Nearly ten years of extraordinarily accommodative monetary policy has clearly affected markets and asset prices. In combination with a strong trend to passive investing it has also had a bruising effect on the business of active money management. While many managers have lost funds due to high fees or poor value propositions, a huge headwind for the industry has been that increased trend following and reduced volatility have broadly suppressed the opportunities on which the active management business lives and breathes.
Ben Hunt captured the situation for active managers well in his recent report [here]. As he describes, dealing with these market conditions "... is a miserable experience for discretionary stock pickers (and the same is true for any security selectors, whether it's bonds or commodities or currencies or whatever ..."
Hunt goes on to expound on the difficult tradeoffs money managers are confronted with in these circumstances: "By far the most common coping mechanism for a market we don’t like and we don’t trust and we don’t understand — but a one-way up market for all that — is to become smaller in spirit even as we become larger in scale. To become transactional. To collaborate with the forces that turn markets into utilities. To become positioners rather than investors. To become model followers rather than idea generators. To hedge out our most pronounced career risk — which is not a large portfolio loss, because so many others will be in the same boat, but is rather a small portfolio loss from independent decision-making while others are making non-independent, collective gains."
He concludes by describing how most of the industry accomplishes the hedge against career risk: "By eliminating independent risk-taking and embracing collective risk-taking, that’s how." What this means for most money managers who focus on security selection, is that "they have to give up their reason for being" in order to stay in business.
What this means for the markets is that the mainstay of active management, idiosyncratic risk, has migrated to systemic risk. In other words, relatively short term inefficiencies in individual securities prices have been substituted for longer term market inefficiencies. This is corroborated by zerohedge [here]: "Which brings us to BofA's striking punchline: between central banks, quants, and ETFs, the market is becoming increasingly inefficient."
More specifically, the report notes, "... ironically, what should be an increasingly efficient market has shown signs of becoming less efficient over the long term ..."
These reports are articulate expressions of what I have been seeing as well. Fortunately, since Areté's marketing strategy focuses on investors with very long time horizons, our business has not experienced the same short term pressures that have forced many other active managers to "change their stripes". Nonetheless, the adverse conditions for stock picking have caused me to re-evaluate where research efforts are best directed. As a result, I have temporarily re-allocated some resources from current stock research to two other activities that I think will provide a greater benefit to investors in the future.
One of those activities is developing and incorporating better signals for systemic risk. If, as it appears to me and both Hunt and BofA suggest, the greater risk for investors is not incremental stock losses but that of a "large portfolio loss", then that ought to be a high priority.
As a result, I have been spending more time on evaluating metrics and mental models that help identify and gauge market risks. For example, Andrew Lo's book, Adaptive Markets: Financial Evolution at the Speed of Thought, provides a great foundation for this endeavor and Everybody Lies: Big Data, New Data, and What the Internet Can Tell Us About Who We Really Are, by Seth Stevens-Davidowitz, provides important insights on using big data.
Notably, in the context of firms pushing harder and harder to accumulate more and more information, Steven-Davidowitz provides a useful reality check. In particular, he notes, "You don’t always need a ton of data to find important insights. You need the right data." Further, he says, "In fact, the smartest Big Data companies are often cutting down their data. At Google, major decisions are based on only a tiny sampling of all their data." The really good news is that these insights play right into Areté's strengths of thoughtful technology adoption and independent thinking.
A second activity that I have been investing more time in is a valuation model that I have been building and adapting for Areté's purposes. My thinking here is that an extremely overvalued market is unsustainable and that when it turns, it will be hugely beneficial to have the best valuation tools available to take advantage of the new opportunities. This has been a big project but is finally coming into service.
In sum, I have been frustrated with the dearth of investment opportunities and I know investors have been too. But if stocks are expensive and there simply aren't good opportunities, it doesn't help to "just do something". In light of these temporary challenges, I've been trying to allocate resources in ways that I think best serve client interests under the existing conditions and will continue to do so. A big part of what keeps me going is the belief that there will be significant investment opportunities to be had for those patient enough to wait and big business opportunities for active managers capable of doing so.
Thanks for your interest and take care!
David Robertson, CFA
CEO, Portfolio Manager