Investors Should Assume That They Are No Better Than Average

Overconfidence bears the traits of many behavioural issues within investment – it is widely known, poorly understood and assumed to affect other people.  Most of us are probably overconfident that we don’t exhibit overconfidence.  Although there are memorable examples of overconfidence in action – such as the majority of people in a room believing they are an above average driver – there seems limited acknowledgement of what forms overconfidence can take or how it can influence our decision making.

The investment industry should be a fruitful area for identifying and understanding overconfidence.  For a start there is an inevitable selection bias, I think it is safe to assume that the majority of individuals working in front office asset management roles exhibit more confidence in their own abilities than the general population.  Furthermore, many investors engage in activities that are ripe for displays of overconfidence – economic forecasting and market timing (to name just two) are key pillars of the industry, despite limited evidence of their efficacy.

In the investment world overconfidence is a sought after characteristic.  In an environment defined by uncertainty, we crave certainty, conviction and confidence (however ill-placed this might be); whereas circumspection, probabilities and caveats are associated with having a lack of knowledge or expertise. Thus, even if being well-calibrated is likely to improve your judgement, it will not necessarily have a similarly positive effect on your career prospects.

Whilst overconfidence is frequently discussed, there remains vagueness around what is actually meant by it; research by Moore and Healy (2008) sought to clearly distinguish distinct types of overconfidence*, defining these as: overestimation, overplacement and overprecision.

Overestimation: This is an overly optimistic view of our abilities or performance level.  For example, we are likely to exaggerate the success of our investment decisions.  As Moore and Schatz (2017) highlight, there appears to be a pattern where individuals overestimate their abilities on difficult tasks and underestimate on easy tasks. Investment would certainly fall into the former category.

If investors are overconfident about their performance level, what would be the benefit of such self-deception? One reason might be to manage the potential cognitive dissonance of believing yourself to be an intelligent and skilful investor, whilst simultaneously adding little value in your investment decision making – embarking on a career where you are no better than average may not be particularly fulfilling.  Of course, such overestimation by investors might not be self-deception at all, but rather an effort to present oneself to others (clients and colleagues) in the most favourable light.

Overplacement:  This is the classic ‘better than average’ perspective.  Despite a litany of evidence on this phenomenon, Moore & Schatz (2017) highlight some limitations with the research in this area – most pointedly the fact that a skewed distribution can result in the majority of individuals in a sample being above average. They also argue that, unlike overestimation, overplacement occurs more for easy tasks with underplacement more common for difficult tasks.

Given that the investment industry is highly competitive and involves lots of people undertaking ostensibly the same tasks, my sense is that over-placement must be pronounced. Indeed, it might be something of a pre-requisite – if you are below average at active management or as an economist then there is seemingly not a great deal of purpose in that particular role.  That is unless you take the view that there is so much uncertainty and randomness in investment that you can be aware that you are below average whilst pursuing a successful and well-rewarded career.

It may simply be the case that overplacement is somewhat irrelevant for asset management.  It is perhaps so difficult to disentangle luck from skill, that nobody knows what the distribution of skill is or where they (or anybody else) falls within it with any sense of certainty.

Overprecision: This is exaggerating our knowledge of the truth, and is typically tested through calibration studies. For example, answering a selection of questions (such as estimating the length of the Amazon River) whilst employing a 90% confidence interval. Success rates are typically far lower than the prescribed confidence level.

Overprecision would seem to be the most pervasive and pernicious form of overconfidence apparent in investment. Despite the inherently unpredictable nature of financial markets there is still an over-reliance on point forecasts, bold predictions and heroic portfolio positioning.  The use of subjective probabilities around potential outcomes is also something of a rarity.

One way to address the issues of overconfidence is to talk more explicitly about confidence levels, probabilities and base rates when making decisions. Let’s take an example:

I decide to invest in an active equity manager and have based that choice on the manager’s strong historic track record, robust process and compelling investment philosophy – we can call this the inside view (evidence specific to this circumstance).  Alongside this I must also strongly consider a base rate for active manager outperformance – in this instance over the last decade only 20% of the manager’s peer group have delivered performance in excess of the benchmark – we can think of this as the outside view (evidence incorporating a broader reference class).

