By Anric Blatt, Global Fund Exchange Group
Investing requires us to battle with natural human tendencies such as extrapolating the past into the future. Quantitative portfolio optimization often favors assets that have positive outlier performance in the past but are often likely to revert to the mean going forward. More often than not, the circumstances for the manager’s out-performance will not be repeated due to market environment changes or asset growth that dilutes the opportunity. Time and time again we have witnessed that a large run up in performance drives significant AUM to the manager after the event but that performance is not sustained. Hubris and arrogance can also play a role whereby a portfolio manager ends up taking risks that would not have been taken in the past. It is also a well known phenomenon that the most significant AUM growth occurs only after the best period of return has passed. Once the manager averts his attention to asset gathering, branding and keeping the status quo intact to build his business, the focus can change and result in lower returns. There are always exceptions to this tendency.
Focus should be on a strategic allocation plan that is appropriate to investment goals, risk tolerance and time frame rather than investing in strategies that have posted the strongest returns in the recent past. The investor must delve into the mechanics of understanding return drivers and these findings must be supported by quantitative analysis, market movers and performance attribution. Using advanced quantitative methodologies to pin point the difference between true alpha added and “luck” is important and worthwhile.
The combination of quantitative & qualitative methods along with global macro research can be directed towards positioning for the high probability outcomes. It is important to have forward looking portfolios rather than good looking past performance. As in a game of football, soccer or hockey, what good is a game of defense without an empowering game of offense to score points?
Theme Based Investing Rather Than Positioning for the Past
Investing in fads is not new to the investment community; fads are short term and often drummed up by sales people looking to exploit recent performance. Consequently, the risk of investing in fads is skewed to the downside as interest in them fades quickly. Investing in themes that are purposeful and satisfy global human needs are more likely to generate returns which are skewed to the upside, as strong demand and scarcity endures the test of time.
This is why at Global Fund Exchange we focus on the biggest macro themes facing humanity. We find these themes to be the scarcity of energy, fresh water and agriculture. We understand investing in the future of our planet represents the most compelling fundamental mega macro trends of our time. We recognize there are more dynamic reasons for investors to take action than ever before and that these investment opportunities in “Human Security”, the water, food and energy needs of mankind, are hardly a fad. They are urgent, evident and compelling.
During the next 10 years, many countries will almost certainly experience extreme scarcity in these vital asset themes. They will likely contribute to the risk of instability and increase geo-political regional tensions if not addressed and managed accordingly. Every major country around the world, both in the developed and developing world is focused on these evident risks. Food scarcity issues might have provoked the Arab spring, but wait till the undeniable and detrimental water shortages come to light.
Water is our most critical resource. The World Bank reports that fresh water demand is doubling every 21 years globally and in some regions every five. A major international study finds that by 2030 the annual global water requirement will be 40 % above current sustainable water supplies, as population growth soars and countries continue to industrialize at record pace. The United States alone will need to spend $277 billion by 2020 to maintain present water standards. China has currently budgeted $600 billion for water conservation investments over the next 5 years. The global water sector, currently valued at $500 billion, is poised to grow to $6 trillion over the next 18 years. Cleaner and more efficient water utilization are imperative for future generations. Huge demand will catalyze profit opportunities in infrastructure, smart meters, water rights, desalination, purification and waste to water. It is not only our greatest threat, but also our single most compelling investment opportunity.
Feeding the world has become a major challenge. Exploding population growth combined with virtually no arable land (or water) in Asia and the Middle East presents immediate challenges. This combined with newfound prosperity and a historic shift in global dietary patterns has put tremendous stress on many countries’ abilities to feed its people. A dramatic growth in the middle class has caused a shift away from a grains and vegetable based diet to a more meat-centric diet. Livestock requires large tracts of arable land and 100 times the amount of water of growing grains and vegetables. Global weather anomalies have devastated crops in recent years leading to price jumps in wheat, soybeans, corn and other basic commodities. As demand continues to increase, prices will continue to escalate despite short term reprieves. The FAO (Food & Agricultural Organization of the UN) reports that new demand requires a 47% increase in annual (yes, annual !) investment in agriculture in the developing world. Current investment levels of $189 billion per year must reach $279 billion per year to keep up with population growth and $479 billion per year to combat global hunger. In the developed world new investment is also critical as the credit crisis of 2008 caused a mass suspension in infrastructure and supply chain investment.
Population and income growth are additionally the two most powerful forces behind energy demand. By 2030 primary energy use is expected to grow by 40%. Demand for oil is expected to grow by 60%. Traditional fuel sources will absolutely be necessary to satisfy future demand over the next 3 decades, but this will need to be augmented with cleaner and more efficient technologies to meet total demand. Emerging cleaner technologies applied onto traditional energy models will provide improved yield efficiency, increased and diversified production and distribution and all at a reduced carbon footprint. Legislative and military induced catalysts will continue driving development capital to these sectors. The IEA (International Energy Agency) projects required spending of $26 trillion in traditional energy alone, to build, maintain and replace aging energy infrastructure. A paradigm shift is however occurring, but it will be an evolutionary process converting the planet to renewable resources. This “Bridge period” presents many opportunities for both traditional energy and clean energy. Global investment in clean energy topped $260 billion in 2011 outpacing investment in traditional energy for the first time in history. The United States spent $48 billion in clean energy last year, representing a 21% growth rate, followed by China at $45.5 billion. Indian clean energy investments grew by 54% in 2011 to $10.2 billion. Annual investment growth rate is expected to be upwards of 15% a year for the next decade across the entire developing world.
As a result of industrialization, population increases, migration, and changing human consumption patterns, demand for water, energy and agriculture will continue to increase dramatically. These are not fads, but long macro cycles that will be akin to the industrial revolution. We call it the Energy Revolution.
Conclusion
Many institutional asset allocation models chase past performance due to our natural human tendencies augmented by the fact that quantitative models only favor assets that have outperformed in the past. Since everything eventually reverts to the mean, we have found this approach to investment selection to be counter-productive in generating consistent positive returns. Successful manager selection is about identifying managers that are positioned well for the economic environment we are anticipating, not identifying managers that were positioned well in past cycles. Natural human tendencies coupled with increasing correlations amongst market instruments and investment strategies suggest non-correlation is becoming increasingly more difficult to achieve. By understanding risk, finding experienced specialist managers whose strategies align with the mega macro cycles and investing with purpose in the needs of humanity, we are better positioned to accomplish such a goal; adding value to our clients’ portfolios and minimizing downside volatility.
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