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4 Sources of Edge for Active Managers

People are deeply flawed when it comes to making investment decisions. It is vital for active investment managers to be aware of their own behavioral defects as humans and counter these shortcomings with process. Good active managers must be able to identify their “sources of edge,” the characteristics that enable them to generate sustainable alpha.

The sources of edge are often described as Informational, Analytic, Decision-making, and Organizational:


In an era of Artificial Intelligence and Big Data analysis, it’s very hard to generate an informational edge through data acquisition alone. Those who do find anomalies see them quickly arbitraged away. There is, though, the possibility of generating an edge by extending your time frame. A large segment of the market today is concerned with generating products based on dataset analysis, which generates excess returns for short periods of time, in the full knowledge that that advantage is temporary. However, no one has been able to turn the identification of companies that can generate returns over long periods of time into an algorithm. Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.


Separating signal from noise can provide a potent analytical edge. As Benjamin Graham wrote in The Intelligent Investor:

“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” Having a series of rules that help determine the passage of a company from the wider universe to research coverage is extremely helpful. Being structured in how to conduct research and pre-committing to the characteristics sought in a company are essential. Be objective in embracing what works from quantitative processes and systematic fundamental analysis. Structure and discipline help overcome human biases. Admit and learn from mistakes to be more objective and establish a framework to help analysts communicate with colleagues. The structure and discipline will help them focus on what’s important, and filter out what is not.

“Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.”


Understand that all human beings have biases that inhibit both thorough analysis and sound decision-making. A good manager needs to set up structures to overcome these biases, and make sure that all team members stick to those structures. Overcoming our emotions and learning how to avoid cognitive errors should be at the core of any process that results in making decisions, especially decisions made under conditions of great uncertainty, which clearly includes investment decision-making. Conviction and confidence help sell ideas but may not be accurate guides to the success of those ideas.


Incentivize analysts to get their decisions right, not to persuade portfolio managers. How an organization is structured, and how its people are incentivized and compensated, can provide the background that facilitates good decision-making and is thus a source of “organizational alpha.” For example, incentives should in part focus on long-term performance so that they’re aligned with the long-term nature of the informational and analytical edge. Moreover, individuals need to be accountable for their decisions to avoid the blame game that arises from consensus or group decisions. Finally, a good investment manager needs to communicate with clients, and, above all, set their expectations accurately.

At Harding Loevner, we think we have an edge because of what we know about decision-making and the structure and discipline of the process. Our analysts provide the necessary ingredients for successful, systematic portfolio construction. Our decision-making structure imposes individual accountability, mitigates biases, and ensures continuity, leading to better decisions and aligning each of us with our clients’ objectives.

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Out of Our Minds—From the Beginning

People who know a little about the history of our firm sometimes credit us with being ahead of our time. When we set out 30+ years ago we made an early decision that we would only invest in stocks of high-quality companies capable of growing revenues and cash flows over long periods of time, and then only when we could purchase them at reasonable prices. Mind you, this was two years before Eugene Fama and Kenneth French proposed their three-factor model incorporating value, and more than a decade before Cliff Asness’s seminal work on quality or the conflicting studies on the long-term premium provided by growth. So, we weren’t thinking of these aspects of our process as “factors,” or permanent sources of returns, in the current sense of the term. We thought they were merely sensible principles, based on our own beliefs about the markets, that would give us the best chance of achieving the above-market returns necessary to satisfy our clients and sustain our fledgling enterprise. Considering we had left well-paying jobs to stake our futures on these ideas, there were probably some people who thought us out of our minds. And, in a sense, they were right.

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Don’t Just Do Something—Stand There

Humans prefer to do something rather than nothing. We like office environments that are a “hive of activity” and commend “men of action.” When stuck in a traffic jam, we will take an alternate route just to keep moving, even if it prolongs the journey. We tend, though, to conflate activity with productivity, mistaking the people whom we see doing the most with those who are the most valuable.

