What Do Portfolio Managers Think of the Market? Who Cares.

While portfolio managers and research teams at numerous investment management firms felt that during 2007 parts of the market were overvalued, many didn’t see the crash of 2008/2009 coming.

    During one mutual fund company’s unitholder meeting in July 2009, a unitholder asked why not?

    Here’s part of the fund manager’s response:

    “What we didn’t see, what we didn’t see, was the domino effect of the financial crisis taking all securities lower. We didn’t see that. I can tell you as well the Bank of Canada didn’t see it, nor did the Federal Reserve System, the OECD or the European Central Bank.”

    Many investment management firms and economic agencies use a top quality global team of hundreds of highly educated, highly paid professionals. We’re talking about the cream of the crop here…these people aren’t dummies. In fact, the entire premise of active management is that these people can reasonably foresee the future.

    So what’s the problem? Why did almost all investment and economic professionals not see the crash of 2008/2009 coming? And why will most underestimate the 2020 collapse?

    Below are 4 major faults of the investment management industry that caused funds managed by world renowned investment firms to fall in lockstep with the plummeting markets:

    1. Forecasting fallacy.

    Is there really any point to using investment professionals if they can’t forecast major market crashes? Many believe investment managers cannot add value through attempts at forecasting.

    An article by Marc Faber illustrates how forecasting may be a fruitless effort:

    “This takes me to James Montier’s critique of the efficient markets hypothesis. According to him, “the worst of its legacy is the terrible advice it offers on how to outperform — essentially be a better forecaster than everyone else”. In his opinion, this is one of the biggest wastes of time, yet it is nearly universal in our industry. “Pretty much 80%–90% of the investment processes that I come across revolve around forecasting. Yet there isn’t a scrap of evidence to suggest that we can actually see the future at all.””

    Marc Faber

    While he feels that forecasting is generally a waste of time, Faber goes on to say that analysts can foresee shifts from major market deviations (such as the NASDAQ bubble in the late 1990s or the Japanese bubble in the late 1980s/early 1990s) but it is very difficult to time these shifts. Unfortunately, being early is penalized just as hard as being wrong.

    Overall, there isn’t much point to forecasting. Therefore there is little value in paying an active manager.

    2. Group think.

    Large investment firms are prone to committee thinking. Investment decisions are usually incremental and made through consensus. This means the portfolios they run are slow to change and tend not to deviate from the average.

    In 2008 I’m sure some analysts had an idea that the market was experiencing death throes, but many were forced to moderate their view to move in-line with their firm’s consensus.

    If investment firms don’t embrace and act on deviance in thought, how will they forecast deviance in the markets?

    3. Being early = being wrong.

    The investments industry is structured so that portfolio managers that seem to be doing ‘nothing’ get fired (or at least suffer from sharply increased scrutiny).

    For example, if a portfolio manager was in cash for 12-18 months leading up to the 2008 crash (i.e. early) he would have eventually dramatically outperformed (and protected capital). While in hindsight we know this would have been a good move, at the time the portfolio manager would have unfortunately been fired within 6 months for missing the late gains made before the crash.

    Anytime a portfolio manager or financial advisor is heavily weighted to cash the standard question arises: why am I paying him 2% to manage cash?

    Giving a portfolio manager unquestioned reign over asset allocation involves a degree of trust that most clients (and investment oversight committees) simply don’t possess. Instead, portfolio managers are incentivized to remain within tight guidelines that resemble the market they follow.

    4. Conflicting incentives.

    Profit margins on equity funds tend to be higher than bond or cash funds so investment management firms have a reason to persuade advisors to sell equity funds.

    Commission-based financial advisors get paid less or nothing to put client money into bonds or cash. They have an economic incentive to invest client money into equities regardless of client needs.

    This also means most portfolio managers and advisors have an economic incentive to present bullish arguments on equity markets. [This is one of the biggest reasons that investors should instead choose to hire fee-based advisors.]

    Finally, to say nobody saw this coming is ludicrous.

    In 2008, there were plenty of signals the world was about to enter a shit-storm. One only has to connect the dots… Housing prices – the source of US consumption and global economic prosperity since the 2001 recession – started moving in reverse. It was pretty obvious that there was going to be an equally powerful reversal of global economic fortunes as housing prices rolled over in 2006.

    Also, when markets for securitized assets seized up and credit was no-longer available to hedge funds that purchased these securitized assets, one might have thought something was amiss.

    But the biggest signal was this: When the pillars of the American Dream (Freddie Mac and Fannie Mae) went bust, a big red flag should have gone up to anyone who understood the degree to which housing contributed to American consumption and global aggregate demand.

    The same is happening today. Portfolio managers have been slow to recognize the global supply and demand shocks created by reaction to Covid-19 coronavirus. Even those that do admit the problem argue the effects will be short and underestimate the impact of a simultaneous supply and demand shock on a complex economic and financial system.

    While true that nobody could have foreseen a pandemic, portfolio managers had at least a month’s warning as the virus slowly spread out of Wuhan. Yet, the most conservative managers have simply tinkered at the margins.

    The Covid-19 crisis will eventually pass. And it might not be as bad as the 2008 financial crisis. Regardless, investors using active funds need to know they’re simply along for the ride and that most portfolio managers will not protect them from downside.

    Bottom line: investors using actively managed funds should expect to be fully invested at all times. Portfolio managers tend not to make moves that protect from market dislocations. Given that, investors should stop paying for something they don’t receive. Instead, investors could achieve the same thing by simply using cheap index funds, potentially earning more over the long run.

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