The miserably low returns achieved by equity investors over the decades to the end of 2009 and 2010 have led to a major shift in the methods of many professional investors and advisers. But they are not owning up to the importance of this and its implications for the investors they advise and manage money for.
The academic evidence that “timing the market” does not work is deep and solid. Scores of studies have shown that selling before a fall and buying before a rise requires far better-timed correct judgments than any investor can hope to achieve with any consistency. Anyone can be lucky with a few such decisions. Nobody, say the academics, can use market timing to generate consistent market-beating returns.
That conclusion is based on evidence, so it is independent of portfolio theory, which provides an explanatory framework. But many people are using the evident failures of portfolio theory as justification for moving the goalposts.
In particular, if you look back five years you will struggle to find many references to “tactical asset allocation” in fund manager or adviser reports. An asset allocation framework based on expected returns and volatility delivered the division of capital between the major asset classes, and this was subject only to periodic strategic reviews. This methodology was theoretically validated by portfolio theory, but it also conformed to the traditional practice of dull and grey inv-estment advisers of the 1950s.
Today, in contrast, both fund managers and advisers talk about tactical asset allocation. Whether or not they use “overlay strategies” (a fancy name for punting with derivatives), these involve short-term market timing – putting a bit more or less into Japan, or resources, or bonds, than the strategic asset allocation model calls for. What they are really doing is short-term trading. It has no place in portfolio theory.
Being pragmatic, fund managers and advisers know they need to generate returns well above cash to keep hold of clients’ money, so, of course, they try to do so. But pragmatism without any basis in methodology or theory is just the old boy stockbroker method all over again. “The backroom chaps say the Japanese economy should recover quickly from the tsunami, so let’s have a punt.”
Value investing and small-cap investing remain the only two proven methods of generating long-term market-beating returns. Both require discipline and stockpicking skills. Both are essentially long-only methods and do not need any derivatives, overlays or stochastics. The evidence also shows that momentum investing has worked in the US and the UK but the academics reckon the costs will usually eat up all the returns.
Momentum investing works for its inventors – hedge funds – because of the huge gearing they apply. Without gearing, it is a sure way of generating lots of trading costs with a low probability of gener- ating extra returns.
I find it depressing that almost every man and his dog in the City have turned into short-term momentum or tactical traders. The Barclays Capital Equity-Gilt Study shows that lousy decades for equity investors have usually been followed by good decades. The fact that most people do not believe this will happen is the best reason I can think of for expecting equity investors who are prepared to stick to old-fashioned methods today to get rich slowly over the next decade.
Chris Gilchrist is director of Churchill Investments and editor of The IRS Report