To persist with recommending an active manager despite the base rate information means one of two things:  i) I believe the base rate is anomalous and in the future the proportion of managers outperforming in this sector will increase, ii) I believe that my active management selection capabilities are sufficiently strong that I am willing to accept the highly unfavourable odds of identifying an outperforming manager (even before considering mean reversion in performance).

This is not to suggest that in these situations one should never go against the base rate, but rather it is critical to consider these factors when making such a decision. Failure to do so means we neglect crucial information, largely ignore probabilities and have no means of understanding the level of (over)confidence underpinning our decision making

For most investors it is sensible to make investment decisions on the assumption that our abilities are no better than average. We can do so by answering two questions:

1: Assuming I have no skill, what is the probability of a successful outcome?

To clarify the purpose of this question, I can make an adjustment to my earlier example – let’s assume that there was an asset class in which active management had historically been particularly successful and 70% of active managers had outperformed the index over the past decade. In such an instance, the odds of a positive outcome from selecting an active manager are in your favour (other things being equal) even in the absence of any particular skill in manager selection.  This approach could apply to assumptions about future returns or, from a bottom-up perspective, company growth rates or margins.  Whilst there might not be a perfect reference class or probability number for every investment decision, it remains a worthwhile exercise.  

2: If I am taking a position where the odds are unfavourable, where do I hold a particular edge / skill and why?

When we take views that implicitly or explicitly reflect a high level of confidence in our own abilities, we should be clear about why this is the case. This is useful both for any given decision and also as a means of tracking decision rationale (and confidence) through time.  

Overconfidence is a major issue for investors and can create a plethora of costly problems, such as insufficient portfolio diversification and overtrading.  If, however, we think about our investment decisions on the basis that our skill is no better than average, we are far more likely to consider crucial factors such as base rates and put our own confidence levels into perspective. This is not a cure all solution for overconfidence, but should encourage us to make investment decisions when the odds are in our favour.


* I was reminded of this research by Jason Collins’ excellent blog.

Key reading:

Moore, D. A., & Healy, P. J. (2008). The trouble with overconfidence. Psychological review115(2), 502.

Moore, D. A., & Schatz, D. (2017). The three faces of overconfidence. Social and Personality Psychology Compass11(8), e12331.

Pulford, B. D., & Colman, A. M. (1996). Overconfidence, base rates and outcome positivity/negativity of predicted events. British Journal of Psychology87(3), 431-445.

 

Few Things Destroy Long-Term Investment Returns Like Short-Term Measurement

I am apprehensive about writing a post that is critical of performance benchmarks for active management as accountability is of paramount importance and comparing returns to a relevant benchmark is a valuable means of assessment. With those caveats in place, I now wish to argue that our use of benchmarks – specifically for short-term* performance measurement – is a major behavioural problem and one that transforms the job of active management from difficult to close to impossible.

The simple, but critical, point is that the way in which we measure something can have a profound impact on our behaviour, and be of detriment to our ultimate objective even if the measure is optically sensible.  Many of us will have heard stories confirming this idea – in the United Kingdom the imposition of hospital waiting time targets by the National Health Service (NHS) has consistently backfired, with behaviours often directed toward hitting the specific target, at the expense of all else (a case of Goodhart’s law in action**).  This issue is discussed in a paper by Bevan and Hood (2006), which compares the NHS situation to measures of productive output in the Soviet Union, which were also blighted by ill-judged performance targets and unintended behavioural consequences.

For active management the situation involves taking a reasonably effective (albeit imperfect) measure of success (long-term performance versus a benchmark) and then employing that same measure over a much shorter-time horizon, a period for which it is often devoid of meaning.  The view seems to be that if it is a valid measure over the long-term then it can also be assessed over far more limited periods.  If we can measure it over five years, why not three months, one month, one day?  A significant amount of time is wasted and behavioural damage wrought by constantly appraising noisy short-term performance data.

