I was speaking with a colleague recently about the most important initial steps in understanding how an active manager might attempt to outperform in a given asset class, and they responded:

“The first thing to work out is how someone might cheat.”

This sounds nefarious, but it isn’t. What they were saying is that for any asset class or investment strategy, it is critical to quickly work out the structural biases that might be adopted to boost returns.

Or, in other words:

Are there exposures that resemble alpha, but aren’t?

This is important because alpha or idiosyncratic returns are, by their nature, elusive and lucrative. It makes sense that investors might seek easier ways of increasing the probability of good performance.

These biases typically come in two forms:

1) Risk premia: Structural market anomalies where a persistent mispricing means that an additional return can be achieved without additional risk (think equity factors).

2) Just more risk: Simply holding greater exposure to assets or securities that are riskier and have higher expected returns.

Neither of the two are alpha in the purest sense. The first of these should be attractive (if you believe in them) but cheaper. The second is just a question of how much risk you are comfortable taking and should be transparent and low cost.

What are some examples of common ‘cheats’?

Investment grade bonds: Permanent BBB / high yield overweight.

High yield bonds: BB overweight and / or CLO exposure.

UK equities: Mid-cap bias.

General equities: Momentum, value, quality, size.

Tactical asset allocation: Long market beta (often masked by heavy trading and narrative spin)

Now, it is easy to look at such things and believe that they are easy to spot with a bit of attribution or maybe just a glance at a factsheet.* This might be true, but I am not sure it matters. For a start many investors don’t have sufficient knowledge to identify such biases, and also they will often be shrouded in beguiling stories about how alpha is being generated. 

But, more than this, when it comes to performance, investors – of all types – don’t seem to care that much where it comes from – just whether it is good or bad. For example, when sophisticated investors talk about private markets do they focus more on the return profile or the underlying exposure to small / medium sized companies and lower quality credit?

Is it important how performance is generated if it is positive? Yes. For any investor it is critical to understand both the risks being taken and the results being generated. We also need to know their worth. Paying alpha-like fees for broad factor exposure or just taking on more risk is giving away returns.

Also such biases won’t always add value. They might go through long periods in the doldrums (equity value) or it might turn out that they don’t exist in the way previously thought (equity size?). And if our bias is simply to run more risk, then we are always exposed to shocks and sell-offs.

Structural exposures that enhance returns can be desirable, but we should know what they are, take them on willingly and pay the right price. Assuming outperformance is not ‘alpha’ is always a sensible starting point.

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* Attribution, whether Brinson or factor or something else, is a useful tool, but it doesn’t tell you definitively whether something is ‘alpha’.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

It is important to think carefully about our investment philosophy – defining what we believe about investing is critical to good decision making. Even if we adopt a sound philosophy, however, it will not do us much good unless it is consistent with our time horizon. A mismatch between our philosophy and the time over which we execute it will almost inevitably lead to bad outcomes. 

In a recent paper on how investors develop asset class return expectations AQR’s Antti Ilmanen made the point that the success of different approaches depended on our time horizon. Of particular note, was this distinction:

– Valuation / Yield: 3 to 10 years. *

– Momentum: Less than a year
 
Over short-run horizons investors tend to extrapolate, performance tends to persist, and we see a momentum effect. The valuation or fundamental attributes of an asset don’t matter that much. If we want to estimate returns over the next year, looking at what worked last year might just be our best bet.

Over the longer-run, however, the value of an asset both in terms of cash flows received and potential for reversion to the mean starts to exert far more influence.

Where investors go consistently wrong is applying their philosophy to an unsuitable horizon. For an investor who cares about valuations, a one-year view is close to pointless. Value just does not have much predictive power over such a short period.**

Likewise, a momentum investor operating on a 5-year horizon is acutely vulnerable to valuation mean reversion. As Cliff Asness notes: “It is sadly common for investors to act like momentum investors at reversal horizons”.

The classic example of this destructive behaviour comes in the active fund industry.

The vast majority of investors in this space are momentum-driven (they might not admit it, but they are). The problem is that they apply a momentum or performance chasing strategy to an ill-fitting horizon. They define what is good or bad based on 3/5 year performance – a quasi-momentum approach over a duration where valuation becomes critical. The entire industry is complicit in this behaviour – private fund investors, professional investors, asset managers, platforms and regulators.

This is exactly why star fund managers emerge and crash, why money floods into top performers and laggards close, why fund buy lists are a carousel of in-vogue styles and why flavour of the month themes almost always fail to deliver. Everyone is (secretly) chasing momentum over horizons where mean reversion risk is severe and fundamentals start to win out.

