The Globe and Mail, Report on Business
Published November 10, 2007

As an equity guy, I don't like to admit it, but I recently spent some time with the bond team at Connor Clark & Lunn Investment Management. Bondies aren't known for being the most exciting people. The good news is that they make my personality look downright bubbly.

In any case, we at Steadyhand selected CC&L a year ago to run our income fund. They got the nod because they bring a wide range of skills and strategies to the fund, which in the past has translated into consistently good returns for their clients.

During the presentation, Brian Eby, the head of the CC&L team, outlined the strategies used, which include predicting interest rates, positioning on the yield curve and switching between government, corporate and global bonds. The strategy that produces the best results, however, is their selection of individual corporate bonds. Their skill at doing credit analysis has translated into more added value per unit of risk than any of the other strategies in their tool box.

Now CC&L's client pitch isn't particularly unique. All managers will tell you about the many strategies they deploy. What makes CC&L and other good managers successful, however, is their ability to focus on the most reliable strategies. By doing that, they are able to produce more predictable and consistent “alpha” (returns in excess of an indexed portfolio).

As I've previously noted in this column, you should never assume that a manager will generate alpha. It is a tough thing to do. Indeed, if you want to bet on something, you're better to go with alpha's poor cousin “beta.” We know the market indexes (beta) will go up over time. Alpha has no such guarantee.

But if you are seeking returns in excess of the index as we are, you want to invest your money with managers that have an approach that has consistently worked in the past — managers that use strategies that are repeatable, but don't expose the portfolio to more risk.

Everyone has an opinion as to where to best find high quality alpha. I'll tell you where I go looking, although I don't expect that my views will receive unanimous support.

Money managers that make the big macro calls garner the biggest headlines because they have the potential to win big, or lose big. There are successful managers who make bets on currencies, commodities or interest rates, but they are few and far between. To me, big picture predictions in our highly integrated world are a crap shoot.

Asset mix calls are slightly more reliable, although there have been plenty of surveys showing that managers add little or no value by shifting the portfolio between stocks, bonds and cash. Long-term assessments of relative value can add to return and reduce volatility, but trying to catch short-term moves is not something I want to pay for.

I also think sector rotation is a tough way to make a living. We often hear managers talking about where market leadership is going to come from next: “It's resources today, but real estate will lead the way over the next quarter.” The managers who bill themselves as sector rotators tend to be at the top of the charts one year and at the bottom the next.

Similar to shifting between industry sectors, some managers rotate between investment styles: value versus growth, large capitalization versus small cap. The challenge with this approach is the same one that afflicts all macro strategies. If you're wrong, you can be wrong for a long time. For example, some U.S. managers started calling for large-cap growth stocks to assume market leadership three or four years ago. It wasn't until recently that it happened.

To my way of thinking, security selection is the highest quality alpha you can get. If managers conduct comprehensive research, focus on stocks or bonds they understand and are valuation conscious, good things can happen. They will get it wrong lots of times, but their batting average will be higher than the macro managers. The big picture stuff (interest rates, currencies, economic growth) will influence stocks or bonds in the short run, but a portfolio of underpriced securities will eventually find its value.

The challenge all investors have, be it amateur or professional, is devising an approach that features their most reliable alpha. Unfortunately, it is easy for overconfidence and too much information to lead investors into making decisions based on factors that have less chance of success. They let the poor quality strategies obscure or negate the good ones.

It's important to understand the strategies your managers are using to earn the money you are paying them. You want to know where the alpha is expected to come from. If out-guessing the Federal Reserve Board or making a call on the dollar is part of the plan, I'm inclined to move on and continue looking for someone to manage our clients' money.