Simple lessons from the global crisis

One of the hallmarks of a bull market is the opportunity for most fund managers to deliver a good return for their clients. Yet, as the last two years have demonstrated, when things go pear-shaped, returns can vary dramatically from one manager to another.

Timing the financial markets is a dangerous game. Investors can easily find themselves over-exposed to the wrong asset manager or the wrong asset class at the wrong time.

Trying to time when an asset class or manager will outperform is fraught with difficulty, and investors invariably get it wrong. Many investors, who lost out as they exited the stock market at the bottom in 2009, failed to get back in again early enough to capture the upside.

While 2008 saw global stock markets record some of their worst ever performances, 2009 ended up being a positive year for most markets with the MSCI World Index up by 30.8%. Emerging markets in particular scored highly with the MSCI Emerging Markets Index closing 2009 up 74.5%, its best annual return in more than twenty years. The JSE recouped much of the previous year’s losses, ending 32% higher on the year.

There is little solace to be had for those investors who were buying into equities at the peak of the bubble, or sold them at the end of the downturn. But, it is important to draw lessons from this period. It is almost impossible to correctly forecast when a crisis will impact negatively on an asset class, or be positively resolved.

Investors who try to time their exposure to the financial markets are often building undiversified portfolios that take big bets on one outcome materialising. Unfortunately, these investors invariably take on inappropriate levels of risk: either too much at the top of a bull market when they’re too optimistic, or too little near the bottom of a bear market when they’re too pessimistic.

The same applies to fund manager selection. It is very difficult to know which investment environment will apply in the next 12 months, and consequently which manager will outperform. Investors implicitly assume the previous 12 month environment will apply going forward by basing their decision on past performance, and invariably invest with just one manager.

Unfortunately, the best manager at one particular point in time is not guaranteed to be the best manager all of the time. There are certain environments where one type of manager will do well, and others that favour managers with a different investment style.

The same argument can be made with asset classes. The best asset class depends on a number of factors that are very difficult to determine beforehand.

One way to avoid this situation is to invest with a multi-manager. This is a broadly-skilled fund manager that outsources the purchase of individual securities to other managers who specialise in a particular market type e.g.: shares, bonds or cash.

Good multi-managers typically focus their attention on constructing diversified portfolios with as many independent sources of returns as possible, instead of trying to time when an asset class or a manager will out-perform.

Until the recent crisis, investors were handsomely rewarded for taking on almost any kind of risk as global growth surprised on the upside. Many investors took on more risk and constructed portfolios that were overly exposed to equities or to a single fund manager. These investors might have outperformed a multi-managed, sensibly diversified approach in such a favourable environment. Recent events demonstrate once again, however, that investors with riskier portfolios are likely to experience disproportionately large losses and in volatile environments can underperform a multi-managed approach with its diversified set of returns.

This is because good multi-managers do not try to time the market nor try to select the manager who will perform best in the next 12 months. Instead, they build portfolios that aim to at least match their benchmark in most market conditions. They spend considerable time understanding the sources of their managers’ returns, how they differ from each other, and how to combine them in sensibly diversified portfolios.

Multi-managed portfolios are ideally not constructed for just the good (or bad) times or for what multi-managers think the next 12 months will be like. Instead, multi-managers look to find as many unrelated sources of returns as possible knowing that there is a much greater chance of getting this right than to accurately forecast what will happen next week next month or next year.