Man at the centre of the investment decision

Gökhan Kula and Markus Schuller are stating and reasoning a realistic holy grail in Asset Allocation by creating an investment process framework that places man at the centre of the investment decision. 


By Markus Schuller (Panthera Solutions) and Gökhan Kula (MYRA Capital)

July 2015


We, Gökhan Kula and Markus Schuller, have already written a few joint articles and have given a number of speeches. The auditorium usually demands equally correct and brave prognoses on DAX closing prices at the end of the year and gentle recitations of the Holy Grail of asset allocation. Not too directly, as one does not want to have their own inerrability questioned too clearly after all.

Dear Sirs and Madams, let us be clear: as a society we do suffer from becoming simplistic, driven by stimulus satiation in regards to selection and interpretation, be it in the form of religious denominations or through the populist promises of salvation of parties on the right and left margins. Now, we could also utilise this escape route in our industry and could refer to other areas of society, where simplification has been accepted.

But not so fast. One has to decide. We are usually well educated, have a healthy level of self-worth and earn a decent income. We are exposed accordingly in regards to our social position. You cannot only walk on the bright side of life, but you have to accept the responsibility that comes with it. Accordingly, a demand has to be set to not surrender to simplistic answers. How does our industry then transcend the simplistic?

On what is feasible

The passionate debate on efficient markets and rational investors is no longer needed. It has been decided. Markets are neither efficient, nor are investors rational (see “On Market Efficiency”, Schuller, 2014). In reverse, markets are, however, not completely inefficient, but adaptive. People are not completely irrational, but oscillate between emotion and reason (see “Unethical Asset Allocation Methods”, Schuller, 2015).

The two conferences GAIM 2015 and Fund Forum 2015, which take place in Monaco in June, are among some of the most important indicators in the world in regards to which topics are currently en vogue for Alternative Investments (GAIM) and the traditional mutual fund industry (Fund Forum). Whilst the AI community is currently making a difference in “mutualfundization” – keyword Alternative UCITS – the mutual fund managers are speculating on ways to save the old business model – keyword Smart Beta/ factor-based investing as an emergent compromise between active and passive.

In short, both industry sectors are currently on the move. Just how difficult the elimination of traditional asset allocation methods is could be seen in the example of the CEO of Amundi AM, Pascal Blanque. Never before had we heard a large player clearly distancing themselves from Modern Portfolio Theory. Chapeau. The way out he presented for equity exposure is called Smart Beta. And his solution for merely temporarily replicable Beta patterns is called Market Timing along the economic cycle by anticipating inflection points. Two steps forward, one back. Nevertheless: Amundi managed to get from generation 1 to generation 2+. Nonetheless. A big step for the organisation, which even its CEO described as brave. The biggest obstacle for him in regards to change management: changing the behavioural patterns of his employees.

And this is why the single investment team member is now to be at the centre of the investment process, in order to get closer to the current knowledge frontier in asset allocation with regards the methods applied? Are CTAs, HFTs and RoboAdvisors not evidence enough that man does not have to play a role in the investment process? Slow down. All quantitative methods/ algorithms are based on assumptions of market patterns and how these can be made utilisable as best as possible. Who decides on the assumptions? That’s right, the human developers, let us call them Quants. As market patterns shift, good CTA managers, for example, continue to reflect on and potentially adapt their assumptions and consequently their algorithms. During the due diligence process with CTA managers it quickly becomes clear, whether they are aware of the reasons for the existence of the market patterns, their chosen approaches and the limitations linked therewith. If not, please avoid.

In order to lead investment methods closer to the knowledge boundary of asset allocation, this only leaves the focus on the investment team and its lived investment process.

What is feasible now? In one sentence:

“More conscious and therefore rational investment decisions by means of proactive management of cognitive dissonances and an analysis focus on causality instead of correlation in regards to understanding market moves create a higher likelihood of  following an anticyclical investment process.”

