I occasionally still hear the idea that 90% of investment returns are due to asset allocation – generally from those who promote passive investment strategies. William Sharp devised the ‘Efficient Market Hypothesis’ to argue that share prices reflect available information and expectations. As I write the stock markets around the world are undergoing significant volatility which we’re told is being driven by uncertainty. Information and expectations would appear to be quite fluid at the moment.
If Sharp was correct, then there is little to be gained from selecting individual investments in the hope of identifying mispriced assets. Investors would be better advised to choose an appropriate asset allocation and invest in a well-diversified portfolio of passively managed funds.
However, this is only part of the picture. While asset allocation provides a broad strategy through which investment managers can determine the mix of assets by type, sector and region to hold to generate return in line with investors’ risk profiles and investment objectives, stock selection can be seen as the tactical way in which the asset allocation is achieved.
There is no right answer but there should be some indication of the need for balance between getting more information and making a decision
The key for our purposes is to consider both components of an investment strategy as they require separate and distinct methodologies.
Asset allocation involves looking at historical data to identify how different types of investment react to market conditions. Generally, the starting point is that the ratio of equities to bonds is driven by attitude to risk with an 80/20 split being seen as ‘quite aggressive’ whereas 30/70 would be ‘cautious’. There is further scope to refine this model by considering size or geographical location – smaller companies in emerging markets offering a different prospective return to investment in a large cap business in a developed economy.
A further refinement of the asset allocation model is to look at other asset classes to increase diversification such as property, infrastructure and other so-called alternative investment classes.
Stock selection is the consideration of which specific holdings to put into each element of the portfolio. This where a more detailed analysis and comparison of alternatives is required and the ability or confidence to make a decision can be more challenging.
So what are the key skills for an investment manager?
My research has identified five:
- Analytical skills – the ability to look beyond the headlines and consider the impact of events. Looking to identify meaningful trends amidst the noise.
- Decision making – having the confidence to make informed choices based on facts and to do so in some situations under pressure as market conditions evolve.
- Strong communication – being able to explain decisions and present conclusions in a way which inspires confidence. Part of this will be around the ability to build good relationships.
- Time management – there is always going to be more information that could be obtained but balancing that with the need to act is a skill.
- Initiative – good investment managers are always on the lookout for opportunities rather than waiting for something to land in their laps.
At the underground station this morning one of the staff had put up a thought for the day from Thomas Jefferson: “I’m a great believer in luck, and I find the harder I work the more I have of it.” That may well be a pointer for skill number six.
Our challenge in the world of T&C is to identify ways in which we can assess these skills and assist in their further development where necessary. Investment performance against benchmark may well be a key indicator that gets us involved – generally when things aren’t going well.
Given that there are so many variables to consider we can look at the five key skills and design tools to assess an individual’s behaviour. I have used ‘explain to me’ exercises where observation is not possible or practical.
The starting point will be to ask the investment manager to set out their investment philosophy and elaborate on his or her views of the key themes in the current economic climate. Identify a fund which has recently been added to a client’s portfolio and ask the investment manager to talk through the process by which it was selected. Does this match with the way they described their philosophy?
For the third skill you may choose to talk to some of the advisers with whom they work: how clear are they in explaining investment strategies and specific holdings to their peers and where applicable to clients? I remember one adviser explaining to a client before the investment manager joined the meeting that it wouldn’t be entertaining, but the investment manager really knew what he was talking about. Clarity is more important than amusement.
Time management is a subject on its own but from your observations you will get a feel for how well the investment manager does. In your assessment you may wish to ask about how they decide when they have enough information to make an investment decision. There is no right answer but there should be some indication of the need for balance between getting more information and making a decision.
Finally, we have initiative. In the ‘explain to me’ scenario, rather like job interviews, you could ask for examples where the investment manager has come up with an alternative asset allocation or stock selection. The discussion should demonstrate what triggered their thought process and how that developed. Of particular interest is how they involved other people before decisions were made.
Overall what you are trying to assess is whether there is a structured approach to investment decision making which is likely to lead to positive client outcomes. In 2018 this may well have been losing less than the market but over the long-term positive returns and client objectives being met with an appropriate risk profile would be the expectation.