Performance fees are one of the more puzzling aspects of the fund industry. They are often hailed as a way of best aligning the incentives of fund manager and client yet, in reality, frequently benefit the former at the expense of the latter. Often in an egregious manner. 

Let’s imagine a hypothetical conversation between a professional investor and a potential client:

Investor: “I have developed this fantastic new strategy that can deliver high, uncorrelated returns. The backtests are incredible. All I need is some capital to put to work”.

Client: “That sounds interesting, what would it cost?”

Investor: “I would want to keep 20% of any performance above cash.”

Client: “Okay. What about the cost of providing the capital?”

Investor: “That would be 1.5% a year.”

Client: “So you will pay me 1.5% to gain an economic interest in my large pool of assets?”

Investor: “Err…no. You will pay me 1.5% for it.”

Client: “Right. And what if the strategy goes wrong?”

Investor: “I am afraid that’s all on you.”

Client: “Sounds great, where do I sign?”

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If we developed our own high conviction investment strategy and sought to make it as lucrative as possible (for ourselves), we would want access to a large pot of assets (ideally somebody else’s) and to participate directly in its performance.* Getting paid a healthy annual retainer would be the cherry on the cake.

Is it unreasonable to suggest that fund managers levying performance fees should actually be paying clients for gaining access to sizeable asset pools? Perhaps, or maybe it is just unrealistic (the lights need to stay on). Clients are, however, providing the necessary capital, bearing the vast majority of downside risk and often paying out fees for volatility. Hardly a textbook example of incentive alignment.

While there has been some evolution in how performance fees are structured, the pace of positive change is slow and certain areas seem to be moving in the opposite direction.** We should not be surprised at this given how asymmetric the benefits and costs can be, and how they often they provide reward for luck or even simple market exposure, rather than skill. Never give up on a good thing!

Of course, it is a free market, asset managers can set their own charges and clients have the agency to decide if the terms are attractive. I would just encourage everyone to think carefully about how well-aligned their incentives really are.  

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* This would also be true for someone who had no investment skill.

** There are better and worse ways to structure performance fees. Too many fall into the latter group.

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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. Not investment advice.

Until recently I was seemingly one of the few people who hadn’t seen the TV show ‘The Traitors’.  It became popular so quickly that my stubborn, contrarian streak prevented me from indulging. After some persistent persuasion from my children, however, I succumbed and have been watching the latest UK ‘celebrity’ version. Not only do I have to reluctantly admit to enjoying it, but I have found the contestants’ – often baffling – approach to the game starkly reminiscent of some of the most destructive investor behaviours.

For the uninitiated, the game is very simple. A group of (20 or so) people are put together and a small subset (usually 3) of them are secretly selected to be ‘traitors’. Each day the traitors covertly select one of the ‘faithfuls’ to ‘murder’ (remove from the game). Also, each day, the entire group have to discuss and vote to banish a member of the group who they suspect of being a traitor. For the faithfuls the aim is to rid the group of traitors, while for the traitors it is to remain undetected until the end and claim a prize for themselves. (Party game fans may recognise this structure from Mafia / Werewolf).

A distinctive feature of the game is the almost complete absence of useful evidence the players can use to guess who might be a traitor in the group. The traitors are selected by the producers prior to the show, and players must make judgements based on their interactions with each other during the game. 

The way players decide on who to banish for being a suspected traitor follows a consistent blueprint:

– There is virtually no meaningful evidence about who is a traitor.

– All players significantly overstate their skill in ‘reading’ people and hugely overweight meaningless information. 

– Players construct persuasive, compelling and entirely spurious reasons about why another participant is a traitor.

– The players who put together the most elaborate arguments are considered smart even though they are consistently wrong.

– The player identified as a traitor is banished and it transpires that they were a faithful.

– Players lament their approach and consider whether a different strategy might be worth considering next time.

– In the following round they do precisely the same thing, seemingly forgetting it didn’t work before.

These are all very human behaviours and almost identical to those that we see from investors attempting to predict the short-term movements of financial markets.

The hallmarks of which are:

– An environment defined by noise and very few signals.

– Massive levels of individual overconfidence in the skill to make predictions about asset class performance.

– A wonderful ability to create impressive and coherent stories about market conditions.

– Credibility and airtime given to investors who sound smart.  

– Those investors frequently being wrong.

– Everyone carrying on doing the same thing anyway without acknowledging it didn’t work before.

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Whether we are trying to guess who the traitor is in a party game or predict the performance of US equities over the next 6 months, the patterns will be familiar. We will inevitably see evidence where there is none, be wildly overoptimistic about our own capabilities, and create stories to alleviate the discomfort of randomness and uncertainty.

Human behaviour doesn’t change much, just the context. 

