Commentary | Jan 17, 2020

We Haven’t Been Swimming Naked

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When it comes to evaluating investment managers, Warren Buffett is quoted as saying, “Only when the tide goes out do you discover who has been swimming naked.”

A bull market makes most managers look good – a rising tide lifts all boats. In good times, it is difficult to separate unsound strategies from those that are truly robust. However, when markets fall, it becomes much easier to separate good strategies from those that were merely riding the wave of a bull market.

August was a difficult month for markets, with the MSCI All Country World Index of stocks declining 2.2%. Despite this challenging environment, our Global Tactical Asset Allocation (GTAA) strategy rose 3.7%, and our Enhanced Dividend fund rose 1.9%. Clearly, we were wearing bathing trunks!

In many ways, August was a repeat of our previous success in protecting our clients from losses and diversifying their portfolios during the challenging final quarter of 2018. Over the course of those three months, our GTAA mandate managed to “gear down”, shift out of equities and into safe harbour assets, and avoid losses as global stocks declined 12.7%.

Sixth Sense or Nonsense?
In a recent newspaper article, a Canadian investment executive described why he chose not to incorporate artificial intelligence (AI) into his firm’s portfolio management process. His reasoning was based on the distinctively human ability to “read a room” and gauge the sincerity of corporate management teams, which cannot be replicated by a machine or algorithm.

Even if you believe that investment professionals possess this “sixth sense”, the simple fact is that it has not enabled them to produce superior results. According to the latest SPIVA (S&P Index vs. Active) Canada report card, over the past 10 years:

  • 91% of Canadian equity funds underperformed the TSX Composite Index
  • 97% of U.S. equity funds underperformed the S&P 500 Index
  • 100% of Canadian dividend-focused funds underperformed the TSX Dividend Aristocrats Index

Aside from the alleged ability to gauge the truthfulness of a person’s statements, there is another human characteristic that AI lacks. Unlike their human counterparts, AI algorithms do not have emotions or cognitive biases, which often lead to poor investment decisions.

We Have Met the Enemy – And the Enemy Is Us
The field of behavioural economics studies the effects of psychological, cognitive and emotional factors on the economic decisions of individuals and institutions. This field has produced countless studies that have conclusively demonstrated that when it comes to investment decisions, people harbour subconscious biases that result in suboptimal results. Moreover, these biases are not restricted to individual investors, but also permeate the decisions of professional managers and institutions.

A study called “Stock Repurchasing Bias of Mutual Funds” investigates whether the emotional association that managers have with stocks that they’ve either bought or sold in the past makes them any more likely to buy those stocks again. The authors concluded that selling a stock for a gain is associated with positive emotions such as pride and happiness, while selling a stock for a loss is associated with negative emotions such as regret and disappointment. To repeat the positive emotional experience and avoid the negative one, mutual fund managers were more prone to repurchase stocks which they sold for a gain (i.e. a past “winner”) and were less likely to repurchase stocks that they sold for a loss (i.e. a past “loser”). The study concluded that this behaviour was associated with lower performance.

Another paper called “Fund Manager Overconfidence and Investment Performance: Evidence from Mutual Funds”, concluded that investment managers are “prone to overconfidence and behavioural biases”, and that “excessive overconfidence is associated, to a large extent, with diminished future investment returns.” In other words, outperformance tends to lead to overconfidence, which in turn tends to lead to underperformance.

Forget Would Be, Could Be, Should Be – Quantify What Is
At Outcome Wealth Management, we eschew intuition in favour of evidence-based investing. We do not rely on our “gut”, nor do we try to “read a room” to make our investment decisions. We apply sophisticated statistical analysis and machine learning techniques to large amounts of data to develop rules-based investment strategies.

This approach has enabled us to achieve a favourable combination of upside participation in rising markets and downside protection in falling markets, which has resulted in superior risk-adjusted returns.

A more detailed view on positioning and performance attribution for both our Global Tactical Asset Allocation (GTAA) and our Enhanced Dividend Fund are below.

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