What's the value of professional investment advice? Not much!

According to accepted research the answer is “not very”. 

The industry so entirely disregards 91.5 per cent of the causes of differences in investment returns, that its activity is mostly a complete waste of time and effort, according to research dating back to articles published in the Financial Analysts Journal in 1986 (updated in 1991) by Gary Brinson and Gilbert Beebouwer which quantified the extent to which quarterly variance between portfolios specifically stems from asset allocation. Whilst subsequent studies have achieved slightly different results it is now universally accepted that the biggest factor in determining the volatility or periodic variance of a portfolio is asset allocation. 

In plain English this means that asset allocation is the most important investment decision and by far overshadows other components of return, namely security selection and market timing.

Security selection (stock-picking) is the detailed process of deciding which specific assets to hold within a particular asset class (ie, whether to buy Microsoft or IBM).

Market timing is the short-term process of deciding a particular moment to buy or sell an asset (for example, buying right now rather than in an hour, a day or a week). 

Asset allocation is the bigger picture process of actually deciding whether to invest or not in an asset class (equities, bonds, property, commodities, deposits or hedge funds) at all, rather than which specific asset within the class to buy or what time to buy it.

This makes fundamental economic sense; whether stock markets are on a significant rising or falling trend (typically super-cycles endure for 10-20 years) will ultimately be a bigger determinant in overall return for any stock than the zero-sum game relating to each stock’s outperformance or underperformance versus its peers. This holds truest in transparent, highly liquid overanalysed assets such as US equities. It also makes technical sense in terms of correlation, variances and co-variances between asset classes. Different asset classes perform differently in different market and economic conditions. The bigger this difference the greater the diversification benefits. The wider a portfolio casts its asset allocation net, the greater the potential for improving returns and/or for reducing risk (real estate, commodities, and high yield paper add greatest diversification value to traditional asset mixes of stocks, bonds, and cash). 

Only investment managers who primarily focus on the most important determinant of return (asset allocation) can expect to consistently produce outperformance. My nine-year-old daughter appreciates this reasoning: 50 years on from its original publication, I bought her a copy of a book that entranced me 40 years ago, Norton Juster’s “The Phantom Tollbooth”. She too was drawn to the Whether Man character’s reasoning:

“I’m the Whether Man, not the Weather Man, for after all it’s much more important to know whether there will be weather than what the weather will be.”

The pre-eminence of asset allocation is apparent to every scrutiny from infant logic to technical analysis with just one exception, the industry itself. The Investment Company Institute’s 2012 Factbook shows that of $11.6 trillion assets invested, 99 per cent is run by financial Weather Men. Only 7 per cent is in hybrid funds, of which genuine multi-asset allocation funds are a further small subset, representing less than 1 per cent.

Why is this? 

Mark Twain rightly said history doesn’t repeat but it does rhyme. Rhyming is a subtle step too far for many statistical models, leading many industry insiders to point to the difficulty of accurately predicting future risks and returns based on historical precedent, in turn highlighting their own superficial understanding of economic theory: Whilst quantitative models have developed sophisticated recognition of recurrent economic patterns their statistical rigidities predicate them to exploit forecasted absolute statistical repetition rather than appreciate the subtle rhymes that really do occur in real life. The best quantitative models are nonetheless effective but seemingly randomly so, unable to distinguish between mirror images of history and imperfect “rhymes”. 

In other words, asset allocation demands a more finessed skill-set than powerful computer models allied to comprehensive data sets. The investment industry is mainly unwilling or unable to provide this skill-set. Its manifold excuses seem to be variants on:

Asset allocation is just too hard for investment companies because it can’t be reduced to simple mathematical or statistical processes

Asset allocation doesn’t earn enough margin for investment companies

Asset allocation increases client demands and expectations

Consequently 99 per cent of investment industry activity remains focused on activities that are jointly only responsibly for 8.5 per cent of the variances in portfolio returns, equating to a deadweight loss of almost 91 per cent in economic terms and a very low bar in terms of client expectations. 

Teams of analysts continue visiting listed companies and publishing (and charging clients for) the output as though it were actually meaningful, even though some 80 per cent of active asset selection mutual funds (according to The Motley Fool) and pretty well 100 per cent of passive index funds even underperform the indices against which they benchmark themselves without ever raising the question whether investing in that index is a good or a bad idea.

The fund management industry has seemingly perpetrated a kind of “emperor’s new clothes” style deception, where for every Whether Man trying to add genuine value to investment propositions, there are nine Weather Men destroying it. 

“The Phantom Tollbooth” ends up at The Island of Conclusions. The fund management industry could well learn from the character Canby’s explanation of how the other characters got there:

“You jumped, of course. That’s the way most everyone gets here. It’s really quite simple: every time you decide something without having a good reason, you jump to Conclusions whether you like it or not. It’s such an easy trip to make that I’ve been here hundreds of times.”

Whilst the greatest theoretical influence on my career has been the research of Gary Brinson and Gilbert Beebouwer, no one has done more to prevent me jumping to conclusions than the Whether Men that MBMG Group has been most closely associated with: Scott Campbell, Edouard Carmignac, Sebastian Lyon, Jonathon Ruffer and above all Martin Gray. All have implemented highly successful asset-allocation-based investment solutions, none more so than Martin Gray who has outperformed S&P 500 Index by over 85 per cent in the last 12 years. Martin visit Bangkok again this week to explain the current opportunities and risks facing investors and the appropriate asset-allocation responses.

 

Paul Gambles is managing partner and chief investment officer at MBMG Group, .