June 2008
Over the last six to nine months investment
managers around the world have faced some of the most challenging
capital market conditions seen for generations. Not only have they
had to endure sharply falling prices across a broad range of asset
classes, they have also had to weather the potential demise of the
global financial system in its current guise. Some practitioners
have witnessed their specialist markets almost disappear overnight,
and regulators and central banks have fought, desperately at times,
to maintain confidence in the infrastructure in which all of
society has become both dependent and reliant upon. This may
be regarded as melodramatic, however, pension trustees, life
assurers and mortgage providers have all been caught in the eye of
this financial storm and very few have escaped unscathed.
Notwithstanding the circumstances described,
investment managers have had a duty of care to their clients and
continued to do what they are paid to do – manage assets. Clearly
investment performance delivered will have varied significantly
subject to the skill of the manager and the risks they were
mandated to take. The results achieved will have been a catalyst
for many investment management firms to undertake a review of their
investment process, their risk management controls and, indeed,
their entire investment philosophy to determine what they did right
or perhaps, more commonly, what they did wrong.
One thing has been made abundantly clear -
managing assets for clients and consistently delivering benchmark,
or better, returns is a very difficult and challenging task. The
fund management industry has long been built on the promise of
offering market beating performance to its investors and, with the
exception of a few, very select providers, has consistently under
delivered on this promise. Indeed, the events of recent months have
triggered a wave of comments arguing this undertaking can never be
met and this trillion dollar industry is built on a completely
flawed premise.
A series of academic papers published over the
last two decades have argued those two fundamental skills managers
claim to have – namely the ability to judge market timing and
consistently select undervalued stocks – are relatively
insignificant determinants of investment performance (2% and 5%
respectively). By far the most significant determinant (over 90%)
is that of asset allocation. For example, those managers who
switched out of equities and moved into low risk government bonds
and cash in late spring 2007 would have rewarded their investors
and also sheltered them enormously from the crises which suddenly
engulfed markets from last summer onwards. This bold asset
allocation move was practised by very few, but some, particularly
those using the process of multi asset class investing, will have
seen the possibility of an approaching storm and used the process
of diversifying across a number of asset classes as a means of
managing the investment risk for their clients.
Asset allocation may have been proven as the
fundamental driver behind investment performance, however, the
means by which an investment manager has been able to express their
asset allocation views has, until recently, been handicapped by the
very use of those market timing and stock selection skills which
have proved to be far less significant. However, this
environment began to change in 1993, when the first Exchange Traded
Fund (ETF) was launched in the US and opened up a new panorama of
investment opportunities. ETFs are open ended index funds listed
and traded on exchanges, like stocks, that allow investors to gain
broad exposure to entire stock markets of different countries,
emerging markets, sectors and styles as well as fixed income,
currency, property and commodity indices. Investments can be made
with relative ease on a real time basis and at lower costs than
many other forms of investing. Following their launch, the success
of these funds can be demonstrated by the US$797 billion of assets
under management at the end of 2007, which were represented by
1,171 ETFs with 1,909 listings on 41 exchanges around the
world.
The ETF ‘tool box’ available to investment
managers is now very broad as well as deep. Those managers who have
embraced the use of ETFs have recognised they can effectively and
efficiently gain access to their preferred markets and asset
classes with the knowledge these core allocations will deliver
market returns for their clients. With this market exposure
achieved, commonly referred to as ‘beta’, the investment manager is
then able to commit resources to researching and accessing those
investment themes or satellite ideas they believe will deliver
superior performance, known as market-beating ‘alpha’.
Building portfolios using this ‘core and
explore’ approach is the style practised by Fairbairn Private Bank
and dovetails with our three fundamental investment principles
- Asset allocation is the key driver of investment
performance
- Multi –asset class investing diversifies risk and maximises the
opportunities to deliver attractive risk adjusted returns
- Passive or index tracking funds will commonly out perform
actively managed funds.
Adhering to these principles can never remove
the possibility of short periods of negative returns in certain
market conditions. However, over time, they have been proven to
create an ideal framework for optimising investment return for
given levels of investor risk. Therefore, despite the
challenges faced in recent months, we consider this investment
philosophy and investment process to be well placed to manage
assets in the current environment.