09 Aug Investments: Are you being sold a concept?
Many investment and advisory firms have a rigid set of beliefs, often referred to as “Our Investment Principles”, or some other grandiose title. Some will claim a contrarian view point just to stand out from the crowd, others will say their modus operandi is evidence-backed.
If your adviser rigidly subscribes to a certain set of beliefs, can they really describe themselves as independent? Are they in fact slavishly selling a concept? And, if so, are you being restricted by that concept?
In a previous article, I argued that investment returns were largely dictated by a simple formula; the ratio of equities to bonds that you hold in your investment portfolio. What other factors influence returns? One such factor is investment style or investment philosophy.
In this article, I will argue that there are four investment philosophies worth considering and, if an adviser is independent, they should offer their clients access to each.
Any investment philosophy that claims to be backed by science is almost certain to be flawed in a fundamental way. Science requires a set of parameters that, if repeated, would replicate the same outcome each time. Investment “science” is based on historical data, which at best describes trends that were occurring at a certain point in time. It is therefore better to retain an open mind, at all times.
Broadly speaking, there are four ways you can access the great capital markets of the world.
1. Market capitalised weighting
Simply, this is the equal weighting of capital markets around the world and is the purest form of investment. For example, if the UK stock market represents 9% of the overall global stock market, this is the percentage of UK stock that the portfolio holds. The portfolio will therefore be dominated by established stock markets such as the US, and light on emerging markets, such as China. This is known as passive investing and removes human decision making.
Historically, returns with this strategy have been robust. But again, however much historical data there may be, the future could be different. The main advantage of this strategy is that it is low cost.
Detractors argue that markets are not efficient and such a strategy can lead investors to follow bubbles but, such is the level of diversification, bubbles seem not to affect the strategy in a pronounced way. Rebalancing, as with all four strategies, keeps the equity/bond ratio at the desired level, so investment risk does not increase or decrease as each asset class changes in value over time.
This strategy is market-neutral. There is no human involved in the selection of the asset and, therefore, this strategy is the benchmark for any other strategy. Has your adviser ever shown you your portfolio returns against a market neutral portfolio? I didn’t think so.
A further benefit is that it is impossible for this strategy to underperform through poor investment selection, ie. active management. The portfolio is the market. And thankfully, stock markets are dominated by successful companies, which is why the returns, on average, are above inflation on a risk adjusted basis. The average cost of this strategy is c. 0.25% per annum.
Proponents of this strategy believe that markets are broadly efficient. They cannot be beaten, unless you change the macro make-up of a portfolio, for that is where the biggest gains are made or lost. For example, if the US stock market does well, so do most sectors within that overall market. If you move away from the market neutral approach, you can exploit inefficiencies in the global market by predicting, for example, that Europe will do better than China – and tilt the portfolio in that direction. For this reason, the strategy is sometimes referred to as “top down” investing. This strategy is the opposite of “stock picking”, which looks for value at the sector or micro level, also known as “bottom up” investing.
The strategy will usually involve a small group of economists looking at big data and global market trends. They are less concerned with how, for example, German car manufacturers will fare but would look at the whole German economy, when deciding where to tilt. Someone who used this strategy would hold the view that, “it is better to be in the worst performing fund in the best performing region”. For this reason, investment managers will often use index funds to execute this strategy, as they are less interested in splitting the makeup of the market, they simply wish to capture the perceived future gains from that particular market, as a whole.
Again, costs are low, as the portfolio strategy is run by a small group of individuals. The strategy, including fund manager fees, will cost c. 0.45% of your invested assets, per annum.
This style combines the first two theories. One, that it is difficult to beat the stock market in developed indices, such as the US, where new market information is rapidly priced into stock values. In these markets, the fund manager will use index funds, where no stock picking occurs and will save cost.
The second theory is that, in less established markets such as China or Brazil, the opportunity for mis-pricing is greater and, therefore, it is easier to exploit this. And in other asset classes, such as bonds, managers can anticipate changes in variables such as interest rates, leading to superior risk-adjusted performance.
The benefits of this strategy are that, unlike the market neutral strategy, it is possible for this portfolio to achieve returns greater than the market average. The investment manager can also rotate the portfolio to reflect their perception of where the global economy is at any point. The downside is that, if their predictions are wrong, or the choices made do not generate returns high enough to beat the market average, you get average returns or worse.
The average cost of this strategy is c. 1.75% per annum of the assets your hold. It will usually involve a small team of wealth managers but you are unlikely to have direct access to them.
4. Discretionary Fund Management
With this strategy, an individual fund manager will design a portfolio using a range of assets and, possibly, even single line stocks. For example, the portfolio might hold a broad commercial property index of shares plus a range of individual US technology stocks. You will usually meet the fund manager and have direct access to them throughout the year.
There is little academic evidence to suggest that individual fund managers can consistently produce superior returns without taking greater levels of risk, over and above the market neutral portfolio listed in the first strategy, after costs. But, if you have a manager that is lucky or skillful, or both, you may consistently beat the market.
This strategy has the highest performance hurdle, simply due to the higher level of costs of running a “high touch” strategy. The strategy must generate excess returns of c. 1.5%, simply to break even versus a market neutral strategy. And that is harder than it sounds. If an investment can beat a market neutral return, it is called “Alpha”. The evidence is that Alpha is shrinking which, if true, makes a high cost portfolio less likely to beat a market neutral, low cost portfolio.
They key word is “bespoke”. The portfolio can be built for an individual and that individual will have direct access to the decision maker. Whilst that may not improve performance, discussing your ideas, concerns and views with an investment manager directly might be something the investor is willing to pay extra for. It certainly has a value to a certain type of investor.
Due to the involvement of a well paid investment professional and their team, this is the most expensive strategy at c. 2% per annum of the assets you invest.
The mistake many firms make is that they select one of these strategies at outset, write many forthright articles and describe their philosophy as “world class” and then, sell their chosen concept to their clients.
At Barnaby Cecil, we believe that an independent planner should, even-handedly, articulate the merits of each approach, and then allow the investor to follow a strategy that resonates with them (or perhaps more than one). Couples regularly pick different strategies to one other, when given the choice.
Investment planning is about confidence in the strategy you have chosen and for that reason, picking a strategy that resonates with you is important. Nobody has a monopoly on the right way to invest. If they did and if basic principles of capitalism held true, money would rapidly flow in that direction. It doesn’t. A lot of what is discussed in this article gets buried and obfuscated in glossy and expensive marketing campaigns, as firms attempt to create illusory differentiators.
Investors continue to choose each of the four strategies listed with success. If you feel you have been offered the market as a whole, great. If instead you feel you have been wholeheartedly sold an “in house” investment concept, you may wish to consider a firm that can offer you a strategy that suits you.