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The Ecology of Investment Strategies

Any investment strategy can be overused.  Part of the job of a portfolio manager is to ask the question “To what degree am I in or out of the consensus? Where am I in the cycle for my strategy?”

Few managers are conscious of the water that they swim in.  They assume their strategies provide consistent advantage, when in truth the advantage is periodic, even if it works better than average over the long haul.  The truth is that every strategy has limits, and when too many parties apply a strategy, the excess returns disappear, or even go negative.

All investors have to sit down and ask the question, “What aspects of the market will I try to take advantage of?” with the corresponding question, “What will I ignore?”  Adding to that, “How much of the market can I invest in, given my advantage?” (What is the carrying capacity of my strategy?)

Most value managers don’t care for momentum.   Most growth managers don’t care much about valuations.  Some things will be ignored.

It is tough to be a institutional asset manager.  The competition is fierce.  What’s worse, you and all of your competition comprise 80% or so of the market.

Further, you know what side your bread is buttered on.  If you have average, or at least not fourth quartile performance, the assets will stick with you, and your firm will make money off them.  The economics of the business are simple.  For the most part, risk-taking is not rewarded, and risk-reduction has some stickiness.

Adding to the problem are the investment manager consultants.  Because most of them are a net loss, they gravitate to what is unchangable.  Modern Portfolio Theory, though wrong, is a respected basis from which academics and some others make investment decisions.  Using Sharpe ratios, and other objective bits of investment nonsense, they winnow the field of investment managers.

The thing is, for those managers that submit to this mularkey, it enforces mediocrity at best.  For those that don’t accept it, not much money flows to them, whether the manager is good or bad.  They don’t fit the model that doesn’t represent reality.

Never underestimate the power of a simple model to overwhelm the minds of simple-minded people.  Most consultants, and most academics, would rather have a wrong model that allows them make money, or publish, than get things right.  Truth is, the right answer is hard to get to, and doesn’t fold into simple mathematics easily.

Technical analysis is akin to voodoo in the minds of most professional investors.  Mention it prominently, and you are kicked out of the game.  There are close substitutes though: for growth investing there is price momentum, and for value investing there are behavioral finance anomalies.

In closing, these two articles that ask why mutual funds don’t adopt technical trading methods illustrate the problems with large scale investing.  Smaller investors can take advantage of market anomalies that bigger firms pass up.  Imagine for a moment that Fidelity, Vanguard, and Capital Group decided to apply the full range of identified anomalies across the entirety of their portfolios, and trade them as aggressively as smaller players might.  The prospective excess profits from the anomalies would disappear rapidly, and might go negative as enough money chased them.  Most players would eventually abandon applying the strategies because they stopped working.  Too much money chasing them.

The lesson for most of us smaller players is to be aware of how much money is using strategies like ours, and adapt when the space where we thought we had a durable competitive advantage has become crowded.  That’s not easy, but then, regular outperformance is tough to do, and tougher, the more money one manages.






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3 Responses to The Ecology of Investment Strategies

  1. But What do I Know? says:

    Very well put–ecology is a perfect analogy for the financial markets. The vast majority of the species invests in a MPT paradigm which “works” for them and so they continue to use it, “true” or not (there is no truth in evolution, only what works, or more precisely, what worked). Only in times of severe stress where the comfortable herd’s food and water diminishes will new approaches be sought and some succeed. Whether or not we are in a time of severe stress remains to be seen.

    I’ve often wondered why we don’t approach the markets from a naturalistic standpoint. Is it because we all want to be “right?”

    Anyway, I love your blog–can you bring back John Davidson?

  2. sysin3 says:

    In this environment,

    You ain’t got no bread.

    You ain’t got no butter.

    “normal” rules do not apply.

  3. Reverb says:

    I am surprised more mutual funds are not changing their mandates to include larger cash ceilings to deal with the current environment. How much longer can the dinosaurs survive, we could be sideways for 5 years.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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