Consultants, Career Risks, and Cash can hurt professional money managers as well as many individual investors who think like “the Pros”
Consultants
A recent Financial Times column by John Authers starts off by recognizing that it is hard, but necessary, to accept the responsibility for mistakes. It is the reason that many investment committees and other fiduciaries hire consultants. The column goes on to describe the results of a ten year study of consultants’ manager selection recommendations. The academic study found that the recommendations underperformed the market and were worse than the performance of the managers that were not recommended. This was also true in the selection of allocations to various sectors. However, the recommended managers’ performance hugged the benchmark better. (Perhaps the consultants recommended closet indexers.) I suspect the buyers of the consultants’ services expected those results. They knew the value of the John Maynard Keynes quote “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” In another quote from Farnam Street discussing Howard Marks’ book, The Most Important Thing, “first-order thinkers look for things that are simple, easy, and defendable.” Howard makes the distinction between first-order and second-order thinkers. First-order thinkers are only interested in the current time period, whereas second-order thinkers are focused on how the present sets up a number of future scenarios.
Disguised Consultants
Many of today’s investment advisers were impacted by the changing economics in the financial community, from being a fixed fee adviser or a commission driven broker to becoming a registered investment adviser charging a management fee. Since many investment advisors have no rigorous training in securities analysis, they focus their client bets on sectors and factors, using statistical measures, current news, and trends. As with manger selection, consultants are often first-order thinkers and produce similarly unappealing results. One tip off as to their performance is the weekly data from my old firm’s publication of the Lipper Performance Report. During the latest week, all twenty categories of US Diversified Equity funds showed positive results, comprising the management of $8 Trillion in aggregate. In contrast 18 out of the 28 sector equity funds showed losses, comprising only $1 Trillion in aggregate. The difference between the two is that the diversified funds owned some of the best stocks in the sector portfolios and had enough diversification to produce less volatile results.
Nervous Contrarian
With the consultant’s focus on short term results, echoed by a number of investment committees and other insecure fiduciaries, the ability to predict short term market moves is critical (This is not true for long term investors.) The current stock market is being driven much more by changes in sentiment than fundamentals. Most transactions are originating from non-price sensitive transactors and the markets are reacting to changes of sentiment driven by news, fake news, and rumors. To see the rapid changes of sentiment, look in Barron’s for the results of the weekly American Association of Individual Investors (AAII) sample poll shown below:
View Latest Week 2 Weeks Ago 3 Weeks Ago
Bullish 34.7% 43.1% 27.9%
Bearish 24.9 29.2 39.3
Neutral 40.4 27.8 32.6
As a contrarian I get nervous if I find myself betting with the crowd. Thus, if neutral approaches 50% I will be forced to make a decision and not just bet against the bulls or bears. At the moment my short-term inclination is to go to the bearish side and maintain a bullish position for the long term.
Career Risks
The challenge for the professional investor is to play according to the consultants’ rules, or attempt to produce extraordinary performance by being different, which almost guarantees underperformance some of the time.
Is Cash an Asset Class?
Last week I attended a Pershing Conference for Investment Advisers. I was particularly impressed with a discussion that included Rob Sharps, who chairs the growth equity committee at T. Rowe Price and is an important input into their best in class target date funds. (I am biased in the favor of T. Rowe, having known each of their chairman back to Mr. Price himself. We are users of some of their funds both personally and for clients, and also hold a position in our private financial services fund. I took particular note when he said that at the margin they were de-risking for the first time this cycle. In addition, State Street is raising the question of cash, pointing out that the current rates of return on US Treasury Bills are closing in on the Fed’s targeted inflation rate.
Years ago I studied the performance of various mutual funds that raised cash defensively. In major declines only funds that had about 25% of their assets in cash like instruments had a meaningfully smaller decline in the market. The longer term problem with these funds is that do not recommit to the equity market fast enough, so that when the market regains its prior peak they underperform and are meaningfully worse as performers.
Avoiding Poor Recovery Syndrome
There are two ways to avoid the poor recovery syndrome. The first is not to raise a great deal of cash but instead move heavily into low risk stocks that pay good dividends and a have a shareholder base to support liquidity in the stock price. We used to call them warehouse stocks. The classic one was the old AT&T, not the current stock of the same name. The second approach is to replace the portfolio manager with the next generation, a generation not burdened by the knowledge of what won’t work because it didn’t in the past. In recoveries, the combination of new enthusiasm and momentum will be early stage winners. The trick is then to replace the successful youngster with a more rounded manager.
Bottom Line
Be prepared to move away from the crowd, examine defensive tactics, and don’t fall in love with cash.
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A. Michael Lipper, CFA
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