If there is any skill in active management, then it can only be identified over the long-term; short-term performance numbers are a sea of randomness searching for a narrative.  To validate this point, let’s take Michael Mauboussin’s simple heuristic for judging whether an activity is more driven by luck or skill – can you fail deliberately?  For active investment management, over the short-term, the answer is absolutely not; it would be impossible to confidently select a portfolio of securities that would underperform over a day or even three months (it is entirely random), however, over the long-term it might just be possible.  Certainly as the time horizon extends someone with skill in the field should have greater confidence in meeting this threshold.

Of course, the challenge for active management is that short-term performance data is available, so therefore we feel compelled to measure it, analyse it and assess it. I find it constantly baffling that anyone believes there is much information of substance such performance numbers, the only obvious exception being where relative performance diverges from what one might reasonably expect given the approach adopted by the fund manager. To believe that short-term returns tell you anything about the skill of an active manager, is to believe that certain individuals have the ability to predict short-term market movements.  They don’t.

The problem with short-term performance analysis is not simply that it is a weak measure and rarely constitutes meaningful evidence, but that it has come to dominate investment thinking and decision making.  Unfortunately, long-term outcomes are reached by experiencing and reacting to many periods of short-term performance.

How do active fund managers react to endemic short-termism? By reducing the risk they assume relative to their benchmark comparator. There is little point being a long-term investor, if you are fired after a year for ‘consistent underperformance’. There is great confusion at the heart of the debate around active management – on the one hand there is a drive for high active share managers who can justify their existence, but also a complete intolerance for spells of underperformance. These views are entirely incoherent.

Active management groups are interested in maintaining and growing assets. The dominance of closet trackers / index-hugging strategies is in part a consequence of the focus on short-term performance measures. Tracking errors are managed and ‘active risks’ are scrutinised as genuine active management is sacrificed and long-term decision making stymied to avoid descending to the foot of performance tables.

What are the consequences of professional fund investors’ use of short-term performance measurement? A great deal of entirely unnecessary activity.  There is so much data available that it is irresistible; it is possible to construct all sorts of compelling narratives backed by supporting evidence and statistics. As fund investors we have every opportunity to scour daily / monthly / quarterly performance and make grand conclusions based on noisy and unreliable attribution. This brings us to a perennial problem of the investment industry – it is hard to prove your worth by doing less (even if it is the best course of action), being busy is often career-enhancing.  It is easy to produce analysis that weighs a lot and means a little.

In defence of active fund investors, even if they wanted to focus on quality of process and genuinely long-term performance, they are often serving others for whom short-term performance is paramount. Why pick a high active share manager if you are likely to be hauled over the coals every other quarter to explain underperformance? Furthermore, remuneration will often be tied to the performance of funds recommended over time horizons where the outcomes can be considered no better than random.  Most professional investors in active funds are incentivised (in the broadest sense of the word), to not take too much benchmark risk, be similar to everyone else and recommend funds with a strong recent track record that might still have some momentum.

Although I am often an advocate of doing nothing as a superior investment strategy, my criticism of the use of short-term performance measures is not about adopting a hands-off approach to active manager research, rather ensuring that the focus is on the right things.  It is possible to have a granular understanding of an active manager without being consistently diverted by short-term vacillations in relative performance. Process must always trump outcomes; time should be spent understanding fund manager behaviour and whether it is consistent with expectations, not whether they have beaten a benchmark over some arbitrary period.

The basic message here is this – if you are worried about short-term relative performance, avoid active managers, if not you will spend a great deal of time making consistently poor investment decisions. For those committed to active management, it is imperative to put steps in place that support and foster it.  This will often involve taking decisions that seem entirely counter-intuitive given how the investment industry has evolved in recent years.  If you are employing or analysing short-term performance measures, you are inevitably shaping behaviour and reducing the chances of long-term success.

