Most investors would be better off doing less. Whether it is the folly of market timing or the irresistible lure of performance chasing in mutual funds, more activity is likely to be bad for us. In most aspects of life doing less is the easiest thing, but in investing it is incredibly difficult – and getting harder. 

The challenge of doing less is in part a psychological one – not reacting to the incessant stream of financial market stories and acute emotional stimulus they provoke can feel almost impossible. As humans we are wired to respond – fighting that instinct takes huge effort.

Alongside this there is also a profound incentive problem, which Warren Buffett captures well:

“Wall Street makes its money on activity, you make your money on inactivity”.

Most, if not all, professional investors are incentivised to be active. Imagine the difficulty of progressing your career when at the end of the year you have barely touched the portfolio you manage. It makes it incredibly hard to make the case for that promotion. 

There will be similar expectations from clients, who may well ask:  “What are we paying you fees for? You haven’t done anything.”

Activity can be good for the professional investor, even if it is bad for their investment results. 

The key reason why more activity is a rational decision for professional investors is the inevitability of underperformance.

Nobody likes to underperform but any concerns your clients or employers may have might be placated by activity – signs that you have ‘done something about it’.

What is totally unacceptable is to underperform and do nothing.

The randomness of financial markets mean that even great investment strategies will struggle for prolonged periods of time. As underperformance is inescapable, activity is an essential survival strategy. 

There is some merit to the argument that investment activity that has very little supporting evidence of adding any value – such as making short-term tactical trades – can have a useful placebo effect. While it is likely to be (at best) pointless, it might make investors feel better to know something is being done (and therefore more likely to stay invested).

Although this may be true in some instances, being more active than you need to be while not destroying value is a tough ask.

I am not advocating never doing anything. There will be times when action makes sense. For most investors, however, this should be a rare occurrence, and you must be very clear in what types of situations you are likely to act.

If you are not extremely disciplined about defining when you might need to make changes, you will almost certainly be captured by the next incredibly consequential story that comes off the conveyor belt of financial market news. 

To embrace the benefits of less activity over more, we need to stop asking – ‘why haven’t you done anything’? And start asking – “why are you doing something?”

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

High yield credit spreads are tight. At the time of writing, the US index trades at a spread of 279 over Treasuries. This is not the tightest on record but the reward for taking additional credit risk is historically slim. Taking the view that spreads are rich is easy; however, knowing what to do about it is much more of a conundrum.

Despite high yield valuations looking optically expensive there are plenty of reasons why investors might still be comfortable holding. Let’s consider some of these arguments:

Credit spreads are ‘always’ tight: Spreads are not normally distributed – they spend a lot of the time appearing rich until the occasional bout of severe stress sees them widen substantially. In that sense tight spreads are not a useful signal. (It can be helpful to think of owning high yield credit as holding a government bond and selling an equity put option – we can happily collect the premium until things turn ugly).

Credit spread levels are a terrible timing tool: This is undoubtedly true – the level of spreads now doesn’t tell us a great deal about where they might be in 6 /12 months’ time. (I would caveat this by saying that everything is a terrible market timing tool, except maybe momentum).

Credit quality has increased: This is talked about a lot – lower spreads are justified because the quality of the underlying companies is better. What this really means is that we think that default rates and / or losses given default are lower now than has historically been the case. Is this true? Perhaps. Although at a 279 spread level, even with lower through cycle defaults and losses, the premium available is hardly plentiful.

Being underweight high yield is a ‘pain trade’: Despite tight spread levels, all in yields appear pretty attractive in this environment – sitting at about 6.5%.  Selling or moving underweight an asset with that level of carry can be a painful decision. Imagine if we replace high yield with investment grade or sovereign bonds – we are immediately short carry and are also investing in assets with a lower long-term prospective return than the one we are relinquishing. This is less of an issue for investors focused on delivering a total or absolute return, but for those where benchmark relative performance matters, being underweight high yield (much like being underweight equity) can prove very uncomfortable even when valuations are expensive.

High yield is a structurally attractive asset class: From a risk and return perspective, high yield bonds have compelling long-term characteristics – contractual returns, observable yields, pull to par, a lower volatility than equities and some duration protection. Why sell?

