Anne Unplugged

Alexander Forbes Research Institute

How do our actions as an industry help or hinder investors’ quests for better solutions

Behavioural finance suggests investors make bad investment decisions. But....

Consultants and advisers aren’t always helping

Let’s have a long hard look at what we’re really doing as an industry

Consultants and advisers exist to guide investors away from potentially damaging investment decisions –

or to at least guide us to the more prudent decisions. But....

Ours has become an industry dominated by heuristics and the “Law of Small Numbers”

Heuristics – Rules of Thumb

Simplify the message to the client

Make the message easy to remember

Make it easy for anyone to become a “distributor”

Make it easy to have cookie cutter solutions

Investors seeking high returns must accept high risk

This is coupled with “The Law of Small Numbers”

Which is the better fund manager:Quartile performance rankings:

These were all randomly generated performance numbers Collections of random events do behave in highly regular

fashion The smaller the number – the higher the probability of seeing

more extreme events

An Industry that is dominated by “The Law of Small Numbers”

Allan Gray Sanlam Coronation

1st quartile 1st quartile 1st quartile

1st quartile 4th quartile 1st quartile

1st quartile 4th quartile 1st quartile

1st quartile 4th quartile 4th quartile

1st quartile 4th quartile 4th quartile

1st quartile 1st quartile 4th quartile

Bias confirmationBias confirmation

Which row of letters were randomly generated?

BBBGGG

GGGGGG

BGBBGB

All three were – but our minds refuse to accept this explanation

Source: Grantham, Mayo, van Otterloo

There are lots of variations on this slide…but you get the gist

99% confidence levels?

We have allowed our industry to be governed by “The Law of Small Numbers”

Similarly we have cavalierly (as an industry) ignored how much “noise” there is in performance data that clouds what you are really looking at.

Even Warren Buffett’s performance lies within the range of potential outcomes for a purely random distribution of performance outcomes over a 20 year period.

(Nassim Taleb)

Haugen & Baker paper attacked for only 21 years analysis

But – do investors really have time?

More importantly:

Cult of active management

Easy for fund managers to beat index (?)

Poor quality benchmarks in terms of representativeness

Overall costs may be high but not large differential in fees between active and passive strategies for a strong push to “smart beta” (passive) strategies

Surveys and performance dominate decision-making

The Unique Challenges of the South African Asset Manager/Adviser/Investor

What can you tell / What can you not tell - from these performances?

What manager performances can tell you: Which asset classes/sectors drove performance? Asset allocation vs. stock selection ? Whether the market was providing alpha opportunities

and where ? Which investment styles/philosophies were successful in

the environment? Which strategies were the most volatile? Which strategies exhibited downside protection in falling

markets or maximum leverage of return in rising markets?

What we cannot deduce from this information:

Which managers are skilful

The Skill / Luck Continuum and Asset Management

How many factors involved in the path to success?

/

Source: Michael Mauboussin 2010

On understanding return and risk

Diwersification – It’s in the nature of the “beast”

Average share

Specific

Common

factors

Market

movement

(30%)

(30%)

(40%)

Average portfolio

Market

movement(90%)

(8%)(2%)

Source: Barr Rosenberg

(98%)

Multiple portfolios

Market

movement

(2%)

Beta Beta

Understanding manager performance – the heart of the problem

Contribution is unconditional.

Hold a beta of 1.00 and you get 100% of

the market movement

Contribution is conditional:

• availability in the market

• manager skill

Beta Alpha

This exposure you need to meet your long term funding

requirement

This is just frosting on the cake – can help cover

costs

Desperately seeking alpha

Against the ALSI, performance was a function of market structure and not manager skill in 11 out of 12 months.

Focused Blend vs ALSIBenchmark

ReturnPortfolio Return

Outperformed Banchmark

Probability of outperforming

benchmark

Probability of better

performanceJan-03 -4.81% -3.53% Yes 100% 64.40%Feb-03 -3.81% -2.72% Yes 100% 8.90%Mar-03 -7.38% -6.63% Yes 81.90% 0.70%Apr-03 -0.93% 0.34% Yes 100% 0.10%

May-03 14.87% 11.97% No 0% 62.80%Jun-03 -1.78% 0.07% Yes 100% 44.50%Jul-03 5.93% 5.25% No 0% 21.80%

Aug-03 5.57% 4.41% No 0% 4.70%Sep-03 -2.56% -1.37% Yes 0% 10.90%Oct-03 10.13% 8.80% No 0% 9.50%Nov-03 0.44% 1.86% Yes 100% 0%Dec-03 7.30% 6.36% No 0% 15.80%

Focused Blend vs SwixBenchmark

ReturnPortfolio Return

Outperformed Benchmark

Probability of outperforming

benchmark

Probability of better

performanceJan-03 -4.09% -3.53% Yes 98.10% 64.50%Feb-03 -4.71% -2.72% Yes 100.00% 7.40%Mar-03 -7.97% -6.63% Yes 99.20% 0.20%Apr-03 -0.27% 0.34% Yes 80.90% 0.10%

May-03 14.10% 11.97% No 0.00% 64.90%Jun-03 -0.77% 0.07% Yes 100.00% 47.10%Jul-03 5.00% 5.25% Yes 85.40% 24.20%

Aug-03 5.00% 4.41% No 0.00% 6.00%Sep-03 -1.89% -1.37% Yes 94.10% 11.80%Oct-03 9.70% 8.80% No 0.00% 10.70%Nov-03 1.62% 1.86% Yes 12.00% 0.20%Dec-03 6.97% 6.36% No 0.00% 19.30%

• Against the Swix, market structure (during this period) still accounted for outperformance 50% of the time.

Performance of Active vs. Passive Managers

Upside-down value chain for the industry

The more you can discern about manager skill, the clearer it becomes that manager selection is essentially a crap shoot

But we seriously end up believing that the greatest value we can offer clients is by being “good investors”

The Unique Challenges of the South African Trustee/Asset Manager/Consultant

Vicious cycle of mediocrity – with an increasing overlay of external controls from an impatient regulator/government

In truth...during times like these our clients need us desperately – we just haven’t listened to what they really need

Charles Ellis and the “Winners Game”

Not financial advisers...............................financial coaches!