Investment philosophy is possibly the most overlooked of the five P's. I think a lot of fund buyers can underestimate the benefits gained by identifying a sound philosophy that underpin an investment strategy. Perhaps therefore, it is not surprising to find occasionally fund managers who struggle to articulate, or indeed, identify what their underlying investment philosophy is. It is quite possible to successfully manage investments without a clear underlying investment philosophy but it is very helpful to consider what might be driving this success. Car drivers don't need to understand how an internal combustion engine works, but if it suddenly comes to a juddering halt, a knowledge of the principles behind what makes an engine tick can act as a solid foundation on which to base the repairs.
Fortunately, most investment philosophies are quite simple and can be set out through basic tenets. These tenets may set out the type of investments the manager is looking to focus upon, hopefully identifying a reoccurring valuation anomaly in the market and why this valuation anomaly might persist. While these beliefs can be expansive in nature, a broad statement such as 'markets do not always accurately price securities' is pretty much implicit in any active management approach and of little practical use. (Incidentally, it does not follow that a belief in market efficiency is required to advocate a passive investment approach). An example of a more practical philosophy for a fixed income investor might be that 'corporate bonds rated just below investment grade are systematically undervalued by the market' and such a valuation anomaly may arise as a result of investor demand. Credit ratings on these bonds are not secure enough for most investment grade investors and the yields are often insufficient to meet the needs of high yield investors. For equity investing an example might be a value approach, where investor behavioural biases can lead to share prices systematically overreacting to bad news and that over time, share prices often revert to mean. There is plenty of empirical evidence to suggest that this approach to investing works well, but proponents need plenty of discipline since cheap stocks can remain undervalued for extended periods.
A well considered philosophy offers powerful support for the investment process. However, a flawed philosophy unsurprisingly is a useful as a chocolate tea pot. For instance, maxims 'never invest in a company where the management have beards' lacks any empirical or logical support. Some philosophies do not survive the test of time, 'never invest in countries where they don't wear overcoats in winter' perhaps had greater validity before the widespread adoption of air conditioning.
Fund Managers who have a firm understanding of their philosophy can more easily identify what and where their edge is and the type of environment where they are likely to flourish. We believe that all investors benefit from a consideration of their underlying investment beliefs and this should include to fund selectors. Below are some of Square Mile's principles of investment philosophy that helps underpin our fund analysis:
• Investment is an art not a science. There are no fundamental laws or universal rules. Markets are continually adapting to circumstances and investors need to do this as well. This is a people business where qualitative inputs and assessments are required.
• It is not possible for all funds to be better than average. Only a small proportion of funds are high quality and that quality is determined by the people behind the fund. The departure of quality personnel will be difficult to replace.
• Professional investors are obliged to maintain and update their skills through structured continuing professional development (CPD). Notwithstanding the importance of this, we believe that the most effective CPD is delivered by the market, though this is often delivered at irregular intervals and in a brutal manner. Some investment management skills cannot be taught in the classroom and they can only be learnt through practical experience.
• Markets pass through periods of fear and greed. The opportunities for active investors vary over time and no single approach is likely to succeed consistently through the investment cycle. Patience is required.
• Good investment management involves consideration of the pay off between risk and return. In certain situations, risks exist and the upside is absent. Examples would include counter party risks and high fees. Such situations should be avoided.
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