—

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. Not investment advice.

Although it could have easily escaped your attention, as it has received such little fanfare, the price of gold has been rising sharply – recently surpassing $4,000 per ounce. Significant moves in the gold price are fascinating from a behavioural perspective because gold is probably the perfect belief asset – that is an asset which is impossible to value in any reasonable way so it’s worth is entirely dependent on what we think other people believe it to be. This has significant implications for how gold might behave, and how people both talk about it and trade it. 

We are currently in the stage of the cycle where many people conjure up reasons for why gold is so attractive because they cannot admit that they mainly like it because its price has gone up a lot. That is not to say that there are not valid reasons why an investor might hold the asset but, as usual, near term performance must bear much of the responsibility.

How should investors think about gold?

Gold is not a better form of money: One of the most common and vociferous arguments from investors who are bullish on the prospects for gold is that it is far superior to standard fiat currencies because it holds its value, whereas the like of the US dollar or sterling lose their purchasing power through time. This view makes very little sense. In a well-functioning and growing economy, a positive level of inflation is desired – it encourages spending and investment – this means currencies should lose value through time. It is a feature not a bug. Yes, a dollar today may buy you less than it did 30 years ago, but I am pretty sure that salaries have changed over that time also, and I am confident people do things with their money – like spend it and invest it.

The merits of owning gold change depend on what question you ask. Is holding gold over the long-term better than putting cash under the mattress? Quite possibly. Is holding gold over the long-term a better option than owning productive, real economic assets (such as company shares)? I am not so sure.

Gold has excellent Lindy properties: Although the ‘debasement’ argument often made about gold is an exceptionally dubious one, gold does benefit from the Lindy effect. This is the idea that the expected life of something that is non-perishable is proportional to its current age. In simple terms this means that the longer something has existed, the longer we assume it will last. (The expected future life of Great Expectations is significantly longer than anything published last week). The concept is named after Lindy’s deli in New York City where it was speculated that a show running for a month on Broadway could be expected to last for another month.

Gold has been used as a store of value for thousands of years. People have believed in it for an extremely long time, which should give us some confidence that people will keep believing in it. This feels somewhat amorphous – but when you don’t have much else to go on it matters.

Belief assets can be extremely volatile: The more assets are based on belief than anything tangible the riskier they are likely to be. Why is this? If an asset is driven by strong fundamental features – let’s say a high-quality bond with a contractual return and fixed maturity – the range of potential outcomes is very narrow. The more speculative the asset, the more it is based on indefinable beliefs, the wider the range of outcomes and the greater the uncertainty.*

Assets that have long-term, fundamental value drivers experience a (sometimes light) gravitational pull towards some form of fair value. As belief assets have no fair value the price can vary widely – this can be both incredibly lucrative and, at times, painful. (Belief assets are perfect for bubble formation – there is nothing to hold them back).

Prices for belief assets change because perceptions change. If the gold price were to drop to $2,000 is it more or less attractive than it is now? Nothing will have changed about the yellow metal, just what people believe other people believe about it.  

Price moves in gold create stories about gold: As we are being bombarded with stories around the reasons for the rise in gold price – debasement, fiscal largesse, central bank purchases, political uncertainty – it pays to remember the causality here. Price moves come first and then the narratives to justify it second. It is not that the stories have no validity, it is just that they become more persuasive the higher the price rises, creating a self-reinforcing loop – for a time at least.   

Do you like the asset or its trend?  Momentum investing has a long and storied history of delivering positive returns – but only if carried out in a deliberate and measured fashion. One of the problems with strongly trending belief assets is that rather than acknowledge that they want to participate in the price momentum, investors need to offer a compelling fundamental rationale. Although this might make them sound smarter, all it means is that they are a closet momentum investor without the discipline required to do it well.

Know why you own it: Perhaps the key for any investor owning gold is to be very clear about why you hold it, otherwise you risk being whipsawed around as price trends (and beliefs) fluctuate. If you purchase it tactically be specific about the precise factors that are informing your view (even if it is just trend following). If it is a structural portfolio holding you should be willing to bear periods of significant losses with equanimity and understand the exact role it is playing.  

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There is nothing inherently wrong with holding gold, but it is important to accept the type of asset it is and the investment behaviour it may encourage. If Ben Graham had been asked about gold, he may have said something like:

In the short-run, the market (for gold) is a voting machine, and in the long-run it is also a voting machine.

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* Whether an asset is a belief asset or a fundamental asset can also depend on time horizon. An equity investor trading on a three-month view is turning stocks into a belief asset because they are worried only about sentiment (belief) changes – the fundamentals are largely irrelevant.

–

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. Not investment advice.

