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Outside voices and views for advisers

How ignorance hampers the pursuit of alpha

Financial advisers and investors too often follow conformist ideas about what is behind a successful portfolio

Jan 29, 2013 @ 9:50 am

By Katrina F. Sherrerd

Investments
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Walking through the art studio at my son's high school last year, I was drawn to a piece featuring a blindfolded woman trying to find an apple that she couldn't see in front of her.

My son explained that this was the centerpiece in a series that he was doing on “Truth versus Ignorance.”

Ignorance — that is the lack of knowledge and/or insight — often is a contributor to prejudices, biases, and bad decisions, he said.

The piece resonated with me immediately. No matter what decision is to be made, the solution will almost assuredly be better if the decision is based on truth (knowledge) rather than ignorance.

It is hard to make good decisions when you are unaware of —or unwilling to accept — the relevant facts and circumstances. This is certainly true for investment decisions, in part because their consequences have a direct impact on the economic options for the ultimate beneficiary.

All too often, investment professionals are unwilling or unable to pursue and act on knowledge that would lead to better invest¬ment outcomes for their clients. The invest¬ment management industry tends to empha¬size product — and its invariably linked goal of beating the benchmark — over education and counseling.

Leaders of tomorrow's successful investment management organizations — those that will have lasting impact — need to foster a culture that values intellectual curiosity, the pursuit of knowledge, and the courage to communicate freely and openly, especially if the truths uncovered are at odds with conven¬tional wisdom.

Ignorance

Ignorance usually is a severely pejora¬tive term. It shouldn't be.

Ignorance is merely a lack of knowledge, education, or aware¬ness. By this definition, we must all live with the fact that we are ignorant in many areas, so ignorance in and of itself isn't neces¬sarily a problem.

I and my colleagues would cheerfully acknowledge our ignorance of the latest innovations in medicine. Accordingly, we routinely seek the advice and counsel of doctors for medical issues.

Merely seeking help from random medical professionals isn't sufficient, however. I am likely to get better medical advice if I make the effort to learn something about my options, such as the credentials and specialties of the doc¬tors under consideration.

The key distinction is, knowing when knowledge is necessary and conversely, when a lack of knowledge is dangerous. As Benjamin Disraeli said, “To be conscious that you are ignorant of the facts is a great step to knowledge.”

Although potentially not as serious for one's health, ignorance in investing can have dev¬astating consequences for individual portfo¬lios and personal wealth. Too often, capital market participants have little knowledge of how markets work, how to make investment decisions or how to manage their portfolios.

For most, the standard operating procedure is to hire a collection of “good” managers in the hope of beating the benchmark. But this prac¬tice ignores the reality that alpha, the return attributable to skill, is incredibly scarce.

As an example, Burt Malk¬iel in 2010 analyzed the 358 equity mutual funds that were in existence in 1970. Remarkably, just 119 — less than one in three — survived through 2009, with the rest presumably closed because of poor performance.

Of the survivors, just five managed to produce net returns more than 2% per annum above the S&P 500. Talk about long odds — that is less than 1.5% of the starting universe.

But many assume that top quartile managers can add value far in excess of 2% per annum. Our own research shows that even with perfect clairvoyance of future profits discounted to today's price, a portfolio weighted by clairvoyant value would produce excess returns of about 6% per annum, a figure routinely “achieved” in shorter-term manager rankings, creating an almost irresistible siren's song.

To be sure, alpha may be achieved but only for a scant few.

So why do nearly all investors and pro¬fessionals continue to pursue returns from active management, an exercise shown to be suboptimal for investment performance? One reason is ignorance — the lack of awareness of, or inability to accept, the well-researched data that may, at first, conflict with stan¬dard practice.

Too often in our industry, people seek the safety of conventional wisdom. Paraphrasing John Maynard Keynes, for most people it is better to fail conventionally than to succeed uncon¬ventionally.

However, as James Surowiecki describes in his book “The Wisdom of Crowds,” groups of people will generally make superior decisions only when the crowd exhibits independent thought and validation of premises and views. Merely mimicking others isn't “wise” and can lead to suboptimal outcomes.

