The idea of an investment edge is a simple one. It means that there are some features of an investment behaviour that improves the odds of better outcomes. Although the concept is straightforward, locating edges and creating an environment that fosters them is incredibly challenging. This is primarily due to the difficulty in specifying and evidencing them. Many established active fund managers – who are selling edges – struggle to articulate their own supposed advantages. Edges are, however, not the sole domain of active managers; whenever anyone is making an active investment decision they should understand the edge they have in doing so, otherwise they should not be doing it. 

Types of Investment Edge

The starting point for overcoming the problems of identifying an investment edge is defining the different types that might exist. I consider there to be three broad groups, which each include a range of more granular sub-groupings, these are: Analysis, Behaviour and Implementation:

Analysis – What information is used and how it is used

Informational – Investors access more / unique information (insider trading is an edge, albeit an illegal one), or use different / new types of information.

Technical – Investors have specific technical skills that provide them with an advantage in assessing securities and markets. For example, a complex MBS strategy.

Critical – Investors use information in a distinct fashion, which provide differentiated insights.

Behaviour – How an investor makes decisions

Decision Making I – Investors structure a decision-making process that mitigates the impact of our behavioural limitations.

Decision Making II – Investors structure a decision-making process that exploits the impact of our behavioural limitations. Most factor-based strategies are founded upon such an edge.

Emotional – Investors manage and control their emotions, so that their decisions are not overwhelmed by how they feel.

Environment – Investors work in an environment that supports the objectives of their investment approach. The obvious example here being a high conviction active manager who is incentivised based on the long-term results of their strategy and supported through prolonged periods of underperformance.

Temporal – Investors make long-term investment decisions absent pressures of short-term performance or noise. This is the incredibly powerful edge that private investors hold over professionals.

Implementation – How an investor implements ideas

Trading – Investors can skilfully trade in and out of positions.

Portfolio Shape – Investors have an advantage in how they construct their portfolio or how they weight conviction in certain ideas.

Not all edges are created equal. Given the abundance of information the potential for a credible analytical edge now seems far lower than has historically been the case. Edges are also not mutually exclusive, often they are dependent upon one another. For example, a temporal edge can only be credible within a supportive environment.

Although there are simple investment edges most (particularly those that are not easily commoditised) are a complex web of complementary or (sometimes) conflicting elements.

Key Questions About Investment Edge

The categories of investment edge are by no means exhaustive, but I would expect most to fall within these groupings. Critically, defining edges in these terms is only a starting point for more detailed analysis. There are three critical questions to ask about any purported investment edge:

1) What type of edge is it? It is not sufficient to state that an investor has an edge that sits within a certain category, we need to be clear about precisely what it is, otherwise it becomes close to impossible to evidence. Edges can be very general – buying companies that are cheaper than the market. They can also be specific – complex country models to assess the credit quality of an emerging market.    

2) Why does the edge improve the chances of better returns? It is important not to accept an investment edge at face value. We need to create a hypothesis as to why it might improve our results. We can never be certain, but unless we can make a plausible claim as to why an edge should lead to excess returns, then it probably isn’t an edge.

3) Can we evidence the edge?  Now comes the tricky part. If we have identified an edge and have created an argument as to why it may lead to better outcomes, we need some means of evidencing it. Obtaining confidence in edge (or skill) is all about drawing a consistent link between process and outcome. The typical and flawed approach to this is to discover an investor who has outperformed and then assume that their edge must therefore be effective. Markets are far too random and noisy to make such inferences. There are many investors with no credible edge that will appear as if they do when we focus on performance in isolation.  Instead, we need to ask what type of behaviours are likely to result from the edge and identify whether that is apparent in the decision making of the investor.

There are inevitably challenges with this approach. Sample sizes are often small and the evidence base lacking. Also, the more nuanced and intricate the edge, the more difficult it is to draw a causal link between it and outcomes. This means we must adjust our confidence in the existence of any supposed edge and should correct our investment conviction accordingly. Any view on an edge is a probabilistic judgement informed by the evidence available.

If we don’t attempt to evidence an edge then we cannot develop a reasonable level of confidence that it exists or observe when it has been compromised or competed away.

How to Identify an Investment Edge  

Generating convincing evidence about the existence of an investment edge is undoubtedly a challenge, but there is an even more fundamental problem. It is often difficult to decipher what the actual edge is. Even investors who should have one (because they charge for it) struggle to convey what precisely they believe their advantage to be. Fortunately, for most traditional, qualitative investment approaches there is a simple resolution. We just need to ask the fund manager one question:

“Could you effectively systematise your investment approach?”

Inevitably most active fund managers would baulk at the notion that their nuanced investment process can be transformed into an algorithm; for a start it does not augur well for their career prospects if the answer is yes. More importantly, if the answer is no the reasons they give as to why it cannot be made systematic should provide a clear view of their purported investment edge. By definition, they must believe that there are distinct elements of their investment process that cannot be easily or consistently replicated. Whatever is supposedly lost through systematisation, is likely to be some form of supposed edge.

