Public markets have become more democratic as trading costs have fallen. Historically, buying publicly traded stocks or bonds was cost prohibitive for most investors. High commissions ate up a lot of value of every time a trade was placed. The best way to access public markets was through mutual funds. Mutual funds lowered trading costs by pooling securities in a single fund. Mutual funds still charged hefty fees though, which made buying mutual fund shares very expensive. Over the last few decades, trading costs have declined dramatically. Competition between brokerage firms has been driving down commission rates for decades. When payment for order flow was introduced it created an alternative revenue stream that finally sent commissions to zero. Product innovations such as ETFs and passive investing allow investors to circumvent more expensive mutual funds. ETFs allow investors to buy and sell a basket of stocks as a single share listed on an exchange with zero commissions. Passive investing gives investors a low cost alternative to the high priced active investing strategies offered by mutual funds, and are commonly packaged inside an ETF. As a result of these innovations, everyone has access to low cost, highly liquid, diversified investment strategies in the public markets.

Asset managers are looking for new ways to charge you fees. Product innovation has disrupted the business model of traditional asset managers. Full service brokers and actively traded mutual funds have been replaced by low cost alternatives such as ETFs and passive investing strategies. A few asset managers saw this transition coming and helped pioneer these new products (e.g. Vangaurd and BlackRock). But asset managers have to compete on fees in order to attract capital flows given the commodity-like nature of a passive investing product. This has resulted in significant fee compression, which has been a boon for investors but forced asset managers to search for additional revenue streams. Asset managers are reverting to more differentiated, higher fee products like active ETFs or private assets. They are distributing these products through traditional retail channels such as financial advisers, target date funds, and 401ks. Investors usually don’t understand that they are being offered an inferior product with higher fees. We recommend avoiding high fee products despite the glitzy sales pitch, given how easy it is to replicate their performance on your own without paying commissions or fees.

Hedge funds can create short-term volatility in markets. The hedge fund industry has consolidated around a handful of multi-strategy managers (a.k.a. multi-strats or pod shops) like Point72, Millennium, and Balyasny. There are three features that distinguish multi-strategy managers from other hedge funds: 1) they pass-through all of their expenses to investors; 2) they run market neutral portfolios; and 3) they manage to a volatility target instead of a return target. Multi-strategy managers have accumulated a significant amount of capital and expanded into almost every asset class, which has influenced market behavior. Multi-strategy managers are very focused on short-term performance. They usually have a quarter-to-quarter if not day-to-day time horizon, which can cause short-term volatility. High volatility can force them to unwind their positions in order to meet volatility targets, which can exacerbate short-term price movements. Multi-strategy managers have a much bigger footprint than single managers or mutual funds in public markets.

Non-discretionary buyers can create momentum in stocks. There are two major non-discretionary buyer groups: Commodity Trading Advisors (CTAs) and passive index funds. CTAs are registered with the CFTC, and use index futures to trade momentum. They are simple trend followers, which can accelerate price swings when momentum changes. Passive index funds buy the entire market, but not in equal proportions. Most major stock indexes are weighted by market capitalization. As a stock’s market capitalization increases, its absorbs a larger proportion of passive index fund flows. More fund flows can increase momentum.

Non-institutional investors can provide support for stocks. There are two major non-institutional buyer groups: corporates and retail. Many large corporations have ongoing share repurchase programs. Share repurchase programs decrease the share count and increase EPS, which supports the company’s valuation. Share repurchases become particularly valuable during times of market stress. Corporate can repurchase more shares for the same dollar when the stock price decline, which increases EPS more than usual. Retail traders are everyday investor with active strategies. They usually underperform the market by chasing winners for too long and selling losers too soon. That said, retail traders have become massive dip buyers, which helps create a floor during market sell-offs.

Your long-term time horizon gives you an edge. Professional investors have access to more information and can react more quickly than you, but they face their own constraints. If they underperform the market or have a large drawdown they will get fired. This makes them extremely risk adverse, and they prefer to sit on the sidelines when market volatility is high. Passive index funds and CTAs are “dumb” money. They follow rules based investing strategies that make them price takers. When volatility is high they can become forced buyers or sellers, which can exacerbate price trends. However, corporates and retail traders usually increase their share purchases when stock prices decline substantially, which can create a floor under stock prices. Since you have a long-time horizon, you should be relatively immune to volatility. That can be a significant edge in a world where everyone else is measured on short-term performance. You can use this edge to take advantage of market dislocations that take time to work out.

The stock market is highly efficient, but it’s not always right. The stock market quickly and accurately prices new information. But even when investors operate with the same information they may disagree on what it means for the future. The stock price is essentially an average of all the views in the market, and may not represent fair value. However, as time progresses and more information about the future becomes available the stock price will converge with fair value. This is the logic that underpins mosaic theory, our core stock picking methodology. Our research process allows us to build a better mosaic than others, and over time the stock price will converge with our view if we are right about the fundamentals. It may sound arrogant to believe we are smarter than everyone else, but the research process for most professional investors has serious limitations. They are usually understaffed and overworked, they cover too many securities and can’t stay up to speed on all of them, and they have additional responsibilities in addition to stock picking that consume a lot of their time (committee meetings, writing investment memos, risk management). They also face significant career risk that incentives them to hug the benchmark, avoid draw downs, and grow assets rather than outperform the market. We are focused solely on picking stocks, which gives us an advantage over most professional investors.