July 6, 2011

Will your portfolio manager avoid the next crash?

Crashes repeat over time. But investors also repeat the same mistakes and get burned every time. To help you avoid walking head-first into another catastrophe, we explore why so many professional investors couldn’t steer away from the 2008 financial disaster.

In 2007/early 2008, many portfolio managers and research teams at investment management firms believed the market was overvalued, but 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 use top quality global teams that include hundreds of highly educated, highly paid professionals. We’re talking about the cream of the crop here…these people aren’t dummies. So why did so few see the crash coming?

Below are 4 major problems within the investment management industry that caused many well-respected professional investors to consciously or unconsciously maintain biases that led them to run head-first into the 2008 financial crash:
  1. Forecasting fallacy. Many professional investors are overconfident in their ability to forecast the future. There’s plenty of research to suggest that very few investors are able to consistently predict the future – and most of those investors are just lucky.
An 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.””
Is there really any point to using investment professionals if they can’t forecast the future? While Faber and Montier feel that forecasting is generally a waste of time, Faber does goes on to admit 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 much 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. Many analysts within large investment teams had an idea that the market was experiencing major problems during 2007/2008, but they were encouraged/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? Unfortunately, many professional investors choose to avoid career risk by aligning their views with the rest of the group. Few people are ever fired for doing the same thing as all their peers.

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 eventually outperformed (and protected capital). While in hindsight we know this would have been a good move, the portfolio manager probably would have been fired within 6 months of sitting on cash for not investing the portfolio while short-term market returns were still positive. Anytime a portfolio manager or financial adviser 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 large degree of trust that most clients (and investment oversight committees) simply don’t possess. This means that few portfolio managers will make significant allocations to cash – even when they feel it is the right thing to do.

4. Conflicting incentives. Profit margins on equity mutual funds tend to be higher than bond or cash funds so investment management firms have a reason to encourage advisers to sell equity funds. Commission-based financial advisers usually get paid less or nothing (depending on which country you live in) to put client money into bonds or cash. Therefore, many advisers have an economic incentive to invest client money into equities regardless of client needs. This also means most advisers have an economic incentive to present bullish arguments favoring equity markets. [This is one of the biggest reasons I think that investors should instead choose to hire fee-based advisers.]

Finally, to say nobody saw the 2008 crash coming is ludicrous. There were plenty of signals the world was about to enter a s*~t-storm. One only has to connect the dots… Housing prices – a major 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.

Clearly the warning signs were there. But, whether consciously or subconsciously, many professional investors had a reason (or were forced) to look the other way.

So what do I look for in a portfolio manager? Modesty, independence, a willingness (and ability) to use cash strategically, and compensation that aligns his interests with mine. Finally, I diversify my exposure to individual portfolio managers and investment firms to ensure my money (at least the portion I don’t manage myself) is not highly exposed to the decisions of a single person or group.

I encourage you to have an open conversation with your financial adviser to see how he/she handles these problems. Your adviser has a fiduciary duty to look out for your best interest, so don’t be afraid to ask questions.

If you’re an investment professional, drop me a line letting me know how you feel about these issues. How do you handle them?