The folly of focusing on absolute returns
Matt Drennan writes that much of the debate about investment markets and methodologies overlooks the importance of client needs.
I recently had the pleasure of attending a number of industry conferences where the dominant theme was absolute returns as a means of better delivering what matters to clients.
The starting point is to state what to me has always been the bleeding obvious.
The efficient market hypothesis is rubbish and always has been.
The more participants there are in financial markets and the more interconnected these markets become, the more susceptible they are to herding, rumours and bubbles.
Like zebras, our herding instinct might help protect us from the lions during periods of weak markets, but does it make the most of the opportunities on offer?
During my time in the industry we have been around the world and back again trying to better define risk and return – with many forgettable stops along the way.
These included: the rise of tracking error as a measure of risk; experiments with crude quantitative models that whip-sawed investments from one losing trade to the next; misinterpreting Markowitz by torturing long-term data to come up with "appropriate" asset allocations without using any common sense overlay – the list goes on.
In the rush to systematise the investment process, "de-risk" it and make it "repeatable", many funds lost sight of their clients’ needs.
One of my first battles at Zurich Investments in 2004-ish was with an international equity product we promoted which was benchmark unaware, ignoring the country weightings in the MSCI when picking stocks and constructing the portfolio.
In those days this was pretty revolutionary and the asset consultants were having a tough time "pigeon holing" the product against competitors.
Their concern was that the tracking error was too high and they weren't convinced the process was systematic enough to be repeatable.
My position was the benchmark was nonsense as a portfolio construction tool and you can't program repeatability of performance into an algorithm (if you could everyone would have done it).
Benchmarks of all descriptions provide an inadequate yardstick for measuring performance, but as a portfolio construction tool they are worse than useless.
Did I really want one third of my clients US assets in TMT stocks at the height of the bubble?
Does it make any sense to have half your international assets in US stocks long term?
Are sovereign bonds a safe haven asset in 2012? Pretty easy questions to answer with hindsight.
On the question of repeatability, my stance has always been that fund manager skill is a risk you want in your portfolio.
Ultimately if a good investment team leaves, as a CIO you can move the money.
But blindly applying an active investment process in the belief it adds value on a repeatable basis regardless of who is at the wheel is rubbish.
The importance of being earnestly aligned
Aligning interests throughout the investment process is critical to success and to do this effectively you must have a clear understanding of how the client sees risk.
Is it underperformance of some nebulous capital-weighted benchmark, or is it the risk of losing capital?
As Warren Buffett famously said – "The first rule in investing: don't lose any money. The second rule: don't forget the first rule".
Clients can't eat relative returns, so why incentivise a fund manager to deliver them?
If absolute returns are the goal, then interests must be aligned right along the value chain.
It should be reflected in the PDS, in the latitude fund managers are given, how performance is measured and most importantly in the target returns of each fund manager comprising the investment product.
One of the best ways to do this is to ensure fund managers have skin in the game.
Performance fees are useful, but only if the base fee is modest, the performance fee is set against the right benchmark and is properly constructed to ensure no excessive risk-taking, high watermarks apply, etc.
In addition, the insistence of co-investment in the product (via initial capital and/or a significant portion of any bonuses paid) helps ensure the fund manager is eating their own cooking.
Sounds easy, but it’s very tough being away from the herd and this type of strategy will mean your asset allocations and returns often look nothing like the "average" competitor.
More importantly, the increased latitude in asset allocation this approach implies brings with it many questions, assumptions and risks.
Q & A
One crucial question: is where does the asset allocation oversight and decision-making sit?
In other words, do you have "true to label", fully invested managers in each asset class, and a centralised asset allocation function within the fund which decides the tactical positioning?
Or alternatively, do you give each manager freedom to hold a large portion of the portfolio in cash or employ shorting if they cannot find suitably priced investments in their asset class?
Another central question is what is a reasonable timeframe for measuring the success or failure of the asset positioning? One year? Three? Longer?
An important assumption underpinning this approach is that traditional diversification doesn't work adequately during black swan events.
The GFC is the latest market event to test this proposition. For mine, the answer is pretty clear.
Are we just compounding risks?
Make no mistake this approach would require asset allocators/fund managers to take very big positions from time to time.
If you are in Martin Ferguson's camp and believe the resources boom is over, how much of the index weight of 11 per cent in BHP do you want to own?
If Bill Gross is your mentor and sovereign bonds indeed represent return-free risk, what do you do with that 10-15 per cent of your balanced fund?
Even if you have the skill to execute this approach successfully, it will be crucial to educate trustees and clients on its implications.
Everyone needs to be comfortable if equity markets are up 20 per cent and the fund is up only 10 per cent – but has nevertheless delivered on its return and risk objectives.
The good news is that financial markets are so fractured at present that there is real money to be made for clients over the next few years.
If interests are aligned and managers focus on the right measure of risk, funds should be less susceptible to massive negative returns, but more likely to underperform traditional benchmarks in bull markets.
But as a former colleague of mine, Don Stammer, would likely opine, that means our clients have the prospect of benefiting from "the magic of compound interest".
Matt Drennan is an economist and commentator.
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