Even if investors do correctly guess which stocks benefit from an event, achieving that sought-after "Alpha" is hard to achieve consistently, which is why low-cost access to the market makes more sense, the author of this article argues.

An overload of news and general market “noise” can distract investors and encourage them to trade in and out of positions. And this can, without certain constraints in place, produce the kind of portfolio churn that does not add sustained, compound value but instead costs in the long term. That’s the argument from those who, for example, argues that mean-reverting markets cannot be easily timed and that the search for “Alpha” has limited effectiveness and repeatability. This is part of a debate that goes on in the sector: Is it best to focus on strategic and tactical asset allocation, and otherwise avoid undue movements?

When the stock market rose on a tide of ultra-cheap central bank money after 2008, low-cost, “passive” entities such as exchange-traded funds boomed. More recently, as rates rose sharply after the pandemic, and markets turned more choppy, some of the enthusiasm for the “passive” approach appears to have cooled. But as the editors know, this debate is never really over, and the definitions of “passive” and “active” investing also shift.

Raymond Backreedy, chief investment officer at Sparrows Capital, a UK-based investment boutique, weighs in on the issue, and considers some of the problems associated with hunting for all kinds of investment opportunities and trading associated with them. With Donald Trump heading for the White House in January, one can expect a good deal of movement, Backreedy says. (This news service carried an article on that firm's strategy, here.) 

The editors are pleased to share these ideas; the usual editorial disclaimers apply to views of guest writers. To comment, email tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com   (More on the author below.)

Many investors will be working feverishly to identify opportunities for their portfolios ahead of the New Year, most notably seeking to benefit from Donald Trump’s return to the White House.

The incoming 47th US president makes it clear what he does and does not like, and numerous fund managers will – if they haven’t done so already – be positioning themselves to benefit accordingly.

That means enacting trades such as jettisoning clean energy stocks and amplifying oil and gas exposure, given Trump’s claim that he will repeal many of his predecessor’s major climate policies.

But while this tactical shift and many others like it might sound sensible, such moves call into question whether a fund manager’s portfolio is set up correctly if they are basing their asset allocation around election cycles or market noise.

The rationale behind such trading sounds enticing, as its aim is to “outperform,” however, constantly trading could have a number of ramifications.

Unintended consequences
It can be challenging for fund managers to avoid responding to world events by altering their portfolios, but if they repeatedly do so, it raises various issues, including considerations based on cost, risk and investment outlook.

Trading underlying stocks or funds costs money – capital that belongs to investors – and so should be kept to a minimum.

And even if a fund manager does select the right opportunities, their job doesn’t end there.

Buying and exiting at the right time to catch the alpha and avoid the troughs is challenging.

Not only that, but as research by Nassim Nicholas Talib (1) shows, active investors then have to decide how heavily they invest in their latest opportunity but tend not to get this right.

And, having chosen their favoured stocks, fund managers will now have to dedicate time to maintaining research on them to ensure the investment thesis remains robust.

Victor Hagahani re-creates the crystal ball experiment here based on Talib’s conjecture “If you give an investor the next day’s news 24 hours in advance, he would go bust in less than a year?"

Risky business
All of this creates risk.

Every portfolio change alters the risk of a portfolio, and this may not be fully appreciated by end-investors.

It also, potentially, creates an unnecessary appetite for risk among clients; if a fund manager does get some calls correct, investors could pile in and potentially get hurt when the inevitable bout of underperformance comes.

As research by academic William Sharpe and S&P’s SPIVA report show, fund managers are incredibly unlikely to be able to repeat periods of outperformance; in fact, the latter has shown that only one in 10 US-based funds has beaten the S&P 1500 in the past decade (2). 

That outcome is quite probably because managers have tried chasing the latest trend, and ignored their own oft-quoted advice that successful investing is about "time in the market rather than timing the market."

Noisy distractions
In spite of that mantra, much of the market ecosystem revolves around the short-term; quarterly results, annual returns, interest rate cycles and US presidential elections.

Those punctuations in time act as alarm bells for investors who are distracted by the noise that these events create.

But an investor’s outlook, which should be characterised by a strategic asset allocation, needs to be truly long-term.Some of the most successful funds in the world, including those run by nation states such as Norway, university endowments run by the like of Yale and Harvard, and giant pension funds like CalPERS, base their portfolios on research that analyses markets over decades rather than quarters.

Being geographically diversified across the world’s broadest equity markets while encompassing exposure to types of stocks – such as small caps – that tend to produce some alpha over the long term is a suitable strategy fit for virtually all investors. 

Conclusion
It is essential not to make changes just because the news cycle is “telling you to.”

Allocations should not be decided by who’s about to get elected to the White House – but by assessing research, analysing years of market returns.

Allocations within multi assets should be weighted according to investor’s tolerance for risk and loss – with a rules-based rebalancing process in place, and as dictated by the market, selling elements that have performed strongly and buying more of those things that have underperformed.

What we believe in is giving investors low-cost access to the market’s return. That might sound underwhelming to some as we’re hardwired to think we can choose someone who can beat the market and do better than everyone else.

But securing the above-market return year in, year out, is a feat hardly any investor can replicate consistently, even if they do guess which stocks will benefit from the next market event.

Footnotes

1 https://www.linkedin.com/pulse/when-crystal-ball-isnt-enough-make-you-rich-victor-haghani-pzwae/?trackingId=0tEFqBgQQMSEoDf9xf018A%3D%3D

2, https://www.spglobal.com/spdji/en/research-insights/spiva/

Author
Raymond Backreedy leads the firm's investment team and process, combining PhD-level expertise in mathematics, statistics, and engineering with strong logical reasoning. His experience spans hands-on research, development, and management of quantitative models and portfolios across both traditional passive and alternative asset classes. He was a founding partner at Evolutionary Trading and Tekio Capital. He also served as a consultant to the executive committee and board of trustees of a major Dutch pension fund, where he was involved in quantifying the impact of regulatory changes on their investment processes. Backreedy holds a PhD and MEng in Fuel and Energy Engineering from the University of Leeds.