The investment industry, like any other, is out to sell its wares. To do this, it needs stories, because people buy stories, don’t they? The story most asset managers and portfolio managers sell is their ability to deliver higher than market performances over time. The pitch is often: “Pay our fees and we’ll beat the market - in other words, we’ll deliver the alpha you want.”

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The buyer, however, is often not in a position to assess what “the market” is, whether alpha is being delivered, or even how much the fees being paid actually are. The result is a decision to purchase based on a vague feeling of trust in the individual or the plausibility of the story.

However, when visiting a medical doctor, we’re not looking for stories and a good feeling about the doctor. We’re looking for evidence-based medicine. We should apply the same methodology to selecting money managers.

The questions to ask are:

  • *How close is your solution to the optimal portfolio?
  • *Where is the evidence behind your investment process?

To understand what an “optimum portfolio” may look like, we can start with this important question: do we know which stocks, countries, sectors, bonds and so on will deliver or be the best performers a month from now, a year from now and in 10 years from now? The answer has to be “no”. We're unable reliably to predict any aspect of life, so the likelihood of doing so in a highly complex and volatile area such as global economics and the stock market is slim. Those who propose to be able to do this should be viewed with suspicion.

Finance academia is awash with studies suggesting outperformance of the market is both random and closer to luck than skill. Therefore, if we are interested in the evidence, we should exclude any portfolio based on a process that attempts to predict the future.

Upside opportunity

Although the evidence of managers able to outperform the market consistently is slim, the evidence that it is beneficial to be invested in the market is significant. Financial markets offer asymmetrical risks. Over the long term, the upside opportunity dwarfs the downside risks. So, we can see that we should be invested if we expect our money to grow faster than inflation.

The decision to invest may send us in a direction of “buying the market” - in other words, circumvent the money manager and buy the index.

That’s a step in the right direction, but “the market” is difficult to define. There are a myriad indices available that represent some aspect of “the market”. No one index represents the whole market.

Ask any portfolio manager who builds index portfolios how they define the market and you’ll receive a long and complicated explanation of the trade-offs involved with one construction over another. Furthermore, most indices are market-capitalisation weighted.

Indices are arbitrary

Let’s think about “market cap” for a bit. The MSCI AC World (that is, MSCI developed and emerging market) index is often the proxy for “the market”. In its current form, the MSCI AC World has 2852 constituents and the largest 10 holdings are 11 percent of the entire market cap of the index.

The index is 52 percent in the US and 70 percent in large caps. China has the largest economy in the world but is only 3.6 percent of this index.

Twenty years ago, this index would have been considerably overweight in industrials. Ten years ago, it would have been overweight in commodities and financials. Today, it’s considerably overweight in technology firms.

What we’re learning here is that indices are arbitrary. They are not designed to be investment portfolios, and the chief executive of MSCI has said so himself on numerous occasions.

Dimensions of return

Since the 1980s, academics have been slicing and analysing stock and bond returns since the start of recorded corporation data (1926) to establish the nature of the underlying returns of the stock market.

The “dimensions of return” that have been discovered have come to be called “factors”. They are one of the most intensely studied areas in finance today. Factors are identifiable patterns in the data soup and represent a reliable dimension of return that is visible in the data over time.

Factor investing is the process of modifying an index portfolio to obtain exposure to these factors. The appeal of factor-style investing is that it can be implemented using quantitative techniques at a lower cost than active management.

Factor-based investing is the middle ground between the guesswork that is active management and the oversimplification that is index investing. It addresses the shortfalls of each - that is, the high cost of advice investing and the structural deficiencies of index investing.

So, the “optimal portfolio” offers access to the factors with the strongest academic support at a cost as close as possible to index investing.

The next time you sit down with your adviser perhaps you should ask him or her if you have the “optimal portfolio” and if not, why not?

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