Innovating Investing: Complex Made Manageable
Joel Berg |
Thursday, January 14, 2010
From tulips to tech stocks, investors have shown a penchant for trading on emotion rather than logic.
It’s not easy to act on that insight. But something called complex systems analysis is proving helpful, at least for James Dailey, chief investment officer of Team Financial Managers, a Harrisburg-area investment firm with about $130 million under management.
A complex-systems approach helped the firm rack up an independently verified return of 11.8 percent for its clients in 2008, a year marked by a nerve-shattering freefall in the stock market. Now, the firm is applying the same approach to a mutual fund it launched in December, called the Team Asset Strategy Fund.
"It's not a magic 8-ball. But it provides a framework of analysis that improves our timing and our probability of success," says Dailey, lead portfolio manager for the new fund, which invests in everything from stocks and bonds to commodities and foreign currencies. Steve Brennaman is the fund’s senior portfolio manager.
Complex systems analysis is a method of analyzing seemingly random and chaotic systems, such as an ant colony or a human cell. It is winning converts in the financial sector.
"I think everybody’s learned that you don't want to just be looking at something as complex as markets with a single model," says Scott E. Page, director of the Center for the Study of Complex Systems at the University of Michigan in Ann Arbor. "You probably want to have multiple ways of looking at something."
Evidence shows that markets don’t always behave rationally, says Kuldeep Shastri, a professor in the Joseph M. Katz Graduate School of Business at the University of Pittsburgh. But he questioned the performance of mutual funds that trade actively, like Team's. "They don't necessarily, on average, do better than a buy-and-hold strategy, especially after you account for the fees paid to these funds."
But Dailey believes a buy-and-hold approach, especially for stocks, no longer suffices. The stock market ended a 20-year run-up in the early 2000s, he argues, and has entered a long-term bear market.
Initially, Team Financial reacted by relying on market fundamentals. But the fundamentals proved inadequate in the face of volatility, particularly in 2003 and 2004, says Dailey. Even if the long-term trend is down, prices swing wildly from year to year. That's when Dailey started looking for alternatives.
Behavioral finance, germinating in academia, provided the diagnosis by overturning the view that markets are always rational and efficient, Dailey says. But he needed something that would help him and his colleagues trade on that understanding. He hit on complex systems analysis, based on the assumption that millions of investors acting on emotion form a complex system, like a beehive.
A beehive appears chaotic to the human eye, Dailey says. "But we know there is a structure there, or the society would not function."
The complex-systems approach started out as one factor among many in making investment decisions. But over the last five years, it has moved to the forefront, Dailey says. Coupled with customized software and other quantitative techniques, it allows Team to identify so-called inflection points when prices can be expected to change direction, either up or down.
It's not foolproof. Dailey, for example, recommended buying financial stocks after the market nosedived in early 2009. Despite models showing the stocks were about to head up, his colleagues balked. They were concerned about the next bomb that might drop and were unsure if the market had really hit bottom, Dailey says. The firm missed out on the run-up in financial stocks that followed.
Team Financial could have kept the strategy to its clients. But Dailey wanted to make it available to investors who otherwise wouldn't qualify for the firm's services. Team's clients typically have at least $100,000 in assets, while the new mutual fund demands a minimum investment of $5,000.
Team also is trying to keep costs competitive. The fund's expense ratio is 1.95 percent, on par with an average of around 2 percent for similar funds, Dailey says.
All but a handful of the firm's clients have moved assets into the fund. Team hopes to find new clients through registered investment advisors who are looking for mutual funds adopting alternative approaches, Dailey says. The fund’s goal is to generate relatively consistent returns regardless of the market’s ups and downs.
Advisors wouldn't put all of a client's money into the Team Asset Strategy Fund, Dailey says. Rather, they might put in a small share to complement the traditional allocation in stocks and bonds.
The chief obstacle for Team is the lack of historical performance. Advisors usually want to see how well a fund has performed over time before parking assets in it. "That's just a reality," Dailey says.
Lynn Evans, an investment adviser in Clarks Summit, says she would want at least 18 months to two years of data. Nonetheless, she adds, Team's fund looks like an attractive option for alternative investments, which can smooth out the ups and downs in a traditional portfolio.
"Usually to play that game you had to have major bucks," she says.
Other advisors are likely to remain on the fence.
Dennis Hursh, an investment advisor in Middletown, is one. He said Team's approach seemed more like speculation than true investment. "Historically, the market has returned 9 to 10 percent per year over very long periods of time," he says. "And I think the less a strategy looks like the market, the less likely it is to achieve those rates of return."
Joel Berg is a freelance writer, part-time writing teacher and recovering business reporter living in York. Send feedback here.
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Photos:
James Dailey
Scott E. Page