On the first Friday in May, the principle investment officer of the Future Fund, Raphael Arndt, spoke about how exactly it is refining its posted equities investment program. The principal concern was whether “they may be spending money on (active) managers’ stockpicking skill”. The principal catalyst because of this thinking is that the Future Fund faces issues similar to all or any investors’ concerns.

This article is not about detailing the direction into the future Fund. The target is to communicate the advantages of a deeper degree of investment analysis than I really believe happens to be performed across our industry. The reason why I mention the Future Fund’s detailed equities program is that the overeign wealth finance is the most recent, and maybe most prominent, example of the application of what I call the fourth stage of investment evaluation.

With improving technology, analytical tools, access to a larger depth and breadth of investment strategy, and the financial planning industry’s move towards managed accounts, it is probably time for encouraged portfolios to go to the fourth stage as well. Successful application of the fourth stage of investment evaluation will probably raise the move towards designing investment portfolios which have a stronger representation of our investment idea (or beliefs), and a more efficient allocation, with increased performance risk management.

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Stage 1 is 100 % pure performance analysis and is what most clients are exclusively focused on. It concerns the overall come back result and the volatility perhaps. But whilst performance is a primary target typically, performance numbers alone provide little insight into whether an investment is actually good or bad. Looking only at performance often leads towards bad investment behaviours, such as selling low and buying high.

MSCI World Index for global equities. If we think that achieving higher comes back requires the acceptance of higher risk, then outperformance only may be a dangerous way of evaluating whether an investment is good or bad. Strategies may outperform their benchmark over long periods of time not because they are necessarily skilful, but because they might be dealing with lots of risk. At Stage 3, analysts adapt for market risk and divide the portfolio’s risk in to the two components we hear a lot about … alpha and beta.

Alpha is the marketplace risk-adjusted outperformance often associated with actions of active management skill. Beta represents a strategy’s contact with the market. Understanding an investment’s beta, or contact with the market, can be an essential part of profile construction, because this is the measure that helps determine the asset allocation’s role in a strategy. If the strategy’s beta is significantly less than 1, then that strategy may be keeping a substantial sum of money, so it potentially compromises the required asset allocation and reduces the portfolio’s goal of taking the intended “equity risk premium”.

A account with an expected beta of significantly less than 1 will underperform its standard in a strong bull market, unless there is significant skill (or alpha) and that is definately not assured. However, that skill can also be due to good fortune or simply styles or factor exposures which have been in favour over a period.

This is where Stage 4 investment analysis may be required. Stage 4 is where in fact the Future Fund is here, along with a great many other institutions and sophisticated investment experts. This stage further adjusts for non-market organized risks, which are usually symbolized by the smart betas, which can be purchased somewhat cheaply. In English, typical smart beta exposures may include style indices such as value (for example, low PE ratios), size (for example, small caps), momentum (for example, last year’s best performers), quality (for example, high profitability and low debt), and others.