In process we trust
A strong investment process is what gets you through ragged markets without making hasty, terrible decisions. But have you actually got a process, or is it simply a bunch of preferences?
The first few weeks of 2022 have definitely been a challenge. It is quite possible the next few months could be as well, as discussed in our latest episode of The Sharpe End podcast, ‘Hike club’. It doesn’t matter how many corrections you experience, they are always extremely uncomfortable, even a bit frightening.
As you lay awake in the early hours of the morning searching for inspiration and solace, there’s a danger of overthinking things. If you’re not careful, you read more comments from economists, strategists, commentators and your peers, who all seem to have called the correction and are doing better than you. This road leads to paranoia and the feeling that you must take action, any action. Now known as doing a Boris.
This is when your investment process is so important. What if, however, your investment process isn’t actually an investment process? What if it’s just a statement of preferences, which anchor you to your personal views?
A preference for process
Earlier in my career I was a fund buyer, so I guess you might say I am a gamekeeper turned poacher. One thing that used to really make me cross was when a fund manager told me I shouldn’t expect them to outperform their benchmark if their investments were currently out of favour. Now I can absolutely understand this over the short-term and I was happy to back a manager who could express a compelling thesis to support their long-term strategy. I was less sympathetic when a manager underperformed year in, year out based purely on a set of long-held, unshakable beliefs. My job was to determine whether the manager sitting in front of me is the former or the latter.
So what is the difference between an investment process and a set of preferences? For me, an investment process is a set of self-governing rules and disciplines that protect the fund manager – and ultimately their clients – from any emotional or irrational response to periods of market turbulence or underperformance when the ‘noise’ is dialled up to 11.
Examples include position sizing limits, sell disciplines, buying triggers, risk concentration limits and selection criteria for liquidity or business fundamentals, all of which complement longer-term strategy. These will not be hard limits in the prospectus but self-imposed rules to fall back on when under pressure. I use these all the time as they really restrict you from that herding instinct that is so compelling at times of stress. In better times they also protect you from FOMO (fear of missing out).
Investment processes that state no investing in a sector or a country or a type of asset class are not processes, but a list of manager preferences. That is a totally legitimate position to take. I do it also. However, it is a set of beliefs, not a process. These preferences are an investment decision not a portfolio construction framework. Therefore, I would argue, these beliefs need to be challenged regularly by the fund managers themselves, their chief investment officers and their investors.
I fundamentally believe that fund managers do need time to allow their strategies to play out, otherwise you end up endlessly chasing past performance and locking in underperformance. The world keeps changing after all and fund managers need to retain a degree of humility to accept this and be open to change. Confidence is good, arrogance not so, and arrogance with complacency is absolutely toxic.
Thirty years ago, I would never have entertained the possibility of the US 30-year Treasury bond yielding less than 5%. Two years ago, I would not have entertained the possibility of it going back above 5% for many, many years. And now? While a 5% plus Treasury yield still seems unlikely, I am entertaining the chance. Anchoring can make you look stupid.
In my experience fund managers who acknowledge their own human failings and build a set of rules around themselves to guard against these potential weaknesses tend to enjoy longevity of outperformance. That’s good for their careers but also good for their investors.