Conservative author William F. Buckley once said he would prefer to be governed by the first 2,000 names in the Boston phone book than by the 2,000 professors on the Harvard faculty. His comment was meant to point out that common sense, wisdom, leadership skills, and good temperament are often not directly associated with the sorts of intelligence found in academia.

Thomas Sowell of the Hoover Institution at Stanford uses the following to illustrate a similar point:  He defines intelligence as the combination of intellect and judgment. Expressed algebraically:  Intellect + Judgment = Intelligence. He points out that a little bit of algebra results in the following:  Intellect = Intelligence – Judg­ment. In other words, being smart without possessing judgment can lead to problems.

Investors looking to select an investment advisor are pre­sented with a difficult task. There are plenty of advisors around with impeccable academic credentials. Top degrees in business or law are a dime a dozen in our industry. Picking an advisor on this basis might seem like a good idea, but investors run the risk of running into the problem which Buckley and Sowell warned about. You can easily end up with an advisor whose pedigree is more impressive than his investment ability.

Alternatively, investors could pick an advisor based solely on their track record. This is not the worst idea in the world, but it can also lead to problems. Investors who picked top performing hedge fund managers in 2007 soon saw their portfolios suffer losses which will take years to recover. The same could be said for investors who got into tech stocks during the internet bubble. Picking an advisor based on this criterion alone can lead to chas­ing good performance at the wrong time.

There are a number of other strategies which could be em­ployed. Some suggest picking the lowest cost producer and in­vesting in an index of stocks. This strategy is based on the so-called “efficient market theory” which, despite being refuted by market reality time after time, still has many supporters. To its credit, at least this strategy will keep an investor from spending too much on investment advice which provides little value.

Another strategy is the so-called “best of breed” approach. Investors in this camp hire an investment advisor to select other investment advisors. The idea is that by picking the best advi­sors in each asset class you will get an optimal portfolio. The problem with this approach is that it assumes that the advisor at the top of the pyramid actually has the ability to select top managers consistently and that there is a structure in place which will allow him to do this. A further weakness is that in­vestments are often chosen from traditional asset classes which have already performed well rather than those which will per­form well in the future. Commodities and emerging markets are examples of asset classes which investors moved into after they had significantly appreciated.

No investment category in recent years has generated more excitement than Emerging Markets. After being universally despised during the financial crisis several years ago, investors jumped back into them in 2009 and 2010 as the fundamentals were quick to turn around after the recession. With interest rates low and the developed economies struggling, these mar­kets became a one way bet in the minds of many investors. In fact we had lunch in London last fall with a hedge fund investor who argued that there was no need to hedge emerging market investments because the asset class had such a high degree of something he called “embedded alpha.”

During the technology bubble of the late 1990s, Warren Buffett wrote a famous article in Fortune. He was being criti­cized by many for having missed the technology boom. In his article he wrote (and we are writing from memory) that invest­ing wasn’t just about who had the latest technology or who was growing the fastest. Rather, it was about identifying quality companies who could maintain their market share and earn good returns on capital. Emerging markets investors would do well to keep this in mind today. There is no doubt that the devel­opment of economies such as China, India, and others is one of the great economic events of our time, and that many fortunes will be made. But this isn’t the same as saying that these markets are a one way bet, or that all the companies in these countries will thrive. Most listed companies in the developing world are far from the model Buffett described. They earn low returns on capital, have little pricing power, and are often dependant on cheap labor, which history shows is not a long-term sustainable advantage.

Investors would do well to keep this advice in mind when picking an advisor as well. Managers who can identify high quality companies and value them intelligently may not out­perform every year but they are unlikely to blow up, and their results over time should be good.

William Andersen, CFA, Portfolio Manager,
Wanger Income and Growth Strategy