Planet Money - Investing in mediocrity

Episode Date: May 20, 2022

Is the key to success in financial markets a matter of luck or skill? One former bond manager shares his strategy: Win big by avoiding winning. | Subscribe to our weekly newsletter here.Learn more about sponsor message choices: podcastchoices.com/adchoicesNPR Privacy Policy

This is Planet Money from NPR. If you've looked at any index of financial markets, this year has been bad. For stocks, crypto, and bonds, everything is heading south. You might have noticed this if you've seen the news, or if you have an investment or retirement account. And it kind of begs the question, is there any way to navigate this kind of period well? Like, can anyone? Or are we just along for the ride? If risk is everywhere, how do we strategize? How can you take risk smartly? Of course, there is a whole industry dedicated to the idea that you can take risk smartly.

You can lose less money in a market freakout and make more money when markets are happy. And in thinking about how to do well in investing over time, it made me think of this guy I met while I was reporting my book about bonds. He had a whole plan that he thought would help him outperform everybody else over time and help him survive these kinds of moments in markets to help avoid blowing up, losing all the money he managed. And it's not so much that his strategy itself was revelatory. It was how he described it, the term he came up with. The idea of strategic mediocrity was my tongue in cheek title or name to put on the idea. Strategic mediocrity. Ben Trotsky developed this theory, this idea, when he was working at this money manager in the 90s. His job was to buy and sell

what are called junk bonds. Some people don't like calling them junk. They prefer to call them high risk, high reward. And it's kind of funny that Ben is in this high risk job because in many ways, he's not really a big risk taker. He likes taking risks so calculated, they're barely even risks. Can you tell me, do you gamble at all? Never.

Really? Don't play games, I I'm going to lose. And the house always has the advantage? Yep. Laws of probability have not been repealed. In his job, the game is to beat a benchmark. Basically to stay above this line that is always going up and down. The line represents what the whole market is doing. The market where he invests,

you know, junk bonds. He's competing against this line, but he's also competing against a whole universe of other money managers who buy and sell junk bonds, too. They all get ranked best to worst every day, every year, every five years, every 10 years. And Ben knows not to care that much about the short-term stuff. Short time periods of your track record are basically meaningless. He wants to be the best over the long haul, to deliver the very best for his clients over time. So at the end of 10 years, he wants to be in the top 10%, the top decile. And Ben thinks he can do it because of his plan, strategic mediocrity. His plan to try not so hard. When I did simulations as to what it takes to land somewhere in the top decile, it became very, very clear that if you consistently stay in the top

third, but never end up number one, two, or three, that over time, you would end up in the top decile of the competitive universe. In this competitive universe, Ben never wanted to be number one in a given year's rankings because when he ran his various scenarios, everyone who showed up in that top slot in a given year, over the long course of 10 years, basically no one stayed on top.

Because anyone who ever got to the number one slot almost certainly got there because they did something reckless. Like they were gunning really hard and taking really big swings and whatever war or sports imagery. They have to have taken too much risk. And they just lucked out. And luck is not skill. And this way of thinking, this strategic mediocrity, it makes so much sense to me.

If you set your sights just a little lower, according to Ben, that's how you win. For your clients and for yourself. Just do less. Hello and welcome to Planet Money. I'm Amanda Aronchik. And I'm Mary Childs. Today on the show, two stories that get to these essential questions in finance. If anyone can take risk smartly, or if it's actually just an enormous casino. First, strategically mediocre Ben puts his theory to the test to prove to himself and the market that the key to winning means actually avoiding winning on purpose. And then a researcher, through the lens of one of the most famous investors, answers that eternal question. In investing, is there such a thing as skill? And if so, what does it look like?

In some ways, Ben Trotsky was not your typical money manager. You had long or longish hair, confirm? Long by corporate standards, but not compared to what it is today. Now he says his ponytail is two feet long. Might be relevant that he is and was based in California. Is it true that you often did not wear shoes? Yeah, that is true. Why people would notice is a bit of a mystery, but that is true. I heard a lot about Ben before I met him. When I was researching this book about bonds and the biggest bond shop, Pimco,

a lot of people I talked to kept being like, oh my god, if you can find Ben Trosky. He'd left Pimco a long time before, but he was still this legendary character. People seem to remember him in large part because he just didn't care about all the preening and posturing that seems to come with the job. He's this strange mix of earnest and really intense. And I think because of that, sometimes when he says things that are kind of basic, standard-issue finance things, I get the sense he really believes them. So when he says it, I actually kind of believe him. For example, the most basic, why he wants to do a good job.