—-

* It is difficult to precisely define what is meant by long and short term and it depends on what you are talking about.  For active management I would argue anything under one year is short-term and anything over five years is long-term.  The bit in the middle we can debate.

** In simple terms, Goodhart’s law states that when a measure becomes a target it ceases to be a useful measure.

Key Reading:

Bevan, G., & Hood, C. (2006). What’s measured is what matters: targets and gaming in the English public health care system. Public administration, 84(3), 517-538.

Are Index Fund Investors More Vulnerable to Bubbles?

One of the most superficially persuasive criticisms of passive equity index investment regards its susceptibility to bubbles and fads.  Indeed, this ‘vulnerability’ is an inescapable feature of market cap based index investing –  if a certain subset of the equity market becomes wholly detached from its fundamental attributes and extremely overvalued, an investor in a market cap tracker of that index will see their existing exposure increase and additional cash flows allocated in a greater proportion to this area.  The dot-com bubble is often cited as an example of a period when a simple passive market cap index investment was a decidedly poor choice.

Implicit in this criticism is the view that active management is better suited to this type of environment and avoids many of the aforementioned issues that would beset market cap equity index funds.  The problem with this line of thinking is that it only looks at one-half of the equation – focusing on what happens to index funds, rather than the probable behaviour of many actively managed strategies.

Let’s assume that a bubble emerges in a particular segment of the equity market and persists for a number of years before the ‘inevitable’ denouement.  We are aware of the implications for market cap passive investments – but what can we assume about the active management industry against such a backdrop?

– Active funds participating in the bubble areas gain flows and popularity due to strong performance.

– Many active managers abandon their philosophy and process to keep pace with market.

– Active managers avoiding the bubble assets lose assets / their jobs.

– Index aware / closet tracker funds increase exposure to bubble assets to manage tracking error.

– Fund selectors bemoan the relative underperformance of dogmatic managers for failing to adapt to the ‘new paradigm’.

– Money flows from active manager laggards to active manager outperformers. Fund investors crystallise recent underperformance and lay the foundations for future underperformance.

– Quantitative performance screens of actively managed funds uniformly highlight funds that have participated in the bubble as the most ‘skilful’ and ‘consistent’.

– Quantitative risk systems will show that active funds are running too much tracking risk by avoiding the bubble stocks.

– A minority of active managers will withstand the underperformance and remain faithful to their investment approach, but not without haemorrhaging assets.  This select group will be lionised as the bastions of active management after the reckoning.

Bubbles are formed by a compelling narrative, which is validated and emboldened by abnormally strong returns.  The notion that there is some great divide between the susceptibility of active and passive investors to such a scenario is spurious – even only on the basis that the active management industry makes for a reasonable sample of the market and therefore in aggregate will suffer in a similar fashion.

The idea that active managers will be standing steadfast against an irrational and unsustainable bubble that occurs in an area of the equity market – whist passive index investors blindly chase returns – runs contrary to the nature of bubbles, and the incentives and behaviours that have come to define much of the active management industry.  Furthermore, all of the evidence points towards fund investors heavily favouring recent outperformers – which will be those active funds that have embraced the new fashion.

Investment bubbles are alluring and persuasive, and it is only hindsight bias that comforts us that they are easy to identify and avoid.  As active management seemingly becomes increasingly myopic and focused on performance chasing / asset gathering, the ability to avoid bubbles reduces – if such a situation persists for any length of time most simply have to participate.

Of course there are exceptions to this – that select group of active managers that have a clear philosophy, operate in a supportive environment and hold a willingness to diverge markedly from the index.  These are the type of managers that fund investors should always seek out, but they are also the hardest to own, particularly in the midst of a fervent and sustained bubble, through which they will come to appear outmoded and unskilled.

In theory, any material and sustained detachment of an asset’s price from its fundamentals should prove a boon for active managers; however, this makes assumptions about time horizons and incentives that are at odds with the behavioural reality. There is no compelling reason to believe that passive market cap equity investors are more vulnerable to bubbles than their active counterparts.

