By Aaron Filbeck, CAIA, CFA, CIPM, FDP, Managing Director at CAIA Association.
A lot happened in the public equity markets last week. Many well-known stocks experienced large drawdowns and recoveries… some of which were record one-day moves. Of course, this prompted some funny memes, posts, and Tweets across social media and reignited the age-old debate on market efficiency, “active” vs. “passive,” and just how many McDonalds-worth of market capitalization was erased from Facebook in one day.
Source: Twitter
Truthfully, I don’t care about the market efficiency debate. I find it unsatisfying and unhelpful when putting together a portfolio. The market efficiency debate is a macro debate, but it ignores the different players, time horizons, and objectives that drive daily market prices. For a practitioner, an advisor, or an asset allocator, the efficient market hypothesis (EMH), like economics 101 supply and demand curves, is a great starting framework, but the truth is likely somewhere in the middle. Once understood, it’s time to move on. Instead, ask more important questions:
- What am I trying to accomplish with my portfolio?
- Do I think I can outperform my selected benchmarks or allocate to someone who can?
- What are the tools available to me to act on my investment thesis? (i.e., the answers to the first two questions)
The beauty of these questions is that, at any one time, the answers to any one is shifting. That’s the beauty and challenge of this profession – institutions have long time horizons with short-term intermediate goals, and individuals do the same. Let’s take each of these questions in lockstep:
What am I trying to accomplish with my portfolio?
I’m a broken record when it comes to advocating for goals-based investing. From an asset allocator’s perspective, the most important thing is to achieve the objectives of the end-client. Rarely do you see an investment policy statement with the primary goal of beating an investment benchmark, or a targeted allocation of assets, or even a specific allocation to a certain asset class. A true fiduciary knows that all these things come after the important pre-work is complete.
Do I think I can outperform my selected benchmarks or allocate to someone who can?
This question calls back to both the EMH debate and the Tweet mentioned above. Rather than argue over the philosophical exercise, ask yourself first: 1) do I understand this asset class at all? 2) even if I am educated on it, does it make sense to allocate to it based on the client’s holistic needs? And 3) If I do allocate to it, can I add value through direct or manager selection?
If you outsource, can you identify the right manager to do it for you? It doesn’t matter how efficiently, or inefficiently, the market’s pricing mechanism is…outperforming benchmarks and other peers is difficult. This is true across all asset classes – on average, long-only public equity managers underperform their benchmarks, the probability of the average GP doubling their money has fallen substantially, and many cryptocurrencies have risk profiles that would make your nose bleed.
What are the tools available to me to act my investment thesis?
The answer to this question is certainly the most dynamic of the three, at least today. Even if you believe there’s an opportunity in a certain asset class or sector, you may not have the access to act on it. This is especially true in private capital today, as many of the top managers aren’t even open for new investors or have high minimums to invest. This is true for long-only public market managers that may be capital constrained. Democratization continues in multiple corners of the market and fund managers continue to blur the lines between liquid and illiquid and broaden their own toolsets to pursue opportunities. The future of asset management seems to be where venture capital managers hold public equities, hedge fund managers participate in private deals, and public equity managers cycle back into venture.
Putting it all together
To focus on objectives first is to objectively compare the tools at your disposal without ideology. Select the best index fund, active manager, factor strategy, hedge fund, or private capital manager at your disposal that will give you the highest probability of achieving your goals. Paying attention to costs, liquidity, and taxes will work itself out as part of that process. Maybe you end up owning index funds! But that should be driven by the investment process, not the ideology.
The next time someone tries to start a riveting conversation around market efficiency, tell them “Efficiency, be damned! Do you think you can beat the market?” At the end of the day, you can’t eat Sharpe Ratios and no one cares if you’re right unless you deliver for the end investor.
Seek education, diversity of both your portfolio and people, and know your risk tolerance. Investing is for the long term.
About the Author:
Aaron Filbeck, CAIA, CFA, CIPM, FDP is a Managing Director at CAIA Association. You can follow him on LinkedIn and Twitter.
As Managing Director, Aaron oversees content and product strategy for the Fundamentals of Alternative Investments (FAI) Certificate Program. Prior to this, Aaron was responsible for the strategic direction of CAIA Association's content agenda, thought leadership, and member education initiatives, and supported content development for the CAIA Charter Program. His work has been published by Oxford University Press and The Journal of Investing, and covers topics such as ESG/sustainable investing, liquid alternatives, commodities, and asset pricing/factor investing.
He is a frequent writer and speaker on these topics. Aaron’s practitioner experience lies in private wealth management, where he served as portfolio manager, overseeing asset allocation, portfolio construction, and manager research efforts for high-net-worth individuals and institutional retirement plans.
He earned a B.S. with distinction in Finance and a Master of Finance from Penn State University. He holds the Chartered Alternative Investment Analyst (CAIA), Chartered Financial Analyst (CFA), Certificate in Investment Performance Measurement (CIPM), Financial Data Professional (FDP) designations, as well as CFA Institute's Certificate in ESG Investing. He is a Past President of CFA Society Columbus and serves on the CFA Society Philadelphia Programs Committee. Aaron is an adjunct professor and serves on multiple advisory boards for Penn State University.