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Better investment theory, in practical terms

Dan Purves




Investors should draw on a number of investment theories to gain a better understanding of different possible outcomes, which can then be used to build better investment portfolios, as even established theories fail to take the world’s complexities into account.

This was a key concept that Tim Unger, head of advisory portfolio group, Australia, at Willis Towers Watson, wanted to impart to delegates at the consultant’s Ideas Exchange in Sydney last week.

“The first implication is that regimes matter and they matter a lot. In an uncertain world we just don’t know what the outcomes are going to be in the short to medium term, so having a more diversified portfolio is going to be a good starting point,” Unger said.

“In all of this, good beliefs are critical … by having a better mental map of how that can impact security prices and asset classes, you can actually reflect those in your portfolios and generate better outcomes.”


Stronger and deeper investment beliefs

He proposed one of the actions asset owners need to take is to develop stronger and deeper investment beliefs.

In an ideal world there is a hierarchy of beliefs, starting at the board and running down to those implementing the portfolio. Obviously, the board sets the high-level views and beliefs that should frame the organisation and the investment portfolio.

However, as there is no settled theory on the more detailed aspects of financial markets, the closer you get to those implementing the actual portfolio, the deeper and richer those beliefs need to become, Unger said.

“Embedded in every single investment decision you make is a set of beliefs. And so what we are arguing for, is that judgement and beliefs need to become a bigger part of the investment process, and those beliefs need to be richer and deeper,” Unger said.

Another suggestion for outperformance was to develop a better mental map of the world and to use those fund managers who were already capitalising on a deeper understanding.

“Those managers that can do that are clearly worth paying fees for because they generate excess returns. But other ways you can exploit better understanding is either through thematic investing or through dynamic asset allocation.”

What both of these strategies require is the ability to identify where the markets have mispriced and then the patience to wait for those to be realised.

“I’m not going to suggest that any of these are easy – none of them are – but they are all doable, that’s the important part.”


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    Allocation to alternatives, even if it’s difficult

    Recently Willis Towers Watson has increased its emphasis that investors should not be relying on risk premia that are macro sensitive, a message Unger believes still needs to penetrate as “most portfolios” are still very reliant on credit and equity market risk despite increases to alternative assets over the past 15 years.

    In Australia, the allocation to alternatives has gone from approximately 8 per cent at the beginning of the past decade, to close to 25 per cent as of last year.

    “While Australia has led that charge in terms of increasing allocation to alternative assets, more recently we’ve slowed down and the rest of the world has actually overtaken us.

    “The question is, why is that? Have we reached the point where we have the right allocation to alternative assets? Or are there factors that are limiting greater uptake of diversity?”

    A straw poll of the delegates revealed the interesting fact that headline fees weren’t the constraint; rather it was a desire not to increase complexities in portfolios.

    “But the fact that there isn’t greater conviction in the equity risk premia is also interesting. I think what it says is there is still appetite to take on greater diversity, it’s just that there are things that are making it harder to do; [that] there are higher hurdles to get new assets in your portfolio and that marries with our experience.”


    Exploiting endogenous risk

    The third and last education from Unger’s talk was that asset owners need to have a truly long-term view.

    “It’s too difficult and it’s too unrealistic to expect that we can build portfolios to do well in the short-term and the long-term,” Unger said.

    “We have to adopt a portfolio that will do better over the long-term, partially because while we may well have a belief in mean reversion, we just don’t know when that is going to apply.

    “Most of the change in markets in the short-term are not due to changes in the fundamentals, it’s due to noise, so the best way to outperform with stock selection or asset allocation is to have a truly long-term view.”

    However, he added, it was possible to outperform by being truly short-term by exploiting endogenous risk that dominants the financial system (but which is largely noise when looked at from the longer term perspective).

    Unger suggested some strategies that exploit and take advantage of endogenous risk were non-price weighing schemes and smart beta.

    “There are also some very short-term oriented strategies that seem to do that, but I would argue probably not as easy to do as the longer term fundamental stuff, but still doable.”