The (Other) Problem with Active Management

Active management is difficult.  Only a minority of managers outperform after fees over the long-term and it is difficult to identify those which will ex-ante. Whilst this dominant critique undoubtedly has validity, there is another major hurdle for active management, which relates to the perceptions and behaviour of fund investors.  It means that even if we can successfully isolate managers with skill, there are no guarantees that we will reap the benefits of it.

There is a paradox at the heart of active management; to justify its existence the focus should be on differentiated and high conviction approaches; however, the more genuinely active a strategy is the greater the likelihood that it will experience spells of pronounced and often prolonged underperformance, which will be unpalatable for many investors.  There is a justified clamour for high active share managers; but little consideration as to whether we are behaviourally disposed to owning such investments.

Let’s take an example; in a twenty-year period ending in 2007 a prominent active equity fund delivered an annualised return of 15.0% compared to 10.9% for its benchmark comparator. This meant the closing value of an initial investment in the active fund was over double that of a passive holding in the index.  This is clearly a compelling outcome (net of fees), however, it is also important to look at the return profile through a different lens; somewhat unfortunately, even as long-term investors we have to ‘experience’ the vicissitudes of shorter-term performance:

– Across rolling one year periods (shifting one month forward) the fund underperformed its benchmark on 34% of occasions.

– On 17% of the rolling one year periods excess returns were more than 10% behind the index.

– For 29% of rolling three year periods the fund trailed the index.

– On 16% of rolling three year periods the fund trailed the benchmark by more than 20%.

Highlighting these features is not designed to be a slight on the strategy; rather it is a reflection that even successful active funds will suffer protracted periods of challenge.  Indeed, if a fund is truly active and idiosyncratic then such spells of poor performance are inevitable and have to be withstood to garner the longer-term benefits.

Historic performance numbers seem anodyne written on the page and we often focus purely on the ultimate outcome delivered rather than importance of the path; yet it is crucial to consider what is likely to occur during those days, months and years of owning an underperforming strategy, and how it might influence our behaviour and decision making:

– Outcome bias will lead us to doubt the quality of the manager and find problems even if they possess significant skill, and nothing has materially altered in their approach.

– Myopic loss aversion will mean that short-term (relative) losses will weigh heavily, even if we are investing with a long horizon.

– A disproportionate amount of time and focus will be spent on the strategy through exacting periods – the emotional and cognitive load will be high.

– If the fund manager has a high profile they will be subject to significant industry media scrutiny, poring over individual decisions and highlighting every stock disappointment. Persuasive narratives will be formed about decline of the manager or style adopted.

–  For professional fund investors there will be constant scrutiny from colleagues, risk teams and clients.  Continual justification for the decision will have to be provided.

– The fund may suffer from outflows – do we want to be the last person remaining in the fund?

– Other flavour of the month funds / strategies will attract attention (many of which will be generating outperformance through sheer chance or some favourable style bias).

Then there is, of course, the additional problem that it might not be an ’admissible’ period of underperformance – something about the philosophy, team or process may have changed to its detriment, or our initial analysis about the skill possessed by the manager may have been incorrect. Thus, whilst we may retain belief in a struggling manager, we could be wrong and facing the worst possible situation – consistently expressing commitment to our initial view before finally capitulating and acknowledging a mistake (or concocting a rationale as to why now is the right time to sell).

It is far easier to buy outperforming funds and sell the stragglers – it is simple, appears ‘sensible’ and is behaviourally comfortable – this type of performance chasing is covered in a 2008 paper by Goyal and Wahal.  Conversely, it requires a great deal of fortitude to persist with a manager that is materially underperforming – even when we know that the shorter-term outcomes are not inconsistent with reasonable expectations given the approach adopted. The psychological and potential career pressures / costs of owning a high conviction manager and persisting with them through underperformance are stark.

