American psychologist Barry Schwartz popularized the phenomenon known as “the paradox of choice.” An endless array of choices (think 100 types of laundry detergent in a single supermarket aisle), he argued, may seem like the pinnacle of convenience, but paradoxically, it can cause stress, anxiety and unhappiness.
When there are countless alternatives to any choice, it’s easier to doubt your decision, leading to buyer’s remorse. Or contrarily, you try to parse a tidal wave of information while staring, frozen, at a cornucopia of options. Ultimately, this analysis paralysis may prevent you from ever making a decision.
Our counterintuitive relationship with choice shows up everywhere — from the grocery store to choosing a college. But there’s one place where it’s especially tested: financial markets. There are thousands of individual stocks, bonds, REITs and MLPs to choose from, and they’re all packaged into thousands more mutual funds, ETFs and countless other products. With a dizzying array of investable options to choose from, how do you prevent succumbing to the paradox of choice?
BUILD A SYSTEM
Fortunately, Schwartz offers us an out: Build a system that defines and ranks your goals in order to narrow the range of choices. That’s exactly what a team of researchers and analysts at the Northwestern Mutual Wealth Management Company do every single day to navigate markets and choose investments that fit clients' key long-term objectives.
And as we approach end-of-the-year rebalancing, it’s important to rely on a proven system for long-term investing. Just look how 2020 has played out in markets. We experienced a historically swift decline into a recession in spring, followed by a robust (though narrow) recovery led by tech stocks — particularly companies that allow people to work and consume from home. Many investors, foreseeing a new paradigm, did away with so-called value stocks or funds and piled into these growth names as result.
However, now that Pfizer and Moderna have announced two highly effective vaccines, we’re seeing a rotation away from those same “at-home” stocks and into sectors — heavily weighted in value stocks — that were hardest hit by the pandemic as investors brace for a broader market recovery in 2021. Those who abandoned value a few months ago may have been caught on their heels. That’s why it’s so important to adhere to a system that balances growth and value, risk and safety, domestic and international. In a nutshell, a system helps ensure you remain diversified and opportunistic in a multitude of market environments.
So, what does an investing system look like? We spoke with Northwestern Mutual’s senior director of research, Garrett Aird, about the process his team deploys when choosing an active manager for Northwestern Mutual’s discretionary portfolios. Every purchase, which could entail billions of dollars, starts with a well-defined framework for manager selection.
“We can’t predict the future, but we can tilt the odds in our favor,” says Aird. “We use this framework to select managers who we believe will have better odds of doing well in the future versus selecting a fund at random.”
An actively managed mutual fund isn’t a passive instrument that simply reflects an index like the S&P 500. There’s a team behind it, and NM’s investment process starts with them. Who are the managers, and how long have they been at the company? Aird’s team also considers management structure, their compensation methods and training, and the company’s recruiting and retention strength. A fund that has great managers but compensation based on a short time horizon, for example, may encourage risk-taking to hit a quarterly number or make up for a loss — an uncertainty worth minimizing.
“We want to understand who’s actually making the decisions and who is providing the research, as it could be one or two dedicated analysts or a centralized team of 100. In some places, for example, a portfolio analyst position is a stepping stone to a fund manager job, whereas at other firms an analyst is a career position. These can all influence management turnover.”
And before purchasing any fund, Aird’s team meets with the fund managers to pick their brains about their process. Given the scale of institutional money flows from NM, it’s a level of access and insight not afforded to every investor.
Just as NM has a process for choosing a fund, the fund managers should have a process for choosing underlying investments. Where do they get their investment ideas? What do they base their buy and sell decisions on? A fund may seek out undervalued, stalwart companies or focus more on companies that are disrupting key industries. A fund manager’s style and philosophy will greatly influence the composition of the portfolio, along with its exposure to risk and volatility.
“The idea with all of these actively managed funds is that they are trying to achieve some objective. It might be outperforming a benchmark on an absolute or relative basis. So, how are they doing it? Is it more aggressive or conservative relative to peers, or is it something we can get in a low-cost ETF?”
A fund focused on value stocks will likely have different returns compared to a technology fund. But if value stocks are posting strong returns and a particular value fund underperforms, it would garner more attention from Aird’s team to find out why. “We always look to ensure that a manager’s performance matches their process and philosophy. If a manager states they are more — or less — aggressive than peers, we expect that to show up in the numbers.”
Whether an actively managed mutual fund is managed by one portfolio manager or by a team of managers, they all work for an even larger company. It’s important to consider whether the parent company is a young upstart looking to establish its name or a well-capitalized, established firm. You want the company to be around for a while. The parent company needs to be able to attract and retain investment talent. The parent company’s culture influences incentives for fund managers and the sources of information and data for their research. It’s also important to examine the parent company’s history with compliance and litigation.
“This is something that’s often overlooked, but we think it’s really important,” says Aird. “For example, a few years ago we had a fund that we really liked, but the parent company was in a somewhat hairy situation and was bleeding assets. The fund we liked was the star at that firm, but their other funds weren’t performing. We decided not to select it. Fast-forward six months, and that fund’s entire team quit and went to another company.”
Of course, the fund’s performance is studied. While past performance isn’t necessarily indicative of future returns, Aird’s team likes to see how funds perform in different economic environments. How did it perform against comparable peers or its objective? In addition to rolling returns and calendar-year performance, they’ll pop the hood and see which components drove performance. Was performance driven by a few winners, or was the fund’s strength broad-based? Did the manager need to stray from their process in order to achieve those returns? Or were they able stick to their knitting [CZ1] and simply do a better job investing in their traditional areas?
“Performance is the most obvious thing people look toward, but it’s also 100 percent a rear-view mirror. One thing we really stress with performance is that it aligns with the manager’s investment process,” says Aird. “Numbers are one thing, but we want to make a decision based on adherence to a strategy.”
For example, if a so-called conservative, lower-volatility bond fund is more volatile than its peers, are the managers really executing their strategy?
Finally, we get to the price tag. More precisely, Aird’s team looks at the fund’s costs. What fees do the managers charge, and how do they compare to similar funds?
Expenses are the highest-weighted factor in their formula. For one, it’s perhaps the only variable that can be forecast with a level of certainty. More importantly, historical research shows that funds with lower expenses tend have a better-than-average chance of outperforming.
“The expense ratio serves as a hurdle a manger needs to jump. If the fund charges 50 basis points, the fund manager will have to generate at least 50 basis points before our clients see a return. The lower the hurdle we can get, the better the odds of outperforming,” says Aird. “We also want to make sure a fund is worth paying for. Can I get similar exposure in an ETF for a fraction of the cost? Is this manager different enough to justify their cost?”
PUTTING IT ALL TOGETHER
After all these pieces come together, they are individually weighted, scored and pushed through a proprietary model that provides a composite score for every fund on their radar. Through this exhaustive process, the team essentially conquers the paradox of choice by narrowing down the investable universe to a small subset of funds that meet NM’s stringent criteria.
This helps ensure Aird’s team is building a diverse portfolio at NM that remains opportunistic in a variety of economic environments and matches the goals and objectives of the company.
“It’s not foolproof [no strategy is], but we do think it ultimately works in our favor,” says Aird.
No investment strategy can guarantee a profit or protect against a loss.