The Intelligent Fund Investor: a sceptic’s guide to investment

Joe Wiggins’ new book is an enlightening guide to how the stories we tell about markets can be harmful to investors

I’ve read a fair amount of the burgeoning literature applying behavioural science to investment, but Joe Wiggins’ new book The Intelligent Fund Investor, published just before Christmas, is a fine addition to the field, with important new things to say.

The book has parallels with others concerned with the psychology of investing from which I have learned much, including John Stepek’s The Sceptical Investor and Andrew Lo’s Adaptive Markets. As with those, Wiggins’ premise is that financial markets are simply too complex to interpret on a meaningful and consistent basis. As he puts it: ‘Economies and markets are extraordinarily complex; an innumerable, intricate web of interrelated and dependent interactions. It is absurd to believe we can accurately explain what has happened, let alone what will happen.’

And yet the asset management industry is built upon the belief that we can. Though himself a fund manager, Wiggins, a sociology graduate, is less interested in trying to trace order in economic fluctuations than in discerning the boundaries of what we can know, coming to terms with those limits, and designing humble investment strategies likely to capture something of the wealth that markets, however erratic they may be, undoubtedly generate.

The Intelligent Fund Investor follows his blog (well worth a look) in developing the principles of behavioural finance, casting a forensic lens on the received beliefs and prejudices that tend to guide portfolio construction. The result is something of a deconstruction of a sprawling investment industry built on the reputations of star managers, the confident prophecy of new trends, and a swelling multitude of ever more complex funds. For Wiggins successful investment is about cultivating the discipline to look at economic data with clear eyes and to rest content with the low key strategies most likely to accumulate wealth over the long term. It is more important to master oneself than complex financial forecasts: ‘Intelligent fund investors must understand themselves better than they understand markets.’

Searching for order in chaos

The essence of the book’s argument is captured in a powerful chapter on the asset management industry’s preoccupation with storytelling. With their ceaseless flux and obscure chains of effects financial markets are as disconcertingly contingent as the world itself. We long to discern order in chaos. When we look at the past performance of markets, ‘we don’t see randomness and noise — we see an arrow.’ And when contemplating the future we ‘never see a random chain of events, rather a pre-ordained path, with one step inevitably leading to another.’

Fund managers take full advantage of our chronic need for stories, weaving narratives out the patterns that briefly shimmer into view amidst the noise of economic data. Take, for example, the current trend towards thematic ETFs. When the strong performance of an emerging market sector — battery metals, hydrogen, cannabis — captures analyst and investor attention, managers are quick to develop funds promising access to the vector. But by the time the fund is launched the moment is likely to have passed: whatever alpha there was has already been exhausted. Wiggins suggests that most thematic funds are ‘price momentum strategies cloaked in a story.’ Even funds offering access to undeniable mega trends, like the transition to a green economy, are premised on the ‘herculean’ assumption that managers can pick stocks both sufficiently accurate and broad to capture it.

We are also deceived by our natural tendency to project a fund past performance into the future. Wiggins considers this ‘outcome bias’ to be ‘the most influential behavioural weakness in fund investing.’ Rather than expecting good performance to continue we should interpret high valuations as a sell rather than a buy signal, an indication that the tide will turn and the market will revert to its mean. There are good fund managers, but they should be judged on their process rather than their past record. Good future outcomes ‘should be a consequence of our investment decision making, not an input.’

Even then, we should be sceptical of managers’ claims to be able to discern the future. Many active funds have responded to the rise of index funds by presenting themselves as ‘conviction’ portfolios, concentrated selections curated on the basis of careful research guided by a clearly stated investment philosophy. The powerful role model is, of course, Warren Buffet’s Berkshire Hathaway, a long term winner constructed from a relatively narrow set of judiciously selected securities (Buffet’s periodic portfolio adjustments still make headlines in the investor press).

It’s a wholly understandable trend given the persistent practice of ‘index hugging’, according to which supposedly active funds quietly trace the index for fear of departing too dramatically from the market return. But Wiggins argues stock concentration is another story of which we should be wary. He cites the deservedly influential 2018 study The Pursuit of Extreme Returns by Hendrik Bessembinder commissioned by Baillie Gifford which showed that the long-run returns of equities have historically been produced by a fraction of companies: the wealth accumulated by the US equity market between 1926 and 2016 was generated by less than 5% of securities.

