Our Approach

In the late 20^th century, the idea that timing stocks is futile gained increasing acceptance. This idea, called efficient market theory, suggests that the price of a stock already reflects all public information about the underlying company. Want to buy a stock because it has a strong growth story? Sell another because you’ve read it’s facing some challenges? Those aren’t your little secrets, unfortunately, so you’ll pay an appropriate amount more for that growth stock, and get an appropriate amount less for the stock of the struggling company. Whether either move will help you to beat the broader stock market, this theory suggests, is a coin toss.

Princeton economist Burton Malkiel has been a leading proponent of efficient market theory, pointing out that the average large, actively managed equity mutual fund does not beat the major market indices. In 1976 Vanguard founder Jack Bogle launched the first index fund, attempting to replicate the performance of the S&P 500. There are now countless stock index funds and ETFs, the fund manager’s equivalent of throwing in the towel, accounting for nearly 50% of all mutual fund investments.

Efficient market theory is in fact probably a pretty good model of the stock market for large-cap, widely traded stocks covered by multiple analysts. Large equity funds, because they have billions to invest, must invest almost exclusively in these kinds of stocks, hence their general failure to beat the major stock indices. Efficient market theory, however, begins to fail at the edges of the stock market, where small-cap, thinly traded stocks are buffeted around by often ill-informed day-traders who are fad trading based on things they read on social media and internet chat rooms. When the market capitalization and float of a stock are small, it doesn’t take too many day-traders to send it flying. For these kinds of stocks, prices often poorly reflect underlying fundamentals, particularly during internet-driven buying frenzies. In these cases, future price moves take on that magical quality that all fund managers covet: predictability. The initial momentum is predictable, and the stock’s eventual fall back to earth is predictable. Trading in anticipation of these moves doesn’t always work perfectly, but it’s like gambling when you’re the house.

If you’re managing Fidelity Magellan, predictability like that would be nice, but you have over $50 billion to invest, and companies with market capitalizations of $2 million, or even $20 million, are off the table, or to the extent they’re in play, it’s at levels that will have a negligible impact on the fund as a whole. These large equity funds are also in general not short-selling stocks to capitalize on downward moves. Diametric Partners doesn’t have these problems, so we can exploit the inefficient and often predicable market of thinly traded small caps. This advantage is why Diametric Partners has soundly kicked Fidelity Magellan’s ass every year since our founding, and why Diametric’s founder and Chief Investment Officer, Eric Jockin, has landed a series of perfectly placed roundhouse kicks to Fidelity Magellan’s ass almost every year since 1998.

Nothing is certain. Markets evolve, and our trading strategies must evolve accordingly. We cannot know with certainty that we will continue to beat the major market indices, and most actively managed equity funds, every year from now on. But we have a solid basis to believe that, under market conditions that have existed for decades now, we are more likely than not to continue to provide an edge to our investors relative to both the broader market and most managed equity funds.