One of the pleasures of working in a rapidly growing organisation is passing on my experiences to the newer members of the team. Recently, I was discussing the the types of investment processes often used within the industry with one young analyst, only to be taken a little aback by her retort 'isn't investment process more about marketing than investment'? What a great question. This article will consider this and what role investment process plays in the asset management business.
A certain cynicism is certainly warranted when considering funds. Fund buyers are confronted by an enormous choice and fund managers are eager to differentiate themselves from their competitors. I too shared similar scepticism on the value of process during my early career, despite its prominence as one of the five key 'P's. Admittedly, my views on the matter were coloured somewhat by my then Investment Director, who had set about devising a fund selection approach based around 3 month relative performance on the basis that "something is required". It didn't take much knowledge to recognise the flaws and limitations of a momentum approach such as this. I busied myself in the subsequent few years devising a more robust alternative approach that was not so fixated on short term performance trends.
An investment process details the steps that the fund manager takes to select securities and build the portfolio. A good process is consistent with the manager's underlying investment philosophy and demonstrates that the approach is repeatable. A good investment process will often refine the potential universe at the same time as narrowing it. It can either be tight and highly systematic or loose and rather undefined.
One of the UK's most successful managers, Anthony Bolton, used to operate without a tightly defined investment process and usually, he introduced his process along the lines of 'I often find interesting opportunities in companies that have one or more of the following characteristics...'. This is not to say that he had no investment process but his approach was very loose and necessitated an impressive cycle of company management meetings. At the other end of the spectrum, quantitative funds employ an entirely systematic investment approach.
Our research team at Square Mile have uncovered a number of funds that have no defined investment process or philosophy. This does not necessarily make them bad funds, but the lack of any formulised management approach makes them very difficult to analyse and requires a very long performance track record to provide validation of the manager's investment expertise. This is not to say that a well defined philosophy and process will automatically lead to investment success. It took me some time to appreciate the importance of investment process and its value suddenly became much clearer to me while playing online poker.
I have always liked complex games that require skill combined with management of uncertainty. Unlike games such as chess, luck has a distinct role. Poker is a game where luck plays a significant role though a small edge in skill can bring significant success over the long term. The stockmarket has some similar attributes and while there are some important differences to poker, some interesting parallels can be drawn. Most stockmarket practitioners recognise that not all their ideas will work, indeed, a success rate for ideas of 55% is generally considered good. In the short term, results can rest heavily upon luck, though over the longer term skill is more likely to play out. In poker, it might take upwards of 25,000 hands before skill levels can be determined with confidence just by looking at the results. Much greater insight incidentally can be gained examining how individual hands are played. A typical poker competition may involve 100-300 hands. Even playing multiple competitions at once, I would go on long periods without success. Emotionally I found this very difficult and there was a great temptation during these periods to 'try something different'. However, I had undertaken substantial research into the game. I had confidence that in time, my approach would win through at the relatively low levels of stakes that I was playing with and so it did. In contrast, at other times everything I touched turned to gold and there was an equally strong temptation to abandon the process.
Portfolio management can also be a numbers game and periods of poor performance should be expected. A manager with a well considered investment process will be able to lean upon it during these difficult periods. An obvious example would be value managers today. Value managers have plenty of empirical evidence supporting their approach. Managers, and just as importantly fund selectors, should be aware of the strengths of the investment process followed. Understanding this underpinning should provide the wherewithal to stay the course even during longer periods of disappointing relative performance.
Questions to be considered on a fund’s investment process:
What is the process?
Is it consistent with the underlying manager philosophy?
How does it refine the investable universe?
By itself, does it identify winning stocks?
How does the process cover selling?
How consistently is the process applied?
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