Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 86

Tim Hodgson: how a profession became an industry

Tim Hodgson has probably spent as much time as anyone in the last decade thinking and writing about investing and funds management, and his conclusions are far from flattering. With Roger Urwin, Tim set up the Thinking Ahead Group at Towers Watson in 2002, and this recently morphed into the Thinking Ahead Institute, a not-for-profit ideas forum with external sponsors that has already attracted 20 major institutions managing US$5.6 trillion in assets.

A couple of months ago, I was at the Research Affiliates conference with Tim in Los Angeles where some of the best minds in the industry, including Nobel Laureates, spent two days discussing how little we knew about markets. How do we value stocks? What value do asset consultants add? Why bother with the fees for active management? Tim presented at the Conference and shared these concerns.

I sat down for a chat with him in Sydney last week. He has not worked as a consultant at Towers Watson for many years, and he brings his ideas to his colleagues and their clients by writing research papers and making presentations.

I asked him what happens when one of his opinions, such as the merits of ‘smart beta’ rather than active management, is not in the best interests of a Towers Watson client. “If you do the right thing, it will have relevance,” he replied.

Alpha is a negative sum game

He argues an articulation of beliefs by a client or investor is the first step in the investment process. For example, it is a truism that ‘alpha is a negative sum game’. That is, the sum of all investment decisions is the market, and after fees, the active performance (the alpha) must be negative. But there are many managers both above and below the market benchmark. One belief might be that it is possible to identify the better managers, while another belief might be that outperformance cannot be done consistently over time.

Hodgson falls in the camp that identifying the best managers is very difficult, and we probably spend far too much time searching for outperformance. It’s no use recognising Warren Buffett’s skill now, you need to identify the Warren Buffett of the next 20 years. He advocates moving away from the majority allocation to active managers to perhaps 70% in various types of passive management. The market still needs active managers for efficient price discovery, but it does not need to pay the fees for so many active relative value managers.

Passive does not necessarily mean the usual cap-weighted index investing. Hodgson was an early supporter of what is now known as ‘smart beta’ but which he called ‘beta prime’ in research papers going back a decade. He supports the view that cap weighting leads to larger allocations to the most expensive stocks, and an index which weights by factors other than price can remove this drag. How have his colleagues taken this view? “It’s my job to initiate ideas. It can sometimes take a long time for them to be appreciated.” Such a move across the industry would remove over $100 billion of management fees from the estimated $350 billion paid globally at the moment, not something which many in the industry would enjoy. It will only happen through bottom-up change from asset owners, who control the mandates they offer.

Risk as permanent impairment of goals

Hodgson defines risk as “a permanent impairment of mission goals or expectations”. He believes risk models struggle in the five ways described in Figure 1. Risk management needs to find a way to overcome these tensions as investors go on a ‘journey plan’ through their lifetime. Funds should be more concerned about impacts that impair long term plans than short term Value at Risk measures or tracking errors.

GH2 Chart1 311014

GH2 Chart1 311014

He supports dynamic or tactical asset allocation, using valuation techniques that measure when markets are expensive or cheap. When I suggested it seems inconsistent to say you cannot pick good active managers but you can pick when markets are cheap, he quoted from F. Scott Fitzgerald in 1936:

“The test of a first rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”

He drew out the comparison to active versus passive investing in a fascinating way. “‘Is there aggregate added value from market timing’ is a similar question to ‘Is there aggregate added value from active investing’. Probably no to both, but we are dealing with highly complex, adaptive systems, and the answers are not simple. Which is why we always start with our beliefs.”

In other words, investing is not like practicing medicine, where an experienced surgeon can become an expert over time because the human body does not change and he knows what to expect when he goes into it. Markets change depending on the actions of others in a highly adaptive way.

We have morphed from a profession to an industry

The Thinking Ahead Group has long championed the need to focus on the ultimate beneficiary, and Hodgson riles against the self-interest of many finance executives. His colleague, Roger Unwin, has seen investment management morph from a profession to an industry. There used to be more focus on stewardship and long term perspectives.

One of his hopes for the new Institute is that by changing behaviour at the top of the investment pyramid among major asset owners, it will improve retail products and client interactions. He likes the analogy of a Formula 1 car and the research impact on the family sedan. “By having better working partnerships, we hope the investing equivalents of antilock brakes and airbags trickle down from the Institute to the end investor.”

(To read some of Tim’s most recent work on the attitudes of investment managers, see the related Cuffelinks article, “Our industry has a problem”).

2 Comments
Ramani
November 02, 2014

Paul, the irony of trumpeting past performance selectively (only in good years, mind) while hoping that this will be ignored is only bettered by the inveterate use of 'this does not take account of your circumstances, we are not liable, take professional advice' as an omnibus disclaimer.

Everyone you go to in finance spouts it as a primordial mantra. If you take it face value, and can make sense of it, the 'professional' you go to advises you - you guessed it - to seek professional advice. A perpetual loop if ever there was one, and a loopy one, at that.

Have you ever come across 'we are professionals, we are liable for our advice, we will take expert advice where we fall short'? No, me neither. Where are these mystery professionals hiding?

If I had the power, I would subject these worthies to a like experience when they have a medical emergency. "We are not liable, we don't know all about you, take professional advice..." This may not prove effective against the pervasive malady, but at least it will be fun! It will also mitigate our longevity concerns somewhat....

Paul
November 01, 2014

It's rather ironic that the entire industry is built around a caveat (past performance is not an indication of future returns) and yet this is precisely the pitch (purported) alpha providers use.
Too many reports (analytical and behavioural) such as SPIVA/ Persistence Indices/"Hot hand" fallacies show that over the long term, it's far too hard to consistently pick longer term winners- particularly those that don't "give it back" with a poor performance, yet an entire (sub) industry is built around it. Little wonder the results of the TW survey around who is deemed the major beneficiary of the industry.

 

Leave a Comment:

     
banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.