Sometimes I wish we had a complex, proprietary, super-secret investment method. I would fit in much better with my peers at investment conferences. I could give vague responses to questions, “Well I don’t want to give too much away, but…” as if our competitors have the room bugged just waiting for me to spill the beans. Maybe our strategy would push the limits of modern technology. Perhaps our proprietary algorithmic trading would rely on artificial intelligence to parse trends on social media and I could hint that our greatest fear is not a bear market, but our AI gaining self-consciousness.
But then I’d be lying. The way we select investments isn’t a big secret. For one, we are big believers in index funds. But when we do seek active management, our analysis generally focuses on four questions: What do they say they do? Do we understand what they do? Do the results match expectations? Is it worth it?
What do they say they do? I am usually in contact with four or more people at a money management firm when doing due diligence. If all of these people have the same story to tell about the strategy I’m looking at, great. If not, that’s a red flag. What is the investment process here? How do they source ideas? Are they using a lot of jargon and buzzwords? If the strategy is being presented as a smart-beta high income liquid alternative, I run the other way. Fad investments are bad investments.
Do we understand what they do? I remember our firm telling a client that was introduced to Bernie Madoff many years ago that we didn’t advise investing there, because we couldn’t understand their strategy, it didn’t make sense. There are many “black box” investment strategies in the marketplace, with complicated trading formulas that worked great when back-tested, but not always so great in reality. If we can’t understand it, why would we want to invest in it?
Do the results meet expectations? If a manager has good performance is that because the strategy was executed well or did they get lucky? From a macro viewpoint, did their investment thesis play out? Many unconstrained bond funds have been launched and marketed recently in response to low interest rates and imminent rising rates, but have misfired by underestimating how slowly the Fed has moved, as rates haven’t shot up.
Is it worth it? What do the fees look like relative to the strategy’s peers? Perhaps even more importantly, is this strategy additive to a diversified portfolio? We’ve found that many strategies marketed as alternative really just mimic a diversified portfolio. Adding these funds doesn’t improve the portfolio makeup, it just adds more of the same, effectively trading high fees for less control over taxes and rebalancing.
This is the easy part.
The hard part is staying with the process in a down market when it seems like everyone else is scurrying about in panic. A flurry of investment activity isn’t a sign of intelligence or sophistication. It’s an indicator of a lack of preparation. Someone who is constantly fiddling with their portfolio, flitting from fad investment to fad investment, and thrashing about during downturns hasn’t put in the time to establish a coherent investment process. An investor who is prepared and has implemented a thoughtful plan adjusts their portfolio efficiently, resulting in better returns, but also greater peace of mind. There’s nothing super-secret about that.