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Beware going down the passive route

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For years, advisers sought to justify their investment advice in terms of performance results. Many still do and continue to use perfor-mance as both a selling point with clients and a selection tool with managers. This simply reflects human nature. We know that somebody always does beat the herd and both advisers and clients want to believe it is possible to select them in advance. And it is – but whether it is possible to do this consistently is highly questionable.

Many advisers and DIY investors chase managers up and down the performance tables and because the costs of trading are now so low, can kid themselves that they are adding value. The alternative is to accept the bulk of the academic findings and climb off the rollercoaster.

Everyone has already bought part one of the proposition – it is strategic selection of the asset classes that is the primary investment decision because this relates to targets for return and risk to an appropriate portfolio.

Most people think the next step is the decision whether to go active or passive. In my view, this is incorrect. It misses out a vital step in the process. Once you have selected the asset classes, you need to identify the range of oppor-tunities within those classes and decide how much capital to allocate to each. Histor-ically, allocators did this geographically but global-isation has made this less and less tenable.

Correlation between national equity markets, for example, has got closer and closer over the past three decades (now 90 per cent or more for the UK, the US and Europe). Some US asset allocators allocate within asset classes by market capitalisation bands. But you can also do it with investment styles (GAARP, value) and themes (resources, intellectual capital). Effectively, you are adjusting the risk-return profile within the asset class.

This selection within asset classes is really about return rather than risk. We know that in a crisis, all correlations go to one – as in 2008, every-thing tanks together and your wide spread of different types of equity delivers nothing in terms of risk mitigation for the client.

You can argue that in “normal conditions” – bearing in mind that these will apply for a proportion of the client’s investment timescale that nobody can predict – there will be some benefit of diversification within asset classes in reducing volatility. But if you make this part of your client promise you will sooner or later become egg-faced after an encounter with a black swan.

Knowing that advance selection of top performers is verging on impossible with any consistency, should you just go passive? No because there are certain strategies that are proven to deliver above-average returns and which – at least to date – are not well implemented in passive form. Neither value nor small-cap strategies have what I regard as good passive vehicles but the most successful active exponents of these strategies are managers with long tenures and records, which increases the level of confidence that they could be maintained. Follow this thought process and, like many people, you end up mixing and matching active and passive.

The dark horse is mom-entum, a strategy shown to work in principle by academics but with costs that most of them reckon wipe out its gains.
The trick here is to use the principle of momentum while avoiding the costs. The Way Hasley global momentum fund is the first I have seen that sets out to do this in an academically credible way.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. Sorry Chris but in my experience this fund will not work as described. To quote their website, it is a “… trading system based on specific moving averages.” There has been plenty of research done by members of the Society Of Technical Analysts, myself included, (most of whom trade for a living) and mechanical moving averages are generally a very poor system for initiating profitable trades. They will occasionally work for short periods but not in the long run. You’ll get “whip-sawed to pieces” as you run up costs and make losses caused by fast moves. Way may surprise us, but I wouldn’t bet on it.

  2. Vaughan Jenkins 8th June 2011 at 9:29 am

    First, the study on the high correlation of returns to asset allocation to has been repeatedly shown by other academics to have been flawed. In fact, even the sacred cow that equities deliver above inflation returns over the long term has been challenged.

    As for the value/small cap “gap” the problem remains as to which funds or stocks do you suggest rather than imperfect passives, and when and for how long do you hold them. What is the insight to determine the vehicle for this vital ingredient?

    I would recommend John Kay’s book, “The Long and the Short of It” which makes a cogent argument for a large core of passive investment and a satellite punt on the odd share (he makes the case more eloquently!).
    see http://www.johnkay.com

  3. @ Vaughan Jenkins: Most active small-cap funds beat the Index on a consistent basis, so it shouldn’t be difficult to find one that meets your requirements. How long you hold them for is, of course, a matter of personal preference.

    For large-cap funds it’s difficult to see past passives, but there’s definitely an argument for holding active small cap funds. In fact, I don’t think you have a choice at the moment anyway, as their isn’t a passive vehicle (that I’m aware of) which tracks the FTSE Small Cap Index.

  4. Andrew Whiteley - assetfirst 8th June 2011 at 2:33 pm

    We use the iShares Eurostoxx small cap (DJSC)as a proxy for UK smallcap. The performance in £ terms is comparable to the FTSE UK SmallCap Index.

    I agree with Michael, the trading strategy of the Way fund will only work effectively in a limited number of market scenarios. There is no market timing holy grail….

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