Price discovery: the alpha-seekers dilemma
In his recent Financial Analysts Journal article ‘The Rise (and Fall) of Performance Investing[i]”, Charles Ellis among other things, frets that improving market efficiency increases the difficulty of locating managers who will produce consistent alpha. He reminds us “Price discovery is the skillful process of identifying pricing errors not yet recognized by other investors.” Ellis observes”… the skill and effectiveness of active managers as a group has risen for more than half a century, producing an increasingly expert and successful (or “efficient”) Price discovery mechanism.”
The article postulates;”As the skill of competitors converges, luck becomes increasingly important in determining the increasingly meaningless performance rankings of investment managers.” It warns “Investment professionals know that any long term performance record must be interpreted with great care.” As evidence, Ellis offers a study of investment performance produced using manager selection consultants. “Despite considerable time and effort and access to managers’ data, the self-chosen task of investment consultant firms has proved far more difficult than expected. As a group, selection consultants have caused their clients to underperform by 1.1% of assets.”[ii]
Given the uncertainty of finding managers who will consistently add alpha, Ellis suggests we re-emphasize “Values discovery” in our client relationships; which he defines as “…the determination of each client’s realistic objectives with respect to various factors, including wealth, income, time horizon, age, obligations and responsibilities, investment knowledge and personal financial history, and designing the appropriate strategy.”
Does Values discovery produce measurable results?
Happily, according to recent Morningstar research, Ellis’ “Values discovery” earns our clients, large, tangible returns. In their Morningstar paper “Alpha, Beta, and Now … Gamma”, authors David Blanchett and Paul D. Kaplan[iii] “… introduce a concept called “Gamma,” which is designed to measure the additional expected retirement income achieved by an individual investor making intelligent financial-planning decisions.
“Measuring Gamma: Although financial planning spans a tremendously broad range of potential decisions, in this paper, Blanchett and Kaplan start out by measuring Gamma for five specific retirement-based planning issues: determining asset allocation based on total wealth; applying a dynamic safe withdrawal rate strategy; incorporating guaranteed retirement income products (e.g., annuities); making tax-efficient allocation (i.e., asset location) decisions; and optimizing the portfolio by treating client cash flow needs as liabilities and matching investments and their risks appropriate to manage (and hedge) those liability needs”[iv].
Surprise: Values discovery is more accessible and powerful than Price discovery
To gauge planning’s contribution; the research compares a base case – what investors do on their own, against against a set of retirement planning strategies. While the improvement varies with client circumstances, the authors found the planning strategies make a significant difference;”… a Gamma of 28.8%, meaning $1.29 for every $1 generated by the base set of assumptions.[v]” So taking a smarter approach to generating retirement income (by working with a planner) earns investors substantial tangible rewards. Unlike Alpha, everyone can earn Gamma because better planning is not a zero-sum game.
Holistic approach: blend Values and Price discovery
Based on evidence that used alone, each yields much less benefit than the combination, orthopedists prescribe a combination of surgery and exercises to treat an injured limb. Similarly, Ellis describes the practice of investment management as “two hands clapping”; “…one hand based on the skills of Price discovery and the other based on Values discovery.” Advisors employing the two-handed approach blend Alpha and Gamma consistent with their firm philosophy and appropriate to each client.
Ellis concludes “[Values discovery] is an admirable way forward that would inspire client loyalty—with all the attendant long-term economic benefits—and would provide practitioners with deep professional satisfaction. Although not as exciting as competing on Price discovery, investment counseling based on Values discovery is greatly needed by most investors—institutional investment committees as well as individual investors—and surely offers more opportunities for real long-term success to both our profession and our clients.”
[iii] David Blanchett and Paul D. Kaplan; “Alpha, Beta, and Now … Gamma Measuring the importance of intelligent financial planning decisions.”, Morningstar Advisor December/January 2013 pages 60 -63 Article Link