If someone entrusts you with their personal funds, that's a big, big statement of trust. And you need to conduct yourself in a way that justifies that trust. What would justify that trust is doing well, being in the top decile over 10 years. And back then, it was his job to make those personal funds grow into more funds. And the most foundational rule of investing, of making money, is to not lose money, especially not all the money, but preferably like not even like a little bit of the money. Which for Ben means not taking big swings that will knock him out of the game. Instead, he took lots of little swings all the time, measuring the risk against the potential reward. Being picky.

Being strategic. Well, it's just the idea that you only take risk when you have conviction that you're getting paid for that risk. Again, this is what everyone says they're doing, feeling sure they're getting paid enough to offset the risk that they're taking. Because in investing, there's this other very fundamental principle. When you take more risk, you're supposed to get rewarded for it. So Ben wants to do well, but not too well. To be in the top 30% of his competitive universe, but not the very top. Never number one in any one year. And he has a few different ways he's going to try to pull this off. One, he's not going to buy the scariest junk bonds that could have the biggest payoffs. He's going to

buy only the barely junky ones. Next, he's going to try to understand every single thing about the companies he's investing in. He will meet the management, read all of the footnotes, study the competition, the market share. And again, this is something that literally every investor says that they do. But Ben says, no, he really did it. I think if you don't do that, you're perpetrating malfeasance. I can't tell you how many competitors I have that, yeah, it was a stab in the dark where some Wall Street analysts told them it was a good idea and they didn't really know what they owned. And that to you is just mind boggling. I think it's borderline criminal. And that to you is just mind-boggling.

Now, Ben says he wouldn't arrest them, per se, but he thinks it's really shoddy. But his competitors doing a bad job did make it easier for him to beat them. And another thing his competitors weren't doing, they also weren't looking into these other areas of the market, areas that were more complicated or poorly understood or whatever. And at the time, that included debt from emerging markets, which included and I know this sounds unbelievable now, back then in the 80s and 90s were actually generally lower risk than the market was perceiving and pricing them to be. It's the idea of a much broader opportunity set. You can find things in the emerging markets. You can find things in the mortgage market. And I had to be able to understand them well enough to compare them to other options. So Ben set his sights on the long game to get better returns for his clients in 10 years than his competitors.

And he got to work. Were you nervous about your strategy not working? No. Never? No. Never? No. You know, timing can be challenging. It may not deliver on the calendar year that you'd like to see it delivering. But whether it would deliver, there was never a doubt.

He invested and he invested. He bought some good bonds and he sold some worse ones. He talked to company management and weighed if he thought their plans were good. He avoided some frauds. He bought some mortgage bonds. He bought some more mortgage bonds. So in the end, your strategic mediocrity, did it work? It worked. The Lipper survey of mutual funds that was ranked the number

one fund for the 10 years I managed it. How did that feel? Look, you have to be proud of it. And I could legitimately look in the mirror and say that the clients that stayed with me ended up better off than they would have been had they hired any other manager. with me ended up better off than they would have been had they hired any other manager. And this might be why when Ben says this kind of textbook stuff, I believe him more than when other people say it, because he actually did it. He got results. He did it for his 10 years and got the trophy he wanted, not just in the top 10%, but number one.

In 2003, he left the company. How did you feel when you left? Glad to be done. And again, this idea of strategic mediocrity, it wasn't totally unique to Ben. Maybe no one else would ever call it that, but it was also kind of the essence of the investing philosophy at the place he worked.

