Bringing investment consulting up to the 21st century
By Ron Surz
Twenty years later, consulting still embraces modern portfolio theory, peer groups, and indexes, which would be fine if these strategies actually worked.
Successful investment consulting encompasses two distinct crafts: the ability to develop quality advice and the skill to deliver that advice — the solution craft and the relationship craft. This article focuses on the pressing need for modernization and improvements in the solution craft.
The relationship craft is evolving quite nicely and, in fact, never has been in better shape than it is today. The deliverer of advice has risen up from report schlepper/salesman to trusted adviser. The consulting industry has compensated for its lack of advancement in the quality of advice by significantly enhancing the delivery of that advice.
By contrast, here’s a brief history of the solution craft. The consulting profession is relatively new, having originated in the 1970s. In the first two decades, there was a flurry of creativity and solution development. The industry embraced modern portfolio theory (MPT), which is now almost 60 years old, so it could be renamed mature portfolio theory. Professionals used MPT for both asset allocation and manager due diligence, but found it lacking in due diligence, so peer groups and indexes became the barometers of choice. Then the dark ages of investment solutions followed — very little has changed, despite the lessons we’ve learned. Twenty years later, consulting still embraces MPT, peer groups and indexes, which would be fine if these actually worked.
On the asset allocation front, we’ve discovered the shortcomings of MPT. The very glue that was supposed to keep markets efficient instead created inefficient bubbles and dislocations. Investor behavior has wreaked havoc upon capital market prices and created the profession of behavioral scientists who tell us this dissociative behavior is not irrational, it’s just humans being human. We’ve also learned that risk is not volatility, it’s failure to achieve objectives.
On the due diligence front, we’ve learned that peer groups are loaded with biases causing them to mislead rather than differentiate. Similarly, indexes are poor barometers of success for all except index huggers, and most style indexes are poorly constructed.
So, how should the solution craft integrate these lessons? Asset allocation should focus on client needs and be more adaptive to market dislocations. Mean-variance optimization is not what the client needs or wants. Rather, policies should be structured and monitored for the achievement of objectives. For example, the truly wealthy can be best served by a “pockets-of-money” solution that matches future spending needs with bullet treasury inflation protected securities (TIPS). For those less fortunate, the consulting process can integrate savings with investment policy; the medicine of more risk can frequently be replaced by saving more and working longer. The consultant can also be a strategist who monitors bubbles and the like. For example, the VIX volatility index was screaming warnings well before the 2008 market meltdown. Savvy investors were bidding up options to protect and profit, and this panicked outlook was quickly reflected in the VIX.
On the due diligence front, it’s time to get serious about the two central questions that must be addressed:
1. Do we like what this manager does?
2. Does this manager do it well?
The first question sets the stage for the second. We need to understand what the manager does, which can be a challenge in some circumstances, such as hedge funds. If we don’t understand, we don’t invest. The first question sets the benchmark, then the second question examines the alternative of passive implementation. We can pretty much replicate just about any investment strategy with passive inexpensive blends of mutual funds or ETFs. This second question is best addressed with hypothesis testing and modern holdings-based attribution analyses. Peer groups and indexes do not work — never have, never will. Hypothesis testing compares the manager’s actual performance to all of the possible outcomes from what he does. For more details, please see [Surz, 2005 and 2006]. Modern holdings-based attribution analysis explains why the manager succeeded or failed, being very careful to get the benchmark right, because if the benchmark is wrong, all of the analytics are wrong. Both hypothesis testing and attribution are best implemented using indexes that are mutually exclusive and exhaustive; there are only two such index families and neither are commonly used.
So will the next 20 years be like the last? Let’s hope not. Nostalgia isn’t what it used to be.
Surz, Ronald J. “A Fresh Look at Investment Performance Evaluation: Unifying Best Practices to Improve Timeliness and Accuracy.” The Journal of Portfolio Management, Summer 2006, pp 54-65.
___________. “Testing the Hypothesis “Hedge Fund Performance is Good”.” The Journal of Wealth Management, Spring 2005, pp78-83.