Asset Allocator: November 2015

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: 24th November 2015 

 

In these weekly articles I spend much of my time discussing the big picture of investing, examining the macro-economic debates that help frame sensible asset allocation. But for many investor’s there’s a much bigger challenge, which forces us to look at the process by which a diversified portfolio is built. Put simply, which type of funds do I stick in my portfolio? Should I go passive or active? Will smart beta help? Otherwise if I choose active funds how do I pick these ‘smart’ alpha managers?

These are all really big questions and they speak to a much broader field of behavioural finance which is utterly fascinating. In particular they talk to a process where an investor is constantly monitoring their investments and understanding how managers and indices change over time.

Transatlantic fund management group Invesco Powershares has recently issued a gaggle of academic research papers by Cass Business School at the City University London looking at this difficult knot of decisions. They’re definitely worth tracking down, but my attention was most focussed on the last paper called, unsurprisingly Smart beta: Monitoring Challenges. The web link to the paper is here at -  http://www.invescopowershares.co.uk/PowerShares/pdfs/Part-4-Monitoring-challenges-Cass-Business-School-Invesco-PowerShares.pdf

The authors are  Prof. Andrew Clare, Prof. Stephen Thomas, Dr. Nick Motson and they draw together a vast wealth of literature to answer for me what is increasingly the most important question – why back active fund managers when you can invest in cheaper, smart beta trackers and ETFs instead?

This is a multi-faceted debate which doesn’t have any simple black and white answers. Put simply, it depends. It depends on the success or otherwise of the active fund manager as well as the intelligence put into the construction of the intelligent ‘smart beta’ index. Clare, Thomas et al examine each of these questions in turn, starting with how to pick an active fund manager. They concede that this is art not science, and that there is no hard evidence in the academic literature, or elsewhere that can really help in this regard. “However, according to John Chatfield-Roberts a good fund manager should:

  • have the necessary skills built into them. There isn’t an exam you can take to make you a good fund manager;
  • be inquisitive, hardworking and ultra-competitive;
  • have the ability to think independently and focus on what’s relevant rather than becoming bogged down with irrelevancies;
  • have the humility to admit and rectify mistakes. After all, it can often take ruthless action to sell those severely loss making stocks that are hurting the portfolio;
  • stick to a proven investment process even when it is not currently working in their favour;
  • be sufficiently experienced, having been exposed to several market cycles; and
  • be in tune with the psychology of the market”.

 

This is an excellent checklist of attributes that I think any investor researching a fund should focus on. But in order to be a little more forensic about fund selection we have to turn to the insights emerging out of behavioural finance. These include: 

  • The tendency for investors to subconsciously create and extrapolate patterns and trends from a series of random events, without investigating the reasons for the apparent trend, known as representativeness;
  • place too much or too little emphasis on the likelihood of an extreme event occurring, based on how easy it is to visualize the event;
  • confuse shorter-dated samples of data with longer dated samples of the same population resulting in the formulation of incorrect notions, referred to as the ‘gamblers fallacy’;
  • overestimate one’s own investment knowledge, skill and ability, resulting in undiversified portfolios and excessive portfolio turnover to the detriment of investment returns, in other words, the tendency towards overconfidence;
  • leave forecasts unadjusted even in the face of new, contradictory evidence, known as ‘adjustment conservatism’
  • place too much emphasis on irrelevant facts and figures, e.g. the price paid for a stock, when considering the stock’s future prospects and the price at which to sell, known as ‘anchoring

 

Again this is an excellent check list that all investor’s should investigate – starting with their own behaviour. But in reality like all psychological based insights these factors are hard to quantify. This naturally forces investor’s to retreat to more familiar territory, notably performance data. Here the Cass authors remind us of the overwhelming thrust of academic research into past fund manager performance – that active alpha doesn’t work very well. Take what I think is the biggest problem for retail investors – what to do when a fund manager is sacked. Should investor’s follow the manager and sell the fund or stay put? The Cass academics observe that 2using a sample of active UK mutual funds, Clare et al (2014)5 find evidence of a significant deterioration in the benchmark-adjusted returns of funds that were top performers before the manager exit and, conversely, a significant improvement in the average benchmark-adjusted returns of funds that were poor performers before the manager exit….somewhat counter-intuitively, the sacked managers, on average, subsequently outperformed those that had been hired in their place!”

