Please Mind the Gap

Have you checked the weather today? While models can be useful for gaining insights that can help us make good decisions, they are inherently incomplete simplifications of reality.

Using data on current and past weather conditions, a meteorologist makes a number of assumptions to approximate what the weather will be in the future. As anyone who’s been caught in an unexpected rain shower knows, reality often behaves differently than a model predicts it will.

In the investment world, ‘smart beta’ have become popular products. Most often, smart beta is based on the seller’s proprietary factor-based models. As informed investors (obviously because you’re reading this!), you can benefit from understanding that the reality of markets, just like the weather, cannot be fully explained by any one model. You should, therefore, be wary of any approach that requires a high degree of trust in a model alone.

Please Mind the Judgement Gap

Similar to weather forecasts, investment models rely on different inputs. Instead of barometric pressure, investment models may look at variables like the expected return or volatility of different securities. The investor should be cautious of the inputs into these investment models. A model’s output can only be as good as its input. Poor assumptions can lead to poor recommendations. However, even with sound underlying assumptions, a user who places too much faith in inherently imprecise inputs can still be exposed to extreme outcomes.

Given these constraints, it’s crucial to have an acute awareness of the limitations involved in order to identify when and how it is appropriate to apply a model. No model is a perfect representation of reality.

What is an Investor to do with this Knowledge?

When evaluating different investment approaches, understanding a manager’s ability to effectively test and implement ideas garnered from models into real-world applications is an important first step. This requires judgment on behalf of the manager, and an investor who hires a manager to bridge this judgment gap is placing a great deal of trust in that manager.

The transparency offered by some approaches, such as traditional index funds, requires a low level of trust on behalf of investors because the model is often simple, and is easy to evaluate whether they have matched the return of an index.

The tradeoff with this level of mechanical transparency is that it may sacrifice the potential for higher returns, as it prioritizes matching the index over anything else.For more complex approaches, like active beta strategies, the level of trust required is much higher. Investors should look to understand how the manager uses models and question how to evaluate the effectiveness of their implementation.

“Success of a model is 10% inspiration and 90% perspiration” – Nobel laureate Robert Merton

Having a good idea is just the beginning. Most of the effort required to make an idea successful is in effectively implementing that idea and making it work.

Conclusion

There is a difference between blindly following a model and using it carefully to guide your decisions. Cut through the marketing behind the “latest and greatest” investment products and identify an approach that employs sound judgment and thoughtful implementation.