Investing can often feel like one giant prediction game. Most financial market commentary involves forecasts about the future that are hastily discarded and wilfully forgotten, and many investment approaches are founded on taking bets about the complex interactions of economies and asset prices. The problem with all this activity is that the world is a highly uncertain place and we are wildly overconfident in our ability to foresee what will happen next. A fact confirmed (again) in a recent study by Jeffrey A. Friedman, an associate Professor of Government at Dartmouth College.

Friedman ran a large-scale study of over 63,000 judgements made by nearly 2,000 national security officials from NATO allies and partners. The expert participants were given a set of 30 to 40 statements and had to estimate the chances that they were true.

Such as:

“In your opinion, what are the chances that NATO’s members spend more money on defense than the rest of the world combined?”

Or apply probabilities to future events: 

“In your opinion, what are the chances that Russia and Ukraine will officially declare a ceasefire by the end of 2022?”

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How did these experts fare when posed these questions?

It is fair to say that their calibration was a little off or, to put it another way, they exhibited pronounced levels of overconfidence.

When the officials believed that a statement was likely to be 90% true, this was the case on only 57% of occasions.  On the flip side, when a statement was assigned a 10% likelihood of truthfulness, it was correct 32% of the time. Notably, participants were more likely to say something was true when it was not, than the reverse (false positives were more common).

There was also a problem in dealing with certainty. When a participant had absolute confidence that a statement was false, they were incorrect 25% of the time. (They were obviously ignorant of Cromwell’s rule).

Here is a visual depiction of the calibration gap, or level of overconfidence:  

Friedman’s paper goes in to more detail on the study, and he has also written an excellent book on decision making under uncertainty, which I would strongly recommend, but I wanted to turn to the implications of this study for investors:

– Be very careful with geopolitical risks: Investors get very excited about geopolitical risk and love the opportunity to become foreign policy experts for the week, but making decisions based on geopolitics should be avoided. In Friedman’s study, experts in the field consistently made off the mark, poorly calibrated judgements – what chance do generalist investors have?

– Financial markets are harder to predict than most things:  Although the foreign policy questions in Friedman’s study were difficult, they are not as challenging as those many investors try to tackle. When investors make market predictions they are attempting to forecast something as complex and chaotic as the global economy and how that will impact financial markets. It is incredible to me that anyone thinks this is possible.

– Reduce your confidence levels: The participants in the study were overconfident, investors are overconfident, humans are overconfident. A very useful rule of thumb is to reduce our conviction every single time we express a view, this will almost certainly make our guesses more realistic.

– Don’t make an investment approach reliant on predictions: I appreciate that it feels like we should be constantly making predictions about financial markets – it is interesting, lucrative and everyone else is doing it – but it is a really bad idea. 

– Make easier predictions:  Of course, all investing involves making predictions about the future in some form but let’s make easy ones. I predict that over the next decade economies will grow, and stock markets will generate real returns. It is a forecast, and it is not certain to be true, but I have a reasonable level of confidence in it being so. Simple predictions, humbly made are always the way to go. 

– Reduce overconfidence by diversifying: Diversification is an exercise in humility. The future is uncertain, and we are terrible at making predictions, so our portfolios should reflect this.

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If you are reading this and thinking that financial market forecasts are not really as difficult as I am making out then feel free to replicate Friedman’s test. Make a set of statements about the future and apply a probability to them being true. Things like these:

The ten-year US treasury yield will be above 5% by the end of 2026.

 or

The US equity market will not lose more than 25% in value at any point over the next 12 months.

Let me know how you get on.

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It is an oddity that investors are often reluctant to systematically measure themselves in this way given how much time we spend making predictions. It suggests that even though we behave in an overconfident way underneath it all we know the truth, we would just rather not remind ourselves of it. 

—

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.

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?”

—
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.

—

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.

—

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.

—

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.

Perhaps the defining feature of modern corporate life is the meeting. Meetings have come to dominate how companies (and all types of groups) function. While frustrations are consistently and fruitlessly aired about what a time sink they can be, there is a bigger problem with pervasive meeting culture – it changes the way we think, and therefore the types of decisions that we make.

Let’s imagine a typical set-up for an important meeting in an organisation, one where a decision is to be made. Papers have been produced, but they are long and everybody in the meeting has been too busy in other meetings to read them. 

This situation means that the attendees are reacting to what they hear in the moment. There has been no time for slow, deliberative thought, instead everyone is thinking instinctively and that is a very different process.   

We can think of this distinction between thinking styles in terms of Daniel Kahneman’s system one and system two framing. System one is automatic, subconscious and immediate, whereas System two is slow, conscious and considered.

System one thinking is incredibly useful and effective in many situations, but typically not fantastic for most of the long-term choices that are made in business, investing or politics.

