs.
However, there’s compelling evidence that disciplined factor-based strategies offer potential for long-term market outperformance. Numerous studies from respected firms in the field support this thesis. Our own testing and real-world experience align with these findings, with an important caveat: achieving outperformance requires unwavering commitment to these strategies through inevitable periods of underperformance – a challenge that many investors find difficult to overcome.
Lesson #2: Financial Crises Exceed Expectations – And Pain Can’t Be Modeled
The Global Financial Crisis of 2008, the COVID-19 market crash of 2020 and other significant downturns have taught us that living through a financial crisis is an experience that defies quantification or modeling. The pervasive loss of optimism during these periods creates an overwhelming sense of doom that challenges even the strongest convictions.
While historical data clearly shows that markets eventually recover and reach new highs, the real-time experience of severe market declines tests the resolve of even the most prepared investors. The emotional toll of these events often leads to behavioral mistakes that can derail long-term investment plans.
This underscores a critical point: while back-testing and historical analysis are valuable tools, they cannot fully capture the psychological impact of living through market turbulence with real money at stake. Understanding and preparing for this reality is crucial for both investment professionals and individual investors.
Lesson #3: Relative Underperformance Can Be More Challenging Than Absolute Losses
One of the fundamental principles of active management is the need to be different from the market to outperform it. This concept, known as active share, suggests that portfolios significantly different from their benchmarks have a better chance of outperformance than “closet indexers” – funds that closely mirror the market while charging higher fees.
However, this approach inevitably leads to periods where returns deviate from the market, sometimes substantially. Ironically, many investors find it more difficult to stomach underperformance relative to the market than absolute losses during market downturns. This is particularly challenging when an investment strategy loses money in a year when the broader market is up, as we’ve seen with some value strategies in recent years.
Managing expectations and behavior during these periods of divergence is often more challenging than navigating market-wide declines. It requires clear communication, education, and a shared long-term perspective to prevent investors from abandoning sound strategies at potentially the worst times.
Embracing Uncertainty and Continuous Learning
As we look to the future, it’s certain that new lessons await. The rapidly changing landscape of finance, influenced by technological advancements, evolving global economic dynamics, and shifts in investor behavior, ensures that there will always be more to learn.
Perhaps the most valuable lesson from two decades in this field is the importance of intellectual humility. Recognizing the limits of our knowledge and maintaining a commitment to continuous learning are essential traits for success in the complex world of investment management.
As we navigate the challenges and opportunities that lie ahead, this perspective serves as both a guiding principle and a reminder of the ever-present potential for growth and discovery in the fascinating realm of finance.
