An investment manager must have the ability to understand how the world is changing and what will work in the future (this is not necessarily what worked yesterday) to consistently deliver on client outcomes in an uncertain environment. These insights will come only from the presence of an effective research capability. This means that financial advisors are well “advised” to understand that the world is uncertain and to look at investment managers’ research capabilities to assess their ability to be consistently effective for their clients in the evolving future.
The Holy Grail is a mysterious object¹ that would confer magical powers of healing and longevity onto its holder. There are many stories detailing the search for this desired object. While it is almost certainly a myth, the idea that such a powerful object exists, and can be found through diligent study and exploration, is very similar to the way the research process drives an investment manager’s pursuit of the goal of consistent outperformance (or “alpha”). It’s the way they differentiate themselves from their peers and it allows them to respond appropriately to a continually changing environment.
Risk relates to situations that can be described in terms of probabilities.
Research can informally be defined as the process of deriving new knowledge about the world that is relevant to the task at hand. Investment managers need to make decisions about where to allocate their (clients’) capital in an environment that is both risky and uncertain². Careful research into the past, linked with the development of theoretical models of the current environment, offers the ability to navigate the future more reliably. Research is thus fundamental in terms of determining the future success of any investment manager.
Research’s importance becomes very clear if we distinguish between risk and uncertainty. While these terms both refer to a lack of knowledge about the future, the nature of this missing knowledge is fundamentally different between them.
Risk relates to situations that can be described in terms of probabilities. For example, the specific outcome of the roll of a roulette wheel is not known in advance, but there is a very clear set of (fixed) rules which define the set of outcomes, and this allows for a set of probabilities to be applied to each of them. In a risky world research involves the estimation of these probability distributions and the testing of different strategies to deal with them. While this is a challenging task it is potentially solvable in the sense of developing and implementing investment strategies that should work well enough over multiple rolls of the roulette wheel.
Unfortunately, we live in an uncertain, not a risky world. Uncertainty refers to an environment where the set of outcomes is not (or in fact cannot be) defined, and thus cannot be described completely in terms of probabilities. Taking the roulette wheel example above, we might find, in an uncertain world, that after the wheel has been spun, that there are a different number of slots in the wheel to the 37 that we assumed to be the case (maybe because that was what it was last time). In this world you not only have to estimate the distributions, but you also have to work out how they are going to evolve into the future.
This suggests that risk-based analysis is not sufficient as it is based on data drawn from the past – which may no longer be relevant. It implicitly assumes that the current environment is sufficiently like those that we have observed in the past. In other words, it assumes history will keep repeating itself, whereas in reality, at best it only rhymes. We live, manage money and must give advice in an uncertain world as it is continuously developing.
The investment in an effective research capacity is thus a fundamental part of an investment management firm’s success. Consistent investment performance requires the ability to correctly evaluate the world from both a structure and risk assessment perspective, and then correctly update this evaluation as the external world changes. Using the roulette wheel metaphor: investment managers need to know both how many slots on the roulette wheel are there currently and what number it will be tomorrow.
The Holy Grail, in this context, is doing this in advance of such changes to make sure that you are correctly positioned for them. While this is effectively impossible, it is still worth searching for the Holy Grail because it is the only way to continue to succeed in an uncertain environment. There is no guarantee that yesterday’s perfect strategy will continue to work as perfectly today.
From an advice perspective, financial advisors need to be able to effectively understand and communicate to their clients the reality that we live in an evolving and therefore fundamentally uncertain world. They need to be able to guide their clients through this world. Firstly, clients need to know that what worked yesterday is unlikely to work the same way tomorrow. This is part of life and must be expected. Secondly, understanding and assessing the research capabilities of investment firms will lead to more effective investment management choices. Sharing these insights with your clients should help them understand that the investment managers you have advised them to invest in will be more likely to be successful in the future as the world evolves.
¹ This was purported to be the cup that Jesus Christ used at the last dinner and which would later be used to collect his blood during his crucifixion.
² While it is common for these terms to be used interchangeably, they do not mean the same thing. The key differences between these terms is explained later in this article.