What are we trying to address?
Imagine you are speaking to your investment consultant for a quarterly investment review. Your first question might be, “did I make any money?” In other words, what’s my absolute level of return? The follow-up question is, “did I make as much money as I should have?” In other words, what the portfolio’s performance relative to its benchmark? The third question is, “why am I making more, or less, money than my benchmark?”
It is this third question which we are trying to answer with this series of articles. For context, this is the 3rd and final article in a series. Our first article, “Why is the Sky Blue”, was our February 2016 newsletter and focused on portfolio level attribution. Our second article, “Why? Because.” was our March 2016 newsletter and focused on investment manager level attribution. Now, we’re going to focus on the qualitative analysis – the unquantifiable information about your investment managers which determines how they operate. What led your investment managers to pick Stock A instead of Stock B, and is that decision making likely to continue in the future?
Why is qualitative analysis important?
When you hire an investment manager to run part of your investments, you might hope for an implicit promise for returns. To justify that decision, you should prudently consider past behavior as a signal of what might happen in the future. However, when you buy a fund, you aren’t buying the past performance. You can’t; it’s already done. Past returns do not indicate future results.
In the same fashion, the quantitative analyses we’ve done thus far, in the February and March newsletters, is a description of the past. We’ve been looking backwards at numbers, percentages, and weights to describe what happened. A sophisticated investor knows the past is immutable and, avoiding the sunk cost fallacy, would prefer to have insights about what’s happening next. That’s why qualitative analysis is important. The qualitative attributes of an investment product will help you set expectations for how it should perform in different market environments.
These qualitative attributes are often categorized as an examination of the Philosophy, People, and Process of an investment.
It is sometimes easier to describe an investment by summing up their basic investment thesis. Does the investment product have a core belief system, consistently applied? In other words, are the securities, the stocks and bonds, in an investment manager’s portfolio just the realization of the product’s philosophy?
Let’s consider a common investment philosophy as a starting point. For instance, a purely passive index fund might be predicated on the belief that active management does not, in aggregate for the long term, outperform an index. Therefore, a passive fund’s approach is to simply replicate an index as inexpensively as possible.
Actively managed funds can take a more unique and nuanced approach to their investment philosophy in an attempt to outperform. For instance, both Investment Managers A and B believe avoiding the worst of market downturns will create better risk-adjust returns. Within that consistent framework, they may still have a difference of philosophy. Investment Manager A doesn’t believe in timing market cycles. Instead, Investment Manager A believes that high quality companies beat low quality companies over time and has created a portfolio of defensive stocks to protect from sharp losses, but should lag peers in market upswings. Investment Manager B tries to tactically move between cash and stocks to dodge downturns while still participating fully in market upswings
There are as many distinct philosophies as there are investment managers, with differing beliefs on top-down macro-economic vs. bottom-up portfolio construction, data-driven screening vs. personal face-to-face meetings with key C-Suite executives, risk-tolerance, and so on.
Put simply, who is making the decisions about investing your money? What are the portfolio manager’s qualifications? How many years of experiences does he or she have? What degrees or certifications? What is their track record? Do they have specific areas of expertise? How closely do their talents align with the investment product? Do they work with a team and how are investment decisions delegated between portfolio managers and key analysts? How does the corporate culture and compensation scheme of the investment management group influence the continued success and stability of the investment product? Looking at the analyst and manager compensation, decision making process, and turnover of staff members will give you clues to how valued different team members are. Going a level deeper, you might be able to find evidence of the firm’s underlying philosophy in its culture.
A thorough qualitative review of an investment product – also known as a due diligence report - should be able to answer these questions.
We know who is making the decisions. We know the overarching goals. Now, as the rubber hits the road, how do the decision makers find the securities they want to buy? Where do they look for investing ideas? How do they sort, select, and weight these choices? How do they decide when to sell a security off? Are these decisions made by analytic discipline or the emotions of the Portfolio Managers (PMs)? Does anyone double-check the portfolio to make sure there are no unanticipated concentration risks? In other words, what’s the investment process?
Let’s start with an easy to understand process – a passive index fund. Their process might involve owning each of the securities within an index, buying or selling as necessary to make sure the weights within an index are equal to their market capitalization. Semi-passive funds might buy and sell securities to have the same stocks as the index but apportion them differently, say, by the revenues of the companies, by profit margins, or even equal weight for all positions.