If we are lucky, we will buy into a differentiated manager with skill who has historically outperformed (because, let’s be honest, nobody buys underperforming funds) and the pattern of excess returns persists with few meaningful blips. This, however, should be treated as an anomaly.  When owning a genuinely active fund we are likely to experience numerous and sometimes severe bouts of underperformance; unless, that is, we have managed to identify a style that is always in favour or a soothsayer who can foretell short-term market movements (I am still searching).

Much attention is lavished on the difficulties of identifying a skilful active manager with the potential to deliver excess returns, but that is only the beginning. As markets don’t provide consistent short-term rewards for the talented – you need to be able to hold for the long-term whilst bearing the inevitable periods of poor performance and all that entails. If you cannot, then you should avoid active management.

Key reading:

Goyal, A., & Wahal, S. (2008). The selection and termination of investment management firms by plan sponsors. The Journal of Finance63(4), 1805-1847.

The Death of Diversification

It has been a propitious period for equity investors; over the previous five years they have enjoyed stellar returns, depressed volatility and relatively few instances of material drawdown. The prolonged nature of this environment risks the abnormal coming to be seen as normal, and our bias towards what is recent and available leading to expectations becoming untethered from reality. This could have profound implications for how we perceive (or ignore) risk and how portfolios are constructed.

The success of equities on a risk-adjusted basis in recent years can be framed in a different fashion – the failure of diversification. Against a backdrop where equities have delivered strong performance with reduced risk (compared to history) there has been scant reward for holding assets that are regarded as diversifying or that may offer insulation in a more inclement economic landscape. Indeed, diversification has come at a cost.

There is a real danger that the current environment is leading investors to worry about the wrong things. Rather than believing that prudent diversification is evermore important because of the unusually strong results delivered by equity markets; we do the opposite and start to question the role in our portfolios of those assets that have failed to keep pace with the ascent of equities. In recent years very few assets compare favourably to equities – so why hold anything else? We spend far too little time critically assessing the things in our portfolios that are out/over performing.

Arguments in support of diversification are made all the more difficult by the fact that equities have exhibited such low ‘risk’ in recent years (by way of realised volatility and drawdowns), a scenario that inescapably breeds complacency. There are technical and psychological aspects to this problem. From a technical standpoint, it is possible to build equity heavy portfolios with low ex-ante risk (in terms of volatility) if their look-back period is only three or five years. From a psychological perspective, memories of the stress and fear that can at times characterise the ownership of equities have been all but extinguished. We can easily recall equities makeing consistent upwards progression, not them halving in value.

The unusually strong risk-adjusted performance of equities has also created a process versus outcome problem, where simply being long equity risk has been consistently rewarded, irrespective of whether it was a prudent course of action ex-ante. Our pronounced tendency to judge the quality of a decision or process simply by its outcome means that we will look more favourably on less diversified, equity-centric portfolios. The corollary of this is that the pressure of unfavourable performance comparisons could lead to diversified portfolios being ‘forced’ to assume more equity risk.

The idea of diversification is to create a portfolio that is designed to meet the requirements of an investor through a range of potential outcomes – it should be as forecast-free as possible. It is also founded on the concept of owning assets that not only provide diversification in a quantitative sense (through low historic correlations) but also sound economic reasons as to why their return stream is likely to differ from other candidate asset classes. Crucially, in a genuinely diversified portfolio not all of the assets or holdings will be delivering strong results at any given time, indeed, if all of the positions in a portfolio are ‘working’ in unison – it will feel like a success but actually represent a shortcoming.

That is not to suggest that we should persist with assets or positions in a portfolio simply because they are diversifying (or have not gone up as much as equities). Rather that we should always remember the long-term benefits of diversification, and consider the merits of all holdings in a portfolio based on their own characteristics and their role amongst a mix of assets or strategies.

Our obsession with outcomes, focus on spurious reference points and our desire for action, makes remaining diversified incredibly challenging. In an equity bull market, we often struggle to see the laggard assets in our portfolio as distinctive and differentiated – serving the role they were required for – we instead identify weakness and something that needs to be addressed. This is exacerbated by the fact that in such periods the returns of everything gets compared to equities – whether the comparisons are valid or not is irrelevant.