Without time to think slowly and intentionally about issues, we will shortcut to quick system one reactions which are driven by factors that can often be shallow and even entirely irrelevant. These might be our feelings about the person talking, whatever our primary incentives are, recent discussions we might have had on a similar topic, how we might want to appear to the group and whether we have had lunch yet.

Again, system one is not necessarily bad thinking. I am an advocate of using heuristics to solve complex problems, but it is best to choose a heuristic as a smart option after considered thinking, rather than because we haven’t had the chance to assess something carefully.  

Even when the process to reach a decision takes time and spans multiple meetings, it doesn’t mean that there has been space for measured thinking. It is more likely just a chain of meetings where instinctive, system one thinking has been the guiding and dominant influence.

The underlying issue is that deliberate thinking just doesn’t hold that much value in the modern corporate world. Meetings are tangible and measurable. If a decision has been made after eight meetings (all with minutes and actions) – it is considered robust, certainly more robust than someone spending the time to think long and hard about a subject.

There is nothing wrong with meetings. They can be an excellent way to debate and discuss ideas, and to benefit from diversity of experience, expertise and approach. They can also be a perfectly reasonable forum for making decisions provided careful consideration has been given to group dynamics and sufficient space is afforded for thinking deeply outside of them.

Increasingly, however, we exist in a world that assumes that if someone is not in a meeting, then they are not working. That is an extraordinarily strange perspective to take for any job where focused, considered thinking is important.

Meetings are increasingly crowding out the type of thinking that leads to better long-term decisions. Maybe we need a meeting to discuss what to do about it.

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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.

The rise of private markets has been supported by the perceived existence of an ‘illiquidity premium’ – or the extra return provided to investors as compensation for holding assets that are difficult to trade. Although the concept has seemingly become commonly accepted, there is no clear definition of precisely what it is or how it comes about. At times it can feel as if it is simply some magic dust sprinkled on private assets to boost performance. Given the growing importance of this area, it feels worthwhile being a little more specific – so just what is the illiquidity premium?

Let’s return to the basic definition – investors demand a higher return for an asset that is hard to buy and sell. This makes sense – if I am going to lock my money away, I want some reward for the inflexibility. *

While this idea may seem reasonable, investors demanding an additional return does not make it so, and the above framing is still a little vague.  A better one might be:

The illiquidity premium is the additional return for holding an illiquid asset relative to a more liquid asset, other things being equal.

The ‘other things being equal’ part is important here. To isolate the illiquidity premium we need to say that if we had two identical assets but one was illiquid (private) and the other liquid (public), we should anticipate a higher return from the private asset.

The next question is – how do we get a higher return from the illiquid asset? It must be because it is cheaper than its liquid counterpart. If there is no difference in fundamentals, then there has to be a valuation discount to enhance my prospective return. How else could it come about?

There are, of course, other ways that additional performance may be garnered from illiquid, private market exposure – the opportunity set might be wider, there may be a benefit to private equity firms having control of a business and a private market manager may have a greater ability to add ‘alpha’. While all these elements may be valid, they are simply potential features of private market investing not an illiquidity premium.

If we define the illiquidity premium as being derived from a valuation gap between private and public assets, it tells us two things:

1) The premium should be in some way observable: Although we will never be able to observe the valuation of a private asset in a parallel universe where it is publicly listed , it should be possible to compare the valuations of similar assets in the public and private sphere, and ascertain whether there is a discount. (This is probably easier to analyse in private credit than private equity). If private assets of similar quality are priced more expensively – where is the illiquidity premium coming from?

2) The premium will be time varying: If the illiquidity premium is about the valuation gap between public and private assets then it will not be static, but will wax and wane based upon the prevailing environment. If private assets are in high demand, the illiquidity premium will be (at best) lower. We should not treat it as a permanent, structural advantage.

One of the primary drivers for the burgeoning demand for private assets has been the long-run return advantage relative to public markets (let’s leave the validity of this argument for another day). Part of this apparent edge is widely believed to have come from the illiquidity premium. We need to be careful, however, that what is being identified as an inevitable premium is not simply a significant valuation re-rating in private assets from a period where demand was far lower and access much more difficult.

There is a not insignificant risk that the clamour to capture an illiquidity premium acts to extinguish it.

The broader use of private assets will inevitably be a critical investment theme over the coming years. Given how consequential this area may be for investors, if we are to use coverall terms like ‘the illiquidity premium’ we need to be clear about precisely what we mean.

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* From a behavioural perspective, there is a strong case that illiquidity improves ‘behaviour-adjusted’ returns by forcing us to be long-term investors and preventing us from following our worse impulses. Perhaps this is the real illiquidity premium.

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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.