A recent paper by highly respected academic Richard M. Ennis, called “Hogwarts Finance” is illuminating in that it exposes how the funds management industry is performing overall, whilst also highlighting some of the most common mistakes professional investors make.
According to Ennis, investment professionals in the US oversee around US$10 trillion in assets. Collectively these money managers and their pool of funds have underperformed passive management (ie low cost index or systematic investment styles) by one to two percent per annum since 2008.
That might seem like a small amount (of underperformance), but compounded over time, it makes a huge difference to how much wealth an investor accumulates.
Here are four examples Ennis gives of common mistakes and miscalculations that professional investment managers make.
1. They disregard the evidence
Most investment professionals, Ennis explains, invest only a small fraction of their assets under management in index funds, or other low-cost systematic funds.
By failing to invest in these funds, Ennis argues, these professionals are ignoring the overwhelming evidence, dating back to before most of them were born, that active management is a losing proposition. He points to a collective failure, and a lack of intellectual rigor in the industry.
Ennis describes, an often-overlooked fact, that he refers to as the “First Law of Active Management”; which he states is:
“Never diversify with active managers. Active bets tend to offset one another, leaving the investor with an expensive closet index fund, that will underperform by roughly the margin of its cost.“
2. They conflate investment strategies and asset classes
Institutional investors, Ennis says, mistakenly treat active investment strategies as if they were distinct asset classes like stocks, bonds, or cash. Legitimate asset classes, he argues, have inherent differences, and are supported by laws, regulations, and market pricing, whereas active investment strategies tend to be short-lived, based on subjective outlooks, and dependent on selection skill or luck.
3. They misrepresent alternative investments
Ennis explains how CIOs and investment consultants often falsely consider alternative investments as a distinct asset class, suggesting that they are likely to behave markedly differently to traditional asset classes (such as stocks, bonds and property) through the cycle.
Ennis argues that apart from the effects of stale pricing, due to illiquidity and irregular valuations, the correlations of these assets are often very close to equity markets. He notes that private equity, private-market real estate and hedge funds have exhibited correlation with US stocks of 0.96, 0.85 and 0.96 respectively since 2008.
Diversified portfolios of alternative investments, he argues, behave like diversified portfolios of stocks and bonds but cost around ten times as much.
4. They compare their performance with the wrong benchmarks
Ennis points to a long-standing problem where CIOs and consultants avoid benchmarking their performance against simple, broad market indexes that match the risk level of the funds they manage. Instead, they prefer custom benchmarks that are often misaligned with their actual portfolios (in terms of risk), to make their performance look better.
He quotes a common example, where a fund manager compares their 50% leveraged private real estate investment fund to a benchmark with no, or low leverage.
This isn’t the first time on Insights that we’ve warned about the dangers of investment wizardry. Sadly it’s rife in the investing industry — it has even infected the financial advice profession — and as research by psychology experts has shown, it’s frighteningly easy to manipulate the mind, and get it to believe the impossible.
The good news is that investors can ignore such wizardry altogether and focus on what the independent, time-tested, peer-reviewed evidence tells us.
The time-tested notions of:
- diversify broadly (both across and within asset classes),
- set a strategic asset allocation and systematically rebalance to it,
- avoid financially engineered and expensive investments,
- take a long-term approach, and
- try and keep your investing costs low.
If you want to learn more about Richard Ennis and his work, this recent profile of him is fascinating, while here is a list of his most recent research papers.