At this point in the cycle the temptation to abandon the concept of prudent portfolio diversification is likely to prove particularly strong; but unless a new paradigm is upon us, investors will be well-served remaining faithful to sound and proven investment principles.  Take the long-term view and remain diversified.

Things to Remember When Selecting an Active Fund Manager

These are simply some musings on active manager research; seemingly random, but hopefully linked by a common thread:

– The more PhDs in a team, the greater likelihood that a fund will blow up. This is tongue-in-cheek comment, but underlying it there is an important point about complexity. It is perfectly acceptable not to invest in a strategy because you don’t understand it. Furthermore, academic pedigree can easily make investors unnecessarily complacent about the robustness of a fund.

– Fund groups will always find some room in their strategy for you, capacity limits are more flexible than you think.  Incentives matter – you should never be reliant on an asset manager to tell you when they have reached capacity in a fund (particularly if they are listed) and, if you are waiting for them to tell you, it is probably too late.

– Although the majority of active managers underperform the market, the majority of slide decks produced by active managers will show them outperforming. The slicing and dicing of performance numbers is a constant wonder.

– Just because a Brinson attribution report shows a positive ‘selection effect’, it doesn’t mean there is ‘alpha’ – it is probably just a style bias. The term ‘alpha’ is banded around with abandon when discussing fund manager performance often without any clarity about what that actually means. Perhaps the most common is stock / sector decomposition – which tells you nothing about style / factor skews.

– The majority of excess return in fixed income strategies comes from assuming additional credit risk. Another attribution problem – this time for credit – is the persistent overweighting of credit risk (relative to the benchmark). Attribution for credit managers is fiendishly difficult but is an investment grade manager permanently overweight high yield skilful?

– Unless you believe that many fund managers can time the market (they can’t), then performance consistency is an example of luck or the derivative of a persistent style bias. It is rarely skill.  I still don’t understand the obsession with short-term performance consistency in the industry – the focus on this does much more harm than good in promoting the right type of active management.

– You will never really know the inner workings of the team running the fund you are researching. No matter the quality of your due diligence, your understanding of the characters, relationships and motivations within an external team will always be partial.

– Diversity for many (UK) asset managers means hiring white men from both Oxford and Cambridge. There is too much virtue signalling and not enough action on diversity in the industry.

– Ego / arrogance is not a necessary or positive trait for a fund manager. I often hear people absolve certain fund managers for being ferociously arrogant on the basis that they need to have high levels of confidence to ‘bet against the market’. This is nonsense – good fund managers will be wrong (a lot) and need both humility and a willingness to learn; believing that their views are unimpeachable or that they are infallible is the obverse of this.

– At least 90% of equity managers say they are buying quality companies (barriers to entry etc…) that are undervalued.  This should tell you something.

Is Volatility Risk?

I disagree with the majority of people I respect in the investment industry about volatility. This is an uncomfortable situation, as holding a view contrary to people more intelligent than yourself is rarely a sensible course of action.  Nevertheless, I shall persevere.

Most of the aforementioned investors have claimed at some point that “volatility is not risk”.  This is, of course, correct; risk is a multi-faceted concept, which no single metric can successfully capture, however, the implicit (sometimes explicit) extension of this argument is that volatility is not a valid measure of risk at all.  I do not believe this to be true.

The renunciation of volatility is often followed by the comment that “permanent capital impairment” is the only genuine risk. This view assumes that risk is based on the probability of the fundamental value of an investment being than less you paid for it.  The problem with this pure perspective is that it assumes that permanent capital impairment is solely about the asset and not the investor, and that the variability of an asset’s price through time is irrelevant.

From a behavioural perspective, volatility and permanent capital impairment are inextricably linked. I would assume that the most common cause of the latter is not a fundamental change in an asset’s intrinsic value but a decision by the investor to sell at an inopportune time.  The path of returns for any given asset is crucial; volatility is not simply about the variability of an asset’s price, but how those fluctuations impact investor behaviour and the resultant cost.

