Efficient markets theory has been challenged by the finding that relatively simple investment strategies are found to generate statistically significantly higher returns than the market portfolio. Well-known examples are the value, size and momentum strategies, for which return premiums have been documented in US and international stock markets. Market efficiency is also challenged, however, if some simple investment strategy generates a return similar to that of the market, but at a systematically lower level of risk. Read the full article.
A research paper that concludes that the funds recommended to institutional investors by investment consultant do not add value, has won the Commonfund Prize, awarded for original research relevant to endowment and foundation asset management. The paper, by academics at Saïd Business School, Oxford University and University of Connecticut School of Business, found that there is “no evidence that these recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless.”
The winning paper, Picking winners? Investment Consultants’ Recommendations of Fund Managers, by Tim Jenkinson, Howard Jones, (Saïd Business School, Oxford University) and Jose Martinez (University of Connecticut School of Business) analyses the factors that drive consultants’ recommendations of US actively managed equity funds, and the impact these recommendations have on flows, as well as how well the recommended funds perform.
The authors find that investment consultants’ recommendations of funds are driven largely by soft factors, rather than the funds’ past performance, and that their recommendations have a very significant effect on fund flows. But there is no evidence that these recommendations add value.
The Commonfund Prize is awarded annually by the Commonfund Institute in collaboration with the Newton Centre for Endowment Asset Management at Cambridge Judge Business School. The winning paper carries a $10,000 prize.
Endowment and foundation funds are most commonly seen in the charity, education and healthcare sectors. Although regular withdrawals from the invested capital are needed to meet on-going operational costs, such funds are typically characterised by a perpetual time horizon.
First awarded in 1996, the Commonfund Prize aims to recognise original research and to set the standard for research excellence and innovation in this area of asset management.
There were two papers chosen as runners-up in the category of highly commended:
Laura Starks (University of Texas at Austin) and Richard Sias and Luke DeVault (University of Arizona) for Who are the Sentiment Traders. Evidence from the Cross-Section of Stock Returns and Demand
Neal Stoughton, Georg Cejnek, and Richard Franz (Vienna University of Economics and Business) for An Integrated Model of University Endowments
The judging panel consists of David Chambers, the Academic Director of the Newton Centre for Endowment Asset Management and Reader at Cambridge Judge Business School; Elroy Dimson, the Centre’s Chairman and Professor of Finance at Cambridge Judge Business School; and William Goetzmann, Professor of Finance and Director of the International Center for Finance at the Yale School of Management.
What would Keynes’ do? Delegates at a London investment think-tank discussed this question with Cambridge University’s David Chambers. Keynes started managing the Kings College, Cambridge endowment after World War I and analysis of his investing style reveals some interesting annotations for investors today.
John Maynard Keynes was not just an economist – he was a fund manager and stock picker. Analysing the way he managed investments, his style, tilts, returns and strategies supports analysis that long-horizon investors have advantages.
Keynes was appointed the bursar of King’s College just after World War I and managed its endowment, which at that time was largely made up of a substantial agricultural property portfolio dating back to the 15th century. Throughout his career, he was an active and innovative investor and his first act to buck tradition, or think outside the square, was to reallocate the portfolio away from property and fixed income securities towards equities. His willingness to make a substantial allocation to this new asset class in the 1920s was unique amongst institutional investors on both sides of the Atlantic and anticipated the widespread move into equities by institutions a generation later.
David Chambers, University Reader and Keynes Fellow at the Judge Business School at Cambridge University, told delegates at a recent London investment think-tank that one of the lessons from analysing Keynes’ portfolio management skill is that as an active investor it is better “not to be restricted by convention and to seek where possible well-considered risks in order to perform”.
In 1921 Keynes’ carved out a discretionary fund within the Kings College endowment which he invested in equities up to his death in 1946.
This UK discretionary fund generated a mean annual return of 16.0 per cent with a standard deviation of 19.1 per cent over these 25 years compared to a 10.4 per cent return and 17.1% volatility for the UK equity market.
“His portfolio had a very high tracking error, an obvious tilt towards value and a tilt towards small and mid cap stocks,” Chambers says.
Following a period of disappointing performance relative to the index in the period between 1926 and 1928, Keynes began a thorough overhaul of his investment approach in the early 1930s and subsequently outperformed the market by a substantial margin.
“Keynes spent the 1920s trading as a macro trader would today trying to time markets. Unfortunately, he didn’t anticipate the 1929 crash at all and was 90 per cent invested in equities.
“He approached currency trading in a similar way, attempting to time currency moves based on his careful analysis of fundamentals such as trade, inflation, interest rates and politics.”
Yet, his currency returns were extremely volatile as a result of his difficulty predicting the timing of currency movements, and although overall he made money, at times he was forced to endure substantial losses. Hence, Keynes wrote in December 1934 about the prospective French franc and Dutch florin devaluation that “Nothing is more rash than a forecast with regard to dates on this matter. The event when it comes will come suddenly. The best thing is to allow for probability and put little trust in forecasts of the date, whether soon or late”.
