5 Min Read
(Reuters) - Your financial advisor probably won’t choose what is best for you because if he did you would very likely fire him.
As a result managers probably don’t recommend enough value investing, which can underperform for long periods, even though its very long-term track record is arguably unexcelled.
The tension between owners of capital, who want top returns but can’t reliably judge the skills and probity of managers, and those managers, who want to thrive in their careers, is one of the central problems in investing. Investors need to choose good managers but must be wary that the managers may be incompetent, or, rather more often, act in their own self-interest.
The solution most investors have used to mitigate these risks is a combination of benchmarking to a market index and regular, usually three-year, reviews. That approach has great advantages, not least that the regular reviews lessen the risks of an advisor running off the rails or being a lemon in the first place.
There are serious shortcomings too, not least that managers inevitably game the system to minimize their own career risk, meaning the chance that they will trail a benchmark over a review period and end up getting fired. Doing this pushes managers into strategies, such as momentum or trend following, which have as perhaps their principal virtue the fact that in buying what everyone else is buying or selling what everyone else is selling, your performance tends to stay within the pack.
Usually self-dealing by investment managers isn’t as blatant as putting it all on momentum, which after all, is a strategy with its own considerable risks.
Fund manager Research Affiliates, using 50 years of data, looked at a variety of investment styles and combinations of styles to explore which outperformed and which were most likely to get a fund manager fired. (here)
The sad news: the single best performing approach, a value strategy which seeks to buy undervalued assets, is the single most likely to end, for managers, with a search for new employment.
The study looked at value strategies, a combination of value and momentum, a combination of value, momentum and random stock picking, a combination of value, momentum and quality stocks, and a traditional allocation combining value and growth stocks.
Value did best between 1967 and 2016, racking up a 12 percent annualized return which was also best on a risk-adjusted basis. Coming in last was the traditional allocation of growth and value with only 10.7 percent. Note that the traditional allocation stays close to the market, meaning less chance of getting fired.
“In the extreme, the (manager) could minimize the probability of being fired with the Traditional Style Box allocation, which produces a value-add of 100–130 bps lower than the robust allocations. Essentially, this 'hedged' allocation recreates the benchmark, potentially at higher fees and higher execution costs, and removes close to all the potential benefits of factor investing," John West, Vitali Kalesnik and Mark Clements of Research Affiliates write in the study.
"The chance of being terminated, however, is practically nil. No wonder the Traditional Style Box dominates today’s investment landscape with $2 trillion of U.S. equity products benchmarked to growth!”
Making some assumptions about who gets fired - those who underperform 50 percent of peers in a given period or those whose portfolios underperform by more than 1 percent - the study calculated the career risks for each approach to investing.
Using the usual three-year performance review, value investors had a whopping 30 percent risk of lagging half the field. That compares to 20 percent for value/momentum and just 4 percent for benchmark-hugging value/growth.
The real tragedy is that the style with the best long-term results, value, is the one most likely to lag in the early years of a long holding period. Only after nine years would a better-performing value strategy with a higher chance of deviating from benchmark returns be less likely, given a two-standard deviation, of outperforming.
“How many agents - CIOs, investment staffs, consultants, and advisors - have an evaluation horizon as long as nine years? None,” the authors write.
“How many principals - retirees, charitable organizations, or IRA beneficiaries - have a time horizon longer than nine years? Almost all!! No wonder some agents are tempted to minimize the tracking error of their portfolios at the expense of value-add for investors!”
In other words, the road to outperformance using value strategies is long and requires the kind of guts and commitment few investors possess.
A leap of faith is required, even when the data is clear. Few investors will take it, and all managers know this.
Editing by James Dalgleish