Proving Investment Selection Processes
Clients, critics, and financial media consumers want to understand how other professional investment managers and I select the securities that are found in their portfolios. For me, the starting points are the financial and emotional needs of the account. I believe that one size does not fit every individual account. Using those elements as a base plus an understanding of critical time horizons colored by views as to the current market opportunities, I decide on one or more selection processes for the funds that will be resident in the account.The purpose of this post is to examine two opposite selection processes, (1) Picking winners and (2) Avoiding losers; as well as to discuss the provability of these or any selection processes before-hand.
Picking only winners
A number of selectors of mutual fund portfolios and some newsletter writers look to near-term performance. In at least one popular case the published pundits select funds with the best available one year performance regardless of investment objective. Under their ministrations the subscriber or account holder will continue to own the fund for a year. At the end of the year the underperforming funds will be replaced with the current year’s best performers. This is a momentum approach adapted from the individual stock world to the portfolios of tax-paying mutual fund holders. Early in a long cycle the momentum approach can produce good returns. Often it has the benefit of producing spectacular results near the top of a highly speculative market. The descent from the peak however can be very painful in the first year of a decline.
Avoiding big losers
While desirous of gains, many of the clients that have chosen me to manage their investment fund oriented accounts are relatively risk averse. With that as a filter I turn to the databank now known as Lipper for Investment Management. (I no longer have any direct connection with my old firm, the producers of the data.) I particularly search for down quarters. Because the majority of the money I manage is in large institutional accounts or on behalf of very wealthy families, I restrict my search to funds with current assets of over $100 million. My accounts are expense-oriented, thus I seek to have total expense ratios below 1.26%.
In this example I focused on three particularly bad quarters since December of 1999 and I was interested only in those funds that declined measurably less than the average in their peer universe. Because of the needs of a particular account I looked at only small capitalization funds. My original sort started with some 400 funds. The resulting roster of funds that passed through my filters was a grand total of five. Three of these were closed to new accounts. I may have to be less stringent in my screens in order to surface a suitable number of funds to examine with current upside potential. Time will tell whether I can come up with winners, but history is on my side. What I am confident in is that when the periodic down markets occur these kinds of selections will perform better than the momentum driven suggestions from the first approach.
Can you prove it?
I have been recently asked “What do you believe about investing, but know that you could never prove?” Before addressing whether I can prove that my approach of avoiding large losers rather than the approach that is momentum driven, I want to share some of my thoughts as to “proof” of investment decisions.
From my exposure being a Caltech Trustee and my vague memory of my physics classes at both Columbia University and the Staunton Military Academy, the discipline of the “scientific method” makes me question whether anything can be proven about investments before the final trade is tabulated. The basis of the scientific method is that anyone following the same procedures will get the same result. In physics there is no attention to the emotions of the experimenter or the fact that all conditions surrounding the experiment are known. As we don’t know why anyone buys or sells a security, we don’t know the critical motivation to the trade.
Is the seller making an investment judgment as to the value of a security absolutely or relative to some other security? Are they putting their portfolio in the desired order or are they meeting a funding need? The buyer may find this particular security attractive in and of itself or may want to increase the portfolio’s exposure to the market or sector. The buyer may need to be in a more fully invested position by a report date. Both the buyer and seller may be reacting to competitive pressures from within their organization or beyond. Given the same general economic, political, and announced corporate results but a change in any of the other factors listed above, a different set of results are possible. As Mark Twain said, “History does not repeat itself but it does rhyme.” A good example of this is when Ruth and I go to many of the wonderful concerts of the New Jersey Symphony Orchestra; the program informs us as to what is going to be played, but not how it may sound to us. Guest conductors and soloists as well as different musicians on stage let alone different concert venues and weather can produce startling different levels of appreciation.Instead of utilizing my academic exposures in getting comfortable with expectations of future results, I fall back on my two real sources of thinking: the racetrack and the US Marine Corps.
What I try to do is guess what the odds are on a result. I use past experience adjusting for current conditions as well as the persistency of trend. (The longer the trend the less likely it will be continued.) Like many who are always focused on survival, I accept that my bias for quality will reduce some of my upside potential. Nevertheless I echo “The Long View” column by John Authers in Saturday’s Financial Times, “Numbers add strength to Buffett’s law of selection not only for Warren Buffett’s focus on quality, but his price discipline.” That discipline can be summed up by “It is better to buy an excellent company at a decent price than a fair company at an excellent price.” I believe the same concepts can be used in selecting fund mangers.
You can have it both ways
One of the nice elements of a portfolio of funds is, when appropriate, one can assemble a portfolio following a number of different approaches. This multi-approach portfolio could make sense for a portfolio that has different time horizons.
Which approach do you use?
Traveling and learning
September will find Ruth and me in London and Budapest. I would be happy to meet with any members of this blog community to share views, particularly from those who will help me learn.
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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.