Importantly, however, when it came to equity investing, Keynes was able to change his investment approach. He abandoned the idea of a top-down market-timing approach in the 1930s in favour of a bottom up stockpicking approach.
This is evidenced by the decline of stock turnover in the portfolio turnover from 55 per cent in the 1920s, to 30 per cent turnover in the 1930s to 14 per cent turnover in the 1940s, Chambers says.
His switch to a patient buy-and-hold strategy allowed Keynes to stay committed to equities, and reflects his realisation of the natural advantages that accrue to such long horizon investorsas endowments Chambers says.
“Keynes’ investment experiences during the Great Depression of the 1930s are relevant to modern-day investors during the Great Recession. He had to discover for himself the difficulty of making profits from market timing when the stock market crashed in 1929. Thereafter, his self-proclaimed switch to a more careful buy-and-hold stock-picking approach in the early 1930s allowed him to maintain his commitment to equities when the market fell sharply once more in 1937-38. In so doing, he provides an excellent example of the opportunity which long-horizon investors have in being able to behave in a contrarian manner during economic and financial market downturns,” Chambers and his co-authors, Elroy Dimson and Justin Foo outline in the paper “Keynes, King’s and endowment asset management”.
“Studying Keynes’ investment record also demonstrates another important lesson for investors today, namely, that it can take a while to discover the nature of your investment skills,” Chambers, who is academic director of the Newton Centre for Endowment Asset Management at Cambridge, told delegates at the think-tank.
When reflecting on the importance of learning from history, Chambers spoke to delegates about the link between the investment approach pursued by the leading US endowments today and that of Keynes almost a century earlier and discussed in a new paper “The British Origins of the US Endowment Model” co-authored with Elroy Dimson. Quotes from “Pioneering Portfolio management” by Yale endowment CIO, David Swensen, could have been taken from Keynes himself:
“…active management strategies demand uninstitutional behaviour from institutions…
“Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent.
“Unless institutions maintain contrarian positions through difficult times, the resulting damage imposes severe financial and reputational costs on the institution.”
In the end, Chambers says lessons from Keynes demonstrate that for an active investor it is important not to be restricted by convention. It is also very important for a manager to be situated within a governance structure, or investment organisation, which, following prior discussion and agreement about the preferred investment strategy, allows them to take adequate risk and to go about applying their skills.
Chambers, Dimson and Foo “Keynes, King’s and endowment asset management” NBER working paper:http://ssrn.com/abstract=2499334
Chambers and Dimson “The British Origins of the US Endowment Model” Financial Analysts Journal http://ssrn.com/abstract=2541034
John Maynard Keynes
1902-05 undergraduate at Kings College
1906 India office
1909 Fellow, Kings College
WWI UK Treasury
1919 First book: Economic Consequences of the Peace
1923 Tract on Monetary Reform
1925 Economic Consequences of Mr Churchill
1930 Treatise on Money
1936 General Theory
1940 UK Treasury
1941 Bank of England
1944 Bretton Woods
Hedge funds are sheep in wolves’ clothing, they are claiming their returns to be alpha, but a large part of it is driven by beta, Narayan Naik, professor of finance, London Business School told delegates at an investment think-tank in London last week.
The good news, Naik says, is a new era has dawned in hedge fund investing where investable risk factors enable investors to identify genuine alpha producers and direct capital towards those managers and products, and the rest directed to risk-factor funds.
“This enables investor to use risk factors for portfolio completion, diversification, and tail-risk hedging purposes, “park” excess cash in a diversified basket of risk-factors until they find the right manager, and most importantly allows them to pay alpha-price for alpha-like returns and beta-price for beta-driven returns,” he says.
Naik told delegates that hedge fund returns look like an iceberg, there’s a little bit of alpha showing above the water and all the beta is under the water.
The returns, he says, are made up of alpha which is the return due to manager skill, and the remaining return drivers – the alternative beta, exotic beta and traditional betas – are the returns due to systematic risk factors.
The evolution of hedge fund offerings has seen alternative beta returns now captured using risk factors whereby the beta is constructed using liquid tradeable securities and their derivatives.
“Combining known risk factors such as rates curve, currency carry, equity liquidity, commodities momentum and value, emerging markets has meant that products can now capture a large part of hedge fund returns,” he says.
In 2007, the first hedge fund strategy clone was launched that delivered alternative beta-based returns but did not carry the high cost of the underlying active management (hedge fund fees).
“These clones are rules-based, cheap, highly transparent, with high degree of liquidity, institutional quality and free of headline risk,” he says.
“Of course sceptics say, can an auto pilot fly a plane better than a pilot? But if you look at hedge fund returns from June 2007 to February 2013 you can see that risk factors explain a lot of what the average hedge fund is doing, alternative risk factors capture a lot of their investment returns,” he says.
The next generation of funds have now arrived, Naik says, where the building blocks, or decomposed risk factors, can be used by investors to build their own basket of risk factors to suit their needs.