A significant amount of active fund manager due diligence is carried out to justify 3/5 year momentum trades.

There is nothing wrong with a momentum approach, but it is important to admit it, be disciplined in executing it and to adopt the correct time horizon. If we can’t even acknowledge we are doing it, we probably won’t be doing it very well.

The additional challenge we face is not knowing what our real time horizon is. It will inevitably be shorter than we believe it to be.

Our genuine horizon is not what we think or say it is, but the time period over which we are incentivised or compelled to act. If our stated horizon is 5 years but we are under pressure after 1 year, that’s our horizon, whether we like it or not. Investors who have control over their time horizon have a profound advantage over those that don’t.

Before deciding on our investment philosophy, it pays to ask how much time we have. 

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* What about longer than ten years? Over the very long-run the impact of momentum and valuation reversals are likely to be overwhelmed by the steady compounding of earnings / cash flows and this will dominate equity returns. (Unless valuations are very extreme). 

** In many cases adopting a value-orientated approach will reduce the likelihood of success over the next 12 months, on the basis that we could well be reducing our exposure to momentum. Not many people are willing to trade-off worse short-term results for the better long-term results.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

You are running a multi-asset portfolio and know for certain that over the next five years there is a 20% chance of an occurrence that will cause it to suffer severe losses. Fortunately, there are some assets that you could add to the portfolio that would protect it from most of the drawdown – but there is a catch. Investing in these defensive positions will cause the portfolio to meaningfully but not disastrously underperform its benchmark in the other 80% of future scenarios. What is a rational investor to do?

It depends.

If we are investing for ourselves, we would almost certainly buy the assets that provide some insurance – the risk of underperforming a benchmark is largely irrelevant. What we care about is meeting our long run objectives.

But what if we are running a portfolio where relative returns matter? What if poor relative returns might cost us our job? The incentives change quite dramatically here – what is rational for an individual investor might not be so rational for a professional portfolio manager.

What is worse: a 20% chance of severe losses, or an 80% chance of underperforming for five years? Five years is a long time. Most investors have patience for about three years of sub-par returns.

The primary goal of running a diversified, long-term portfolio should be to maximise the probability of delivering good enough outcomes, while minimising the likelihood of very bad results. It requires us to make decisions about things that could happen but don’t. This seems obvious but the structure of the industry makes it far from easy to follow. 

In the (admittedly heavily stylised) example I outlined a professional investor who makes the smart decision to protect the portfolio from a low but meaningful probability risk looks like they are doing a bad job in 80% of future worlds. Conversely, the investor focused on improving the odds of personal survival looks like they have made better choices 80% of the time.

The underlying challenge is that good portfolio management is about creating a mix of assets that is robust to a complex and chaotic world, whereas our means of measuring and incentivising success assumes the world is linear. A choice was made and it was either right or wrong.

This situation creates an agency problem where a portfolio manager is primarily assessed on an outcome that is subordinate to what should be their primary goal, and this can overwhelm their decision making (whether they admit it or not).

If the ultimate aim of a portfolio is to deliver a real return of some level over the long-run, but the portfolio manager has a separate reference point (benchmark or peer group) and time horizon (three years if exceptionally lucky, probably much shorter) their choices will almost inevitably be driven by the latter. That might be entirely acceptable, but we should not ignore that it will encourage very different behaviours.  

Of course, having these types of discussions is like howling into the void – nobody really cares. In no other industry is Goodhart’s law (when a measure becomes a target, it ceases to be a good measure) more apparent than the investment industry. You could boil the whole thing down to one dictum: “number higher good, number lower bad”.

Doing anything other than obsessing over short-run relative portfolio performance is admittedly exceptionally messy. Nobody is going to wait twenty years to find out if something has worked well, and you can excuse any investment mistake by saying: “I was just preparing for a world that didn’t occur”. Just because something is imperfect and difficult, however, doesn’t mean it is not better than the alternatives.

What has seemingly been forgotten is that there is a yawning gulf between these two statements:

“I am investing to meet my clients’ long-term outcomes, hopefully my approach will mean I can do it better than others over time.”

and

“I am investing to beat the returns of people doing similar things to me, hopefully I might also deliver good long-term outcomes”.
  
The focus of these two statements is completely distinct and the types of decisions we are likely to make similarly disparate.

Although the investment industry is not going to change, it is worth asking whether a portfolio manager’s incentives are skewed so much that decisions that are good for them might not be best for their client.   

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).