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Wednesday
May042011

Calling the markets: Beware the Enthusiastic Amateur!

It used to be simple.  Investment consultants offered strategic advice based on an understanding of the needs, objectives and liabilities of their client.  Fund managers implemented tactical investment decisions based on predicting which markets and which stocks will perform well.

Increasingly we see this distinction blurred.  Many investment consultants have started to dabble in tactical decision making.  We believe that in almost all cases this is misguided.  It is usually outside their area of expertise and most are enthusiastic amateurs at best.

This is not because we believe that investment markets are efficient (which would make it impossible to consistently add value through predicting markets.)  We believe that it is possible for talented individuals, when organised correctly, to spot anomalies in the market and exploit them. 

This is also not because we believe that fund managers are inherently more skilful than investment consultants.  We have worked both in fund management and in investment consulting, and have met talented individuals (and not-so-talented individuals) on both sides.  We believe that the quality of individuals to be of a similar level in both professions.  However, the skills and character traits necessary to succeed in the two roles are very different. 

So why do we believe that to take investment consultants’ advice on tactical market-based decisions is so misguided? 

There are two requirements to consistently add value through market-based decisions and we are not convinced that traditional investment consulting firms are set up to deliver either.

  •  Spotting anomalies

We do not believe that it is impossible to find imperfections in the market where something is either overpriced or underpriced, i.e. anomalies.

It is just far more difficult than most lay people believe.

A common phrase used by enthusiastic amateurs when justifying their market view is that “It is obvious that…” Usually these are seductive, compelling sounding arguments that tend to particularly appeal to practical, down-to-earth clients (the sort of clients that we enjoy working with).  However, this phrase should set alarm bells ringing immediately.  If something is obvious to trustees, and is obvious to their investment consultant, then it will have been spotted by the fund managers and other professional investors in the market.  Given that everyone already knows <<Insert your favourite obvious point here>> then it is already priced into the market.

In order to make money you need to spot something the market has not yet woke up to. 

  • Portfolio construction

The second skill that good fund managers need to have is portfolio construction.

Once you have found anomalies you need to make sure that your investments reflect those views in a sensible way.  The size of each “bet” needs to be reasonable in relation to the conviction you have.  You also need to be mindful of the way in which your various “bets” interact with one another.  It is very easy to double up bets by selecting ones that although they may superficially different, are actually related.  (This accounted for Long Term Capital Management’s demise*)

In our view a good fund manager is right 51% of the time; a great one is right 52% of the time.  The way they can turn this into a good long-term track record is to take lots of small “bets”.  Casinos successfully run their roulette tables on similar odds.  Certainly they would not bet the house on a single view. 

We think it is naïve to believe that an enthusiastic amateur will have a better success rate than a top rate fund manager.

So why can’t investment consultants acquire these two skills?

In theory they can.  However we have never seen it in practice.  They would need the follow elements in place:

  • People 

They need to devote enough high quality individuals full time to this task. 

Rugby fans of a certain age will have witnessed the huge jump in the fitness, strength and organisation of top-flight players that took place when the sport became professional.  Once players could devote all of their time into rugby, pitting them against amateurs (no matter how naturally gifted) became bloody one-sided affairs. 

Recruiting such a team would be expensive.

  • Process

They need to have a systematic approach for coming up with views across many different markets, rather than ad hoc observations on one or two markets.  Remember that for your tactical decision-making to be consistently successful, the aim is to have lots of small “bets”.

There also needs to be a measured way of taking the right size of position.  This is linked to risk controls below.

  • Character traits

Fund managers need a very different mindset from investment consultants. 

They have to be decisive, enjoy making decisions with limited information and look for reasons to place bets and take risks.  Investment consultants tend to be more cautious (perhaps it’s the actuarial background a lot of us have), looking for excuses to get rid of risk. 

Fund managers need to be fickle.   They need to be able to make 180-degree turnarounds in their viewpoints if new information comes to light; and to do so without hesitation or embarrassment.  Investment consultants tend to be far more tenacious in their views (which is helpful in strategic areas, but potentially catastrophic in market-based decision-making).

  • Risk controls

This is our biggest concern. 

We have seen recommendations by investment consultants for trustees to take risks so large that they would make professional fund managers lose control of their bodily functions.  Often these are based on very flimsy evidence.

A classic example lies within bond portfolios. 

There are experts who are paid to predict what will happen to bond markets.  They are called bond fund managers.  Most of the credible bond managers have all but given up trying to predict the overall direction of the bond market (i.e. the level of long term interest rates) because it’s too difficult.   (There are other areas, such a relative value, where they stand a better chance of consistently adding value.)

If they wanted to express a view on the direction of the market they could do so by increasing the average duration of the bonds (if they were optimistic) or reducing the duration (if they were pessimistic).  Most fund managers would consider changing the duration by a year (in either direction) to be a reasonable sized “bet”; a two-year bet would be considered very aggressive.

However, there have been cases of investment consultants advising their clients to take a 20-year duration bet (compared to the liabilities) by investing in cash rather than bonds, based on nothing more concrete than “it is obvious that bond yields cannot fall any further”.  Shocking.

If investment consultants are to give market-based advice, at the very least they should try to quantify the amount of risk they are advocating.

There is a secondary issue of “doubling up”. 

If a consultant believes that equities are overvalued at the moment, it might influence their strategic advice.  This could be quite subtle and unintentional.  For example if might affect their assumed investment returns in their modelling.   If they then advise their clients to go underweight equities compared to the strategy they recommended, they can end up with the “bet” that equities are expensive expressed in the scheme twice.

  • Timescales

If trustees delegate market-based decisions to their fund managers, their managers can implement changes to the portfolio the moment their views change.  The governance process of investment consultants advising trustees, and then formal decisions being made, is likely to be too slow to be effective in this area.   Implemented consulting would avoid this last concern.

 

In short, investment consultants would need to basically build a fund management operation within their organisation.  So it is possible, albeit unlikely.  It would be expensive, and trustees shouldn’t expect to receive this advice for the £300- £500 per hour when their consultant turns up for meetings.

Trustees should use the same criteria, and demand the same standards, in assessing an investment consultant offering tactical advice as they would if they were hiring a fund manager to provide tactical asset allocation.  On this basis it seems unlikely that an investment consultant would pass muster.

As well as being wary of the amateur enthusiast, it is important to watch out for the hidden tactical bet.  Deciding to delay an agreed strategic change because “equities look expensive at the moment” or “interest rates are going to rise” is a tactical bet.  We strongly recommend to our clients to either delegate such a call to their fund manager, or not take it at all.  (The neutral position is to implement the agreed strategy at the earliest occasion possible).

 

*”When Genius Failed” (Roger Lowenstein) is an accessible and entertaining account of the failure of this hedge fund.

 

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