Systematic vs. Judgemental
Following the rollout of our new Evidence-Based Investing proposition, we thought it would be a good time to delve a little deeper into our process and, in particular, to highlight the difference between what is known as a ‘Passive’ investment approach, and our ‘Evidence-Based’ investment approach.
We put in place a sensible long-term portfolio strategy, rebalance it when required and refine it over time if new products and evidence allow us to improve its structure.
We like to talk about the way we invest as being systematic. We do things according to a disciplined system that is efficient, rules-based and objective. We do not make short-term forecasts on the direction of markets or the value of individual securities as the evidence suggests that this is extremely difficult. Instead, we put in place a sensible long-term portfolio strategy, rebalance it when required and refine it overtime if new products and evidence allow us to improve its structure. This approach is sometimes referred to, confusingly, as Passive Investing. There is a subtle yet important difference.
The opposite of a systematic approach is a judgemental approach, where a fund manager is able to act according to their own discretion or judgment, making subjective forecasts of security prices in order to try to beat the returns offered by the market. This is often referred to as Active Investing.
To be truly Passive – in its purest form – is to own the companies that make up the market, weighted according to their size i.e. market capitalisation. This can be a pretty effective means of investing compared to most judgemental approaches. However, an important differentiator of Evidence-Based Investing is how it goes beyond market cap weighted asset classes to identify the deeper ‘factors’ that drive risk and return. This provides the investor with the opportunity to improve the portfolio’s relationship between risk and return, compared to a purely Passive approach.
Decades of academic research has identified certain market risk factors which have higher expected returns than the broad market, and investors can seek to capture these returns by including allocations to them in their portfolios. These types of funds are sometimes known as ‘Smart-Beta’ funds, as they aim to combine the benefits of Passive and Active Investing strategies by using transparent and rules-based methodologies. The goal of ‘Smart-Beta’ is to obtain above market returns, lower risk and increase portfolio diversification at a cost lower than traditional Active Management but marginally higher than straight Passive Investing.
Some ‘Smart-Beta’ fund managers construct indices based on some measure other than market capitalisation, such as sales or earnings, that they then track in a Passive manner. Others make explicit allocations to factors such as value stocks (trades at a lower price relative to its fundamentals, such as dividends, earnings, or sales), and small cap stocks (those with high price momentum or high quality to deliver a return greater than the market alone). This is the traditional domain and definition of the Active Manager.
As a result, the distinction between Passive and Active funds has become increasingly blurred, as this diagram illustrates:
Evidence-Based Investing in Practice
We utilise the services of Dimensional Fund Advisers to provide us with exposure to the empirically researched risk factors outlined above. They have been successfully implementing their investment approach, which is grounded in economic theory and backed by rigorous academic research, for nearly 40 years.
Dimensional believe that it is possible to capture higher returns than the market without having to resort to judgemental guesses by starting with diversified exposure to the broad market and then making explicit tilts to factors such as value, small cap and more profitable stocks as these have tended to provide higher expected returns over many years.
Whilst in many ways Dimensional seeks to outperform a market portfolio there can be periods of time when a particular factor doesn’t deliver, which they seek to mitigate when designing their investment strategies. Their goal is to help investors benefit from these factors when they are realised and to offer ‘Passive-like’ returns when they fall flat. Incremental returns, when captured, can help to offset costs involved in investing and financial planning advice, compared to a purely index-tracking approach.
Incremental returns, when captured, can help to offset costs involved in investing and financial planning advice, compared to a purely index-tracking approach.
As Dimensional do not track a specific index they are able to use the information in new market prices to reposition the portfolio to maintain the highest expected returns. The flexibility they have in which stocks to buy and sell, allows them considerable advantages in minimising trading costs by providing liquidity to those who need it in the market, such as Judgemental i.e. Active Managers.
Dimensional’s methodology highlights the main differences between a pure ‘Passive’ approach and an ‘Evidence-Based’ approach and is why we have chosen to include their funds in our portfolios.
When it comes to selecting our best, we are looking for funds that are systematic in their approach to identifying market risks and building a rules-based system for capturing the market returns that these risks deliver. Our selected funds need not be following a market index (Passive).
Source: Albion Strategic Consulting
Developed market equities sit at the core of our growth asset allocation, and we then include – in moderation – return enhancing assets such as emerging market equities (e.g. China, Taiwan, Brazil and South Korea), smaller companies and less value companies, which accounting for their higher risk, should deliver a return premium. We also include global commercial property to diversify some of this equity risk, but without giving up too much return.
On our defensive asset allocation side, we primarily include short-dated bonds as they offer an efficient trade-off between picking up higher yields than cash, without the higher volatility of longer-dated bonds. We also weigh heavily towards AA rated bonds with a smaller allocation to investment grade BBB bond, as they provide a yield pick-up over AAA bonds without overly impacting the defensive qualities in the way that lower quality (particularly high yield) bonds do.
By its own definition, Evidenced-Based Investing will change with the passage of time as new empirical evidence and theory becomes available. Right now, the evidence points to an approach of capturing the market return using Passive funds in combination with ‘Smart-Beta’ funds, which include tilts towards the various factors that have been shown to provide higher returns over time.
Part of our duties in Investment Committee Meetings are to review and challenge our processes to ensure that they reflect the latest empirical evidence available to us. It is always open to review. If new evidence suggests that doing things differently would be in our clients’ best interests, then the Investment Committee would revise our approach. First Wealth is a business that puts clients first, and it is our duty to position ourselves at the cutting edge of current thinking.
This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.