If you were searching for the Holy Grail, you have now found it.

Innovation & Asset Allocation

The asset management industry is currently being attacked on two fronts.

  1. Regulators increasingly see a systemic risk in asset managers and are trying to implement regulatory measures in order ensure a better handling.
  2. Fintechs are questioning inherent business models and are increasing the margin pressure.

Other industries are already demonstrating the two solutions for this increasing limitation of room for manoeuvre.

Temporary Solution:  Economies of Scale

Due do consolidation movements in the market, one can go against the margin pressure. This is already the case in our industry. Be it in regards to asset managers, product suppliers or service providers. There are regulatory and organisational constraints in regards to the oligopolisation of industries. It is only a temporary solution.

Sustainable Solution: Specialisation

Competitive advantages by means of specialisation can be won through innovation. This is the only sustainable solution.

In our industry, innovations are rare, an unusual demand on the competitive ability of market participants. Here, we are not talking about pretend innovations, such as Smart Beta, or complex illustrations of the quantitative modelling of forecasts. Currently en vogue at IMF, ECB et al: “factor-augmented Bayesian vector autoregressive forecasting models.” No joke. Do they work. No.

Innovation means a shifting of the knowledge boundary on asset allocation, a measurable improvement of the service provisions of capital markets to the real economy.

Smart Teams instead of Smart Beta

The innovative ability and motivation of the investment teams (investment committee, trustees, family office managers etc.) therefore moves into focus.

When students are being taught about entrepreneurship, they are told the following: it is better to operate in a bad market with a great team than in a great market with a bad team. Of course, the same also applies to our industry: The sustainable competitive ability of an investment process stands and falls with the investment team. Let us refer to them as high performance investment teams from now on.

High Performance Investment Teams (HPIT, © Panthera Solutions)

So it is getting personal. Unavoidable.
How to establish and manage high performance investment teams?
The following are starting points, which we use to form HPITs for our clients (Panthera Solutions).

I.     Reducing the Behaviour Gap
II.   Reducing the knowing/doing gap
III.  Establishing new rituals
IV.  Idleness as a source of creativity
V.    Individual qualities
VI.  Team culture
VII.   Skin in the game–based incentive systems
VIII.  Transparent governance structures
IX.     Quantifiable, transparent performance measurements

This article looks at the first point. The authors are very happy to discuss points II-IX upon request.

I.    Reducing the Behavior Gap

The “Behavior Gap” (coined by Carl Richards) has been sufficiently researched and quantified from an academic point of view. It is the result of the pro-cyclical behaviour of market participants, explained by their cognitive biases. It is self-explanatory that this structural underperformance leads to significantly reduced returns for investors over time even compared to a buy-and-hold strategy.

At this point we would like to quote the classic amongst the behavior gap studies, presented by Jack Bogle (Vanguard founder) in 2003 during a hearing in front of the US Senate (the authors are in the possession of current studies, which may be requested):

Bogle(Source: Vanguard, Bogle Financial Markets Research)

Unsurprisingly, the analysis shows that the structural underperformance of active investment strategies already take up a significant share of the market returns due to the cost penalty – down from 12.2% to 9.3%. The record sales figures of ETFs indicate a learning effect in that investors have realised how to easily reduce the cost penalty – to the disadvantage of the classic fund industry (see “Smart Beta Deconstruction” Kula/Schuller, 2014).

Although Bogle was mainly highlighting the cost penalty during his testimony, his presented research shows the even larger potential for improvement when it comes to minimizing the timing and selection penalty.

Easily realisable forms of behavior gap reduction are, for example, rebalancing, margin of safety and a number of other rule-based investment strategies. Implementing those would already mean a small step forward.

For more significant reductions, we would like to return to the initial point, namely the necessity of establishing High Performance Investment Teams. The rules of an investment process are only as good as their justification and the team’s conviction that their utilisation is sensible.

Quod erat demonstrandum.