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90% of active investment funds fail to beat the S&P 500. So, most investors are switching to passive investing. To me, it makes perfect sense. But, here is a paradox. The more funds flow into passive investing, the easier it is for a small number of investors to beat the market. That path is very narrow though. But, one hedge fund manager shows the way how to do it.
As flows to passive index funds accelerated in the last 10 years, it led to one problem: price-insensitive buying. Many index funds don’t look at fundamentals and allocate money based on market cap. This creates distortions with high concentration in mega caps like Microsoft or Apple. So, if passive investing doesn’t look at fundamentals then who is actually setting stock prices?
At the same time, the number of active funds and their assets under management has declined. In 2024, passive funds overtook active ones for the first time according to Morningstar. This leaves fewer competitors and more alpha for the remaining active funds. And yet, very few are actually doing it.
Chris Hohn And TCI Fund Management
One active hedge fund manager showed returns double of the S&P 500 since the early 2000s. It has topped the hedge fund list generating $18.9 billion in profits or 27% annual return in the last year. That has beaten the S&P 500 by over 10%. And the way he does it is not what you would expect. What’s this hedge fund? It is TCI Fund Management led by Chris Hohn out of London.
The problem is that TCI does not look like a typical hedge fund. It barely shorts stocks or uses complex option strategies. If anything, it looks a lot like Berkshire Hathaway in many ways.
That’s surprising. The impression I got from hedge funds is that you need something complicated for alpha. But, TCI uses simple strategies that have outdone complicated ones.
Chris Hohn invests in a concentrated portfolio of about 10 stocks. Many of his holdings have strong competitive advantages, reliable and stable cash flows. On top of it, his fund holds on to these cash generating machines for 8 years on average. This has allowed extraordinary compounding of long-term returns. That’s unheard of. So, what’s the secret behind TCI’s success and what can we learn as investors from Chris Hohn?
How Chris Hohn Started Investing
Chris Hohn started TCI back in 2003. Like Warren Buffett, he first invested in companies with depressed valuations. First Hohn’s investments were turnaround stories or companies with structural issues. Those were bloated cost structures or lousy management. Also, Hohn pursued activism. TCI bought stakes in companies only to pressure them into changing the course.
One example is massive profits TCI made on its relatively small holding of ABN AMRO, a Dutch bank. After a high pressure campaign, ABN was sold off in the same year to other banks. TCI made a killing with a massive gain in a matter of 6-8 months.
But around the early 2010s, Christ Hohn began a shift in his strategy. Instead of buying companies with problems, he pursued high quality ones. He no longer used activism as the primary investment strategy. TCI also stopped trading a lot. Fast forward to today and here is what we have.
Current Chris Hohn and TCI’s Investment Process
The current TCI portfolio consists of
- 9 stocks only with high concentrations (GE Aerospace alone has 27% allocation)
- monopoly like business with wide economic moats
- predictable cash flows
- holdings periods around 8 years
The surprising thing for TCI is almost no trading at all for years. The fund holds certain stocks for 10 years or longer. Economic moat plays a central role in stock selection for TCI. Here is Chris himself on this:
Chris emphasizes classic features of a durable competitive advantage. These are:
- Barriers to entry
- irreplaceable assets like infrastructure
- Low or no substitution options
- High switching costs
- Network effects and scale
Ferrovial SE Example
Let me show you what that actually looks like in practice. TCI holds a Spanish construction firm Ferrovial SE. Construction companies are known for their low and volatile profitability. On top of it, they don’t enjoy significant competitive advantages.
But, Ferrovial is different. Over the last 20 years, it transitioned to operating toll roads and airports. Ferrovial does not only build infrastructure. They also contract with governments to operate these assets as concessions over decades. Toll fees that Ferrovial charges are very stable and inflation-linked. But, toll fees also grow too as urban congestion in North America gets worse.
Essentially, the Ferrovial valuation story has changed. It is no longer a construction company, but a very profitable infrastructure operator. The profit margins on toll roads are insane in the realm of 80%.
That’s unheard of. I know very few if any big tech companies with margins like that. Plus, once these roads are built, there won’t be another toll road opened next door. These are quasi-monopoly irreplaceable assets.
Chris Hohn’s TCI Current Portfolio
Ferrovial is one example of high economic moat that TCI and Chris Hohn hunt for. In fact, if we look at other companies TCI holds, the same pattern emerges. These are companies with large scale, high switching costs and huge network effects. So, Chris Hohn no longer holds companies that need fixing. He looks for those that are bound to show stellar performance among their peers.
There are only several hundred public companies worldwide that fit his investment framework. Once Hohn finds gems like Ferrovial, he buys and holds them for a very long time. Sometimes for a decade or more. This allows him to compound profits over many years as story plays out. And why would you trade often in his case?
