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Models behaving badly: Prospering in an era of financial transformation

January 14th, 2014 by

An exclusive Q&A with Tyler Mordy of HAHN Investment Stewards uncovers why a "supermodel" is now irrelevant


The supermodel era is over. But unlike today’s “It Girl” and her fifteen seconds of insta-fame, many investors are still banking on traditional financial models despite an ongoing global economic and financial re-alignment. According to Tyler Mordy, President and co-CIO of HAHN Investment Stewards, it should now be obvious that “supermodel” approaches are no longer working. Tyler is on a mission to expose these “models behaving badly” and provide an investment makeover through an alternate investment strategy: exchange-traded funds (ETFs).

Models behaving badly: Tyler Mordy explains

  • Q: It’s become almost expected for fashion idols to get caught misbehaving. What models are you referring to specifically as “behaving badly”?

Well, I wouldn’t know much about fashion models as I spend most of my time laboring in the less glamorous (but no less exciting) world of finance. The models I study are of the financial type.  

And we have arrived at a unique period in history. Many of our models have lost their forecasting abilities. These are models that worked reasonably well during the post-war period and especially in the lead up to the global financial crisis.

Despite trillions of dollars in policy stimulus from worldwide central bankers and interest rates tethered to near-zero, inflation is actually declining and economies are not gaining the self-sustaining traction that has been widely forecasted.

What marks our time is the immensity of policymaker’s response. Before the financial crisis of 2008, this scale of government intervention was unprecedented. And massive intervention has only prompted a modest business expansion. Five years on, “slow growth” still lingers despite soaring investment markets. In 2013 alone, the balance sheet of the U.S Federal Reserve expanded 37% to surpass $4 trillion yet, for example, employment levels are far lower than where they should be.   

More than ever, investors need to be informed of policymaking actions and be ready to respond in portfolios. The above factors are not fads - they are structural issues that will be with us for some time.

  • Q: Models are supposed to be showing us the latest trends. Why are so many investment strategists still insisting on an outdated approach?

The simple answer is behavioural inertia. Investors have a hard time conceding that the paradigm has changed and are more comfortable doing what they have always been doing, even though that may be the riskiest position. 

For example, we stock our wardrobe with the latest trends - justifying the purchases with the notion that an expensive suit or dress is “for life” - even though we know from personal experience that trends change over time (just look back at what you were wearing in old photographs from 20 years ago!).

There is also a second reason and that is the concept of “physics envy”. Many of us in finance experience this envy, desperately wanting our models of economic systems and financial models to be as predictive as the laws of motion in physics. Unfortunately, it cannot be that way because in finance, you are modelling human behaviour, which is based on changing regimes and ephemeral opinions.

The lesson is simple. When we rely too much on a steady state for our financial models, it creates a dangerous illusion of safety. History is full of examples where investors became too comfortable with quantitative methods.

  • Q: What has been the impact of outdated investment strategies on us as investors? Have we all been caught out in our mom jeans?

Well, I have “dad jeans” so I won’t judge those with limited fashion discernment.  But every financial crisis leads to behavioural changes - even if they are only temporary.  This one will be no different.

The question is whether investors will learn the right lessons. We are beginning to understand what the investment world will look like in the aftermath of this crisis, but it is not too early to learn important lessons that can improve the way portfolios are managed.

To date, many investors have simply recoiled - fatigued by two difficult market periods in the last decade. But we are encouraging investors to go a step further than just risk tolerance. Examine the basic investment structure that you have been using and challenge conventional methods. The good news is that many investors are becoming more strategic in their thinking.

  • Q: You are calling for a makeover - a new era of investing. How is your team at HAHN bringing the edge back for investors?

Many of the intellectual models and industry standards that were created during the great bull market of the 1980s and 1990s are simply outdated.  That doesn’t mean that we are repudiating basic portfolio management principles that have served investors well - diversification, maintaining low costs, and so forth. 

But we certainly do think that much of what the industry has been doing in the past - and still are doing - will be ineffective for the type of markets we see going forward.

At the basic level, there are three things investors should be doing. First, embrace the ETF. Someone once joked that the only good financial innovation of the last sixty years has been the ATM machine. We agree, but we would add the ETF.

But ETFs are only tools. Investors still need a process. Find one and stick to it.  And, finally, recognize that domestic investing is now an oxymoron. It doesn’t exist. Everything is now globally interconnected. A global perspective is mandatory.

  • Q: Just like any fashion trend, some of us are catching on to ETFs a little later than others. You’ve noted that we’re moving from Act I to Act II of the ETF story. What have we missed?

Act I was all about brand recognition and being first to market. For example, "first mover advantage" was incredibly important. GLD - the first gold ETF launch - was wildly successful even though competing products with comparable attributes did not experience the same success.

Investors now recognize the benefits of the ETF product structure - low cost, tax efficiency, etc.  We are all believers. But we are moving beyond that. 

Act II is driven by a more educated investor. At a minimum, they are demanding reasonable liquidity, tax efficiency, and, above all, low fees.

But the most important feature of Act II’s landscape is an emphasis on investment process. The conversation is moving from “what” to “how”…from product to process. What investment process do you use to construct an ETF portfolio? 

In Act II, the story is one of empowerment. ETFs have revolutionized portfolio management and a new breed of asset manager has emerged - the ETF portfolio strategist. These are professional investors who specialize in assembling ETF portfolios. We are part of this collective and it is a very exciting time.

So for the ETF industry as a whole, competition is heating up. There will be new managers, pressure on fees, ETF closures, etc. It will become a more efficient industry and, ultimately, better for the individual investor.

But, make no mistake, the ETF growth evolution is here to stay. We are only in the foothills of a long journey.

  • Q: How do you see ETFs continuing to redefine the investment world?

ETFs are getting more press than the Kardashians, but I think often for the wrong reasons.  It’s great that they are transparent, low-cost, tax-efficient, and so on.  Who can argue with that? 

But these are just advantages of the ETF structure itself.  The game-changing benefit of ETFs lies in the sheer breadth of content now available.  ETFs have colonized virtually every asset class globally.

And I don’t think it is an exaggeration to say that this has caused a paradigm shift for active investors. That is, ETFs have made the portfolio construction process different and better in so many ways. Less than a decade ago, this toolbox was not available for the top-down, global investor.

The founder of our firm, Wilfred Hahn, who was the former head of Royal Bank’s Global Investment Group, says that we can build a better portfolio today for $100,000 than they could for a $10 million dollar pension fund back then. That’s a powerful statement. 

  • Q: Where can we go to follow the latest on ETF portfolio trends?

You can track developments on our website, www.hahninvest.com , or follow us on twitter @tylermordy and @HAHNinvestment.


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