CORE AND EXPLORE

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You are watching Brian Koppelman’s and David Levien's hit show Billions and see all of the portfolio managers making trades and swinging markets. You’re jealous, and I am too.

Could you (or me) make it as a trader at a hedge fund or as an analyst on Wall Street? You are probably even tempted to test your ideas in real life, looking for opportunities to invest and earn multiples on your initial investment.

Should you take on the additional risk of creating an investment strategy of your own? Is there a way to give your ideas a trial run or to see if your investing skills/abilities stack up?

“Core and Explore” is used by many individual, retail investors. Your “core” is a large portion (typically 90% or so) invested in a broad market index, a passive strategy. Your “explore” is the remaining percentage of your overall portfolio. You use this relatively small portion to test your ideas, taking on the additional risk of investing in single companies or specific strategies.

This is a popular strategy for individual investors because it allows for the simplicity (and relative safety) of index-tracking mutual funds or ETFs alongside the optionality to experiment with any ideas or convictions.

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Active v. Passive

For many years (and maybe still today), there was a debate about active portfolio management or passive portfolio management. Which will offer better long-term returns? How much should an investor pay for those returns? What strategy ultimately offers more value to investors?

An active investor attempts to choose investments in an effort to outperform an index. This excess return or alpha is created by the savvy strategy or Bobby Axelrod-like brilliance of the fund/portfolio manager. Essentially all hedge funds and many of the famous fund managers use an active strategy.

There is one famous investor who stood against active portfolio management. Jack Bogle founded Vanguard in 1974 in an effort to offer low-cost, index investing opportunities to regular investors in the form of mutual funds. He was one of the first believers in the passive portfolio.

A passive investor simply invests in the index and tracks its performance. This also may be referred to as “buy and hold” investing where there are regular purchases of the index fund or ETF but no selling (until retirement or some other external need).

The active versus passive debate is ongoing to a degree, but passive has been a clear winner in recent years. It may not be flashy or exciting, but passive has outperformed active on average.

Is Outperformance Possible?

When you choose to invest and actively manage your portfolio, you are forced to measure your performance against the performance of the overall market, just like a fund manager.

There is an opportunity cost in choosing an active strategy. Your funds could have been placed in an S&P 500 ETF. If you choose to actively invest your dollars, you forgo the performance of the S&P in favor of the performance of your own ideas.

Outperforming a benchmark is no easy task. The volatility in 2022 has provided opportunity for professional active managers. BUT, even in a year where the narrative around active funds is more positive than in past years, the active funds still do not beat their benchmarks on average.

The best fund managers in the world attempt to outperform the market/the S&P 500 and struggle to do so in many cases. The small percentage that do outperform in any given year are unlikely to do so in the next year(s). It is more likely that the outperformance is due to luck not skill.

The success in active management over time is concentrated among a small number of elite hedge funds, like Bridgewater (Ray Dalio) or Citadel (Ken Griffin).

Outperforming the market is not impossible but incredibly difficult. Only the best of the best can do it.

Core and Explore Strategies

1 - Playing the Peter Lynch stock-picking game.

Peter Lynch is a famous fund manager. He is widely considered to be one of the best investors of all time. He managed the Fidelity Magellan fund (FMAGX) from 1977 to 1990. His performance over this time was simply incredible.

After the decade-plus tear of investment performance, Lynch wrote the book One Up on Wall Street, explaining his strategy and advice for picking winning investments. His now-famous outlook on stock picking is simple. When you see a company doing well in your everyday life, find out if it is a public company and do some simple examination/research to determine whether it is a worthy investment.

Lynch’s approach led him to invest in companies like Dunkin Donuts and La Quinta Inn & Suites. He suggests that everyone is capable of walking around the world and discovering excellent companies (and in turn investment opportunities).

This is an easy way to fill out the “explore” portion of your portfolio.

2 - Subscribing to a stock service.

There are a number of popular stock picking services, all of which claim to have excellent track records. These claims may or may not be true. It’s important to remember the difficulty of stock picking even for so-called professionals.

If you would like to lean on the experience or expertise of people who focus on the markets daily, you can easily pay a monthly or annual fee to receive investment recommendations. This is akin to gaining access to otherwise exclusive hedge funds with high fees and/or account minimums.

In this case, you are not the one exploring, but this portion of your portfolio is still utilized. You may have the optionality to pick and choose among the list of recommendations, allowing some exploration on your own.

3 - Tracking trends or news.

Nearly every day the market opens and any company’s shares can move up or down based on breaking news. This is typically the exact opposite of a wise investment strategy.

In this case, we are not discussing jumping on the wild momentum trades where millions of individual investors artificially inflate the price of a stock or the wildly swinging shares frequented by day traders.

There may be trends or newsworthy events that actually affect the value of an underlying company. Previously insider information becomes public, your hunch turns into reality, or government regulation changes the overall landscape. Suddenly, a company’s outlook is entirely different. There is more opportunity to expand top-line revenue or a chance to quickly/easily fortify profits.

Even when investing in single companies, a long-term strategy is best. You may not hold on to a single company forever, but the time horizon of your investment should reflect a company’s full business cycle (typically years not weeks or months). Perhaps it should be called "informed day trading" or something similar.

This may be a good strategy if you love to research and dig for useful information about a company. The explore component of your portfolio could be filled with innovative companies yet to be discovered by the broad population.

4 - Finding stocks related to your interests or curiosities.

This strategy can go a few different directions.

You may be uniquely qualified to invest in certain types of companies. If you are a doctor with access to certain information about medical device companies or pharmaceutical companies, you might find opportunities to invest in some of these companies. If you are a small business owner, you might use certain software or service providers that could be a worthy investment.

Much like the Peter Lynch method, you may be able to notice something an average person may be unable to recognize as valuable/important. Your expertise might allow you to see if something is a hoax or fraudulent while others may believe it is infallible or a sure thing.

You may be uniquely interested in certain areas of innovation or sectors of the economy. Perhaps you are especially interested in athletic performance and health. Your interest drives you to dig deep into a company offering vitamins, supplements, and other related products. Or maybe you are a technology guru and are able to easily identify the next useful, mass-produced product (like an iPhone in the late 2000s or Airpods in the late 2010s).

Your interests and hobbies may not always be useful in finding companies to purchase shares. That being said, in some cases your tastes may align with thousands or millions of other individuals, fueling growth for the company and leading to a valuable opportunity to invest. The explore portion of your portfolio could be filled with what you are interested in and the companies you actually use in everyday life.

The Behavioral Upside

Investing will always have heuristics and biases. Our natural tendencies as human beings typically do not lead to shrewd portfolio management or peak investment performance. It takes immense effort to overcome biases to effectively manage a portfolio.

The idea of actively trading and managing your portfolio can be appealing, but it is incredibly difficult to outperform the market.

Some people need the rush of actively investing though. The thought and even the slimmest probability of potential alpha is too tempting.

The “Core and Explore” strategy can provide a useful hedge against our own behavior. It withholds the largest portion of the portfolio and total assets at a distance and allows a small percentage to be directly under your total discretion and control.

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TL;DR

Sometimes, it is fun to play the role of portfolio manager.

Simultaneously it is very difficult to outperform and potentially dangerous to even attempt to do so.The "Core and Explore" method provides a way to test your skill as stock picker while still maintaining a strong allocation to passive investments AND keeping your overall financial plan intact.

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Does the "Core and Explore" strategy intrigue you? Are you utilizing something similar?Share this post on LinkedIn or with a friend!