August 12, 2009

Your World Class Mutual Fund Company…Didn’t See It Coming?

While portfolio managers and research teams at numerous investment management firms felt that during 2007 parts of the market were overvalued, many didn’t see a crash coming.

During one mutual fund company’s unitholder meeting in July 2009, a unitholder asks why not? Here’s part of the fund company’s response:

“What we didn’t see, what we didn’t see, was the domino effect of the financial crisis taking all securities lower. We didn’t see that. I can tell you as well the Bank of Canada didn’t see it, nor did the Federal Reserve System, the OECD or the European Central Bank.”

Many investment management firms and economic agencies use a top quality global team of hundreds of highly educated, highly paid professionals. We’re talking about the cream of the crop here…these people aren’t dummies.

So what’s the problem? Below are 4 major faults of the investment management industry that caused funds managed by world renowned investment firms to fall in lockstep with the plummeting markets:

1. Forecasting fallacy. Is there really any point to using investment professionals if they can’t forecast major market crashes? Many believe investment managers cannot add value through attempts at forecasting.

A recent article by Marc Faber illustrates how forecasting may be a fruitless effort:

“This takes me to James Montier’s critique of the efficient markets hypothesis. According to him, “the worst of its legacy is the terrible advice it offers on how to outperform — essentially be a better forecaster than everyone else”. In his opinion, this is one of the biggest wastes of time, yet it is nearly universal in our industry. “Pretty much 80%–90% of the investment processes that I come across revolve around forecasting. Yet there isn’t a scrap of evidence to suggest that we can actually see the future at all.””

While he feels that forecasting is generally a waste of time, Faber goes on to say that analysts can foresee shifts from major market deviations (such as the NASDAQ bubble in the late 1990s or the Japanese bubble in the late 1980s/early 1990s) but it is very difficult to time these shifts. Unfortunately, being early is penalized just as hard as being wrong.

2. Group think. There may be an organizational problem inherent with large investment firms. Some are prone to committee thinking where decisions are incremental and made through consensus. I’m sure some analysts had an idea that the market was experiencing death throes, but perhaps they were forced to adopt a moderate view to move in-line with their firm’s consensus. If investment firms don’t embrace and act on deviance in thought, how will they forecast deviance in the markets?

3. Being early = being wrong. The investments industry is structured so that portfolio managers that seem to be doing ‘nothing’ get fired (or at least suffer from sharply increased scrutiny). E.g. if a portfolio manager was in cash for 12-18 months leading up to the crash (i.e. early) he would have outperformed (and protected capital) today. While in hindsight we know this would have been a good move, the portfolio manager would have unfortunately been fired within 6 months for not investing the portfolio while short-term market returns were still (at that point) positive. Anytime a portfolio manager or financial advisor is heavily weighted to cash the standard question arises: why am I paying him 2% to manage cash? Giving a portfolio manager unquestioned reign over asset allocation involves a degree of trust that most clients (and investment oversight committees) simply don’t possess.

4. Conflicting incentives. Profit margins on equity funds tend to be higher than bond or cash funds so investment management firms have a reason to incent advisors to sell equity funds. Commission-based financial advisors get paid less or nothing to put client money into bonds or cash. They have an economic incentive to invest client money into equities regardless of client needs. This also means most advisors have an economic incentive to present bullish arguments on equity markets. [This is one of the biggest reasons that investors should instead choose to hire fee-based advisors.]

Finally, to say nobody saw this coming is ludicrous. There were plenty of signals the world was about to enter a shit-storm. One only has to connect the dots… Housing prices – the source of US consumption and global economic prosperity since the 2001 recession – started moving in reverse. It was pretty obvious that there was going to be an equally powerful reversal of global economic fortunes as housing prices rolled over in 2006.

Also, when markets for securitized assets seized up and credit was no-longer available to hedge funds that purchased these securitized assets, one might have thought something was amiss.

But the biggest signal was this: When the pillars of the American Dream (Freddie Mac and Fannie Mae) went bust, a big red flag should have gone up to anyone who understood the degree to which housing contributed to American consumption and global aggregate demand.