Corporates are more attractive than governments: This idea is something I hear increasingly, but one which I find somewhat puzzling. The central thesis is that because of the poor state of government finances in the US (and elsewhere), with high indebtedness and persistently large deficits, corporate balance sheets are more robust than most sovereigns’. This seems to ignore the fact that corporate and government balance sheets are not directly comparable, particularly if the government in question controls its own currency. The US can print the currency in which it issues debt meaning that it ‘cannot’ default unless it actively chooses to (I include debt ceilings in this definition). No corporate has that ability.

It is fair to argue that a ‘default’ in this situation comes in the form of inflation rather than a nominal failure to pay. While this is true – it seems a stretch to believe that US government bonds face an inflation risk that is not at least shared by corporates issuing debt in the same currency.

One caveat to my view here is that the current US administration does probably imbue some new form of ‘credit risk’ in US treasuries, but one that is incredibly hard to define or price in any reasonable sense.

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I haven’t written anything about the credit cycle conditions, as while they may be meaningful for spreads levels, I do not consider them to be knowable in a way that might aid investment decision making.

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Credit spreads are unequivocally tight, but there are a range of reasons as to why that might be palatable.

What could investors do?

Do nothing: This is a perfectly sensible option. High yield bonds have solid through cycle return characteristics and attempting to time them is a fool’s errand. Yes, high yield spreads will spike substantially at some unknowable point in the future, but that is simply something to weather. Furthermore, it is not just about getting out but knowing when to get back in.

For those in this camp, an interesting thought experiment is to ask what we would do if high yield spread levels dipped below a conservative estimate of default rates and expected losses? Or, in other words, is there any level of spread tightness that would compel us to act? 

Reduce exposure and increase credit quality: We can take the view that the additional return for bearing the increased risk of drawdowns and losses is not currently attractive enough, and therefore replace exposure with investment grade credit or sovereign bonds. From a pure valuation perspective this makes sense, but we need to be willing to bear the loss of carry in the near term and the long-term reduction in expected returns. (And, as above, know when to get back in).

Find a replacement asset with similar risk levels: We don’t necessarily need to replace high yield with lower risk assets, we can instead find assets that have broadly similar characteristics to high yield but without such stretched valuations. The problem is that most assets with spread are trading tight and / or bring a whole host of new risks that we must get comfortable with (see: private credit).

Use more active strategies: High yield has always been a go to asset class for active investors due to the perceived limitations of passive replication; while this argument has almost certainly weakened through time, an environment of tight spreads and low dispersion may strengthen it once again. Perhaps it is a ‘credit pickers’ market!’

Create a mix of assets to replace high yield: High yield bonds are akin to sovereign debt exposure with some credit risk on top, so it is possible we could replicate that structure by combining assets to create something with similar risk characteristics but better return prospects. An obvious example might be government bonds plus exposure to some undervalued equity markets. This sounds easy but is complicated to get right, plus it is probably amplifying the risks we already hold in our portfolios.

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There is no right answer to the question of narrow high yield spreads. Our own approach will come down to a multitude of factors including our objectives, philosophy and behavioural tolerance for underperformance.

Credit spreads being tight seems obvious, what we should do about it depends on the type of investor we are.

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

It seems a fair bet that in a few years’ time we will come to see the two most dangerous words in investing as “democratisation” and “innovation”. Although one might feel like something of a luddite when criticising progress, it is difficult to escape the notion that too many ‘solutions’ in investing are designed to solve the problems faced by the industry, rather than the clients it serves.

New markets, new instruments, new platforms and new structures. It is wonderful to see such a bewildering array of choice available to all. Who doesn’t want to trade single stock options at three o’clock in the morning?

The idea that providing everyone access to everything will provide clear client benefits is a dubious conceit. In most cases all it is doing is creating greater confusion, temptation and cost, while making it increasingly difficult for investors to manage their behaviour.

It is frustrating that minimal thought seems to go into answering the question: how is this development likely to impact client outcomes once we account for the behavioural impact?

There is a seemingly accepted view that opening access to ‘institutional’ assets and instruments previously unavailable to the retail market an undoubted positive. As if most private investors are being shut out from exclusive areas of the market that could transform their fortunes. This exact argument was made about hedge funds years ago, and I am not sure that it worked out too well.

