Going Somewhere?

[Guest post by Tom Warburton] Most of us who have survived and thrived in the money management industry were trained under the traditional model of ‘getting in front of somebody and making a pitch’.  Our ‘pitch’ was designed to make us look smart and normally started out with something like “our best idea right now is blah blah”.

Thanks to our persistence and personal charisma we succeeded in winning a few clients that referred more clients and ultimately created a book of business from which we could make a living.  So off we went with more ‘best ideas right now’ and more ‘blah blah’.

Over the years my clients and I heard countless presentations about ‘our best idea right now’ and ‘blah blah’ from Active Managers (Sector Rotators, Asset Class Rotators, Market Timers and Stock Pickers) who had been recently (i.e. temporarily) successful in predicting or outperforming the market but soon (i.e. inevitably) lost their touch.

As expected, a few of our clients, motivated by their faith in us and the prospect of outsized returns, lapped up the pablum and entrusted their money to our recommended Active Managers.

After some reasonable period of time, without fail, the performance of our recommended Active Managers reverted to sub-median and my firm and I were on the road with a new cadre of Active Managers and their new version of ‘blah blah’.  We apologized for the mediocre performance of our old managers and proselytized that we had found new Active Managers with ‘better ideas right now’.

It didn’t take me long to figure out that I didn’t want to be part of this.

Armed with my computer, an internet connection and Google I set out to see if there was actually any science to the wealth management industry.  Well – Seek And Ye Shall Find.  Yes!  There is a wealth of science pointing the way toward strategies that make sense.

Of course, it wasn’t a brief research project and before I found the science I found a lot more ‘blah blah’.  An example that sticks in my mind was ‘Continental Bias’.  The majority of US Money Managers recommend that the bulk of their client assets be invested in the US Equity Markets with smaller allocations off Continent.  The majority of European Money Managers recommend that the bulk of their client assets be invested in Europe with smaller allocations off Continent to the US and Asia.  Similarly, Asian Money Managers recommend major allocations to Asia with minority allocations to the US and Europe.  Gimmee a break…where is the science in this?

Continuing my independent research I stumbled across ‘The Efficient Market Hypothesis’.  This theory, primarily attributed to Professor Eugene Fama of the University of Chicago, postulates that “it is impossible to beat the market with clever security selection because prices already incorporate and reflect all relevant information”.  The practical application of this theory is that ‘nobody can pick stocks that will outperform their peer group’.  For an irrefutable example of the inability of stock pickers to predict future information, and thereby future prices, one need look no farther than British Petroleum (BP).  Over the past decade BP was lauded for their proven reserves and their ongoing expansion of those reserves.  Gosh, how is BP looking right now?  Is their Balance Sheet even strong enough to avert bankruptcy let alone should a cautious investor buy their shares?  It was pretty hard to predict the oil spill!

Although The Efficient Market Hypothesis has non-believers I have found no statistically significant evidence to refute it.  In fact, significant data has been presented by and exists within the databases of CRSP, SPIVA, MORNINGSTAR and others to support it.  The likelihood of any stock or bond picker outperforming a relevant benchmark is not good over the short-term and decreases over longer periods. It is for good reason that the Third Restatement Of The Prudent Man Act directs fiduciaries to utilize a Passive Strategy.

So, let’s presume ‘you can’t pick stocks’ and move onto another form of Active Management.  How about Market Timing?

Is it possible to figure out when to move between the stock market and cash?  Mark Hulbert, the publisher of THE HULBERT FINANCIAL DIGEST, has compiled the most comprehensive data I have seen on market timers.  Mark’s data has led this observer to conclude that the chances of generating out-sized returns are small and the chances of grossly underperforming the relevant benchmark are high.  Although I have never seen evidence as academic as Professor Fama’s, I have had lengthy conversations with numerous well educated market timers who have dedicated their careers to the discipline.  Each of them has represented to me that “the best you can hope for with Market Timing is to replicate the returns of a Market Index with less volatility and inferior Tax Efficiency”.

So, let’s presume ‘Market Timing makes no sense’ either.  What is a Financial Advisor to do?

Well, I think the answer is clear – admit to your clients that neither you nor anybody else can cleverly pick stocks or market time, but, you have a more worthwhile objective – You Can Help Your Clients Achieve Their Goals!

Represent to your clients that which is accurate.  Utilize well reasoned tools like purposeful asset dedication, purposeful asset allocation and tax efficient asset location to stack the deck in the client’s favor while we all set back and let the capital markets deliver the performance that is probable.

Of course, inherent to my recommendation is that an advisor utilizes passive management – some form of indexing.  This causes heartburn for many advisors and elicits comments like “how can I attract and retain clients utilizing anything that resembles indexing”?  To this question I can only answer, “You will be surprised”.  Once your clients understand that you understand their goals and have produced an investment plan that has a high likelihood of achieving those goals consistent with their values, resources, obligations and needs; the clients will be pleased and you will be on the road to being their Trusted Advisor.

As advisors we have a choice, stand for a bunch of worthless ‘blah blah’ by having a ‘best idea right now’ and ‘attempting to predict that which cannot be predicted’, or, stand for helping our clients achieve their goals with financial science on our side.

The choice is easy for me.  I won’t bet my reputation or my client’s financial goals on Active Management, any ‘best ideas right now’ or any ‘blah blah’.