A bigger problem relates to consistency of fund manager out performance – once you’ve spotted a potentially good manager, how likely is it that they’ll continue to outperform in the future? The academics reveal that in 2002 around 40% of managers had outperformed their benchmark two years in a row; while in 2010 only 20% had outperformed over 2009 and 2010. They conclude that “ on average only around five percent of managers managed to outperform the market cap-weighted benchmark over five consecutive years.”

I’ve always felt that the key selling point for rival smart beta trackers is the absence of these personality and behaviour based considerations. You don’t have to worry about a star manager losing their mojo, because there is no ‘individual’ powering the process. You also don’t have to worry about a lack of personal consistency because again there is no active manager.

Smart beta funds are thus, in my humble opinion, an easier bet. The challenges of personalities are removed and the investor can focus on whether the ‘style’ of investing is most appropriate. The Cass academics suggest that smart beta funds have three big selling points for private investors:

  1. “The investment process is generally very transparent and rules-based. And it is this transparency that allows index providers to produce indices based upon the rules.”
  2. “There is generally significant evidence to indicate the sort of performance that investors should expect from these approaches.
  3. “The ‘fund manager’ will not be susceptible to behavioural biases over time, because the fund manager is a set of rules. In the same vein, they cannot leave either!

 

But smart beta ETFs and trackers are not without their own challenges either. Whereas with active fund managers we need to worry about the personality of the investor, in smart beta we need to focus on the index itself. Put simply a badly constructed and maintained index – and accompanying ETF – could destroy your wealth. The Cass academics argue that “investors will need to be certain that the ‘production’ of the index is of a very high standard and that all the rules are laid out clearly in the published description of the index”. The main international association of securities commissions, IOSCO, has suggested that investors should focus on issues such as how the index is governed, benchmark quality, detail of methodology and accountability. “Before investing in a smart beta fund investors might wish to check that the index provider is committed to the high index production standards laid out in the IOSCO paper” suggest the academics. More importantly looking at the ETF investors need to satisfy themselves then that the manager has the operational skills and capabilities to replicate the smart beta strategy in an efficient manner.

I’d add my own checklist of concerns surrounding smart beta to watch out for including:

  • Look at the investment debate and see whether particular styles of investing – value or growth – for instance are becoming more popular. Not every investment style (expressed in a smart beta index) works all the time. Quite the contrary in fact -  some investment styles such as value investing can under perform for many years
  • See how concentrated the index is in individual stocks. One index might contain only 50 stocks, another 500. One is not better than the other but you do need to understand how your index is built and how concentrated the holdings are
  • As we’ve mentioned in these articles before be aware of how much turnover there is in the index and what the likely impact of trading costs will be on performance
  • Is the smart beta index a genuinely independent, third party creation? On a related theme I’d be keen to see if there’s any independent academic evidence – or research cited – that backs up the central insight of the index
  • Closely examine any white papers or background guides which explain the thinking behind the smart beta strategy and which explore past performance
  • Be cautious about smart beta back tests. In my experience any data of this kind has limited value unless the back test goes back over many decades.
  • Transparency matters. More than a few smart beta indices are built on black box approaches where the key investment metrics are not revealed. This makes me very nervous as I can’t really check on the provenance of the measures used.
  • Monitor your smart beta picks carefully. The Cass academics note previous Invesco Powershares research amongst professional investors which suggests that 38% of respondents said that they were reviewing their clients’ smart beta investments on a monthly basis; 45% on a quarterly basis; 13% every six months, with the remainder reviewing the investments annually.”

 

 

 

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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