Don't know which forecasts to believe? Start by ignoring most of them

David Thornton

Livewire Markets

Livewire trades in the currency of ideas. Ideas from the leading minds in Australia and abroad, all in the name of making you better investors.

You can understand my consternation, then, when Ken Liow, REALM Investment House’s head of strategy and risk, said this during what I thought would be a normal Q&A interview:

“I’m sure it's very attractive to people who buy funds management products to listen to somebody who sounds like they actually know what's going to happen in the world. It feels safer somehow. But if you took the time to assess what they're saying and put it through the filters that we're talking about here, you would find quite quickly that no matter how brilliant they were, the uncertainty around what they're projecting is incredibly high… their ability to know is inherently impaired.”

I was shocked. Was Ken serious? Was he really saying that everything I work to report, and you read, is a waste of time?

Thankfully, he wasn't. Well, not really. 

In fact, by the end of the chat I felt much surer about the kinds of forecasts and research I should be paying attention to. 

Unknowns, subjectivity and moving goalposts

Ken reckons that many of the forecasts we all sweat over aren’t worth their salt because they’re based on too many unknowns.  

"If I was to add the numbers one to 10, I know I'm pretty much going to get that answer right. There's 10 variables in there, right?" says Ken.  
"But if I'm trying to forecast the RBA cash rate and what that's going to be in 12 months' time with insights based on 10 different economic variables, that's obviously much, much harder." 

Let's stay on the cash rate example. Not only are we trying to forecast something based on multiple unknown variables, but also something that's laundered through the subjectivity of central bank governors. 

Last year RBA governor Philip Lowe stated that he didn't expect to lift rates until 2024. We all know how that turned out. 

And it doesn't stop there. We've also got to deal with shifting goal posts.

A central banker might say something like 'We're looking for wage inflation to be above 3% for a little while before we have confidence that inflation will be at the target band and therefore we'll raise rates.'

"But as we've observed in the last six months, and when you go back through history, their description about how they'll make those decisions evolves over time and is ultimately unstable," says Ken. 

As former US Federal Reserve chair Alan Greenspan once said, "I know you think you understand what you thought I said but I'm not sure you realise that what you heard is not what I meant." 

It's a bag of unknown variables, wrapped up in subjectivity, delivered through moving goalposts.  

And somehow analysts are meant to take that, interpret it, then spit out a number and a timeframe.  

Is that going to be very accurate? In the words of Jerry Seinfeld, "Not bloody likely!"

Portfolios at risk

These kinds of unreliable forecasts can spike the risk profile of portfolios. 

"If portfolio managers act as if their forecasts are more accurate than they are, the effect is not costless. They will tend to over-trade and produce portfolios which are overly concentrated but lacking sufficient forecasting advantage."

The result can be higher risk and lower long-term compound returns. 

For instance, say the volatility of the S&P500 is 15% per annum and cash rates are zero. 

A long-term passive investor chooses to invest fully into the index and does nothing else, while an active investor with strong convictions in forecasts tries to outperform the index by spending their time at either 0% exposure or 200% exposure. 

The average exposures are the same, but the risk and possible returns are far from. 

"Although the average exposure to the index is identical in both instances, the active portfolio is riskier as the potential range of daily returns is wider given exposures can reach 200%. The volatility of the active portfolio would be 21%, which is materially higher than the passive alternative of 15%."

So when a 50% loss is taken on an investment, it takes a 100% subsequent return to get back to the original position. 

The power of simple decisions

Unlike the complex and unreliable decisions described above, simple decisions based on more reliable variables can have far greater power. 

REALM Investment House use these principles to find mis-priced securities. 

They do this by comparing securities that are:

  • Fairly linear: The larger the gap, the greater the mispricing in an approximately 1:1 relationship;
  • Require a short inference chain: The extent of observed divergence translates directly into a mispricing estimate;
  • Can be accurately measured: The price information is tradeable and not subject to measurement errors and subsequent revision;
  • Don't rely materially on institutional decision rules: Over time, these types of relative value relationships tend to converge with high likelihood and this is often not particularly reliant on the vagaries of central bank decision making;
  • Is subject to slow-moving adaptive processes: The forces which drive the spreads together are present, but don’t operate too quickly. This may occur because the participants in the AUD and USD market are different in composition and hence arbitrage activity is limited.

A good example is a relative value comparison between the yields on a substantively similar credit security issued by Westpac, albeit in different currencies. 

"It's the same company, it's the same credit bands. It's Westpac hybrid, and you can even see the prices, the prices are known. You can actually trade it. Those prices that you're seeing right at this very moment. So, you can measure that gap precisely."

At the end of the day, it's also about having some humility about the way we make investment decisions. 

"Perhaps one of the things REALM is somewhat good at is to understand the difference in the quality of those ideas. And we operate that way and that has helped us deliver very high risk-adjusted results over time."

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1 contributor mentioned

David Thornton
Content Editor
Livewire Markets

David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.

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