And it helped to define their success for decades. But it's kind of still this question at the heart of all of investing. How much of that success can you chalk up to skill versus luck? After the break, someone actually crunches the numbers to find out. I've been thinking a lot about this idea of luck versus skill in the money world, especially the other day when I was wandering around Las Vegas. I was there for this conference with a bunch of quants, people who invest in the markets using quantitative strategies like algorithms and machine learning and all that. And to get to the conference, I had to walk through the casino part of the hotel where people sat playing blackjack and poker and slots, those machines that are

literally programmed so that you lose. And I kept hearing this voice in my head, like, I hope you're having fun because you're not making any money. And in fact, this was something Bill Gross, the founder of PIMCO and Ben Trotsky's boss, actually said to me. He had spent months in Las Vegas playing blackjack and counting cards, using a strategy that he learned from a book. And he told me that he would watch all the other gamblers in Vegas who didn't have a strategy, who weren't counting cards. And he'd think that they were losers because they had no edge. So they couldn't win. How did you get into finance

in the first place? I got in via gambling. This is Aaron Brown. He's a researcher and investor. Finance seemed very natural. And I discovered you He's a researcher and investor. Finance seemed very natural, and I discovered you could make a lot more money. The other big advantage is you can tell your mother-in-law what you do. It's much more polished sounding, even though it's fundamentally... It's fundamentally the same thing, yes. In investing, there's actually this really interesting divide between people who will say out loud that it's gambling and people who won't. Ben Trotsky, who we heard from earlier, obviously not a gambler. Ben's boss, Bill Gross, firmly in the says it's gambling camp. By the way, if you listen to The Indicator, our daily show, you may have heard this part of the story already. A few years ago, Aaron saw a study.

A lot of people saw the study kind of went finance viral. And it looked at what Warren Buffett has done over 35 years investing in the stock market. And it found that Warren Buffett's returns appear to be mostly attributable to using leverage, like being able to borrow money and then just buying cheap, safe, quality stocks. So Aaron is inspired. That study had looked at the biggest name in stocks. So he's like, what about repeating this study but looking at the biggest name in bonds?

Most of my good ideas are simple thefts of ideas. I say, well, why not do it for the best bond investor, too? Let's see if Bill Gross has alpha. Alpha. The returns an investor can get that are not just whatever the market is doing. Like if you did great, but you only did great because the market went up, you didn't generate alpha. You didn't generate returns beyond just what the market did. If you did better than the market, alpha. And the reason this matters is because if someone is delivering something a bit rare and special, they can charge higher fees for that. And if they're not, then they don't or they shouldn't. You know, you can just buy an

index fund run basically by a robot. No human is making any active buying decisions. And pay almost nothing. And this is a pertinent question right now because the past few decades have been largely up markets, especially for bonds. So that's at least a tailwind of good luck. Basically, everyone in this period was undeniably lucky. But could they also have been special? Skillful? So, to find out if Bill Gross was delivering anything special, first, Aaron and his research partner have to break down what Bill Gross actually did. We had to gather data on Bill Gross's performance. We tried to gather data on his actual holdings. I really would have loved to do it that way, but they're just not available in enough detail to do that. Annoying, but fine. They can work around it

because luckily for them, Bill Gross loved being in the press and he would talk about what he was doing on TV and monthly missives all the time. He would say he's buying this or selling that because interest rates are going to go up or down. So we said, OK, replicate what he said he did. You know, listen to his lectures, talks and papers, and let's do the simple minded version of what he said he did. So, for example, he said he bought more credit exposure. He bought lower rated bonds that were in his benchmark. So that's pretty simple, right? Some of this might sound familiar, like it overlaps with what Ben said he was doing. And indeed, Ben was one person in Bill Gross's company and more or less in his fund. And one of Bill Gross's strategies is he would buy more riskier bonds than the benchmark,

the line that he was trying to beat. And because the bonds were riskier, they gave him a little more compensation. There were two other main strategies they found. Investing in mortgage bonds and a strategy known as rolling down the curve, which basically means selling bonds before they mature. Because time is full of risk. So a bond that matures in 10 years is riskier than one that matures tomorrow. And the prices reflect that. So Bill Gross would sell bonds as they got closer to maturing because for him, they were no longer risky enough. So he said he did those three things. So he said, fine, we're going to construct a portfolio and we're going to measure Bill Gross's exposure to

those factors. So Aaron and his research buddy built a fake portfolio of those three things. What the performance would have been from simply buying more debt of riskier companies, buying more mortgage bonds and rolling down the curve. They mush those three things together. They add in a little bit to account for the overall direction of interest rates and tracked the mushed together portfolio through time to see how those factors performed, how much money those things would have made. So we kind of get a synthetic bill gross, you might call it, a mechanical bill gross. So they have the returns of this synthetic mechanical Bill Gross,