The scarcity of alpha is but one of many lessons of history that are ignored in today's conventional practices. Some of the other more prevalent ones are:

Long-term returns. Many investors are still expecting their investments to produce 7% to 8% nominal returns. With 2% bond yields, this requires some very heavy lifting from the rest of the portfolio. The sources of long-term equity returns are well-docu¬mented, so we know that dividends are the dominant contributors. So how do investors extrapolate 8% to 10% stock market returns with dividend yields of 2%, a level half the histori¬cal average? If not from stocks, many think that they can “get there” from allocations to alternatives, such as hedge funds. But the data suggest otherwise; the HFRI Hedge Fund of Funds Composite Index trailed a simple 60/40 blend by 300 basis points per annum for the 10 years ended Dec. 31. How can trillions of nest egg dollars be invested with such a blind eye to reasonable and logical expected returns?

Efficiency of cap-weighted indexes. Cap-weighted indexes represent the most reasonable and accurate manner to measure the performance of an asset class such as equities. The collective returns of all investors will match the cap-weighted index. But are these benchmarks the most effec¬tive way to build a portfolio? Only if we assume that prices are efficient. If they aren't, do we really want to own more of a stock that doubled in price? Or in bonds, should we really lend more to the most indebted? The literature of the past several years indicates that there are opportunities for improvement. Yet tracking error to cap weights still dominates most investment decisions.

Two-pillared investment portfolios. Often our ignorance is directly attributable to our experience set. Individuals and investors who lived through the Great Depression never considered equities a viable asset class for the bulk of one's savings. Most individuals and investors today haven't experienced a sizable bout of inflation and have structured their portfolios accordingly. Mainstream stocks and bonds dominate most allocations despite the fact that these two primary pillars fare poorly in an inflationary environment. Given this susceptibility to underperformance in a different economic regime, shouldn't we be having more serious conversations about achieving truer diversification?

Choose Truth

Clients rely on investment professionals to make sound decisions on their behalf, and thus would be better served if we chose truth, not ignorance, in fulfilling our fiduciary duties. For the most part, we do.

That said, there are many instances where we act “ignorantly,” and one of those is the tendency to become complacent — to discontinue the quest for more knowledge about the decisions we make — or to prefer the conventional wisdom even if the facts don't support conformist thinking. The quest doesn't have to lead to some world-changing discovery.

In our experience, the quest for truth and knowledge brings us back, more times than not, to basic time-tested practices of investment success, such as reducing costs, re-balancing aggres¬sively, being contrarian and diversifying broadly. These basic tenets can always be sharpened and reinforced by rigorous research and education.

Success in the asset management indus¬try isn't guaranteed. It is hard enough to be successful when we are open and curious rather than defensively operating within familiar territory, blindfolded to the panoply of alternatives that are avail¬able to us.

We are wise to remember that conventional wisdom may not always be

“the truth.” The firms that succeed will be those that can take transformational steps to adapt to changes in the industry, take advantage of new and emergent opportunities, and, importantly, educate clients along the way.

In such an environ¬ment, we see more emphasis on trans¬parent, diversified, low-cost products as the core for most portfolios. We still see a role for higher-fee, alpha-oriented products, but the standards for evaluat¬ing their attractiveness will toughen, and many offerings won't be viable in the future.

We think that, increasingly, decision makers will seek more knowl¬edge and insight based on independent thinking before making investment rec¬ommendations or taking action.

In the future, the successful investment management firm will be able to add more value to the client relationship than the simple bottom line of excess returns over the benchmark. The quest for insight and education should join — not subsume or downgrade — the quest for alpha.

Further, and potentially more important, we would like to see investment profes¬sionals take the lead in helping investors to understand the facts and consider¬ations that are relevant to their invest¬ment decisions.

Katrina F. Sherrerd is the chief operating officer for Research Affiliates. This commentary originally appeared in the firm's Fundamentalsnewsletter for January.

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