Investment Management: Why You Need A Complete Rethink. Part 1 – The best assessment of Investment Management is not Returns.
How can you judge whether your returns or any investment manager’s returns demonstrate superior asset management either compared to a benchmark or another asset manager?
Certainly, there are many important factors, like total fees, but what what is the overall metric that clearly separates one manager, or set of results, from another.
Returns are usually a main focus, but they can be dangerously misleading.
Most people just look at returns and even short term returns! It is understandable to the extent that it is one or the few clear statistics that investors have, and it is the number investors want to get. However, the link between past returns and future likely returns is far more complex than most people take on board. High past returns may often even be a warning sign!
After all, chasing returns essentially means buying higher highs, and selling lows! Even with a great deal of skill, a one factor return model is unlikely to be optimal.
Just looking at returns to assess investment management skill, is particularly problematic in bubble markets, with enormous central bank intervention. As we have now. It is hard to separate out many key elements of the return, from investment management skill.
The chart below shows what happens to investors who chase returns in a bubble.
LTCM became the world’s biggest hedge fund and employed numerous noble prize winning scientists. As the chart shows, the returns from inception in 1994 were spectacular. Any investor allocating on the basis of past returns would always be allocating to LTCM because their returns were the simply the best, and by a wide margin. The fund seemed to have superior knowledge and persistently higher returns.
Unfortunately this was a disastrous error as the chart also shows. All returns were wiped out and, in addition, turned into losses, in just a few months in 1998. Clearly, chasing returns broke down badly as an approach.
This is important because bubble economics has become a part of structure of our markets now. How can you possibly conclude anything other than that we are now in yet another bubble?
Just looking at returns ignores risk. Clearly LTCM had bigger changes in account value. All successful professional investors assess risk first and only then the potential return! Investors must make a genuine and valid assessment of risk otherwise they could make losses far greater than they understand, with a significant possibility of permanent capital impairment.
Risk assessment is the hardest part of investing but it is also the most valuable part.
The problem with risk is that we can not quantify risk very clearly or objectively. We can measure past volatility very accurately, but volatility itself is highly variable and so past volatility experience may not be an accurate guide of the future.
Nevertheless, I believe the best you can do is to assess performance is
Repeatable Volatility Adjusted Returns or RVAR.
Volatility Adjusted Returns can be accurately calculated and should form the basis of initial analysis. However, it is crucial that these volatility adjusted returns are repeatable.
Whether they are repeatable is always going to be subjective to some degree, but this element is as important as the analysis of past volatility adjusted returns.
Any investor who can demonstrate superior RVAR is clearly offers something different and I believe superior investment results. RVAR would certainly have required a deeper analysis before investing in LTCM.
With RVAR an investor benefits from the prospect of peace of mind that comes with low volatility and consistent returns. This helps with life planning and lower levels of stress and anxiety.
In Part 2 I will analyze allocation methodology. Most investors currently have very suboptimal allocations, which are not even historically based or even theortically based. Furthermore, these allocations now have the worse prospective returns in history!
45 years of data suggests there is a much more balanced allocation easily available.
In Part 3 I will show how crucial money management is to RVAR
In Part 4 I will show what I believe is the path to further improvements to RVAR through making a shift to Active Asset Management with tactical allocation models.