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.