Avoiding the crash and burn of investing for performance
By Brandon Zietsman - January 14, 2018
Being custodians of your clients’ money carries much responsibility and, ultimately, it is performance that drives what investors see on their statements every month. Your clients expect their investments to grow and you, as their trusted adviser, are part of the chain of responsibility for making that happen, regardless of whether you manage investments yourself or outsource to a third party.
Performance is often seen as a fickle mistress, but that is mostly true when the goal is set at shooting the lights out. Over the seven years that PortfolioMetrix has been operating, our results show that it is possible to produce extremely compelling numbers over different time periods without ever having to take extraordinarily high conviction bets.
Randomness plays a massive role in markets, so placing very high conviction bets – which so many investment managers do and market as their “style” – is, to my mind, incongruent with the evidence. The simple question must be, “Surely conviction must be proportional to likely forecasting success?” Why then did so many portfolios exhibit levels of “conviction” that defied all reasonable evidence of success, typically leading to somewhat haphazard patterns of out and underperformance?
It is a myth that to add value, portfolios need to be loaded to the gunnels with high conviction directional calls. In fact, the greater part of wealth accumulation over time has to do with meticulously crafted strategic positioning and efficiency.
Instead of diving straight into market dislocations and placing our bets, we start with engineering the “base case” assuming you have little directional insights. Our thesis is pretty simple. If 80% of the time active opportunities are more apparent than real, then we should be spending a significant proportion of our efforts in navigating randomness. Only when you have constructed chassis with a degree of precision can you then seek to finesse the outcome with insights into market dislocations.
Markets are not efficient and sentiment drives asset values into objectively overvalued or undervalued territory. At times, this mispricing demands action to be taken in portfolios. We tend to see the world in terms of scenario asymmetries; in plain English, try and imagine a whole host of potential paths that events might take and decide whether they are stacked to the left or right of what markets are pricing in. If the asymmetries become too stretchy, it’s time to act.
Our work as investment managers can be distilled to two very basic activities: asset allocation and manager/fund selection. Underlying each of these activities there is, I’m afraid, considerably more complexity. Whilst our manager selection has proven to be very successful and has contributed to positive returns, we haven’t “invented” anything new. What places PortfolioMetrix at the cutting-edge of investment practice globally are our optimisation, risk-management and portfolio construction processes.
In a world where risk plays such a crucial role in advice, the importance of portfolios behaving as expected under different return environments cannot be overstated. Schizophrenic portfolios with unstable risk characteristics will lead to tears and advisers need to know that their investment partners have developed well-oiled processes that aren’t expected to crash and burn when conditions get challenging.
This article first appeared in the January edition of The Trade Press publication.