Identifying a possible edge does not mean that an investor possesses a genuine one – most of the time it will not be – but it gives us a clearer sight of what that edge might be. We can then test it.

Most active investment strategies will feature two levels of potential edge – a base level ‘risk premia’ that can be easily systematised and then a more nuanced secondary level which reflects the specific features of their approach.  For example, the manager of a value equity strategy will have a base level edge of buying cheaper companies than the market (easy to replicate, but still with historic efficacy) and the second level that is the distinct elements of their process that allows them to produce better outcomes than the cheap, simple version of the base level edge. The second level is what investors are paying for, but it is much harder to evidence credibly, and we should have less belief in it.

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This post might read as if it is solely about how we perceive the investment edges of other investors, but it is not. We must always view ourselves through the same lens that we judge other investors.

When we make an investment decision, do we know what our edge is?

It is easy to think of investing as a technical endeavour, where we can develop specialist knowledge and insights to improve our results. We expend a huge amount of time and energy on enhancing models or refining processes to gain some edge or advantage. It is difficult to argue against this drive for progress.  Yet, in investment, what feels right can often lead to worse outcomes. The desire for more information, more precision and more complexity almost inevitably impairs the quality of our decision making. 

Despite its rise to prominence in recent years, investors are still not thinking about behaviour nearly enough.

The arms race to improve technical sophistication is understandable, but a major failure in prioritisation. Do we really believe that our analysis is going to be better than the next person? Is it worth allocating inordinate resource to the slim chance that it might be? Are our research and analytics going to be superior to the house with 100x the capabilities that I / we have?

There is nothing wrong with enhancing our technical proficiency, but it should be subordinate to considering our behaviour. The potential to improve our results by understanding and managing our behaviour outstrips any other changes we could make that might enhance our investment fortunes.

The first question any investor should ask is – how can I create an environment that minimises the behavioural challenges I will face?

So, why don’t we do it? In part, it is because we still don’t believe it. We can pay lip service to behaviour, but at heart we still see ourselves as rational decision makers.

Most importantly, making behaviour the critical part of an investment approach doesn’t feel or look right. Creating strong behavioural frameworks is often about doing less. Less activity, less information and fewer decision points. Good luck trying to pitch that.

To be successful long-term investors, particularly if we have short-term accountability, is staggeringly difficult. The very minimum we should be doing is acknowledging that the potential to make poor short-term decisions based on noise, emotion and incentives is exceedingly high.

Our default expectation should be that over the long-run we will make a lot of bad investment decisions driven by our behavioural limitations.

We should be trying to fix that first, rather than worrying about extracting some uncertain analytical edge.

The question that is never asked

The problem with treating behaviour like a distracting but ultimately meaningless sideshow is not only evident in the lack of priority attached to it, but how rarely it seems to be considered across the industry. All the way from asset managers to technology providers and regulators.

The obvious example is about the access all investors now have to their portfolios / investment accounts. An optically wonderful development but what are the behavioural consequences? (They seem obvious to me).

Whenever anyone is making a change to an investment process the first question that should be asked is:

“How will this impact behaviour?”

I am not sure it is ever asked.

Every change we make to our approach to investment will alter our behaviour. Even slight, seemingly inconsequential adjustments can have a profound influence on our judgements.

So often alterations are made which have good intentions but spell behavioural disaster. It is difficult to think of many developments in the investment industry in recent years that are not likely to make us more short-term and trade more frequently.

But if behaviour is so important, why don’t we care about it enough?

1) Many things that are likely to aid our behaviour appear regressive and unsophisticated (less interaction with markets / fewer decisions). Constraining choice, reducing information and adding friction rarely seems like a winning ticket.

2) As we struggle to see behavioural weakness in ourselves, we find it difficult to understand how it will likely impact other investors.

3) Many behavioural issues seem so minor that they are easy to disregard. We should never underestimate how small changes will have dramatic consequences for choices and outcomes. 

4) The requirements to be a good behavioural investor run counter to the structure of the industry and its incentives. The management of career and business risk are far more powerful than many realise. Short-term incentives always trump aspirations of good long-term behaviour.

5) The benefits of good behaviour are not always easy to see. There is no obvious counter-factual and they accrue over the long-term. We much prefer quick wins or approaches that feel like quick wins (but create long-term losses).

6) Good behaviour that gets the odds on our side can feel very painful in the short-term and is easy to abandon. It is not comfortable spending time doing less, when everyone else is doing more.

Every development to an investment process, platform or piece of regulation should be viewed through a behavioural lens. Ideally, each change should be designed to improve investor behaviour, as nothing will provide a greater net benefit. When changes are implemented that have the potential for negative behavioural consequences then specific steps should be taken to ameliorate these. This is the least we can do.

There is plenty of talk about behaviour, but unfortunately not much action.