As I have mentioned several times in Areté blog posts and most recently in the market overview for the third quarter [here], the landscape for investing has been transformed under the reign of massive and persistent monetary stimulus from central banks.
All of this has affected stock prices, but it has also affected the business of managing money in important ways. As Christopher Cole describes in a wonderful analysis of volatility [here], "The alpha from active management often comes down to two factors: (1) asset selection and (2) short volatility or short correlation exposure. When markets become more correlated, asset selection becomes increasingly irrelevant. The only thing that remains is the short volatility exposure."
And more correlated markets is exactly what has happened – partly as a result of central bank policies and partly as a function of strong money flows into passively managed funds. Regardless, the effect has been to temporarily deprive the market of what is normally a healthy array of opportunities for money managers to produce alpha by way of asset selection.
Denied of this conventional avenue of alpha generation, managers have instead been forced to allocate more attention to the “short volatility” channel. As long as markets are rising, it is very difficult for most managers to do anything other than be fully exposed to the market. As a practical matter, any significant reduction in exposure in this landscape, regardless of long term investment merits, runs the risk of losing clients. It’s really not much of a choice at all.
It is in the midst of such a dilemma for the money management industry that Areté really shows its independent colors. Unlike many of my peers, I have been unwilling to acquiesce to these challenges, and have responded to them with what amounts to three different initiatives.
One is to not give up on the the potential for asset selection, and more specifically, for valuation, to matter again. My belief is that because high correlations have persisted for so long, there are vanishingly few managers who retain deep institutional ability to incorporate valuation modeling.
As a result, when things turn (and I think they will since current conditions are unsustainable), there will be significant opportunities for those of us still around.
In order to prepare for this, I have further developed and built out Areté’s in-house valuation modeling capabilities. This has been a big project but is finally coming into service. This effort serves to avoid stocks most subject to valuation risk during this period of strong market sentiment while also serving as a powerful means by which to exploit opportunities in the event of a downturn.
The second initiative has been to very deliberately reduce the Mid Cap Core’s exposure to volatility selling by reducing overall exposure and by seeking out stocks with low correlations. This decision explicitly recognizes the increasing level of systemic risk in the market and expresses my sense of fiduciary duty to make the best investment calls I can in any given environment. This is really just another way of saying that I am not going to forsake the long term goal of attractive absolute returns for the purpose of trying to keep up with short term relative returns.
Conversely, many money managers simply cannot afford to exhibit the patience to make the better investment decision of avoiding volatility selling. Although a handful of managers may be able to successfully navigate this high risk/low reward game, the vast majority will not. It makes me wonder what these managers get paid for and I’m sure their clients will be wondering the same soon enough.
The third initiative was to launch the Personal CIO service, which I believe has great potential. In the event that volatility continues to remain suppressed and valuation elevated, there really is no useful purpose for conventional money management, per se. However, investment expertise can still be redirected in a way that is useful by highlighting sytemic risks and recommending alternatives. For many reasons, I believe few providers will be able to adapt in this way and even fewer who can do so on an a-la-carte, hourly basis.
Finally, there is no doubt that conditions have been tough on active managers the last several years. However, there is also no doubt that there has never been a greater need for objective investment expertise to help navigate an increasingly treacherous investment landscape. I founded Areté to do just that and look forward to the challenge.
Thanks for your interest and take care!
David Robertson, CFA
CEO, Portfolio Manager