Chris Hohn’s edge is his long-term focus. He also acts as a business owner in companies he invests in. In fact, a lot of his fortune is tied to TCI. Of the $77 billion of assets under management, $14 billion came internally.
That’s a lot of skin in the game. The parallels to Warren Buffett and Berkshire Hathaway are too close to ignore. So, TCI is much closer to a long-term equity investor than a traditional hedge fund.
What Chris Hohn Avoids In Investing?
But, besides what he invests in, it is even more important what Chris Hohn avoids. Mainly, these are companies with high substitution risk. It is fatal in his own words. If customers can switch to someone else, the economic moat is weak. TCI steers clear of businesses where technology or new entrants can disrupt.
Hohn also dislikes growth if it is not paired with high barriers to entry. He especially dislikes profitless growth, which tends to destroy value. He cited industries like airlines or tech startups. These are areas that show growth but little profits behind it. Ability to raise prices above inflation is key to growth and compounding.
We saw how many tech and software stocks tanked when Claude AI news came out. If AI can do the same at a fraction of a cost, these software companies will see a reduction in their pricing power. That was the biggest theme playing out in the last 3-4 months.
Passive vs. Active Investing Debate
The question that pops in my mind is what if TCI is just an outlier? We saw those sad numbers where 90% of active managers fail. A retail investor seems to be much better off holding the S&P 500 or a similar diversified passive index fund.
In fact, that’s what Warren Buffett recommended over ten years ago. In one of his Berkshire Hathaway letters he stated that he invested 90% of his wife’s bequest in the S&P 500 index fund. The remaining 10% sits in government bonds.
Passive index funds are cheap, simple and hard for active managers to beat for a reason. They use a disciplined, transparent and consistent investment process year in, year out. It is mechanical, but it is the main advantage of passive index funds along with their low fees.
Conversely, active fund managers tend to make mistakes. They can also quit and take their knowledge elsewhere. This can lead to disastrous returns. For instance, what if Chris Hohn retires at some point? Will TCI be able to continue its stellar performance?
Passive Investing and Market Inefficiencies
Many analysts pointed out that passive index funds don’t just track stock markets. They also shape and reshape them. As more people put money into the S&P 500, more money flows to large-cap stocks. Hence, market prices tend to be influenced by capital flows, not necessarily fundamentals.
Don’t take it from me. There was a research paper published in 2023 that examined this exact question. It concluded that passive investing leads to decreases in market liquidity. Passive investing also lowers informativeness of stock prices. Nonfundamental news flow and noise play a bigger role now thanks for passive investing.
This creates a paradox. Passive investing may make stock markets a bit less efficient. So in theory this should make it easier to beat the market. This creates an opening for active managers. And yet, most of them still fail to outperform and generate statistically significant alpha. How is this so?
Larry Swedroe looked at this and concluded that there could be a few reasons. There are many passive index funds that actually do factor investing. It could be value, growth or small size.
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Factor investing used to generate distinct alpha for active funds. But now, this is no longer an alpha. What used to be alpha is now beta. On top of it, small investors like you and me can do the same at a fraction of a cost. Anyone can buy factor based passive funds like SCHG and many others.
There are other reasons, of course. But, either way, the task for active funds has gotten much harder. Active management seems to be incapable of taking advantage of these market inefficiencies.
Investors Takeaways
What’s the result? Even more declines for the active management industry are coming. Most fund managers will disappear and only a few exceptional ones will survive. With less competition and more inefficiencies come greater opportunities.
Chris Hohn and TCI show the way how to do it. But, it requires a lot of discipline and an unorthodox approach. Like Warren Buffett, Hohn despises diversification. He thinks that once you understand a business, you don’t need 100 positions.
There is also so-called time arbitrage. Most hedge funds trade frequently and chase short-term catalysts. But, Hohn clearly shows that longer holding periods can generate alpha if done right.
Finally, economic moat is more important than growth. Hohn does not focus on fastest growth possible and cheapest valuation. Instead, he goes for companies with products that competitors cannot replicate. That way, their profits are more durable and won’t vanish in the future.
All this active investing comes with lots of caveats. Understanding a business is crucial. Peter Lynch, Warren Buffett and Chris Hohn often point this out. But, this understanding takes a lot of time and research. Not everyone has it.
For this reason, going with passive index funds still works for most people despite those documented inefficiencies. Buying the market is better than a sloppy stock picking.
Related Content: What is Economic Moat?
For me personally, I found Chris Hohn’s approach refreshing. It is very close to Warren Buffett’s. It is also a reminder how hard active stock picking is.