The Role of Investment Philosophy In Evaluating Investment Managers

Transcription

1 The Role of Investment Philosophy In Evaluating Investment Managers A Consultant s Reflection on Attempting to Distinguish Alpha from Noise Presented to QWAFAFEW by John R. Minahan, CFA Director of Research NEPC January 17, 2006

2 Contents Why Is Investment Philosophy Important? What Is An Investment Philosophy? Using Investment Philosophy to Evaluate Managers The Investment Philosophy Test Common Ways of Failing Uncommon Ways of Passing Concluding Thoughts 2

3 Why Is Investment Philosophy Important? Investment Returns Have a Substantial Random Element Realized (ex-post) alpha = ex-ante alpha plus noise A consultant is charged with finding managers with ex-ante alpha Difficult to tell if good performance is due to ex-ante alpha or noise Hence, the logic of the investment process is central Alpha-generators versus Alpha-pretenders Generating ex-ante alpha is secondary consideration for some managers These managers exploit the fact that randomness will sometimes cause good returns This can be successful business strategy because it is difficult for investors to distinguish alpha from noise Yet Not All Managers Are Pretenders How can one use the concept of investment philosophy to differentiate alpha from noise? 3

4 Why Is Investment Philosophy Important? In One Sense, Active Management Is Simple Discount cash flows to get present value Buy if price is below value, sell if vice-versa Hardly a philosophical endeavor But Failure Breeds Introspection No one knows what the cash flows of a risky asset will be No one knows what the right discount rate is Market prices tend to reflect information and points of view as they are traded upon This Reframes the Problem: Why has the market not yet discounted the manager s perspective? What is the manager s competitive advantage at finding and exploiting mispricings? How does the manager avoid the winner s curse? (the tendency in auction markets for the winner to have the largest overestimate of value.) 4

5 What Is An Investment Philosophy? Definition: an investment philosophy is: A set of beliefs regarding the security pricing mechanism and what it is about that mechanism which affords the opportunity to add value A set of beliefs about the manager s competitive advantage in exploiting these opportunities A thesis about how these beliefs can be exploited to generate alpha (an alpha-thesis ) What is a good investment philosophy? Knows where it stands with respect to capital market theory Knows where it stands with respect to evidence Is living: it constantly wrestles with confirmation and disconfirmation, and adapts as necessary Has deep enough core principles that adaptation does not result in total change 5

6 Using Investment Philosophy to Evaluate Managers The concept of a good investment philosophy suggests a set of questions on which an evaluator should focus: What is thesis of how the product generates alpha? What is the conceptual basis of the alpha-thesis? What is the relationship of the alpha-thesis to capital market theory? What is the evidence that that alpha was generated by the valuethesis and not a mismatched benchmark or luck? If evidence is lacking, how does the manager convince himself that the thesis is well-grounded? What is the manager s competitive advantage in executing the thesis? How does the manager think about the possible need for the valuethesis to change over time? 6

7 Common Ways of Failing the Philosophy Test Not Having an Alpha-thesis Many managers never offer an argument about why their process should be expected to outperform Having an Alpha-thesis That Isn t Conceptually Grounded In the long run X always wins Data helps, but isn t enough Sometimes the data doesn t connect with the thesis Not Giving a Lot of Thought to Where Performance Comes From Good performance does not speak for itself The manager has more at stake than anyone in knowing where their performance comes from Not Thinking about the Possible Need for the Alpha-thesis to Change Might the underlying cause of the alpha-opportunity change over time? Currency example 7

8 Uncommon Ways of Passing the Philosophy Test Measuring the Success of the Steps of the Process Value-added of different stages of the funnel Upgrade/downgrade example Recognizing that Alpha-opportunities Decay with Time E.g. quant managers that measure the value-added of every signal and consider there competitive advantage to be the ongoing discovery of new signals Identifying the Specific Inefficiencies Exploited Many managers state they exploit inefficiencies, but few can tell you the specific inefficiency they exploit The Exception that Proves the Rule Sometimes a manager just has talent and can t articulate why his or her approach works 8

9 Concluding Thoughts The Investment Philosophy Concept Is Underused Consultants can t get good answers, and don t press the point Managers don t invest in developing good answers, because consultants don t press the point The norm is to use pretend investment philosophies for marketing This Does Not Serve the Interests of Clients, Consultants, or Alpha-generators Only alpha-pretenders benefit How did we let the pretenders get the upper hand? Alpha-generators Can Distinguish Themselves by Developing Answers to the Investment Philosophy Test It is hard for alpha-pretenders to come up with credible answers Consultants Need to Press Managers More But should be open to finding exceptions to the rule 9