Once upon a time, portfolios were constructed via story-telling. Once built, they were marketed via data.
Our understanding of how returns are generated has changed in the past two decades, which in turn has led to a change in ways the financial industry assembles, manages and markets investments. In broad terms, the paradigm has been flipped on its head: Portfolios now are carefully constructed based on data and marketed by way of narrative story-telling.
For those who doubt this inversion, let’s do a little comparing and contrasting. If you started in the industry before the dot-com implosion of 2000, you have surely heard some variation of these from asset managers for adding a stock to a portfolio:
* “This company has great competitive advantages.”
* “Revenue and earnings can surprise to the upside.”
* “We love the way the company is executing on its business plan.”
* “The business is gaining market share at the expense of the competition.”
* “One of the most innovative companies we have ever seen.”
* “Their product pipeline is second to none.”
* “The quality of the company’s management is top notch”
These statements imply unique if not anecdotal insight into the future performance of a company, and more importantly, its stock. This may seem quaint to readers of a younger generation, but this is how lots of professionals once selected stocks for mutual funds, which retail investors would buy, paying a stiff annual management fee for the privilege.
Some money managers still seem to operate this way. It’s a squishy, imprecise approach, more art than science. Aside from a very small handful of exceptional money managers, most people are not very good at it. The problem for investors is one can only identify the outperformers after the fact.
By then, it’s too late to be of any use.
And the marketing back then? Strangely enough, it was mostly driven by numbers: the fund’s decile performance rankings; total net return to investors; Lipper (now part of Reuters) scores, ValueLine measures, Morningstar ratings. It all looked like a mathematically sound as a basis for which funds to buy.
Many publications — Money, Barron’s, Kiplinger’s, Smart Money, Fortune, ValueLine, Forbes, US News — would create rankings and annual lists of mutual funds to own. That they did this based on past performance, despite Wall Street’s insistence that one should not, is almost beside the point.
Of course, all of the lists, rankings and breathless articles on why ABC Fund was better than XYZ Fund was fodder for the mutual-fund families to use in their marketing and advertising. All it took was a casual glance at the ads in those publications, in which fund providers touted their ranking on this list or that.
There was nothing nefarious or particularly misleading about this; it was simply how business was done in the 1980s and 90s.
The world has changed a lot since then. Today, investment portfolios are assembled via math and marketed via story-telling.
Consider the major investment trends during the past two decades: indexing, the rise of quantitative funds, factor-based investing, smart beta, exchange-traded funds and all of the variants: Their creation is primarily driven by math. Even socially responsible and ESG (environmental, social and governance) investing, which is heavily dependent upon narrative, is more easily and cheaply constructed these days via computer-driven modelling.
Dave Nadig, managing director and ETF expert at CBOE, in an email notes that “the active vs passive debate is really just this tension between narrative and data playing out. Passive, indexed strategies are all just math, so marketing folks have to create stories to drum up interest.”
This distinction is easy to overlook. Consider indexing, which during any 10-year period beats almost every other approach after fees. Selling it requires telling a tale to interest potential investors.
When I write about how emotional investors can be, how their cognitive errors lead to mistakes, I am really constructing a narrative. I can’t simply say you should buy an index and then do nothing else; that’s incredibly dull. I can, however, create a story that makes it clear to readers why doing something else will likely lead to a worse outcome.
And so we use stories of how we should be investing our capital, turning to compelling narratives — if only because the probabilities and statistics that inform us about future expected returns are likely to bore most of us, even if the actual outcome is better.