How the Best Money Managers Exploit Market Inefficiencies

Earlier this month, Prima Capital, in conjunction with AdvisorOne.com and Investment Advisor magazine, announced the eighth annual 2012 SMA Managers of the Year award winners. The identification of these “best in breed” managers was based on a combination of quantitative and qualitative criteria, not least of which is the ability to consistently execute an investment process that delivers above-average results.

In our view, one of the most important—and intriguing—factors that leads to that good end is a manager’s “alpha thesis.” Successfully exploiting market inefficiency, whether behavioral, structural, fundamental, or otherwise, is a difficult task to be sure, but an examination of this year’s SMA Award winners proves there are a number of ways a good manager can add value.

Theses in All Shapes and Sizes

One of this year’s Large Cap Domestic Equity winners was BRC Investment Management’s Large Cap Concentrated Equity strategy. BRC (an acronym for “Bounded Rationality Concepts”) predicates its alpha thesis on behavioral finance and attempts to exploit the irrationality of investors. Specifically, BRC believes that Wall Street analysts can have a substantial impact on stock prices and that Wall Street analysts’ behavior is extremely predictable. Based on that thesis, the BRC team focuses its efforts on identifying attractively valued stocks that are poised for upward analyst revisions and positive earnings surprises. By getting ahead of such upward revisions, BRC is able to realize value from the price appreciation that follows their release.

In the fixed income space, the Gannett Welsh & Kotler Municipal Bond strategy was this year’s SMA Award winner. GW&K believes that the municipal bond market is highly inefficient for a number of reasons, including the large number of issuers, the large number of bonds, poor press coverage and the lack of a central exchange. And on top of all that, the municipal market is dominated by retail investors. GW&K attempts to exploit these structural issues and add value through fundamental research focusing on credit quality, bond structure, and the relative value between sectors. 

The Cambiar International ADR strategy, meanwhile, one of the 2012 International Equity winners, combines both structural and behavioral elements in its alpha thesis. On the structural side, Cambiar utilizes an unconstrained approach to stock selection that allows the managers to invest wherever they see the most value in the international equity market, regardless of the strategy’s benchmark construction. On the behavioral side of the alpha thesis, Cambiar takes a relative value approach that attempts to take advantage of persistent bouts of market myopia where the price of the stock is trading at the low end of its historic range due to the market’s failure to recognize the company’s longer-term prospects. 

The alpha theses for the remaining 2012 SMA Award winners—Santa Barbara Asset Management, Geneva Capital Management, Kayne Anderson Rudnick, and Invesco—share similar traits. Each strategy seeks to invest in securities of companies exhibiting certain fundamental factors or characteristics that the managers believe have a long-term positive impact on price—things like dividend growth, earnings growth, and ability to self finance—but the market, for whatever reason, undervalues in the short term. 

Strategies, in other words, that seek to exploit inefficiencies.

It’s Hardly Like Throwing Darts