Now, on a subject as broad as investment, you might argue that the notion of not being able to come up with anything to write on seems implausible and if I were to use that excuse it would probably be to cover another reason for not being able to write. Yet on so many occasions I have sat with fund managers who have told me that they are “short of ideas” and so have raised their exposure to cash until they find more “good investment ideas”.
Now, is this fair? Can someone who is paid to build a portfolio of investment ideas – often supported by a team of analysts – genuinely say that they have run out of ideas? Or would this, as with me, be a poor excuse? Let us just think of the numbers for a moment. There are 604 stocks in the UK’s FTSE All Share, and – rather obviously – 3000 in the Russell 3000 US equity index. Globally, meanwhile, there are around 20,300 stocks with a market capitalisation greater than $100m (£63m) each. So, looking at these numbers, is it possible to run out of ideas?
It will come as little surprise that my answer is an unequivocal no. I do not believe that a manager can plausibly run out of ideas, with one proviso. Their investment process needs to be designed to have a degree of relative, rather than just absolute, criteria – by definition, on this basis, some stocks are better than others and so, with a sufficiently large starting universe of stocks, a process that is relative will identify a number of possible candidates for investment.
So why do managers claim to have run out of ideas? There are two principal answers: an excuse for market timing, and risk aversion. Taking each in turn, trying to time the market is all too common and is, in fact, often partly, if not fully, responsible for the statistic that the average fund manager underperforms their index. The problem is that fund managers are, in aggregate, not good at predicting market direction but, again, in aggregate, do not realise this and so hold cash when they expect the market to decline – or even, sometimes, when they expect it to stay flat. Frequently they are wrong and the market rises, so delivering a cash drag on the portfolio. This is bad in any case, but what, in my view, compounds it is the fact that even in aggregate down markets there are many stocks which will give positive absolute returns. In other words, even if a manager is right that an overall index will decline in the next three months, a good stock picker could, in theory, find sufficient stocks that will rise in this period to build a portfolio. And besides, this is a relative, not absolute, game. Owning stocks is closer to a manager’s investment objectives than holding cash, even if the expectation is for a market decline – cash is just the easy option when good ideas become harder to find.
What about risk aversion? All equities carry a degree of risk. Particularly in times of market volatility, it is easy to think that every stock is more risky, and so many fund managers prefer the ‘safe haven’ of cash. But this is perhaps more laziness than actual investment-driven. If sufficient analysis is carried out on a stock, surely a good fund manager with a talented analyst team should be able to accurately assess its risk? What we see, however, is that fund managers often prefer to avoid these difficult decisions, and to hold cash. Managers will also cite avoidance of concentration as a reason to hold cash when they struggle to find good ideas. Rather than holding more in each of the names they have managed to identify, and compounding any mistake in markets when outcomes are uncertain, they spread their risk by diversifying into cash. Not only is this short-term investing, when managers should have a longer-term investment horizon, but again it could demonstrate a reluctance to do the hard work, and look more widely for those companies they perhaps know less well or have not owned in the past, but which now fit their investment criteria. On those rare occasions where there truly is a shortage of ideas, a good manager should have enough confidence in his research process to hold larger weights in his higher conviction names.
All equities carry a degree of risk. Particularly in times of market volatility, it is easy to think that every stock is more risky, and so many fund managers prefer the ‘safe haven’ of cash.There is a danger that some managers unintentionally narrow their investment universe by focusing on a core ‘comfort’ zone of stocks which they have owned in the past and know well, ignoring those which are less well understood. For some managers, building a universe of companies that they know well and have researched extensively for a long period of time is part of a clearly defined philosophy and works well as an investment strategy. But for those who claim to start with a broader universe of ideas, not fully exploring that universe in times of market change or uncertainty is a wasted opportunity to generate returns for their investors.
As someone once said: “Opportunity is missed by most people because it is dressed in overalls and looks like work.” A fund manager who has ‘run out of ideas’ possibly needs to look again more closely at his universe. Fortunately there are managers who understand the importance of turning over stones to find those good ideas and so avoid the easy option of cash.
James Bateman is head of manager selection in Fidelity’s Investment Solutions Group
