A Fair Deal

7 Minutes Reading Time

I’ve been spending a lot of time over the summer thinking about my business and my plans for 2018. Basically, I’m trying to answer this question: “Why does the world need yet another investment advisor/asset manager?”

Its a tough question to answer. After a few weeks of frustration and feeling like I was going around in circles, I’m starting to get close.

My wife suggested that I blog about it, which is a fantastic idea.  This is the first in a series of posts where I try to flesh out what it is that I’m trying to do and hopefully why it matters. 

I hope that blogging will help me in two ways: 

  1. Clarify my thoughts
  2. Elicit feedback and helpful criticism 

Please post your questions and comments as they will help me to work this out. 

The investment industry is full of information asymmetries, conflicts of interest and zero-sum games (i.e. winners and losers). The result is that the end users often don’t get much value-for-money from the investment industry. What if it didn’t have to be this way?

I believe that there’s demand for investment advisors and managers willing to offer their clients a fair deal. But this raises a few questions:

Q. Could an investment manager run a profitable business and still put their clients first at all times?

A. Yes, it’s possible, but it requires a very different business model to make it work. The good news is that technology is reducing costs which is making a range of different business models possible for those brave enough to give them a try.

Q. If so, how would such a manager describe their investment philosophy and guiding principles?

A. The remainder of this post is my first attempt at answering this question.

My Guiding Principles and Investment Philosophy

The economy and financial market are dynamic. Consequently, it makes little sense to adopt an investment approach designed to look only for specific attributes (e.g. cheap stocks or growth stocks) when the circumstances influencing the success or failure of these attributes are constantly changing.

This is why we invest using a clearly defined intellectual framework that considers both circumstances and attributes. Frameworks also have two other important benefits:

  • Allow flexibility while at the same time sticking to a set of core principles and keeping the overall objective clearly in focus
  • Promote consistent decision-making over time (which is not the same as always doing the same thing regardless of the circumstances)

We believe that in most circumstances investors are better off investing in passive investments designed to track a benchmark index at low cost. History shows that such an approach outperforms 60-90% of the time. We use passive investments where evidence and experience suggest that the market is toughest to beat.

In other words, we always try to be honest with ourselves and with you. It’s not fair for us to risk your capital while charging you a fee if we’re not reasonably confident that we can do a better job than a simple, transparent, low-cost index fund. And confidence is not enough, we also need to back our conviction up with evidence.

While odds are against active management, it is possible to out-perform the market a) under the right circumstances and b) by investing in opportunities where we have a competitive edge.

We have developed a framework that helps us to assess whether or not circumstances are favourable toward active management and to identify and measure our competitive edge.

Finding the right circumstances includes looking for:

  • Opportunities that large institutions are constrained from investing in (i.e. less competitive areas of the market).
  • High dispersion
  • Low correlation
  • Volatility
  • The tell-tale signs of over-reaction (e.g. value) and under-reaction (e.g. growth)

Competitive edges come in three types:

  1. Information
  2. Analysis
  3. Behaviour

Experience has shown us that the first two competitive edges are the hardest to sustain. Most investors have access to the same information and their ability to access that information has never been faster. Maintaining an analytical edge is difficult in a business such as asset management, which attracts a steady stream of MBAs, CFAs, CAs and PhDs.

There’s always someone bigger, smarter, faster. We know we can’t win that game, so we don’t even try. But it’s OK because there are other games where size, speed and complexity make investing difficult. The years that we spent as institutional investors working with hundreds of fund managers from around the world made that very clear.

The good news is that a behavioural edge is possible to sustain. So, we’ve organised our investment process around maximising our behavioural edge. You’re probably wondering, what do we mean by a behavioural edge? There’s a positive and a negative side to gaining a behavioural edge.

On the negative side are the pitfalls that we make a deliberate effort to avoid. The easiest way to improve your performance in any competitive activity is to simply avoid making the same mistakes as your competitors. What are some of our competitor’s mistakes? They include:

  • Short-term thinking
  • Behavioural biases
  • Over-trading
  • Conflicts of interest
  • Prioritising sales and marketing over investment
  • Portfolio construction based on market benchmarks
  • Rigidly sticking to an investment approach focusing only on a single type of opportunity

On the positive side are the behaviours that we make a conscious effort to perform. These behaviours are designed to continually improve the quality of our decision-making over time. They include:

  • Long-term thinking
  • Using a flexible framework, based on time-tested principles, that allows us to evaluate and compare a range of opportunities
  • Creating an investment process designed to minimise the impact of behavioural biases
  • Tools such as checklists that promote consistent decision-making over time
  • Creating feedback to assess the quality of our decisions
  • Deliberate practice

Yes, this is basic stuff, but you’d be surprised by the difference that it can make. Remember, it’s the little things, compounded over time, that grow into something big. You’d be even more surprised by how many investment firms are really slack about these things.

