1. Executive summary
Passive investment management in liquid, mainstream markets can be a more efficient and generally superior strategy compared to active investment strategy. Asset allocation accounts for the vast majority of most portfolios’ returns and allows for risk targeting. Constructing a portfolio to reflect a specific strategy is a disciplined due diligence process.
The method described in this paper gives a model for efficiency in liquid investment portfolios.
2. Introduction
The aim of this paper is to describe the philosophy for liquid investment portfolios pursued by Method Asset Management (MAM).
The audience for this paper is potential and current clients of MAM.
Section 3. discusses the concept of active versus passive investment management.
Section 4. outlines the importance of asset allocation within investment management.
Section 5. discusses the factors regarding the physical implementation of a portfolio.
Section 6. brings these three concepts together into the MAM investment philosophy.
Section 7. details the sources and references for this paper
3. Active versus passive
An active investment management strategy is one in which the investment manager selects which individual assets should be invested in. For example, in equity markets, this is often referred to as “stock picking”. In essence, the investment manager considers themselves to be smarter than the market. They believe they can identify which individual assets are under-valued by the majority of other investors (i.e. the market) and, importantly, believe that eventually the rest of the market will come to realise that under-valuation. This will lead to an increase in the value of that asset. Fees for active investment management tend to be high.
A passive investment management strategy is the complete opposite to an active investment strategy. Such a strategy will choose a benchmark, for example the FTSE-100 index, and then will simply mimic the investments which make up that index. The strategy should yield exactly the same return as the index minus fees. If an index is considered to be representative of “the market”, then a passive strategy can be considered to be a straight investment in the market, good and bad. Fees for passive investment management tend to be low.
The economist John Galbraith said “There are two kinds of forecasters. Those who don’t know and those who don’t know they don’t know.”
Consider a world where investment managers are the only investors in a market (as of 8 August 2020, it was estimated that the ten largest institutional investors collectively owned more than a quarter of the US stock market¹). Then, by definition, half the investment managers (measured by assets under management in this market) will beat the market (i.e. produce better returns than the market average) and half will underperform the market. Take into account fees, then actually less than half of the investment managers will beat the market. So, randomly picked, an investment manager is more likely to under perform the market than to beat it. An investor without any knowledge of well-performing investment managers is better paying low fees for a return equal to the market average.
But what if well-performing investment manager can be identified? This is also troublesome, as research shows that, on average, investment managers which beat the market tend to do so for three years but then revert to underperformance. There are a couple of posited reasons why this may happen – successful managers become complacent (and possibly rich?); and the success leads to more assets to manage which diminishes returns. So, if a well-performing investment manager is found, say after two years of good performance, then typically there is only one more year of good performance before returns revert to underperforming the market.
As long ago as 1968, academic research was highlighting this situation. In that year, Paul Samuelson published research² which, in effect, showed that (in the US) the majority of mutual fund managers failed to beat the market average, and those that did could not be trusted to repeat the trick. Nothing suggests that the situation has markedly improved. In 2008 Warren Buffet made abet for $1m (for charity) with Protégé Partners. Mr. Buffet’s side of the bet was that, over ten years, an index fund would outperform a portfolio of actively managed funds, handpicked by Protégé³.
So, in reality, unless for some specific reason a consistently well-performing investment manager can be identified with full confidence, long-term investors are far better investing in low-cost passive strategies than in high-cost active strategies.
The caveat to the above is that it is valid for mainstream, liquid markets such as equity markets and bond markets. There are other markets which are more specialised, more dominated by professionals and where sensible benchmarks don’t exist – the two obvious such markets are FX and commodities. An active manager is required due to the specialisation required for investments in such markets.
4. The importance of asset allocation
Asset allocation is the process of dividing a client’s investments between different assets – for example equity, bonds, property, cash, etc. Why is it important to do this?
By investing in different asset types, a client’s portfolio achieves diversification. Portfolio diversification is as close to a free lunch that investors can get in financial markets⁴. By investing in assets which are relatively uncorrelated, diversification is a simple way to maintain exposure and maximise returns whilst lowering risk and volatility. The process of asset allocation implements that diversification within a portfolio.
How is the appropriate asset allocation determined? There are two elements to this. One is the investment managers’ view of the markets – assets which are expected to perform well will be over-weighted, and assets which are expected to do poorly will be under-weighted. Importantly, the current state of the economic cycle is taken into account – a macro view. The second, and more important, element is to achieve the correct exposure and risk level for the client. An elderly client about to retire will want a very different exposure to a young client with many years of earning potential ahead.
All good traders go by the maxim “buy low, sell high”. A sound asset allocation which is rebalanced regularly and with discipline achieves this automatically. As markets move, cheaper, lower-priced assets will be bought and more expensive, higher-priced assets will be sold. Buy low, sell high.
This also means that being invested over the full cycle is also crucial. Re-balancing a portfolio based off asset allocation will naturally buy cheaper assets and sell dearer assets, resulting in a disciplined investment process which both takes risk off the table and looks to realise gains as they occur. A traders’ rule of thumb is that 90% of markets returns are accounted for in only10% of the trading days. It is imperative that an investor stays invested in the market.
Studies suggest that asset allocation can explain over 90% of a portfolio’s returns⁵ – over the long term, this is far more important than stock picking or market timing.
Factor tilts can be overlaid in order to improve the risk/return profile. These may offer increased exposure to low volatility assets, small capitalisation equity, value stocks and momentum assets, depending on the risk and exposure required, and may vary over time.
5. Portfolio construction
Having decided to invest in passive, low-fee investment assets (e.g. ETFs) and to pursue an asset allocation strategy, the next step in the process is to construct the physical portfolio. The investment manager will research and conduct due diligence to identify the best in class investments to achieve the risk and exposure required. Key factors to check on any such investment are:
- Liquidity. The portfolio must be made up of liquid investments, this is a non-negotiable requirement.
- Minimal tracking error. Any investment must achieve the risk and exposure of the required asset with minimal discrepancy.
- Low fees. To enhance performance and minimise wastage.
Other factors which are considered include:
- Structure. Will the legal setup of the investment cause any issues?
- Methodology. What is the investment philosophy and process of the investment vehicle?
- Counter party risk. Typically needs to be checked for synthetic ETFs and any other investments which use OTC derivatives.
- Lending policies. Does the investment vehicle lend out its assets, and if so then what security is there against this?
6. A model for efficiency
7. Sources
- “Top 10 institutional investors fuel market volatility, study finds”, Financial Times, 8 August 2020.
- “The performance of mutual funds in the period1945-1964”, Michael Jensen, The Journal of Finance, May 1968.
- In 2008, financial markets collapsed during the Global Financial Crisis. Mr. Buffet’s chosen index fund, an S&P 500tracker, dropped by 50% in the first 14 months. The Protégé’s portfolio lost far less – the active managers, in the short-term, were able to adapt to the market conditions. But by the end of the ten year period, though, Mr. Buffet’s fund returned just over 7% p.a. compared to the 2.2% p.a. of the Protégé portfolio. See “Why I Lost My Bet With Warren Buffet” by Ted Seides, Bloomberg, 2017 – Mr. Seides was president and co-chief investment officer at Protégé in 2008.
- “Portfolio Selection”, Harry Markowitz, TheJournal of Finance, March 1952.
- “Does Asset Allocation Policy Explain 40%, 90%or 100% of Performance”, Roger Ibbotson and Paul Kaplan, Financial AnalystsJournal, January 2001.