Simplicity is not just a business and regulatory imperative. Investor revulsion at the global financial crisis has led to a renaissance for simplicity. Certainly the complicated mathematical models so beloved in some quarters of finance have lost significant credibility by failing to predict the crisis. With our strapline as “simply asset management”, Aberdeen believes that “keeping it simple” needs to be embraced by financial services as a whole.
Concerns about short-termism in markets, government thinking and corporate strategy have only increased in the wake of the global financial crisis. Addiction to leverage, derivatives and greed that caused the market to become a “casino” would only have been possible in a business culture where short-term gains are prioritised over long-term costs. Companies, shareholders, traders and politicians are all increasingly short-termist, irrespective of the social and other costs. Some of this is pure human psychology: we undertake excessive discounting of the future in favour of the present and an innate bias towards action.Self-awareness and discipline can help.
Transparency makes investors confident they understand what they have bought and builds trust. The global financial crisis witnessed a failure of transparency around mortgage-backed securities. Openness helps to counter market ills such as moral hazard, asymmetric information and principal-agent problems. But transparency is not a silver bullet as risks come from different directions and data overload can lead to complexity.
The central tenets of modern portfolio theory and beliefs in rational markets have been found wanting. Critics have observed that Sharpe’s “Capital Asset Pricing Model” (CAPM) and the Modigliani-Miller theorem were written during periods of extreme market stability. The standard neoclassical model assumes that an extraordinary expectation of rationality that people carry out a full rational analysis of all their available options when making decisions. Life and behaviour are not like this
The main criticism of active management is that the cost of performance is expensive relative to passive investing and that most active managers underperform. But funds which have a high “active share” typically outperform. “Active share” defines how similar or different the securities in a fund are from its benchmark.
The idea of convergence in economics gained currency in the 1990s on the back of the theory poorer countries’ per-capita incomes tend to grow at a faster rate than those of richer economies. Hurdles include how much macro-economic policies encourage greater balance and equity in the distribution of the fruits of growth. Convergence has driven the sorts of companies we believe will succeed as a result of themes such as a growing middle class and the success of well-established industries that will help power the economies of Latin America, India and increasingly China.
Outcomes and solutions
Low yields, volatile markets, extreme events and pressing demographics are all driving attention towards solutions-based investment. Pension funds are under pressure, and there is a need to be able to find asset returns in a difficult environment where even sovereign risk is actually risky. Opportunities to succeed will lean on those asset managers who are able to develop more flexible and dynamic asset allocation in their models.
Risk is always going to maintain an air of mystery. Its elusive tendencies will unlikely ever be fully conquered. However, by thinking more intelligently about it, accepting our cognitive limitations when trying to tame it, we can make progress, by making better policy decisions at the macro-economic level and better investment decisions at the portfolio level. And so as we wait for the academics and industry professionals is to invent the 'mathematics of surprise', we must adopt a practical and thoughtful approach to dealing with risk.