Monday, October 31st, 2011
a very delicious direction

The lead article in the October 3 edition of Pensions & Investments focused on the changing strategies of institutional investors in response to the low-yield environment of today.  That brutal reality was the subject of an earlier chapter (“bond math”) of my ongoing series on investment styles,the research puzzle | This PDF will update with a link and description for each posting through the end of the series. which now proceeds with a look at one of the most important aspects of due diligence, style analysis, and manager selection.

And that is the extent to which the prevailing environment — what has worked and what hasn’t worked — alters the actions of investment managers, those that choose them, and the process itself.  The title for this posting comes from a quote in that P&I article; John T. O’Shea of J.P. Morgan remarked how the three-decade drop in yields drove returns in “a very delicious direction.”

As investment trends go, that’s an extremely long one.  When it finally reverses, the ripple effects will last for years, because there is little appreciation for the extent to which investor behavior has been distorted by the length and magnitude of the move in interest rates.

But there are other “very delicious directions” of lesser renown and shorter duration that alter the actions of investment decision makers.  They come and go, attracting attention and money until disappointment sets in.  The well-documented phenomenon of chasing performance affects individual investors, professional investment managers, and those fiduciaries who are charged with selecting managers.  By the time many jump on “the next bandwagon,”the research puzzle | This piece, from that fateful fall of 2008, includes an image of the life cycle of an idea and the “stuff” on the line. it has become the last bandwagon.

It is easy to lose sight of the impermanence of the factors that generate the numbers that captivate us; our evaluations get sloppy in the face of attractive returns.  How we describe and analyze an investment style can morph and be molded in ways we don’t realize until there’s a reversal of fortune.

When I was an independent consultant on the Global Research Analyst Settlement,the research puzzle | Here’s a series of nine postings I did about the settlement after its end. the first three years were a period of market quiescence.  The last two were anything but.  As a result, the patterns of research performance changed dramatically.  Looking at a narrow measure of performance to determine who was “good” and who wasn’t would have guided you in precisely the wrong way when it mattered most.

It seems to me that (in addition to the aforementioned fixed income elephant in the room) one area that needs a great deal of scrutiny right now is the effect of currency movements on results for U.S.-based investors.  Many who buy individual stocks, for example, could not explain the economic or accounting impact of a sustained move higher for the dollar on the companies that they own.  Investment managers who have generated good numbers relative to their benchmarks by using foreign securities talk about greater opportunities in those other lands, but are less forthcoming about the extent to which the performance comes from currency effects — and downplay its importance when talking about their strategies.  Likewise, returns attributable to holdings in gold and other commodities should be considered in light of the way in which they move relative to exchange rates.

I recently received a note from a hedge fund manager saying that if he were hiring now, he’d look for someone who managed to make a lot of money investing in no-growth Japan over the last two decades.  Why?  He said, “We don't know how to trade/invest when there are not big winds at our back or in our face.”

Of course, we expect investment managers to generate performance as they can.  It’s just that we need to remember that we aren’t very good about figuring out whether it’s “wind-aided” and never to be repeated again.