For my final investment blog post of 2016 I want to change tack from the usual technical analysis and market commentary and address the more philosophical aspects of investing. The key question is this. Is investment planning and advice on investments an art or science? Should I be going to the Tate Modern for inspiration or the Science Museum and the Institute of Mathematics?
I think fund managers who actively manage their portfolios, primarily but not exclusively see their work as a science. They and their team will engage in comprehensive qualitative and quantitative analysis of the companies they invest in, seeking to understand their business models, markets, balance sheets, cash flows and valuations. Most companies are filtered out at an early stage in the analysis. It is all very process driven. However fund managers also typically meet the management of hundreds of companies each year. I suspect that this is where art becomes part of the stock selection process as they gauge key executives’ competence and thinking. With the personal contact they get a feel for the business and the people in charge who are driving it forward, or potentially into the ground.
My investment processes work in a similar way. When choosing investments for a client I first need to identify which assets and markets to invest in – equities or bonds; developed or emerging markets; larger or smaller companies? I then need to recommend specific funds to clients. Naturally I undertake qualitative and quantitative analysis of investments but decisions are not made purely with the head. Some come from the heart with a strong feel for markets and sectors that I like. Some picks are long term favourites, for example US equities and smaller companies, others assets and sectors are temporarily in my good books and may be recommended for tactical investment. Currently I like value and recovery investment strategies.
Ask me why I favour smaller companies, for example, and I can point to more than just feelings. Historically they have outperformed larger companies in the long term and the lack of analyst research results in mispriced companies whose values have not been recognised by the market. It is about market inefficiency and my confidence that good stock picking fund managers can unearth mispriced gems. The feelings are rooted in facts and convictions.
The same goes for selecting funds. Whilst again there is objective analysis I also buy people. Listening to fund managers speak at seminars and webinars and present their case for the market they invest in and their portfolios is very important to me. Every now and again my interest is especially piqued and I am attracted to a fund manager and his or her investment thinking. Quite a few years ago I listened to Jeremy Gleeson, manager of the Axa Framlington Global Technology fund and I thought, “Hey I really like this guy. He understands technology.” Over periods of time his fund has under performed his actively managed peers over one, three and five years he has beaten the sector average fund (Source: FE Trustnet 10/12/16) and he has served my clients well.
Passive fund managers as you know do not make stock selection decisions obviating a need to meet with company managers. Their methods are entirely process driven, employing index tracking techniques to replicate the market. Due to management charges, trackers and exchange traded funds (ETFs) invariably under perform the index they are tracking. You won’t see these fund managers at the Tate Gallery; they’ll be seeking inspiration from algorithms and mathematics.
The underlying premise of the philosophy of index tracking investment is that few active fund managers outperform the index and when they do they are inconsistent. Why invest in an active fund and pay 0.85% p.a. in fund charges when an index tracker may cost just 0.15% p.a. and deliver better returns? It is a fair point and there is evidence of index tracking delivering superior returns in steadily rising markets and with US equities, the market for which is highly efficient in pricing stocks. However I don’t subscribe to this view as a universal principle across all markets and market conditions. Index tracking is a poor strategy in volatile markets that move sideways. A clear example is the FTSE 100 index which is virtually unchanged from its December 31st 1999 value. Another example can be found with smaller company investment.
The passive v active debate is complex and space and time does not permit further discussion here. However those who strongly advocate index tracking strategies hold an implicit belief, that is, active fund managers are not very good at their job and those that outperform are lucky. Now I don’t believe they would express this view in quite such dismissive terms but I think they hold it. If they are correct, there is not much skill involved in their investment management and active fund managers are effectively highly paid gamblers. They are no better than giving a chimp a pin and a copy of the Financial Times and getting it to pick stocks for your portfolio. I use hyperbole to make my point.
I am an advocate of active fund management and my clients’ portfolios are dominated by investments that are run by managers with strong asset allocation and stock picking convictions. However in rare circumstances I see value in adding passive strategies. In general terms though I just don’t get the point of a strategy that requires investment in basket case companies just because they are in index!
In conclusion is investment an art or science? I think it is both. Is investment a gamble? To some extent it is. Fund managers and IFAs like myself make asset allocation decisions that go wrong. A few years ago after commodities hit what I thought was rock bottom prices I advised some clients invest in commodity funds. Prices however continued to fall. With hindsight I called the rally in commodities too early. Without certainty of certainty, investment decisions must surely have an element of being a gamble. In this respect I think art and science results in investment decisions that may be just best guesses, albeit educated ones.
Finally and briefly an investment manager or investment adviser is not only an artist, a scientist and a gambler but he or she needs to be a gardener too. Investment portfolios are dynamic. A well-constructed, balanced and suitable portfolio may be entirely appropriate at outset but it is not static. It is like a garden. A neat, well-tended garden doesn’t stay like that for very long. Plants become unwieldy, weeds appear, grass edges become scruffy and left untended the garden reverts back to an unkempt wild state. It is the same with investment portfolios, adventurous risk funds get too big and under performing funds may need to be weeded out. Reviews are required to rebalance portfolios and reduce risk. In the last six months I have done a lot of gardening.
This blog post is my own investment thinking and commentary only. Nothing in this article should be construed as investment advice. Investment in US equities, smaller companies and value investment strategies may be unsuitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Past performance is not necessarily a guide to the future.