Everything I do in my day job is in one way or another a function of the investment committee. My roles vary from governance oversight as Chair, keeping consultants and portfolio managers on their toes as an investment specialist independent member, or perhaps I am the consultant who provides advice on portfolio design including asset allocation and investment selection. For each of these roles, my job is definitely easiest when the Investment Philosophy is well-defined.
Believe it nor not, each of the investment committees I work with have different investment philosophies, but not only that, some of these investment philosophies … well … aren’t really philosophies at all. I’d say they’re closer to secondary objectives … except without the measurement that makes a good objective. What a poor Investment Philosophy often results in are investment portfolios at increased risk of losing their way … because they don’t really stand for anything or anything that is well defined. Now over the short term, that may be ok as a portfolio may still produce strong performance, but if they don’t perform … well … there is likely some explaining to do, and I would prefer to rely on an evidence supported, well-defined investment philosophy, that the investor is in agreement with.
What is an Investment Philosophy?
In short, it is a set of investment beliefs about what type of investing works … and by “works”, I mean is likely meet stated objectives, whether those objectives are to outperform a particular market by z% or achieve x% pa over a minimum of Y years. According to Drew & Walk (2019), the investment beliefs are the “guiding principles for investing”.
Famous investment philosophies include “Value Investing” of Warren Buffet and Jeremy Grantham; “Index Investing” of John Bogle’s Vanguard, et al. The evidence supporting “Value investing” may include the numerous academic studies that show buying cheap stocks tend to outperform the market over long periods of time. Evidence behind “Index Investing” requires belief that markets are efficient or perhaps the frequently published surveys showing most investment strategies underperform their respective market after adjusting for the market risk and fees.
These examples are quite simple, but they do follow some fundamental steps as defined by Aswath Damodaran:
- There is a belief about how human’s learn
- There is a belief about how markets behave, and
- You devise strategies that reflect these beliefs
So if we return to Value investing, the market belief that cheap stocks outperform expensive ones (say on a PE Ratio basis), may be due to human error in overpaying for growth. So the strategy a Value investor employs to capture that is to buy low PE Ratio securities and avoid, underweight, or short expensive high PE Ratio securities. If the implemented strategy is anything but that … well, the strategy has some alignment issues which should raise a red flag.
So returning to my initial concern, which is the less than perfectly defined investment philosophy. The most common I see is a statement along the lines of, and let’s call it Exhibit A, “We believe that investors wish to maximise returns whilst minimising downside risk. As a result our portfolios are designed with benchmark unaware strategies that have the flexibility to allocate to cash or defensive securities to reduce loss potential in times of stress”.
You may be thinking that Exhibit A seems quite logical…and it is. But it is definitely not an investment philosophy. The first statement in Exhibit A about what investors want is not a belief but an unmeasured objective … “maximise returns whilst minimising downside risk”. Because it is not measured, that even makes it a poor objective. As an objective, perhaps it should be rewritten with words to the effect of, “Our portfolios aim to have risk-adjusted returns in excess of comparable appropriate benchmark over rolling x years”, or all of that plus a statement about “…lower drawdowns than the market”.
The second part of Exhibit A simply states the investment strategy, which is an active non-benchmark aware approach. A strategy is also not an investment philosophy as it is not a belief, but is an articulation as to how it may achieve the objective. But why do we believe this strategy will achieve the objective? We don’t because this is where the Investment Philosophy comes in. With all of that said, and despite these statements not articulating an investment philosophy, there does appear to be one lurking beneath the surface.
Firstly, the fact the objective and strategy are looking to outperform a market or benchmark, means there is the belief that markets are inefficient and it is possible to produce positive alpha. To minimise downside risks or have a lower drawdown than the market, suggests that active market timing, whereby cash allocations could be increased before a downturn, or superior security selection that does not expose the portfolio to the same downturn as the market, can achieve this.
So, without going into what type of investment management, it appears the investment philosophy should be along the lines of … Exhibit B … “We believe that markets are inefficient and our portfolio managers have the skill to take advantage of these inefficiencies, outperform markets using their market timing and/or security selection skill, and protect on the downside”. The evidence supporting this is the next issue that requires addressing … perhaps it could be a track record, or a style of investing with a track record that reflects this, but either way, if you have an investment belief, make sure the portfolio reflects that belief, and if not, its either a problem with the belief or the strategy, but rest assured it is a problem that will be uncovered one day.
References
Damodaran, Aswath. Investment Philosophies, https://pages.stern.nyu.edu/~adamodar/pdfiles/country/invphil1day.pdf – extracted 6 Jun 2022
Drew, ME and Walk, AN (2019), Investment Governance for Fiduciaries, CFA Institute Research Foundation