My observations about the financial advice world as is relates to investment advice is that most advisors believe that asset allocation is “the” answer when it comes to successful investing. Some carry this belief further that it is the only issue at hand and one should invest only in index funds because there is no realistic chance that beating the market exists. While ample evidence can be brought to bear that the job is difficult, one should not be lured into the notion that any effort to try and out do the averages is futile. That would be like telling the owner of a professional sports franchise to not even try and get the best athletes on the team since most don’t (including and especially me!) aren’t above average. Or like telling a concert promoter they will make more money putting on a show with the local bar band down the street rather than the top stars like Madonna, Bono or other proven talent. Talent is always in the upper quintile or quartile of the best in any field or endeavor.
Much of this belief is focused on the Efficient Market Hypothesis put forth by Eugene Fama and the Markowitz Efficient Portfolio Theory. This is indeed important work as it showed that most of the return from several large pension funds came because they invested in a certain asset class not from individual market returns. For example, if a fund invested in large cap stocks and the asset class did well then the returns were higher than if a fund did not. No attempt was made to further segregate the funds that did well and then drill down to see if a particular manager did well.
The Markowitz and Fama work has often been mis-represented to conclude that the “only” issue is picking and optimizing asset classes. Many advisors (we do not) use a software tool generically referred to as mean variance optimizers to calculate the appropriate percentages that should be put in a portfolio based on a clients preference for return and risk tolerance. Our own experience is with tools of this type is that with only slight modifications in input the optimizers will spit out dramatically differing results. This has caused the majority of advisors to conclude they should only use historical inputs over long periods of time as inputs. This, of course, is a rear view mirror of trying to manage a portfolio on a forward basis. I once heard the line, “Do you think Tiger Woods gets his golf techniques from Golf Digest?” My question is – do you think a successful investor like Warren Buffet would use a mean variance optimizer to make long term investing decision? We don’t think so.
A core and satellite approach to arranging an investment portfolio is an attractive alternative strategy. A core part of the portfolio is put in to place (some would argue with passive investing strategies). This core would make up 50% to 80% of the portfolio. This would be made up of traditional investments such as long positions in stocks and bonds. This gives an investor exposure to the long â€“term opportunity of the traditional investment markets. This is the Markowitz approach. Around this core several high probability “satellite” positions would make up the balance of the portfolio. These “satellite” positions could be made up of additional weightings to asset classes that are under-valued relative to their current valuations. You would like to buy some investments “on sale” wouldn’t you? Other considerations may be to high probability investments like real estate, energy and other alternative investments that will be longer term holds to increase returns beyond a passive index approach.
Just like in every walk of life there are many talented managers of investments. The challenge is selecting the right ones. It is not hard to find who has done well. Some will look at a ten year track record and conclude that a good manager has been found if the return is above the index. While simple and easy to do in this age of information and computers it unfortunately is only the beginning. The artist who has had two hits will not necessarily have consistent star power. Year by year analysis of manager track records is vital to help understand whether the record is a flash in the pan or an exceptional talent.
Paying attention to asset class relative valuations is critical in understanding where to deploy assets. Understanding what is and how to find talent is the other critical element. With both working well, above average returns are reasonable to expect.