This article has been sent me by Per Andelius, a tireless correspondent who tries to educate me (and others) in what matters in investing.
Although this article is difficult and contains one quote by Markus Schuller which re-defines gobble de gook , it brings together a number of themes I have been struggling with
- Harnessing technology will improve value for money
- Costs matter (even more) in a low return world
- “Innovation” – especially in asset management, is mostly snake-oil.
- Buy and Hold remains the key for most private investors
Well worth a read
Putting people at the centre of the investment decision: Implications for Private Pension
Ladies and gentlemen, let us be clear: as a society we are increasingly attracted to simplistic solutions, be it in the form of religious denominations or through the populist promises of salvation of parties on the right and left margins. Now, we could also utilise this escape route in the financial industry we work in, on the grounds that simplification has been accepted in other areas of society. But not so fast. Our position and status as well-educated, well-paid and (often) with high self-esteem brings responsibilities with it. We must not surrender to the call of simplistic answers. How then does our industry transcend the simplistic?
On what is feasible
The passionate debate on efficient markets and rational investors is no longer needed. It has been decided. Markets are not efficient, nor are investors rational (see On Market Efficiency). On the other hand, markets are not completely inefficient, but adaptive. People are not completely irrational, but oscillate between emotion and reason (see Unethical Asset Allocation Methods).
What remains the biggest obstacle in regards to change management is changing the behavioural patterns of employees along the investment process.
Does the employee have to be at the centre of the process in order to get closer to the knowledge boundary in asset allocation? Are high frequency trading and RoboAdvisors not evidence enough that humans may not have to play a role in the investment process? Slow down. All quantitative methods and algorithms are based on assumptions of market patterns and how these can be made utilisable as best as possible. Who decides on the assumptions? That’s right, the human developers. In order to lead investment methods closer to the knowledge boundary of asset allocation, this only leaves the focus on the investment team and the investment process it experiences.
What is feasible now? In one sentence: “More conscious and therefore rational investment decisions by means of proactive management of cognitive dissonances and an analysis focus on causality instead of correlation in regards to understanding market correlations create a higher probability of anti-cycles in the investment process.” (Schuller).
If you were searching for the Holy Grail, you have now found it.
Innovation & Asset Allocation
The asset management industry is currently being attacked on two fronts. Regulators increasingly see a systemic risk in asset managers and are trying to implement regulatory measures in order ensure a better handling; and Fintechs are questioning inherent business models and are increasing the margin pressure.
Other industries are already demonstrating the two solutions for this increasing limitation of room for manoeuvre. The temporary solution is economies of scale. This is already the case in our industry. There are regulatory and organisational constraints in regards to the oligopolisation of industries. It is only a temporary solution.
The sustainable solution is specialisation. Competitive advantages by means of specialisation can be won through innovation. This is the only sustainable solution.
In our industry, innovations are rare. Innovation means a shifting of the knowledge boundary on asset allocation, a measurable improvement of the service provisions of corporate finance compared to the real economy. The innovative ability and motivation of the investment teams (investment committee, foundation chairpersons, family office managers etc.) therefore comes into focus. The sustainable competitive ability of an investment process stands and falls with the investment team. Let us refer to them as high performance investment teams (HPIT) to uqse Panthera’s terminology.
Reducing behaviour gaps
Creating a concept is one thing, establishing and managing HPIT is another. There are a number of well-tested starting points, including skin in the game–based incentive systems, transparent governance structures, and quantifiable, transparent performance measurements. But here we’d like to concentrate on reducing the behaviour gap.
The “behaviour gap” has been sufficiently researched and quantified from an academic point of view. A result of the pro-cyclic behaviour of market participants, explained by emotional and wrong decisions. It is self-explanatory that this structural underperformance leads to significantly reduced returns for investors over time compared to buy-and-hold.
(Source: Vanguard, Bogle Financial Markets Research, Dalbar)
Although Bogle is mainly highlighting the cost penalty, his research shows the even larger potential for improvement when it comes to minimizing the timing and selection penalty. For reductions of selection penalties, we refer to our initial point, namely the necessity of high performance investment teams.
Implications for private pensions (Third pillar of pensions)
Within ongoing demographic change, a significant shift in pension policies can be observed. Private pensions (the “third pillar”) become increasingly important to close the pension gap, opened by the pillars 1 and 2 (state and employer plans). This puts European trustees in the difficult position of becoming long-term investors for their own private pension plan, with all the difficulties like selecting the right asset allocation and investment vehicles – and the right insurance company. Our trustee should keep three concrete facts in mind:
- Costs matter. In a secular low yield environment, each basis point in fees is spent unnecessarily. A focus on passive replication is recommended. If active management fees are justified, the investment products used within the private pension plan should be institutional share classes without distribution costs.
- By incorporating strategies based on the body of knowledge led by behavioural asset management, a higher emphasis of rule-based investment processes and dynamic asset allocation strategies could be a way to structurally increase equity allocations in private pension plans. Structurally higher equity allocation will transform mid- to long-term to higher expected returns for private pension trustees, which can alleviate the expected drag of the other main pension pillars due to demographic change.
- Insurance companies offer to pre-select and perform due diligence on investment products. Trustees then select from this shortlist, trying to assemble a feasible asset allocation for their pension plan. How can our thoughts on HPIT be of relevance for insurance companies? During an insurance company’s due diligence process of selecting investment products for private pension plans, it should only consider those with a stringent rule-based investment process committed to high performance investment teams. Like that, the whole investment industry would be forced to focus more on the most important risk and performance driver, namely the man at the centre of the investment decision.