We are human and we do make mistakes. Which is why we have a process to learn from them. We are not shy about making mistakes for four reasons:

  1. Our mistakes always teach us the most important lessons
  2. We are prepared to make mistakes with our own money, which is why the majority of our net worth is invested in our funds. We think this is only fair
  3. Investing is all about the future and nobody knows the future. So, it’s only reasonable to expect that we’re going to make a lot of mistakes when making decisions about the future
  4. A portfolio’s purpose is to help us manage our mistakes

The last point is worth elaborating on. The wonderful thing about a portfolio is that it allows investors to do well over the long-term despite making a lot of mistakes. The key is to make sure that a portfolio’s winners are much larger than its losers. This is sometimes referred to as “money management” and it is a significant part of our behavioural edge. It includes decisions such as when to buy, hold or sell and position sizing.

In contrast, most institutional investors are forced to invest in ways that rob them of many of the advantages that a portfolio offers. All of those MBAs, CFAs, CAs and PhD’s aren’t cheap. There’s also the shareholders who expect to make a profit. Consequently, most institutional investors are focused on maximising amount of money that they manage. They do this by using a market benchmark as the starting point for portfolio construction. This allows them to do two things:

  1. Reduce the risk of getting sacked and losing money due to short-term underperformance
  2. Run portfolios that are highly liquid and have the capacity to accommodate a lot of money

Unfortunately, this comes at the cost of performance. It’s no surprise as, in this case, the portfolio is constructed to maximise the fund manager’s return on their investment, not yours.

This is one of the reasons why we’re organised the way that we are. It allows us to keep our costs low which is important for two reasons:

  1. We pass the savings onto you
  2. We’re not forced to invest in a way that maximises our fee income at the expense of your investment returns

One last comment about mistakes. We’ll always tell you what our mistakes were, why we think we made them, what we’ve learned and what we’re now doing to avoid repeating them. At the end of the day, it’s your money, which is why we owe it to you to be transparent and honest both in good times and especially in bad.

There may be times when the right thing for us to do is to return part or all of your capital. Here are two reasons why this might be the case:

  1. We can’t find any opportunities that we believe are reasonably likely to do well over the long-term and we believe that the returns of passive investments will inadequately compensate you for risking your capital
  2. It becomes clear that our investment approach and your expectations don’t fit

We understand and accept that our investment approach is not for everyone. Investing is all about the future. Each of us approaches making decisions about the future in a different way. That’s why its important for each investor to chose an approach that suits them.

Our most important strengths are curiosity and insatiable desire to learn. This means that our investment process will grow and develop over time. We believe that this sort of change is positive.

We aim to build our investment approach on timeless principles. While the process may change, the principles that guide us will not.

In summary, we assess the companies that we invest in as the owner of the business would. We treat our clients as partners. We aim to be fair and transparent in everything that we do. We invest only where we are reasonably confident of success. And we believe that the keys to our success lie in making better and more consistent investment decisions over time.

 

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3 comments

  1. Hi Daniel – it all sounds reasonable, and most of the points I totally agree with as essential items, but for me, it doesn’t describe what you will actually be looking for in an investment. I also agree on the learning aspects of making mistakes and accepting the uncertainty of the market’s often bizarre decisions (e.g. Bitcoin or any of the other bubbles, or some of the crashes for that matter) – so you have to work with uncertainty and accept mistakes – just get more calls right than wrong, and let the winners run! However, I wonder if your clients will read it as overly concentrating on making mistakes, without talking about how you will attain your victories!

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    • Hi Greg, Thanks for your comment. You make some very important points.

      The how is something that I’ll address soon in a future post. The short answer is that it will be “fox like” – in other words, it won’t be growth and it won’t be value.

      My inspiration is the flexible framework used by Peter Lynch. He invested in all sorts of stocks. Buffett also did something similar in his partnership days, although the range of opportunities that he looked at was not nearly as wide as Lynch.

      I’m also researching an asset allocation approach to beating the equity market. This work is looking really promising. Very different from a traditional stock picking approach.

      A blend of the two approaches may be complementary. This is also something that I’ll be exploring.

      The focus on mistakes is part of a larger idea that I’ll be elaborating on further in future posts. The idea is that how and what you pick is probably less important than how you manage the position and construct the portfolio.

      Like

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