Being smart does not beat the market

Among the beliefs that asset managers must challenge in coming years is that they can make more money in the markets based on the fact they are smarter than the competition. This was one of the views that emerged from the panel discussion at the 4th Annua

The smartest investment minds in the world failed to anticipate the 2007 sub-prime crisis despite exponential increases in property valuations in the five years preceding it. “And even smart people are undone by market enthusiasm,” says Chris Hamman, Head of Fixed Interest Investments at Sanlam Investment Management.

It is common knowledge that investors exhibit maximum enthusiasm when markets are near their top and are most pessimistic near market low points. Hamman reminded the audience that even Sir Isaac Newton – one of the smartest minds of our time – could ‘account’ for the movement of stocks, but not for the madness of people.

Irrational behaviour could explain why investors are quick to blame fund managers for poor market performance when the fault may lay closer to home. Hamman says there are two factors that weigh heavily on how retail and institutional investors assess their fund managers: First a short term bias in decision making and, second, an unrealistic return expectation.

“Fund managers are expected to report returns on a quarterly basis despite our underlying investment strategies and decisions built around five or 10-year views of the market,” Hamman says. Even the principle officers and trustees of pension funds end up making decisions that affect billions of rand of retirement savings based on performance measured over these inappropriate time frames.

The panel agreed that expectations of 20% a year from products held up as ‘risk free’ were extremely difficult to manage. One way to address such unrealistic return expectations was for investors to rethink their view of risk. Risk should not be shrugged off as the standard deviation of an investor’s portfolio against some notional benchmark, but rather for what it is: A loss that will never be recovered.

Others look to regulation to improve the savers’ lot. But as pro-consumer lobbies push for greater regulation in the financial services space, the panel warned that more regulation just for the sake of it is not the answer.

The trouble with regulation is that it is backward-looking. Regulators devise safeguards against a financial crisis that took place in the past in the hope the next crisis is of a similar nature. But the complex nature of financial systems means this is highly unlikely.

The reason is that global financial markets experience instantaneous change. For example, the regulatory response in the aftermath of the Enron and WorldCom scandal was to make directors legally liable for similar transgressions – but the legislation that followed was powerless to prevent sub-prime.

Asset managers believe that regulators have an important role to play, but want regulators to understand the difficulties they face. The desire for standardised contracts between asset manager and client, for example, was seriously questioned because no contract or investment mandate can cover all possibilities.

The debate is further complicated because long term allocations of savings in an uncertain environment require that the risk of capital losses be weighed up against the individual saver not having enough capital to retire on. “It is obvious that if you are too short term orientated then you have a real risk of not being able to retire,” Hamman says.

The warning from the conference is that if short termism and unreasonable expectations are not addressed, investors will end up with real returns that are insufficient to achieve their savings needs.