A different approach

24Sep06

One consequence of the proliferation of investment vehicles, like exchange traded funds, that all claim a unique ability to outperform the market is that it makes it more difficult (and frustrating) for rank and file investors to sort through the competing claims. We received an e-mail from one reader who was finding it difficult making their way through the many competing claims out there.

One way of dealing with this uncertainty is to create an investment philosophy, from which a logical investment strategy may follow. This may, or may not, include allocations in actively managed or “quasi-active” portfolios. We recently came across a profile of a prominent investment consultant that helps put the challenge of investment strategy into some perspective. In the Chicago Tribune (registration required), Richard Ennis of Ennis Knupp + Associates is interviewed by Bill Barnhart.

Ennis, who is set to become Editor of the Financial Analysts Journal, opines on a range of topics, including the difficulty in knowing for certain if a manager or strategy can truly best the market. We pass along this (extended) excerpt because it draws together a number of themes of this blog.

The problem of designing a portfolio and finding the best money managers is essentially the same for ordinary investors with a 401(k) as it is for institutions, Ennis said.

A major error, which investment advisers have worsened over many years, is to confuse an investment product with investment skill. The inability to predict investment talent has led money managers to market investment techniques, he said.

“They talk about the latest strategy as if these characterizations might be winners,” he said. “We have absolutely no evidence that any particular investment style or technique produces superior results.”

There are two kinds of investment skill, he said. Individual skill is unique to the person and difficult to define systematically or detect in advance: “You could take several top golfers to the tee and have them each hit a dozen balls. There’s not that much difference among them, but we know that when the game plays out there is a difference in the result.”

A more promising type of skill lies in identifying quirks in financial markets that can be exploited for gains. “It’s not just reading tea leaves,” Ennis said. “It’s a different approach, and I’ve seen it work.”

For most investors, however, the cost of finding and retaining superior individual talent or quantitative systems erodes the chance for above-average investment gains.

“Most investors simply aren’t equipped to differentiate among truly skillful managers and, therefore, most investors really would be better off in index funds,” he said.

We appreciate that fact that Ennis noted the asset allocation process is essentially the same for a billion dollar pension fund as it is for your personal portfolio. Once we move beyond (strictly) indexed vehicles, the challenge for investors of all stripes is to try and identify skill wherever it may reside.  Unfortunately for all of us is this challenge is difficult, costly, and ongoing.

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