For an industry perspective there are certain things that are critical from a revenue perspective – activity, complexity and differentiation. Unfortunately, these things are all too often a drag on client returns – not many investors who trade a lot, own complex products and struggle to deal with too much choice ever come out well from it.  

There is certainly nothing wrong with innovation, but we must accept that there can be an acute friction between what might be good for industry outcomes and what might be good for client outcomes.

Of course, it is possible to have industry developments that are beneficial for both clients and companies, but the more something egregiously benefits the seller, the more scrutiny we should place on the question – which client problem is this solving?

When shiny new things are brought to market (particularly the retail market) far too little effort is given to making the case as to why clients will benefit. In a world of rapid technological change and declining industry margins, investors will need to be on guard that what is presented as progress, isn’t actually likely to make them worse off.

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

As an investment theme AI has it all: the potential for transformational societal and economic change, huge capital investment and the prospect of dramatic corporate winners and losers. It would be hard to design a better setup for investors to lose a lot of money. 

I have no confident view on quite how profound the continuing developments in AI will be for our lives – but then I don’t think anybody really can. The problem is that many investors will be tempted to behave as if they do. 

All investment themes are dangerous, but a narrative as powerful as the one that currently surrounds AI requires a particular level of caution. When investors anticipate (or worry about) extreme change we find it hard to escape the feeling that our portfolios, and even our entire investment approach, needs a rethink. 

If there are to be winners and losers, then surely we must act to best exploit the opportunities and mitigate the risks? This notion sounds eminently sensible, but really isn’t. 

When we adapt our investment strategy in reaction to potentially dramatic thematic market shifts – such as AI – what we really mean is that we want to be more concentrated in our portfolio. Concentrated by idea, country, sector, stock – focused on all things seemingly related to the prevailing narrative.

Becoming more concentrated in our investment approach is simply a way of expressing that we are increasingly confident about the future. The more conviction we have in our predictions, the less diversified we need to be.

Unfortunately, taking a more concentrated approach at a time of (possibly) seismic shifts is precisely the wrong thing to be doing.

If AI is to lead to genuinely consequential change our preference should be to be more diversified not less.  Nobody can say with any confidence how it will play out, so why would our portfolio activity suggest that we can?

When investors talk about AI beneficiaries and focusing their portfolios on such areas, it is worth considering the critical questions that need to be considered:

• What will be the pace and scale of development in AI technology from here?
• What will be the economic and societal impact?
• How will it impact corporate profitability across sectors?
• To what extent are AI developments already reflected in stock prices?

These questions are just the start of what is a staggeringly complex topic. We should be ensuring that our portfolios reflect the sheer level of uncertainty that exists around AI, not make investment decisions that imply that the outcomes are self-evident.

There are, of course, a range of AI-associated stocks that have already benefitted grandly from the theme’s emergence, but whether these are anything more than first order momentum trades is fiendishly difficult to decipher. 

The temptation to adopt an increasingly concentrated investment strategy in order to best capture the impact of AI exposes us to two potentially disastrous risks. First is that the consequences of AI are less significant than anticipated and ‘AI related’ stocks are materially overvalued. Second is that AI is as transformative as many anticipate, but the companies that benefit are very different to current market expectations. 

It is always important to remember that being right about some economic or technological development does not mean that we will make money from it. The internet did change the world, and China did rise to become a global economic superpower.  Knowing both of these things in advance would not have been sufficient to deliver good investment performance. In fact, knowing these things in advance would probably have increased the risk of very poor returns.

Despite constant lessons from history of the dangers of making concentrated bets on seemingly inevitable themes, the lure of repeating such mistakes will prove irresistible to many. The combination of strong performance, and compelling stories will draw us in. 

There is, however, no need to have an ‘in or out’ view on AI. Being diversified allows us to benefit from holding the areas of the market that benefit most significantly from the progress of AI, while providing some protection if its impact is underwhelming relative to expectations, or it has economic or corporate impacts that we did not foresee.

The most powerful investment themes can often make us feel as if things are becoming more certain just as they are becoming more unpredictable and risky. Our best guard against the risks that might stem from unknowable change is to remain humble and diversify. The more AI hype grips markets, however, the more likely we are to do just the opposite.

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.