Day: December 24, 2013

Unconstrained Will Get Overdone

Unconstrained Will Get Overdone

Maybe I’ve just had a couple of unusual random draws from the information urn, but it seems to me that unconstrained mandates are getting more favorable investment attention from investment consultants than they used to. ?The “style box” is breaking down a little, and I think that is a good thing.

My view of the investing world starts with industries, not market cap size, and not even growth/value. ?Much as I end up on the value side, I am flexible on what constitutes value in different industries. ?I range from growth at a reasonable price to deep value. ?It depends on the state of the industry.

All that said, let me talk a little about what it takes to be a good unconstrained manager. ?Organizationally, you have to understand a lot of things better than the rest of the world. ?Do you understand the market, factor, and industry cycles, as well as asset level misvaluations? Investors have the choice of the informationless index, which typically does well versus the average active manager.

As consultants analyze unconstrained managers, their models will get stretched. ?The more degrees of freedom a manager has, the tougher it is to evaluate them. ?If an unconstrained manager made a brilliant tactical move once, can he do it twice? ?Three times? ?More?

Think of the few market players that got short prior to the 1987 crash. ?Aside from Elaine Garzarelli, none were heard from again, and Garzarelli never had a second episode like that in 1987.

It is really tough to come up with significant ideas that will make a huge difference in security returns. ?Home run hitters usually do not hit for average.

What I suspect will happen is this: the initial unconstrained managers will do well, but they will reach capacity limits, and lesser managers will put out “me too” products. ?Consultants will buy into those products to some degree, and a decent number of them will fail to meet expectations. ?The investors hiring the consultants will wonder why they hired them. ?If there is no skill to picking unconstrained managers, then why not pick them directly themselves, or just go back to indexes?

I write this as one that mostly manages equities, long-only. ?I like having no constraint on market cap, value factors, industry, and country selection. ?I like to roam the world in search of value. ?I like to concentrate on industries when I have a good thesis. ?Why should I have non-economic criteria limiting my choices, if I reason well?

That’s why I like unconstrained mandates. ?I run one for upper-middle class individuals, and small institutions. ?But every manager will not do well with it, because most investment organizations are not designed to think that broadly.

Thus I expect that investment consultants will revert to the “style box” (or something new like it) once they realize that few managers can consistently generate alpha over a full market cycle whether unconstrained of constrained. ?At least with constrained, the variation when they do badly is more limited, which protects the consultant, who also does not want to end up in the fourth quartile, where business is lost.

Post 2300 — On Business Issues

Post 2300 — On Business Issues

Every 100 posts or so, I take a moment to think about the broader aspects of what I do.? As a blogger, my goal is to educate, and I think I have covered many issues well here.

As an asset manager, my goal is to serve existing clients well.? Most of my assets under management stem from value investing, and 2013 has certainly been good to my clients and me.? 2013 has made up for 2011-12, and then some.

What has surprised me is how existing clients have added to their assets with me.? I expected growth to mainly come through new clients, but at present, most is coming from existing clients.

Another thing that surprised me is that a number of my clients said have said something like this to me, “I really appreciate that you don’t press us to give all of our assets to you.? But you help us as if you have all our assets.”

I know that I have to do marketing, but I don’t like it, and so I do as little of it as possible.? Part of it is the unpredictability of investing.? I have a good track record, but does that really mean I will do better than the index in the future?? Markets are fickle, and much more is due to favorable providence than most of us imagine.

All of us say, “Past performance is not indicative of future returns,” but few of us truly act as if we believe it.? How many consultants? will bring forth managers that are underperforming but have good prospects?? Isn’t the proof in the pudding?? Past may not be prologue, but it is incredibly difficult to get in the door with those who advise individual and institutional investors if you don’t have a winning track record.

Why is that?? Secretly, everyone believes that “Past performance IS indicative of future returns.”? Success breeds success, right?? The man with the hot hand will remain hot, no?

Sadly, no.? Though momentum effects sometimes work in the stock market, there is no evidence for manager outperformance persistence, outside of Graham-and-Doddsville.? But you can’t get naive buyers to think otherwise.? Almost all individual and institutional investors choose managers at least partially on past performance.? That’s the sad truth, and all the disclaimers in the world can’t change that.

I am grateful for the trust my readers place in me.? I am grateful for the trust my investors place in me.? And I hope that I never disappoint you badly.

Sincerely,

David

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