A recent conversation with a friend caused me to go back and read a 2012 speech entitled “The dog and the frisbee” by Andrew Haldane (member of the Bank of England’s MPC) and one of his economist colleagues. The paper looks at appropriate strategies for financial market regulation, and the premise behind the title is that whilst catching a frisbee involves a series of complex calculations involving physical and atmospheric factors (such as wind speed, rotation of the frisbee, speed of frisbee launch) the task can be completed not only by a human with absolutely no understanding of the physics behind the action, but by your average border collie. Indeed, by using one simple rule (which studies have shown dogs employ; that is run at a speed so that the angle of the dog’s gaze to the frisbee remains roughly constant) dogs complete the task. Humans apparently use an identical rule of thumb when attempting to do the same.
Over the next 20 pages, the authors argue, using empirical and theoretical justification, that the world of finance is too complex for detailed rule books (such as Dodd Frank in the US and Basel III global banking regulations) to fully cover all risks and their correlations thereof. Instead, they suggest that if financial services oversight is to be effective, it needs to stick to fewer “broad rule of thumb” tests, and more experienced monitors who can use that experience to see the whole picture of what is happening to the industry, or a firm or product type within the industry. Less time looking at trees – more time looking at the whole wood. To paraphrase their conclusion – modern finance is complex; you cannot fight fire with fire, so equally complex regulation is likely to fail.
This harks back to various attempts in the past for the FCA/FSA to invoke “principles-based” regulation – where those of us in the industry were instructed to run our businesses with broad commandments like “thou shalt conduct your business with integrity” and “thou shalt not lie to the regulator”. Which was perfect until someone out there broke one of the commandments, and the rest of us were punished with countless rules to stop it happening again. It is easy to see how regulators get sucked into ever more reams of rules and obligations. However, they are almost always fighting past wars – not the one about to face them.
There is a point to this ranting, because reading this paper got me thinking about the same challenges in equity fund management and stock selection. The canvas is essentially the same – we have an immensely complex inter-relationship between the future (and therefore unknown) trading performance of a business, and calculations made by countless individuals about what that business might be worth as a consequence. Then selecting the right number (out of thousands of possible candidates) of these businesses in the right portfolio structure (with an infinite number of combinations available to us) stretches human and computer analytical skills to the extreme. Many market participants try and fight fire with fire and try and combat such complexity with equally complex models that analyse and react to data that changes every second. It is no surprise that global investment banks are amongst the leaders in pushing the boundaries of what is possible in supercomputing.
I found it comforting when reading “The dog and the frisbee”, that we seem to be much more in tune with the authors’ approach to dealing with financial services complexity. We stick to a few, basic touchstones. We buy established business, that are cash generative, that have the capacity to generate attractive returns on shareholder assets, and operate in a business environment that will allow that to be sustained over our investment horizon. Beyond that, we let our fund managers do what they have done for years, if not decades. Let experience guide what might seem to be an instinctive approach to building a portfolio, but is in reality a pragmatic application of those broad rules.
In addition, the authors make a compelling case for simple, evenly weighted portfolio construction over complex “risk adjusted” weightings of different assets in a portfolio.
The dramatic impact on emerging market currencies last year when the first sign of a reduction in US quantitative easing appeared shows just how interlinked (and in many ways, surprising) the global economy is. This is predominantly a new phenomenon. We do not have a massive back store of empirical data that covers this type of environment. So as fund managers, like regulators, we are better keeping timeless or classic principles at the heart of what we do.