Investments  

What is evidence-based investing?

  • To be able to define evidence-based investing
  • To be able to identify the reasons for the performance of evidence-based investing
  • To explain the significance of value investing
CPD
Approx.30min
What is evidence-based investing?
(Olivier_Le_Moal/Envato Elements)

Advisers rightly want to know about the processes fund managers use to select the investments they make and how these lead to success.

While traditional active investment managers may have used the same strategy for picking stocks for some time, their decisions are invariably based on interpretation of current company and market data and are reliant on an element of gut instinct.

Evidence-based investing aims to remove subjective assumptions and psychological bias from the investment process. It seeks instead to rely on the output from academic studies of how markets have performed over long periods of time. It is based on robust, unimpeachable data.

Article continues after advert

While some advisers might be less familiar with this approach, it is espoused by some of the largest endowment funds in the world, including the £1.3tn Norwegian Government Pension Fund Global and the £1.5tn Japanese Government Pension Investment fund.

Right first time

A key tenet of evidence-based investing relates to the notion that the biggest driver of long-term returns rests on how a portfolio is set up at the beginning of its life.

Some studies – including Brinson et al (1986) – suggest that between 90 per cent and 94 per cent of a portfolio’s returns comes from the asset mix, or strategic asset allocation.

This suggests that only between 10 per cent and 6 per cent of returns (positive or negative) come from stock-picking and market timing. Because evidence-based investing is truly long-term, it does not seek to trade frequently or to buy or sell single stocks at ‘the right time’.

Active intervention’s patchy record

Much has been written on the active/passive debate. The annual S&P SPIVA Scorecard marks the active investment industry’s homework, and the grades have not been terribly promising.

In 2023 alone 60 per cent of all large-cap US equity funds underperformed their benchmark S&P 500 index. The percentage of underperformers in a given year ranges from 45 per cent to 87 per cent since SPIVA’s first report in 2002. 

More importantly, of the 164 large-cap US equity funds in the top quartile in 2019, not even one remained top quartile in 2023, underlining the absence of persistent performance in the industry.

While active managers can, in some cases, generate fantastic returns, finding managers that can do this year in, year out, is extremely challenging for investors and advisers.

Much has been made about the passive industry’s impact on active managers, but there is a school of thought that suggests stock-pickers should find life easier if a greater proportion of the market is in passive funds.

This is because passive funds follow the market, meaning that an active investor in a sea of passive disciples has less competition when trying to identify something the market has mis-valued.

Embracing factors

Returns are largely a function of risk; essentially, the more of the latter you take, the more of the former you should receive over the long term, but the 'noise' along the way, including volatility and drawdown, is also likely to increase.