Active processes are usually more complicated. Artist renderings of active security selection processes often look like a funnel. Starting with an appropriate investment universe (say, the largest 1000 stocks for a Large Cap Blend investment product), the stocks are successively limited by various quantitative screens and desirable attributes to a manageable portfolio. Risk control and monitoring systems may optimize those selections based on risk, return, and correlation data.
Describing common investment approaches as “styles”
The underlying process and philosophy has created a unique investment profile of the product relative to peers. Generally, these profiles are associated with the underlying criteria used in the products philosophy or investment selection process. Just reporting the idiosyncratic and non-comparable truth of each investment manager candidate is only marginally helpful. Knowing where different products fit in context is more useful. To see how an investment compares to peers, professionals often categorize products into investing styles.
This style might refer to where the product fits on a value vs. growth spectrum. For instance, a large cap value fund could be traditional, contrarian (target companies with headline risk and recent price pressure), deep discount (target companies with very steep or sustained price pressure), or dividend centric (focusing on dividend yields). Managers can describe their style as deep value (targets have lowest price/book ratios), relative value (higher price/book ratios than value peers, but still less than the market as a whole) or high quality value (emphasizing low debt to equity ratios on balance sheets). Similarly, a large cap growth manager’s style could be traditional growth, blue chip growth (low earnings-per-share growth but focused on dominant market leaders), growth at a reasonable price (often abbreviated GARP), aggressive growth (targeting highest EPS growth) or momentum growth (targeting companies which have benefitted from recent upward swings).
For simplicity, we are focusing on traditional US stock classifications. Just know these stylistic tendencies could describe everything from international investments (i.e. how much emerging market exposure is allowed?) to non-traditional alternative investments (i.e. will we hedge inflation risk through staid TIPS or through riskier commodity futures).
Random chance is always a factor
Investment managers try to create an investment product which outperforms benchmarks regularly or to a sufficient degree to offset durations of extended underperformance. The underlying selection process or philosophy of the fund creates a unique style that may not be rewarded by the current market environment. No investment product outperforms all the time. Even when the investment thesis is 100% successful in the long term, you might still be looking at an investment product which is still going to fall behind about half of the time due to style biases.
Moreover, we’ve considered investments as 100% deterministic, with no real world complications of chance or mistakes. The decisions made by the portfolio managers are applied without error. Even if short term market environments don’t favor a particular type of investment style, in the long term, the investment manager’s thesis is presumed sound and their long term success is assumed.
Given a very loose definition, unsophisticated investors view the stock market as a machine. They might think, in broad terms, that you put money in stock market, wait for a number of years, and more money comes out. However, markets are not a machine with predictable outputs for given inputs. Markets are an amalgamation of millions of unique opinions about thousands of securities, and there’s no rule which says how it’s going to behave day-to-day or even decade-to-decade.
Here’s a far-fetched example: imagine a huge asteroid is hurtling towards the Earth and will hit tomorrow. It can’t be stopped and it will pulverize the continent of Australia. So, what happens to global economics and interconnected markets? If people know about the asteroid, it could be chaos, panic, and mayhem. However, what if nobody knows? What if astronomers simply don’t see the thing? The markets won’t react at all until it hits. The truth of the matter its coming and it will have a tremendous effect, but the markets only reflect the information known to investors. Bad luck has the potential to impact market growth assumptions for a generation or more. The notion of the market as a money-making machine breaks down.
Fortune favors the prepared, but the reality is that stupid dumb luck affects us all. The most clever investment thesis can fail. Huge positive discoveries (like technological breakthroughs) and negative events (unrecognized threats) happen all the time and it’s just random chance which will happen and to what magnitude. Without perfect information, investors must accept the possibility of long-term underperformance even for the soundest investing thesis made by the best managers.
So, how can you know if an investment manager is good or bad when random chance has such a strong impact on numeric, relative returns. Here is the true strength of qualitative analysis. The people, philosophy, and process of an investment does not change often and should be consistent.
Your bond manager may have posted great returns last year, but if their entire staff of key decision makers just got replaced, a savvy investor might use that as an opportunity to investigate further and possibly withdraw their money. In a market upswing, a defensive fund may unexpectedly outperform; have they changed their investment process or are they no longer committed to their core principles? In other words, the quantitative metrics of an investment are often influenced by random events and noise, but their qualitative attributes should be more consistent over time.