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OPINION

Stop and think

Stop and think
August 24, 2016
Stop and think

This conclusion was a key finding from a chunky piece of research from McKinsey earlier this summer, which surveyed 27 institutional investors from across the globe who, in aggregate, manage £5.5 trillion-worth of assets (16 times the amount managed by Schroders (SDRC), the UK's biggest independent fund manager).

However, if investors are too inclined to do what they do because that's what they do, then what should be their response? McKinsey suggests several improvements. Here are three especially relevant to private investors.

First, they question whether - to use the jargon - the pursuit of 'alpha' is worthwhile. In conventional investment theory, 'beta' is that part of a portfolio's returns driven by the markets in which an investor participates. So beta is low value-added stuff that an investor gets without trying. Meanwhile, alpha - supposedly - is the bit of overall returns that stems from an investor's idiosyncratic and enviable skills; it's the value-added portion.

This judgment about alpha and beta grossly distorts the statistics of regression from where the terms originate, yet, more important, it's debatable whether it's worth seeking alpha anyway. True, this is a well-established view, but McKinsey adds the twist that, in today's world of near-zero interest rates and inflated asset prices everywhere, alpha-seeking just isn't smart; basically, returns are too low to compensate for the risks involved.

Despite that, McKinsey discovered that institutional investors still spend about 80 per cent of their time alpha-seeking and only 20 per cent minimising the costs of capturing beta. That's because too often they haven't adjusted their institutional mindset to the new reality. Meanwhile, those who are switched on increasingly conclude that the game isn't worth the candle and are keeping more and more of their funds in cash. When risky 10-year government debt yields 1.5 per cent and riskless cash yields 1 per cent, that's surely the right response.

Second, investors should spend less time thinking about their assets - ie, what their funds are invested in - and more time thinking about their liabilities - ie, the obligations that they must meet or the uses to which they will put their funds. For those sovereign wealth funds that seem to invest without rhyme or reason, that observation may be a revelation. For others, such as the diminishing number of defined-benefit pension funds, it should be a statement of the obvious. For private investors needing to invest to generate a top-up pension or, say, to meet school fees it should be pretty obvious, too.

Yet, chances are, many private investors give too little attention to the uses to which their portfolio will be put. That could mean they end up taking unnecessary risks. After all, if you have a liability whose present value is £500,000, why expose a portfolio of, say, £600,000 to risk - as measured by the standard deviation of returns - of 30 per cent?

Sure, there is a counter argument which says that for much of someone's investment horizon the aim is the accumulation of assets without too much worry about whether the pot has become big enough; chances are, its size remains woefully inadequate for the purposes for which it is earmarked and that deployment remains years into the future. So for quite some time it suffices to say that, if you look after the assets, then ultimately the liabilities will look after themselves. Clearly, however, that can remain true only for so long. Eventually there comes a time when it makes sense to focus on the liabilities side.

Third, too many investors are scouring the same investment opportunities. In consequence, according to McKinsey, "they find the same deals. The result? An auction in which the successful bidder often suffers the winner's curse" (ie, pays too much). So the smartest investors diversify and plan to diversify further. Fine in theory, but for private investors it may be especially difficult - and costly - to develop new sets of skills. Even so, the new conventional wisdom of investment says that they should make the effort.

That's because investors are rarely as diversified as they imagine. Take a typical UK-based investor, if he is middle-aged and affluent then far too much of his wealth is likely to be tied to the value of UK house prices and far too much of his income - from which the future capital will be creamed off - may depend on the success of the UK economy. A few equities with an international outlook won't diversify away much of those risks. He needs to do something more. Additionally, the new conventional wisdom says that only by being very widely diversified can investors realistically expect to catch the star asset classes. Which particular classes those will be there is little way of telling, yet the precedents say that the storming performance of just one or two holdings can make all the difference between ordinary and outstanding portfolio returns.

In a phrase, McKinsey is telling us to forget alpha, de-risk and diversify. Got it?