Unsurprisingly Baillie Gifford presented the study’s striking findings as evidence for its philosophy that funds should be concentrated, focused on the magic circle of emerging and future winners. But for Wiggins this is ‘the exact opposite of the view that should be formed’. It is an argument for diversification rather than concentration. Even the brightest fund managers do have the foresight to identify and hold the big winners of the future. Diversification is the only way to guarantee that over time we will have exposure to the right companies. Baillie Gifford’s narrative feeds on our natural discomfort with diversification, the obligation to hold many, many losers along with the select group of winners. A diverse portfolio ensures exposure to the success stories, but at the significant cost of dilution. The cautious investor, however, will resist the siren call of concentration, and rest content with the steady returns an appropriately diversified portfolio is likely to bring.

Two cheers for passive funds

Given his scepticism regarding the claims of even the best active managers it’s no surprise Wiggins likes passive investing. But the now conventional advice that mainstream investors should be content to hold a set of off-the-shelf low cost index funds is another story that should be examined. This is an emerging orthodoxy based on the exceptional performance over the past decade of cheap market cap index funds — funds that weight firms according to their value — against their active counterparts on mainstream indices such as the S&P 500.

Close examination of the hard data, however, shows that the recent outperformance of market cap funds has depended on prevailing market conditions rather than any inherent superiority. Quite simply, they perform well when the big companies that dominate mainstream indices do well. S&P 500 trackers, for example, have done well because the giant tech stocks that account for an ever greater proportion of the index — Apple, Google, Tesla, Microsoft et al — have boomed over the past 10 years. But it was a different story over the preceding decade, when, in the wake of the tech blowout at the turn of the millennium, the last wave of growth firms foundered, opening the way for smaller ‘value’ stocks to shine. In those years market cap funds fell behind those weighted towards smaller companies. Indeed Wiggins cites research showing that market cap funds — had they existed back in the 1960s — would have lagged for much of the period between 1968 and 2011. This explains why market cap funds focused on the FTSE index have done less well in the past decade than their US counterparts: the FTSE is not so dominated by larger companies. All this sounds very simple once stated, but it is rarely noted, and it is much to Wiggins’ credit that he emphasises it here.

The future success of market cap index funds, then, will depend on the continued outperformance of larger companies. And that may well turn out to be the case. Today’s big tech companies are more substantial enterprises than the speculative stocks that drove the 1990s dot.com boom. Their struggles over the past year, however, indicate that the tide may once again be turning. It’s too early to say. Wiggins suggests a simple hedged strategy. Half of a portfolio might be allocated to a market cap weighted fund: since it represents the aggregate views of all investors we should expect half of all active funds to perform it and half to underperform. The other half should be allocated to non-market cap funds, reflecting the fact that their relative performance varies through time. Those need not be traditional active funds, but different kinds of index funds, such as equally weighted, smart beta or alternative trackers. Just as with traditional 60/40 equity/bond portfolios, investors might want to adjust the balance in response to market conditions. When market cap funds are performing exceptionally strongly, for example, it might be prudent to increase allocation towards equal weighted funds in anticipation of a change in sentiment.

Another chapter notes that all of this will only be effective if investors can summon the patience to invest for the long term. The ‘higher returns available for a long-term approach only exist because it is difficult to do.’ The challenge is psychological rather than technical, of resisting noise and the tendency to change course during market drawdowns. Both passive and active funds underperform relative to their peer group over long periods — three to five years or longer over a 25 year period — enticing many investors to sell out. Wiggins notes that investors would only have benefitted from an exceptional fund such as Berkshire Hathaway had they had the patience to hold for the long term: for more than 40% of observed three-year periods Buffet’s fund trailed the market. The desire to chop and change in response to evolving conditions is influenced by another story, useful in other parts of life: that we should always strive for the optimal outcome, making continual improvements in response to changing circumstances. That is not true when it comes to the uncertain world of the markets. Here, to use the term coined by the economist Herbert Simon, we must ‘satisfice’: settle for the least compromised option our limited knowledge affords us.

A recommended read

In the spirit of the book, I should note that my receptiveness to Wiggins’ argument is filtered through the cautious investment philosophy I brought to it. History suggests that some investors have succeeded in beating the market over time. But they are very few. And it isn’t clear how much of that can be attributed to luck rather than skill: read for example the ongoing debate as to how much of Buffet’s return is due to preternatural wisdom as against specific circumstances that might have prevailed when he was securing the highest returns. Berkshire’s performance has dipped in more recent years. For most investors - myself included - for whom the markets present too great a challenge, the wisest course is to develop a considered, patient strategy, and stay the course. Wiggins’ well written and tightly argued book, from which I learned much, is a valuable contribution to what might be called the sceptical school of investment. I’ve picked out a few of the themes covered here, but there is much more. Highly recommended.

The Intelligent Fund Investor by Joe Wiggins is published by Harriman House. Photo by Zdeněk Macháček on Unsplash.