Fund managers with a solid investment philosophy can identify their edge and the environment in which they will flourish
My last column highlighted the weakness in relying on past performance in fund selection (weakness is putting it politely). I then provided an overview of some of the more qualitative factors advisers should consider when analysing investments. This article is the first of a series looking at these qualitative factors in more detail.
Investment philosophy is perhaps the most overlooked, with many fund buyers underestimating the benefits gained by identifying a sound one. With that in mind, it is not surprising to find fund managers that struggle to articulate, or indeed identify, what their underlying investment philosophy is.
It is quite possible to successfully manage investments without a clear philosophy but it is very helpful to consider what might be driving this success.
Fortunately, most investment philosophies are quite simple and can be illustrated through basic tenets. These tenets may set out the type of investments the manager is looking to focus on, hopefully identifying a recurring valuation anomaly in the market and why this might persist.
While such beliefs can be expansive in nature, a broad statement such as “markets do not always accurately price securities” is pretty much implicit in any active management approach and of little practical use.
An example of a more practical philosophy for a fixed income investor might be that corporate bonds rated just below investment grade are systematically undervalued by the market and such a valuation anomaly may arise as a result of investor demand. Credit ratings on these bonds are not secure enough for most investment grade investors and the yields are often insufficient to meet the needs of high yield investors.
For equity investing, an example might be a value approach, where investor behavioural biases can lead to share prices systematically overreacting to bad news and that, over time, share prices often revert to mean. There is plenty of empirical evidence backing this approach but proponents need lots of discipline and nerves of steel since cheap stocks can remain undervalued for extended periods, as many value managers are currently finding.
A well-considered philosophy offers powerful support for the investment process.
Unsurprisingly, a flawed one is as useful as a chocolate teapot. Something like “never invest in a company where the management have beards” lacks any empirical evidence or logic, for instance.
Some philosophies need to be adapted over time and not all survive. “Never invest in countries where they do not wear overcoats in winter” perhaps had greater validity before the widespread adoption of air conditioning.
Fund managers with a firm understanding of their philosophy can more easily identify what their edge is and the type of environment in which they will flourish. Here are some of our investment philosophy principles that help underpin our fund analysis:
- Investment is an art, not a science. There are no fundamental laws or universal rules. Markets are continually adapting to circumstances and investors need to do this as well. This is a people business where qualitative inputs and assessments are required.
- It is not possible for all funds to be better than average. Only a small proportion are high quality and that quality is determined by the people behind the fund. The departure of quality personnel will be difficult to replace.
- Professional investors are obliged to maintain and update their skills through structured, continuing professional development. Notwithstanding the importance of this, we believe the most effective CPD is delivered by the market, though this is often delivered at irregular intervals and in a brutal manner. Some investment management skills cannot be taught in the classroom and they can only be learned through practical experience.
- Markets pass through periods of fear and greed. The opportunities for active investors vary over time and no single approach is likely to succeed consistently through the investment cycle. Patience is required.
- Good investment management involves consideration of the pay-off between risk and return. In certain situations, risks exist and the upside is absent. Examples would include counter-party risks and high fees. Such situations should be avoided.
Jason Broomer is head of investment at Square Mile Investment