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Investment flows and the trifecta of desire

I started my current role as Platinum’s investment specialist in 2013, representing the investment team I had previously been a part of, to advisers. I spoke to a wide range of clients trying to determine their needs. After a process of collation and reduction of countless notes into lists of words, headings and subheadings it struck me that three things came up again and again – Performance, Connection and Simplicity – the “trifecta of desire”.

We all now know that our biases affect investment decisions. But they also affect investment communication and a simple question captures this for me. A lot of meetings begin with advisers enquiring: “How are your flows?” It’s simple, and it’s about connection. It's the herd mentality in action, and they are really asking, "What are others doing?", almost as if others’ endorsement is a critical requirement. Less obviously, it’s all about performance.

1. Performance

Strong performance is desirable and should be sought, but not chased. Finding a rare and genuine edge in delivering long term performance for clients is the goal of fund selection.

But, flows do not and cannot predict future performance. This is recency bias at its worst; industry surveys and our own data confirm that collectively consumers chase past performance. The relationship is alarming.

Recent past performance is a very strong predictor of flows. I use an algorithm[1] to track this as it helps me empathise with clients. I know when people are likely to take money away, or give us more. It's an emotional rollercoaster.

The simple fact is that the best managers are not always the best short-term performers. Staying the course is the challenge. Discerning between process and outcome is hard. The industry ('sales and marketing') focus is on outcomes; good outcomes sell funds, processes remain conceptual. Despite its triteness, it’s right to disclaim that “[recent] past performance is not a reliable indicator of future performance”.

Performance is based on a single sequence of events. No one can measure a portfolio in advance yet risk analysis uses realised historic outcomes to model possible future ones. Successful managers buy cheap stocks and sell expensive ones but expensive stocks can rise and cheap stocks can fall (witness 2018!). So sound processes will often deliver poor outcomes and vice versa.

But at softer times, clients ask the tough questions, and Connection and Simplicity become important. The risk is that these are 'tools of selling' at odds with 'tools of investing'. They open us up to exploitation.

2. Connection

Connection is a basic human need. We feel exclusion as acutely as physical pain so fitting in is very important. The herd mentality is well documented.

Influence guru Cialdini cites seven 'weapons of influence' with four directly relate to connection - reciprocity, liking, social proof and unity. Strong connections are essential for the persuader.

Salespeople know 'How to win friends and influence people': Listen, take an interest, smile and use peoples’ names but above all, avoid disagreement. Yet most successful fund managers are contrarian. Bringing an opposing message is a tough starting point. But unless active managers take on the market, they will be replaced by index funds, which naturally attract flows in rising markets according to my algorithm, and the evidence of recent years!

Motherhood statements like “Apple is a good company” could be exploited as sales tricks. No one can disagree and subtly most equate good companies with good investments. By making statements that can’t be challenged, we win people over but may not make them money (ironically, Apple has!). Connection is aided by agreement but successful investing is about challenging consensus thinking.

3. Simplicity

Simplicity is helpful – the world is a complex place. Portfolios are hard to distill down to key drivers, so stereotypes make life easier. We can’t model all possible outcomes but they can lead us astray.

Remember that if your business could be written as a set of simple steps, a computer will eventually replace you. That’s robo-advice for advisers, that’s smart-beta for fund managers.

But look around you today - simple slogans, logos, promises, hopes and dreams. Just do It! Make America Great Again! We are all easy prey, for manipulative marketers, predatory politicians and mercenary media moguls. Our industry exploits this via personification (celebrating individual star fund managers despite teams producing better results), slogans (such as disruption), familiarity (the cause of home-bias) and storytelling (usually about stocks that have already performed).

People like asking questions that can be answered and tracked. “What’s your economic view?” is easier than examining useful but more abstract portfolio characteristics.

Simplicity misses the psychology of successful investing. The best investment decisions are the most uncomfortable, and at the time, they often sound crazy. If tough ideas are presented coherently, we don’t convey this angst. The entire existence of active managers relies on rare talent for exploiting uncertainty, disagreement and complexity. Machines will replace the simple and those who simply agree with the market.

In my view, 'tools of selling' are at odds with the 'tools of investing'.

To balance the trifecta of desire, investors will benefit from remembering to consider the following two points:

  • Acknowledge the relationships between luck and the short-term versus skill and the long-term
  • When meeting fund managers, replace questions such as “How are your flows?” and “What’s your economic view?” with the critical “What is your edge?” and “Why will it persist?”

 

Douglas Isles is an Investment Specialist (Retail) at Platinum Asset Management. The above information is general commentary only. It should not be construed as investment advice or any form of financial product advice as it does not take into account any particular investor’s investment objectives, financial situation or needs.

[1] I simply average 4 numbers – the 1 and 3 year absolute returns of the fund, and the 1 and 3 year returns of the fund relative to the appropriate index. The correlation with net flows over the next six months is striking.

 

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