Be Open Minded

Three weeks ago, my wife and I had the pleasure of hosting two financial advisor colleagues for a few days during their visit to Colorado. The husband & wife duo own an advisory firm in Austin, TX. Like my company, they offer financial planning and investment management on a fee-only basis.

But that's where the similarities stop.

They employ a tactical strategy in client portfolios. This means they adjust what asset classes they're invested in at any given time. Their philosophy is that there are times to be invested, and there are times to be out of the market. Our philosophies couldn't be more polarizing, and our conversation regarding our different approaches was definitely interesting!

Semantics?

The first thing they will say is they are not market timers, since they define market timing as a "very short-term strategy in which the investor trades from day-to-day based on presumptions about what the market will do on that day".

I couldn't find a single definition of market timing aligning with their short term definition. The rest of the world defines market timing as any trade based on an attempt to predict future pricing. Market timing is a dirty phrase these days, so they've modified the description to make what they're doing sound better (or at least less offensive).

I would challenge an investor trying to determine optimal market entry and exit points, does the time frame really matter? They're still choosing a specific time to buy and sell. That's market timing folks! It rarely works. Just ask all the market timing Fund Managers Who Chronically Underperform Their Benchmarks.

Rules

When I asked why their approach is superior to all the other actively managed strategies, I received an answer I really liked. "Active managers break their own rules. After a trade, they second guess themselves or they adjust the criteria by which their next trade(s) are based on". To clarify, I asked if they were failing their own processes. "Absolutely, yes".

I would note that active management must also overcome higher fees, the incentives influencing fund managers (to either take more risk or hug a benchmark, both being detrimental to investors), as well as when a strategy gets too big for its' own good (tough to manage to a concentrated philosophy). But those are all for other blog posts.

I'm a process guy, borderline OCD for that matter. I really like rules. I appreciate the commitment to a process. It makes sense that an active manager can be his own worst enemy for not sticking to the game plan. Rules + Process = Better Outcome.

How Do They Know?

When their portfolio manager explained that "Historically, many market characteristics tell us when we are entering a bear market and when we are entering a bull market", I couldn't help myself with a full court press on what exactly are those indicators. Here it comes, the holy grail of what predicts market movements! But, I never received an specific answer. "Phenomenons such as interest rates, unemployment, valuations can predict the market" was all I was going to get.

I'm smart enough to know that there are a hundred potential factors that influence which way the market winds blow, but I wanted more. I wanted to know at exactly what P/E ratio signals large caps are now overvalued. I wanted to know what other thresholds within the economy historically correlate with different market environments. I was dying to understand how it was possible to know exactly how to position a portfolio for such a unique event like the Brexit earlier this summer.

Unfortunately, I had to accept that all I was going to get was the picture on the box, not the step by step instruction guide within. When someone is trying to convince you to do something but is vague regarding exactly why or how, use caution.

So What Did I Learn?

I'm still fascinated with beating the market. There are various strategies to do so, and each one feels theirs is superior. It never hurts to understand why someone does something different than you. Many times you'll actually evolve your own beliefs and correlating strategies as a result. This is usually a good thing!

I also learned that active managers have their own Professional Group. They also have a nifty "Exposure Index" that charts the average current allocation to US stocks based on member voluntary reporting. I suppose if you are an active manager and don't know what to do next, you could always just follow the herd.

Last, I realized that the average investor doesn't know if a market timing approach is best or not. Within the vacuum of not possessing all relevant information, timing the market to achieve superior returns sounds like a no brainer, right? Careful with that...

The Challenge Is Real

For every trade, there has to be someone on the other side willing to bet against you. Active managers have to consistently get both the buy and subsequent sell correct. There are many examples of active managers outperforming over shorter time periods, but can you rely on 1. your ability to identify them in advance, 2. avoiding them when they underperform, and 3. any shred of consistency?

As a buy & hold + rebalance strategist, I don't expose client money to these very real portfolio threats. My clients can expect to track the market, while sometimes earning a little extra return from Factor Premiums.

Although I respect my colleague's rules, they never fully explained those rules. Highly annoying! Additionally, they don't have a long term track record to judge performance or risk over multiple market cycles. So for me, the idea of beating the market through timing strategies will remain a romantic one.

At least I'm open learn more about how they're trying to over time. I could've just written them off, and I would have never had the outstanding professional conversation that I did. What fun is that?

Just like in life, being open minded approach exposes you to alternate ideas, reduces at least some of your bias, and most times the combination of those two things results in superior decision making.

#investorbehavior