This is why fund managers should be open about their mistakes

This investment manager believes it's time for fund managers to be more transparent and make sure they are taking minimal risk with their portfolios writes Danielle Levy.

Have you ever wondered why or how your fund manager got things so wrong?

Investment manager Hermes believes it is time for fund managers to come clean about the degree of certainty in their predictions – and ensure they are not taking too much risk in portfolios based on these forecasts.

"It is perhaps a key message that many may not wish to discuss, but the accuracy of most portfolio managers’ forecasts is low," says Lewis Grant, who is a senior portfolio manager in Hermes's global equities team.

He notes there is a huge amount of uncertainty in predictions – and this should be factored into the way that investors construct portfolios. This is particularly relevant at a time when tweets from US president Donald Trump can drive the direction of markets.

"Market behaviour is incredibly erratic – style drivers in the market change rapidly, investor sentiment can reverse for seemingly no reason, unanticipated tweets from world leaders can send the Volatility Index (VIX) spiking without warning. Diversification can help to insulate a portfolio against these unpredictable externalities," Mr Grant explains.

The fund manager likens investing to trying to forecast the winner of the F1 Grand Prix. For example, in the same way that mechanical and engineering knowledge provide insight into the car's engine and tyres, accounting knowledge can assess the state of a company’s financial statements. 

"The competence of the driver, in terms of skill and experience, would be considered as well as their ongoing control of the vehicle, like that of the senior management driving the strategy of a company. But can we as spectators truly observe all these variables and have a full understanding of how a company is functioning?"

Mr Grant asks.

The answer is inevitably 'no' and Mr Grant concludes that investors can never truly know what is going on inside an enterprise. 

"There are many influences on a company’s future, only some of which could ever be predicted. Too many portfolio managers underestimate the amount of uncertainty and consequently overestimate their ability to make accurate predictions," he explains.

In Mr Grant's opinion, this over-confidence results in overly concentrated portfolios, which means news flow ultimately drives performance rather than fund manager skill.

In the light of this, the fund manager urges investors not to jeopardise potential long-term returns in the quest for short-term gains. In addition, he says savers must consider the risks that are being taken within portfolios and the implications if a fund manager gets a call wrong.

"The power of compound interest can turn a small steady gain into much larger and more exciting returns. And yet investors frequently favour higher-risk portfolios, failing to recognise the damage that volatility can do to compounded returns. An investment that falls by 50% in value will subsequently need to double simply to restore the investor to parity," Mr Grant says.

He concludes that fund managers need to be honest about the accuracy of their forecasts. In reality, if their portfolios are diversified appropriately, this will provide a natural buffer should something go wrong.

"With the correct structure and appropriate diversification - even a small degree of accuracy is sufficient to generate meaningful outperformance," he adds.