Choppy markets and political uncertainty are making investors think more about risk. The global economy is slowing, and faith in some star managers has been dented. Investors wonder about manager behaviour during uncertainty or after a setback, but behavioural finance points to some helpful clues. Market risk is always present, but managers can compound this with their own overconfidence. Unsurprisingly, some of the ‘stars’ have fewest self-doubts.
It takes a lot of objective data to prove skill in investment ― 22 years according to some research. But, even the best records are punctuated with lengthy setbacks. And, if manager behaviour changes ― adding to risks ― they can trigger a downward spiral. Clients like managers to be confident and reassuring in difficult times. But recovery typically involves humility, reappraisal and risk reduction.
Clues to manager behaviour when underperforming can be found in the narrative they offer to investors. The key is to look beyond the confident headline. Is there real insight into the underlying issues? Managers and clients should be gathering more information to assess whether underperformance is simply market rotation, or is driven by failure in investment process.
One star manager recently described how he tends to get more aggressive at times when his views strongly diverge from the market. This may appeal to clients who love a contrarian, but the timescale on which things revert to the mean can be long. Indeed, in a world where returns in a business can increase, as competitors are wiped out, the pendulum may never swing back. Investors often rely on the concept of economic equilibrium, yet there is little evidence to support that. In psychology this is seen as the gamblers’ fallacy – believing that probabilities will fit into a defined timeframe.
Managers should note that in poker the best hand does not always win. Risk must be judged; no-one has unlimited time or funds. Potential reward might be greater after a performance setback, but that just means that the original potential can be achieved with a smaller position. Managers can misinterpret the opportunity of increased reward when they should actually be dialling down position risk.
Not all the risk comes from market valuation and prices. Liquidity itself can shrink as fashions change and market flows reverse. Unfortunately, volatility-related measures such as the summary risk indicator favoured by regulators, can flatter the apparent risk of thinly traded or unquoted investments. Recent months have made many investors concerned about volatility, but share prices that do not move much might have hidden danger. Underlying liquidity can drain from a portfolio just as it might be needed to allow a change of course or to meet outflows.
Without an active price formation process, what can be readily realised from these investments is anyone’s guess. There is now little free capital in investment banks and market-makers to take on lumpy positions. Regulations put huge pressure on managers to ensure that redemptions are not met by selling the most liquid shares. In an open-ended fund, liquidity can be a bigger risk factor than volatility. And even in a closed-end vehicle, ongoing capital requirements from investee companies can create the same challenge.
Although manager stories can be revealing, it seems a subjective way of looking at risk. Clients and analysts feel more comfortable with the apparent objectivity of numbers. But numbers are not always clear-cut: there can be subjectivity over picking the right timescale. Too often, performance assessment seems a bizarre mix of selective periods. Is it ever right to highlight the most recent two or three months as evidence of a turnaround? And style might have changed in ways that undermine the validity of the record.
Clients should look for evidence of candour and realism. Instead, star managers often deliver a heroic narrative describing their fight against the naysayers. Imagined foes are short sellers, the consensus and myopic investors. The embattled manager is visionary and contrarian. Managers know the emotional appeal of epic tales.
Clients should pay attention to the investor updates and press interviews that star managers give. The search for objectivity is understandable, but behaviour and narratives can reveal much. Dealing with a challenge involves personality and psychology. The right message on a setback is not redoubled confidence, but renewed analysis and an understanding of risk.
A version of this article was published on citywire.co.uk on 08/04/2019.