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Some investment principles

6 Dec 2013 90 month(s) ago

“Principals”There are some key features of investment soundness: correlation, management skill, risk management, alignment of interest. These have different levels of relevance to SMSF investors but all should be considered.

“Principals”One of the key investment principles is to make sure investments are not correlated with each other. This means that when one type of investment fails then another does not. That is, they do not all go up and down together. In theory, that kind of coreelcation is potentially alright for SMSF investors who do not want to withdraw any money for some time. But even then it is probably going to result in a poorer return over the long term.

For SMSF investors who need access to the returns on their money, it is not acceptable. ‘You don’t want the funds that you invest in to all have a high correlation to each other and the markets otherwise the diversification benefit is reduced.’ Pengana Capital head of distribution Damian Crowley.

Crowley points to the importance of manager skill: ‘How much of the return that has been generated is just from the market (i.e. beta) and how much is skill based or alpha?" ‘You want some of the funds you invest in to be truly active or benchmark-unaware and be able to go to cash or vary net market exposure to reduce the market risk of the portfolio.’

This is a much more arguable. Manager skill is highly debatable. There is a great deal of evidenceto show that it is a mirage. The Economist writes that outperformance may be just the herd mentality, not greater skill:

"Investors select fund managers on the basis of their recent performance. Those managers take the cashflows and invest them in their favourite stocks. By definition the favourite stocks of top-performing fund managers will already have done well; the new buying pressure means they will continue to do so. As a result such fund managers will keep outperforming.

Eventually this outperformance comes to an end. The momentum effect seems to reverse after 2-3 years. When it does fund managers rush to sell the stock. The effect is both to drive the share price down further and to damage the performance of the previously successful managers. Woe betide the small investor who gets sucked into investing in the “star” fund at just that moment. As someone once said, past performance is not a reliable guide to future returns."

The risk-metrics of a fund are important, according to Crowley. He says these include its Sortino ratio, downside deviation, maximum drawdown, percentage outperformance in down markets, and percentage outperformance in up markets.

The problem with this is that it rarely covers systemic risk of the type that caused the GFC. Most of the risk was thought to be managed by fund managers in 2007. No-one was more shocked than they to find that they were completely wrong.

Finally, Crowley says it is important to check the fund manager’s alignment of interest with the portfolio and with the outcomes of the fund. ‘So, properly structured performance fees are good for investors because you want to have incentives for the fund manager to perform that aligns the fund manager’s interest with investors’ interests. You want the fund manager to have an economic interest in the fund – that the fund manager owns ‘x’ and has a financial interest in the profit & loss. The fund manager has to have an economic interest and be incentivised.’

This has less relevance to SMSFs, which are less likely to be run by third parties. But it is worthwhile for SMSF investors to examine their own interests and biases. They will affect how they invest and they may not be entirely positive.