The Basis of Our Recommendations
There is a plethora of academic research around the most efficient way to invest. In fact, many a Nobel prize winner has spent their life’s work on the subject. In the last 40 years there have been ground breaking discoveries and a revolution in technology that has changed the way that we view investing. This, combined with a sound core economic philosophy, enables us to confidently advise our clients on how best to invest.
So, what are our investment recommendations based on?
Securities markets are relatively efficient. By efficient we mean that at any one instant in time all information about any security is available to and known by all investors in the market, and consequently the price of the security reflects this situation. However, in the next instant all this information is updated and the price changes again to reflect the new knowledge. This information flow is an analogue not a digital process. Information flows constantly. In truth it is not so much that markets are efficient, as that they are seeking efficiency in every instant of every day. Clearly this does not mean that the market always gets the pricing “right”. Indeed, it cannot, as ‘the market’ is a price setting machine with infinite variables. So, in a sense all prices are ‘wrong’ all the time. However, the moment a security is mis-priced the market recognises it and the price is corrected. Those moments are fleeting and the new price information could equally be ‘wrong’ – until the next instant.
These observations have been crystallised into the Efficient Market Hypothesis (EMH). This proposition was developed in the 1960’s by Eugena Fama. It is controversial as it challenges a lot of vested interests in the investment management business and academia. But as we say above we think of this as the market constantly seeking efficiency, not actually ‘being efficient’.
Evidence based investing
If the EMH is true, and we believe with our modified description that it is, then active managers who seek to outperform the market or a segment of it by selecting securities that they feel are mis-priced and then realising the gains when the price is corrected, will most often fail to make any excess return.
Many Studies have been carried out to check whether or not active management works. That is, can it deliver a consistent out performances, add value, over time? All these studies, at least those with true academic rigour, have shown that they cannot do so, consistently. In other words, they are unable to consistently identify mis-prices and to profit from them. Critically they cannot consistently exceed market returns.
We are therefore convinced that active management for the majority of the time offers no advantage for the retail investor. And it is costly.
On the other hand, ‘passive’ managers, commonly referred to as index managers, seek to capture market rates of return. Index funds do this by buying a statistical sample of the securities that make up the whole market.
Therefore, do we consider index-tracking funds are better suited to the retail investor? Yes, but with qualifications. Certainly, they have lower costs but do they offer a better way of capturing market returns?
Index funds attempt to replicate the market by the use of a statistical sample of the market. They most commonly use a computer algorithm to manage this process, which will trigger buys and sells as required to maintain the accuracy of the sample. Very often these buys and sells are executed in a manner that materially affects the share price. And frequent dealing increases the costs of the fund. Furthermore, it is difficult for index tracking funds to properly sample and efficiently deal in the less liquid sectors of the market, for example smaller companies.
But, there is a third way. What we refer to as ‘evidenced based investing’.
If we agree that passive management is about market and stock characteristics, not company characteristics, is it possible to structure a fund that both minimises the value and trading issues inherent in pure index tracking and attempts to consider securities characteristics? We think it is using evidence based management of asset allocations within funds.
Rigorous academic research has shown that over 90% of the variability of returns on any investment portfolio arise from asset allocation not stock selection.
So, what is asset allocation?
An investment is defined as an asset that has a cash yield. There are only four of these in the Universe (and probably the ‘multiverse’) and they are:
- Shares (dividends)
- Bonds (interest, yield or coupon)
- Property (rent)
- Cash (interest)
These four main classes can be further subdivided into sectors or segments for example:-
- Shares Smaller companies/Large companies
- Bonds Short dated/Long dated
- Property Commercial/Domestic
- Cash Sterling/US Dollar
The diversification across asset classes and within asset sectors reduces risk. For example, there is a negative correlation between stocks and bonds.
And diversification within asset classes into the underlying ‘sectors’ can both increase returns and reduce risk. Differing asset sectors have differing return characteristics that can be utilised to match portfolios to client’s specific risk tolerances and need for return. For example, smaller companies demonstrate a higher return than large companies and the market –because they are riskier. The trick is to work out how to exploit these extra returns without excess risk.
Diversification is also needed across geography. Why concentrate all your investments in the UK when the UK represents only 7% of global market weights? Our preference is distributing portfolios in line with global market weights.
Research by financial economist including William F Sharpe, Eugene Fama and Ken French (all of whom are Nobel Laureates) have revealed that risk drives return. Therefore, it must be appreciated by all investors that without any risk there would be no return. It will depend upon each investor and his attitudes as to how much risk he is willing to take to achieve the desired outcome.
Combining all of this academic research, with modern technology we are able to advise and build client portfolios that have the weight of science and robust data testing behind them. We are confident that not only does this produce the most consistent returns but that this is the most ethical and effective way to invest.