As the mutual fund and institutional investment industry grew between the 1950s and 2000 a generally accepted approach to investing developed. This approach combined fundamental analysis with modern portfolio theory. This is the traditional approach to investment management.
More recently, over the past few decades, and alternative systematic approach has developed – rules based investing. This approach combines empirical data, computing power, and statistics.
In this article, we compare the two approaches and look at the pros and cons of each.
Rules-based investing vs Traditional Investment Management
Traditional Investment Management
The traditional approach to investment management uses top-down analysis and bottom-up analysis. Some investors focus on one more than the other, while others combine the two. The top-down analysis considers macroeconomic factors first, then sectors, then industries and finally companies. Bottom-up analysis considers the fundamentals of a company. The focus is on the company’s financials, management, products, and market. This is commonly known as fundamental analysis. Some investors focus on one more than the other.
Both of these methods attempt to forecast the prospects for share prices based on potential earnings growth and current valuation. Forecasts rely heavily on economic forecasts, interviews with management and analyzing financial statements.
Asset allocation models use macroeconomic trends and forecasts to allocate capital. The model will allocate the portfolio amongst asset classes. It will also allocate the equity portion amongst sectors and industries. The portfolio manager uses the results of the bottom-up analysis to construct a portfolio for a given level of risk.
The pros and cons of traditional investment management
The traditional approach works very well when the analysis is both contrary to what the market expects and correct. If an analyst can uncover facts about a company that is not widely known, they are rewarded. When the market discounts these facts, strong price moves take place.
However, this often happens less than investors would like it to. When analysts make forecasts they are vulnerable to a long list of biases. More often than not their analysis is already discounted into market prices. Consequently, the price move they are looking for has already taken place. When too many investors have the same idea, prices overshoot and then revert to the mean.
In addition, without a disciplined strategy investors in these types of funds tend to chase performance and react to short-term events. As a result, they find themselves behind the curve.
There are skilled managers who manage to get it right often enough to generate good returns. However, they often end up managing funds that are so large they lose their edge.
Rules-based investing
The systematic approach differs in two noteworthy ways. First of all, systematic strategies are based on empirical evidence. That means decisions are based on patterns that actually exist and relationships that can be statistically proven. Systematic strategies use measurable data such as price, volatility, earnings and cash flow. To a greater extent, they ignore forecasts and opinions. This eliminates the effects of bias which affects all investors.
Secondly, there is no room for the investor to react to emotions such as fear and greed. In addition, there is no room to react to short-term news events, the effects of which can’t be quantified.
The pros and cons of systematic investment management
Using a rules-based approach eliminates emotion and bias. It also exploits patterns and relationships between assets. Furthermore, it just doesn’t allow for investors to react impulsively.
There is another advantage for retail investors too. Often, even if an actively managed mutual fund performs well, the average investor in that fund misses out on that performance. The reason is that retail investors often invest in funds after they have done well, and withdraw their capital after the fund does poorly. The result is that investors capture the downside while missing out on the upside.
The weakness with rules-based systems is that there are occasions when an analyst might be both correct, and have an opinion that is not widely shared in the market. These occasions could result in generating excess returns or in reducing risk.
Summary
In theory, traditional approaches to investment management should work best. In reality, biases, errors, and emotions play a large role in determining how well a portfolio performs. It turns out that people are actually not very good at forecasting and as a result investments based on forecasts usually perform poorly.
Systematic investing has the advantage of exploiting patterns and relationships that are statitically proven to exist, while also eliminating emotions and bias. The downside is that systematic investors don’t get to profit in those few instances when their opinion is both contrarian and correct.