From time to time we have guest posts on Validea’s Guru Investor blog from others who we admire, respect and are providing valuable insights to investors. Today’s post is from Joe Wiggins, who publishes the Behavioural Investment Blog and is Director of Liquid Markets at St. James’s Place Wealth Management, a multinational wealth management business based in Cirencester, England.
By Joe Wiggins (@BehaviouralJoe) —
The idea of an investment edge is a simple one. It means that there are some features of an investment behaviour that improves the odds of better outcomes. Although the concept is straightforward, locating edges and creating an environment that fosters them is incredibly challenging. This is primarily due to the difficulty in specifying and evidencing them. Many established active fund managers – who are selling edges – struggle to articulate their own supposed advantages. Edges are, however, not the sole domain of active managers; whenever anyone is making an active investment decision they should understand the edge they have in doing so, otherwise they should not be doing it.
Types of Investment Edge
The starting point for overcoming the problems of identifying an investment edge is defining the different types that might exist. I consider there to be three broad groups, which each include a range of more granular sub-groupings, these are: Analysis, Behaviour and Implementation:
Analysis – What information is used and how it is used
Informational – Investors access more / unique information (insider trading is an edge, albeit an illegal one), or use different / new types of information.
Technical – Investors have specific technical skills that provide them with an advantage in assessing securities and markets. For example, a complex MBS strategy.
Critical – Investors use information in a distinct fashion, which provide differentiated insights.
Behaviour – How an investor makes decisions
Decision Making I – Investors structure a decision-making process that mitigates the impact of our behavioural limitations.
Decision Making II – Investors structure a decision-making process that exploits the impact of our behavioural limitations. Most factor-based strategies are founded upon such an edge.
Emotional – Investors manage and control their emotions, so that their decisions are not overwhelmed by how they feel.
Environment – Investors work in an environment that supports the objectives of their investment approach. The obvious example here being a high conviction active manager who is incentivised based on the long-term results of their strategy and supported through prolonged periods of underperformance.
Temporal – Investors make long-term investment decisions absent pressures of short-term performance or noise. This is the incredibly powerful edge that private investors hold over professionals.
Implementation – How an investor implements ideas
Trading – Investors can skilfully trade in and out of positions.
Portfolio Shape – Investors have an advantage in how they construct their portfolio or how they weight conviction in certain ideas.
Not all edges are created equal. Given the abundance of information the potential for a credible analytical edge now seems far lower than has historically been the case. Edges are also not mutually exclusive, often they are dependent upon one another. For example, a temporal edge can only be credible within a supportive environment.
Although there are simple investment edges most (particularly those that are not easily commoditised) are a complex web of complementary or (sometimes) conflicting elements.
Key Questions About Investment Edge
The categories of investment edge are by no means exhaustive, but I would expect most to fall within these groupings. Critically, defining edges in these terms is only a starting point for more detailed analysis. There are three critical questions to ask about any purported investment edge:
1) What type of edge is it? It is not sufficient to state that an investor has an edge that sits within a certain category, we need to be clear about precisely what it is, otherwise it becomes close to impossible to evidence. Edges can be very general – buying companies that are cheaper than the market. They can also be specific – complex country models to assess the credit quality of an emerging market.
2) Why does the edge improve the chances of better returns? It is important not to accept an investment edge at face value. We need to create a hypothesis as to why it might improve our results. We can never be certain, but unless we can make a plausible claim as to why an edge should lead to excess returns, then it probably isn’t an edge.
3) Can we evidence the edge? Now comes the tricky part. If we have identified an edge and have created an argument as to why it may lead to better outcomes, we need some means of evidencing it. Obtaining confidence in edge (or skill) is all about drawing a consistent link between process and outcome. The typical and flawed approach to this is to discover an investor who has outperformed and then assume that their edge must therefore be effective. Markets are far too random and noisy to make such inferences. There are many investors with no credible edge that will appear as if they do when we focus on performance in isolation. Instead, we need to ask what type of behaviours are likely to result from the edge and identify whether that is apparent in the decision making of the investor.
There are inevitably challenges with this approach. Sample sizes are often small and the evidence base lacking. Also, the more nuanced and intricate the edge, the more difficult it is to draw a causal link between it and outcomes. This means we must adjust our confidence in the existence of any supposed edge and should correct our investment conviction accordingly. Any view on an edge is a probabilistic judgement informed by the evidence available.
If we don’t attempt to evidence an edge then we cannot develop a reasonable level of confidence that it exists or observe when it has been compromised or competed away.
How to Identify an Investment Edge
Generating convincing evidence about the existence of an investment edge is undoubtedly a challenge, but there is an even more fundamental problem. It is often difficult to decipher what the actual edge is. Even investors who should have one (because they charge for it) struggle to convey what precisely they believe their advantage to be. Fortunately, for most traditional, qualitative investment approaches there is a simple resolution. We just need to ask the fund manager one question:
“Could you effectively systematise your investment approach?”
Inevitably most active fund managers would baulk at the notion that their nuanced investment process can be transformed into an algorithm; for a start it does not augur well for their career prospects if the answer is yes. More importantly, if the answer is no the reasons they give as to why it cannot be made systematic should provide a clear view of their purported investment edge. By definition, they must believe that there are distinct elements of their investment process that cannot be easily or consistently replicated. Whatever is supposedly lost through systematisation, is likely to be some form of supposed edge.
Identifying a possible edge does not mean that an investor possesses a genuine one – most of the time it will not be – but it gives us a clearer sight of what that edge might be. We can then test it.
Most active investment strategies will feature two levels of potential edge – a base level ‘risk premia’ that can be easily systematised and then a more nuanced secondary level which reflects the specific features of their approach. For example, the manager of a value equity strategy will have a base level edge of buying cheaper companies than the market (easy to replicate, but still with historic efficacy) and the second level that is the distinct elements of their process that allows them to produce better outcomes than the cheap, simple version of the base level edge. The second level is what investors are paying for, but it is much harder to evidence credibly, and we should have less belief in it.
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This post might read as if it is solely about how we perceive the investment edges of other investors, but it is not. We must always view ourselves through the same lens that we judge other investors.
When we make an investment decision, do we know what our edge is?
Watch/Listen to Joe Wiggins discuss investor behavior on the Excess Returns podcast.