As volatility is a somewhat nebulous concept, it is worth considering what drives fluctuations in asset prices.  I tend to think of three related aspects:

1) A change in the fundamental value of an asset.

2) Uncertainty over the fundamental value of an asset and our behavioural reaction to uncertainty.

3) Investors reacting to the behaviour of other investors (momentum) or anticipating how they think other investors will behave. Markets are reflexive.

Investors do not experience volatility in isolation, it is not simply about detached price movements – there are inevitably accompanying narratives that lure us into action.  Volatility is circular; it is created by our behaviour – our emotion laden decision making, our myopia, our loss aversion, our recency bias – and in turn it drives our behaviour. It is often absurd and frustrating, frequently bearing no relation to sound fundamental investment thinking, however, it is a reality and it matters.

In addition to the behavioural nature of volatility, it is also heavily reliant on technical factors such as how an asset is priced and how it is traded. To take an example of this, let’s assume that an S&P 500 index tracker only provided liquidity windows every five years and the underlying components were revalued quarterly based on some form of DCF methodology.  Given that the holdings are identical would the risk differ from the market priced, daily liquid version we have available today? It is almost certain that the volatility would be considerably lower*.

Someone from the ‘permanent capital impairment’ camp would likely argue that this proves the flaw in using volatility as risk – the same assets can exhibit different levels of risk if judged by their volatility just by altering how they are traded and valued. However, the notion that volatility should be ignored because it is about more than simply the fundamental features of an asset seems spurious – a sensible theoretical concept that does not match reality. Investors have to experience price variability when holding investments and that has material implications for their behaviour and decision making.

Volatility is an imperfect measure of risk, particularly in regard to the distribution of asset class returns (non-normality) and assumptions around correlation. It is also backward looking and insensitive to valuation. It is certainly limited in the following circumstances:

– Investments with significant tail risk (such as selling insurance). Volatility is a poor gauge to the potential risk in such situations.

– Undiversified portfolios with high idiosyncratic risk.

– Assets with stale / slow pricing such as direct property and private equity.  Assets which are illiquid or aren’t daily traded often benefit from compelling Sharpe Ratios, simply because volatility is subdued relative to more frequently priced counterparts. This is never a fair comparison.  There is certainly a behavioural return premium attached to illiquid assets because it is harder to make stupid decisions when you are unable to trade.

We should be measured when conflating investment risk with any specific metric, it is heavily dependent on the individual, the environment, the instrument and the asset(s). Each method we employ will have limitations, take the following two examples:

1) Assume that the long-term volatility of global equities is 17% and you make an investment when realised volatility has been 17% over the previous three years.  In the subsequent three year period, global equities rise by 50% (primarily through valuation change) with a realised volatility of 14%.  Given that the historic volatility (three year) is  lower than when you made your investment, is the risk, other things being equal, now reduced? Given valuations are significantly higher it would be difficult to make this case, although using a simple (short-term) standalone volatility look-back would suggest so.

2) The probability of realising a loss over a 30 year holding period for global equities is low; from a permanent capital impairment perspective, does that mean that for those with a 30 year holding period holding equity exposure is close to riskless? ** To believe so suggests that the path, distribution and sequence of returns are irrelevant, as is how an investor may react to these factors.

Investment risk is nebulous and difficult to define – there is no unimpeachable means of gauging it. Volatility certainly has limitations and it is not ‘risk’, but can be an important measure of it.  One should never view risk purely through the lens of volatility, but ignoring it is equally naive – permanent capital impairment is as much a behavioural phenomenon driven by the individual human reaction to price fluctuations as it is about the fundamental value of any asset.

*We now have greater liquidity risk.

** Of course a 30 year time horizon is only such for one year, then it becomes a 29 year horizon.

Please note all views expressed in this article are my own and are not necessarily shared by my employer.