By John R. Minahan, Ph.D., CFA, and Thusith I. Mahanama, M.S.
Why do you think you have a shot at outperforming a passive alternative? This is the central question every active investment manager must answer.
Answering it requires a set of beliefs—an investment philosophy.
This paper takes a fresh look at the critical role an investment philosophy plays in helping today’s active manager define, execute and communicate the underlying beliefs that drive their approach to outperforming passive options. It describes how investment philosophy can be used for both investing and marketing purposes, provides a working definition of what constitutes an active investment philosophy—including key attributes of a viable investment philosophy—and offers views on how a well-articulated investment philosophy can enrich the investment process and facilitate external communication.
Key topics discussed
1. What is an investment philosophy?
We define an investment philosophy as a set of beliefs that guides an investor’s approach to investment management. With respect to active management, we believe a meaningful investment philosophy must, at a minimum, address the manager’s beliefs about: a) How the security pricing mechanism works and why it is that some securities are priced more attractively than others; and b) The skill sets necessary to identify and exploit attractive opportunities before prices move to eliminate the attractiveness of the opportunity.
2. What is not an investment philosophy?
Many managers confuse implementation-oriented concepts—what they do—with statements of beliefs—what they think—and often present them as their investment philosophy. Common examples of this confusion are “investment philosophy statements” that focus on: a) Investment Strategy; b) Investment Process; c) Investment Style; and/or d) Investment Objective or Goal.
3. Common myths about investment philosophy
We constantly encounter misperceptions and myths about what constitutes a “good” active management investment philosophy. Our paper identifies five of these myths: a) Investment philosophies should be data-driven; b) An investment philosophy should not change over time; c) Investment philosophy should be short and simple; d) All members of an investment team must share an investment philosophy; and e) Each investment manager should have a unique investment philosophy.
Each myth is deconstructed and used to illustrate what an investment philosophy is—and what it is not.
4. The benefits of an investment philosophy
Active investment managers make decisions that have far-reaching consequences for themselves, their firms, their clients, and the beneficiaries of clients’ funds. A set of theoretically sound beliefs about the markets—an investment philosophy—provides clarification and guidance to active managers in three critical areas: a) Defining the firm’s overall approach to investing and decision-making; b) Framing internal communication and risk management; and c) Facilitating external communication with clients, consultants and other stakeholders.
5. Essential components of a “good” investment philosophy
In order to be useful, an active manager’s investment philosophy must address the manager’s beliefs about how investment opportunities come about, why some opportunities are more attractive than others, and how the manager identifies and exploits those opportunities before others do. We believe it should also embody these attributes: a) It should be conceptually grounded; b) It should be fully informed of existing knowledge; and c) It should be open to new knowledge.
What justifies active management, which costs an order of magnitude larger than passive options? Evidence of future net-of-fees outperformance could be one justification. However, such evidence does not exist. Track records—performance, holdings, asset growth, personnel, etc.—provide a view of the past, not the future. Given the lack of evidence regarding the future, we think an investment philosophy provides the basis for a sound argument about why an active manager has a shot at outperforming passive options. Finally, we believe the wider use of investment philosophy in manager selection and monitoring may help identify managers with potential to outperform, drive mediocre managers to improve, and eliminate managers with no hope of adding value to clients—all good things for active managers, consultants, clients, and especially, fund beneficiaries.
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