We see this bias in many domains. Our political leaders tend to respond to a crisis with ill-considered policies that capture attention but often do little good and may even do harm. It would be unacceptable for them to stand by and simply do nothing. While serving as both vice chairman of Harding Loevner and as chairman of a professional soccer club that competes in the English Football League (EFL), I have been struck by the parallels between investing and sports when it comes to the biases that damage effective decision-making. Studies have looked at penalty kicks in soccer. When a penalty is awarded, the ball is placed 12 yards from the center of the goal and a kicker gets the opportunity to score with only the goalkeeper standing in the way. It turns out that because of the goalkeeper’s bias for action, the optimal place to kick the ball is directly at the center of the goal. A goalkeeper will almost always dive one way or another in anticipation. If he dives the wrong way, he’s forgiven as having simply guessed wrong, or as being sent the wrong way by the kicker’s supposed feint. If he dives the right way, he has a chance to stop the ball entering the goal. If he merely stands in the middle, however, he is the subject of much abuse for doing nothing.

Investors fall victim to similar pressures and impulses. The immediate costs of transacting are low, and the propensity to transact is high. The result is that investors transact too much, and their returns suffer. They tend to transact at the wrong time, buying after prices have risen, and selling after prices have fallen.

Underlying these behaviors is a general misunderstanding of the roles of luck and skill. In sports and in investing, short-term results are the outcome of a combination of the two. Yet, we tend both to attribute the outcome more to skill than to luck and to extrapolate a series of outcomes (good or bad) into the future. This tendency stems from our deep-seated need for explanation, and a need to feel we are in control even when we are not. This occurs particularly in those sports, like soccer, that are generally low-scoring affairs. Unlike in basketball, for example, where there will be more than a hundred points in a game, the average number of goals in a professional soccer game is roughly three. The result of a single game will largely be driven by luck—one bobble of the ball, the inches between hitting a goalpost and scoring, a poor refereeing decision. Yet the narrative in post-match interviews is seldom “we got lucky.” At least, it’s seldom the case that “we got lucky” when the interviewee’s team wins. When the team loses, the loss is the result of bad luck! How similar this is to investment narratives, where there seems to be only two kinds of investment managers: the talented, and the unlucky.

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Culture Club

In sports, dynasties like the American football Packers of the 1960s, the New Zealand All Blacks national rugby squad, and basketball’s San Antonio Spurs have demonstrated the power of culture to bind individuals together and enable a team to produce results above what could be expected by simply adding up the expected contributions of each member. The business world has tried to produce similar results; although exactly what culture is remains poorly defined, the hundreds of jobs available on LinkedIn seeking an individual to oversee a company’s culture certainly attest to its importance. I’ve been fortunate to have a front row seat at an investment firm (Harding Loevner) known for its strong culture and, more recently, at a UK football club (Plymouth Argyle) that is trying to develop a culture that will strengthen the organization behind the team on the pitch. As is frequently the case because of my dual roles, the parallels between the two industries and the two organizations are very much on my mind.

There are many similarities between cultures at football clubs and investment organizations, despite the underlying processes required by their core activities—making decisions on the pitch about how to try and score and defend or making decisions about buying and selling securities—being very different.

In both industries, the goal is for the team to be greater than the sum of its parts. On the pitch, an individual must rely on teammates, but certainly not debate or challenge them. Rather, coaches teach decision making so that, like muscle memory, it is instantaneous and requires little active thought.

At Harding Loevner, rules and processes constrain decision making to prevent it from being dominated by cognitive biases. Colleagues think for themselves but must expose their ideas to challenge. This is the core of our investment culture—what we call “collaboration without consensus.” We believe that one of the most difficult biases to overcome in conducting research is the tendency to give precedence to evidence that confirms our beliefs and to ignore evidence that challenges them. So, it is important that our ideas be continuously exposed to challenge. However, this leads to other problems. Humans, as social beings, generally don’t like disagreement; they are literally fearful of it. That’s why an important part of a culture of collaboration without consensus is that it be enabled by both transparency and the value of tolerance. We strive to sustain an environment in which colleagues do not feel threatened by disagreement and recognize that challenges—while discomfiting—are essential for good decision making.