and they hold those up to the real Bill Gross's returns to see if they've actually been able to recreate what he did. And the results very nearly match. It explains 89% of the variation of Bill Gross's returns. So every month it comes very close to Bill Gross's return. And, you know, if you did a graph, they look very similar. So he has his answer. And we found out, yes, Bill Gross did in fact do what he said he did. So that's great. At this point, Aaron can say he basically understands what Bill Gross did,

how he generated most of his alpha. It was by doing the things Bill Gross said he was doing out loud at the time. But that mechanical bill only explained most of the extra returns Bill Gross had generated above the benchmark. Of that outperformance that the real Bill Gross delivered, a small but significant slice was still unexplained. Bill Gross had 0.84% extra alpha. Just magic. Something he did that wasn't described by the things he said he did or some extra ability.

And 0.84% doesn't sound like a lot, but in the bond world, over long periods of time, that's tremendous. Aaron has a few theories about what that magic might have been. Like the fund Bill Gross ran, it was really big and that gave him some advantages in the market. But this big thing that Aaron is talking about here, it's actually kind of weird. To a lot of people like Aaron who are in finance or who study finance, this extra unexplained magic, that's real alpha. Because it's special and different. You can't easily explain it or recreate it with a simple rule

or things that a robot could do. Everything that you can create synthetically, even though it's still outperformance over the market, which is technically alpha, if it's mechanical bill, if it's something a robot could do, to those purists, it's not real alpha. Now, this is important because you should only be charging clients high fees if you are giving them something special or different. If you're not, you should just offer a robot fund for almost nothing. a robot fund for almost nothing. Which, sure, but this purism is kind of silly to me. Like, yeah,

a robot could have done these things, but it didn't. To me, the skill is in identifying the things that will make money in the future and then actually doing those things. People expect you to be able to, you know, forecast things like a wizard. And you can't. You just have these tiny edges. So finding the alpha is not hard. Sticking with it over long periods of time is the real skill. And that's what sets them apart. But however you define alpha, Aaron's study showed that Bill Gross generated it through that unexplainable wizard magic stuff, but mostly the long-term strategy he developed and stuck with. The Steady Eddie stuff. Strategic mediocrity is what skill looks like. And maybe you've been thinking, because the markets are absolutely falling apart, it'd be great to be able to identify a good manager beforehand.

That's obviously the classic problem in finance. It's that disclaimer. Past performance is no guarantee of future results. Even Aaron Brown says it's not obvious. It's kind of hard to tell. Like he met Bill Gross a long time ago. He thinks sometime in the early 90s. He was near Bill Gross's headquarters in Newport Beach.

He was at that point a rising star portfolio manager. And so, you know, so I talked to him and he seemed like a intelligent, but fairly standard bond portfolio manager, a little more imagination than most, a little more quantitative sophistication than most, but I had no idea he was going to be a big superstar. That's really funny. He just seemed kind of ordinary. Well, the people who are good at doing it, it's not obvious if you watch them for a year. They're right 51%. The person next to them is right 49%. You don't see a huge difference, but over 25 years, Bill Grossman's the biggest bond fund in the world with the best fixed income track record anybody's ever put together. And that other person is, you know, unemployed 18 months later.

Even Aaron didn't see that this ordinary guy would turn out to be extraordinary. He says the way to find out in advance is to listen to what they say they're doing. And somehow think yourself if their investment strategies sound real and smart. But the only way you'll really know is at the end. It is listener question time here at Planet Money. And we want to hear from you again. question time here at Planet Money. And we want to hear from you again. Do you have some money related conundrum that you've seen in your city or community that you want answered? Or are you facing a puzzle in your life that you think economics might be able to solve? If so, send us

a voice memo with your question to planetmoneyatnpr.org. And you might end up on the podcast. We listen to every message you send. That's planetmoneyatnpr.org. We're also on TikTok, Instagram, Facebook, at Planet Money. Special thanks to Richard Dewey, Aaron's fellow researcher. This episode was produced by Emma Peasley and engineered by James Willits. It was edited by Jess Jang. Our executive producer is Alex Goldmark. I'm Mary Childs. And I'm Amanda Aronchik. This is NPR. Thanks for listening.

And a special thanks to our funder, the Alfred P. Sloan Foundation, for helping to support this podcast.