I was recently reading through an industry publication and came across some news that an investment firm, F-Squared Investments Inc., had filed for bankruptcy protection a few quarters ago. As it turns out, the American-based money manager admitted to fraud charges brought on by the U.S. Securities and Exchange Commission going back to late 2014. In addition to realizing that I need to stay a little more current on industry events, this story reminds me of a number of things that are wrong with how the investment industry works.
Rewinding back several years ago to when I worked for a previous employer, I was presented with the idea of investing some client money in a new product that our company was going to launch, managed by F-Squared. The background information that was presented to me was impressive. Their investment strategy was unique but easy to understand and their investment performance demonstrated relatively high returns with low risk, very impressive. Almost too impressive.
The basic premise of their investment strategy was to rotate investments in a combination of sector-based exchange traded funds (ETFs) and cash, based on their proprietary quantitative formula. The strategy seemed plausible and is one that is often lumped into a category of investment strategies known as Active-Passive. These strategies attempt to beat the market by placing bets against the market based on preferences for a sector, asset class, or country, but not specifically on individual stocks. This is a strategy that I often refer to as “guessing”.
A good analogy to compare an Active-Passive strategy to is the good old-fashioned coin flip. You guess the outcome of the flip and you are either right or wrong. So here is a question: If I am able to correctly guess the outcome of a coin flip 5 times in a row, does that make me an expert? Or am I just the lucky 1 in 32 people who probabilistically will get it right? Because it was a coin flip, many would be inclined to believe it is the latter. But when it comes to investing, many investors believe it is the former, whether they are investing themselves or believing in others. This is a well documented behavioural investing flaw.
Making a bet on investment sectors is really no different than guessing the outcome of a coin flip, and this logic can apply to almost any active investment strategy. Just because someone may be able to show a track record of good historical performance, it does not necessarily imply that they are skillful, nor is there any guarantee that the “expertise” will continue in the future. If it sounds too good to be true, it probably is.
Getting back to my investment dilemma, I was comfortable dismissing the much-better-than-market investment performance as luck rather than skill, but what was more problematic was the fact that the investment strategy also demonstrated low risk as measured by the traditional metric of standard deviation of returns (often referred to as volatility). Even if this strategy was destined to have a 50/50 success rate, or in other words equal to the market return, if it was able to do so with lower volatility than the market, then it may still be a reasonable investment (since most investors would prefer less risk to more risk if all else was equal). Too often, investors (including “professionals”) will get locked into a mindset based on common industry practices and stop here, concluding that it is a good investment.
Thinking about this a bit further, and considering that the investment strategy often employed large investments in cash, which has a very low measure of volatility, it made sense to me that the strategy should have relatively low volatility. Thinking further, if this strategy could produce abnormally positive results based on 50/50 odds, could the opposite not also be possible? The real measure of risk here was not the historical standard deviation of returns; rather it was the potential for abnormally negative results. But that way of thinking is rarely used in practice by investors since it involves forward thinking. Too many investment professionals focus on looking backwards so that decisions can be justified by “hard data” which is erroneously thought to be “proof”.
I am proud to say that I did not put one dime of client money into that investment, although it would seem that I was in the minority, as F-Squared Investments Inc. saw its assets under management growth absolutely explode upwards! To be fair, not for one second did I ever think that F-Squared was fraudulent. Predicting successful investments is difficult, but predicting fraudulent companies is even harder, although I am sure that there will be some people who will claim that they are “experts” at it.
Written by James Gauthier, Chief Investment Officer at Justwealth.