“A new era has dawned where investable risk factors enable you to identify genuine alpha producers. Most importantly it allows you to pay alpha-price for alpha-like returns and beta-price for beta-driven returns,” he says.
“Alpha is different for different people it is a nebulous concept. But I define it as what I can’t do or access in a cheap and transparent way. It is partly perception, partly what you can do versus what you can’t do.”
In answering the question if there is enough alpha around for investors to share, he says it is important to go back to expectations.
“What am I expecting from hedge funds, what should a manager earn after transaction costs before I pay 2:20?. You have to go back to expectations of what you want from hedge funds, what am I expecting from these investments and how does it complement the rest of the portfolio?
In looking at return and risk expectations Naik reminded delegates that between 2002 and 2010 the MSCI World worst 21 months produced -6.8 per cent, and the best 21 months produced 6.94 per cent.
The returns for the mega firms in the hedge fund world, those that hold 90 per cent of the hedge fund assets, for the worst 21 months were -0.4 per cent and the best 21 months were 1.6 per cent.
Naik cautioned investors there was agency problem in the concentration of assets in the hands of a few hedge fund managers. The capital distribution of the industry is such that the big funds seem to be getting bigger. The good old 80:20 rule appears to be more like 90:10 for the hedge fund industry, with 90 per cent of the assets are being managed by 10 per cent of the names.
“It’s the age-old saying you can’t be fired for buying IBM, the same thing applies to hedge funds today, you can’t be disciplined for buying the big funds like Highbridge, Bridgewater, Brevan Howard, Winton and so on. These choices seem to be driven, in part, by career concerns on the part of institutional investors – a common agency problem we face in delegated portfolio management.”
Investment professionals from pension funds, endowments and family offices in the UK and Europe were brought together for an investment think-tank with leading academics from London Business School and Cambridge University to discuss the latest investment thinking and application to institutional investors’ portfolios.
The academics presented to the investors who then discussed the outtakes and the implications of the lectures with their peers via roundtable discussion.
The highly interactive format, expertly facilitated by Conexus Financial and conexust1f.flywheelstaging.com with sponsorship support from Winton, allowed for the fusion of academic thinking and investment best practice, giving investors an edge in their decision making.
The presentations were:
• Investing in financial assets for the long term, presented by Elroy Dimson
• Hedge fund factors and extracting absolute returns, presented by Narayan Naik
• Incorporating lessons of financial history into investment practice, presented by David Chambers
Analysing equity market returns over a very long period – 1900 to 2014 – reveals a dramatic transformation in the dominance of certain sectors. Elroy Dimson, chair of the Centre for Endowment Asset Management at Cambridge Judge Business School, and emeritus professor of finance at London Business School, outlined the lessons investors can take from long term financial asset returns at the Conexus Financial Investor Think Tank in London last week.
In his presentation “Investing in financial assets for the long term” Dimson analyses sectors and returns over more than 100 years using a database of market returns from 23 countries from the period 1900 to 2014 that he co-developed with Paul Marsh and Mike Staunton.
The database includes 21 unbroken histories – with China and Russia having broken histories – that looks at stocks, bonds, bills, inflation, currency, and GDP over 115 years.
Analysing the data reveals a “great transformation” in the dominance of industries, or sectors. For example in 1900 in the US around two thirds of the index was in railroads, but come 2015, the industries that occupied 80 per cent of the weight of the index in 1900 either don’t exist or are very small. In modern-day analysis the index is made up of banks, health, tech and other industrials.
“We can learn something from these long-term changes,” Dimson says. “In 1900 about 80 per cent of the weight was in sectors that don’t exist or are very small today, and conversely the industries that dominate today didn’t exist a century ago.”
In the UK it is the same pattern, with 65 per cent of the index made up of industries that don’t exist in 2015.
“Long term sector changes are important,” Dimson says, “particularly when you look at performance.”
From the period 1900 to 2014 the top performing sector in the US was tobacco.
“$1 invested in 1900 would be worth $6.3 million in 2010,” Dimson says. “In the UK alcohol was the biggest winner, with £1 invested in 1900 giving you $243,152 in 2010.
“When you are projecting into the future, this history tells you there are only a few sectors that survived the time period that outperformed the market.”
Dimson points out that one of the risks of looking at history like this is it leaves out industries like wagon makers, canal boats, steam locomotives or candle makers that were not going to survive. It is also important to consider that the start date of the period being assessed will affect the result.
“If you start at 1930 then history is very different,” he says.
What is clear is there is a “technology effect” in markets over time.
“200 years ago a disruptive technology was the use of water canals, where you could move 60 times the amount of goods compared to wagons. But if you were an investor in canals the returns weren’t very good in the 19th century. Investors lost out.”
Over time, this theme of disruptive technologies not benefiting investors plays out.
In fact analysis shows that the creators, owners and innovators of new technology, along with society, are winners, but investors are often losers.
Dimson quotes from Alasdair Nairn’s book, “Engines that Move Markets: Technology Investing from Railroads to the Internet and Beyond”, and concludes that there are a number of timeless lessons from technology that still apply today:
-new technologies generate bubbles
-there needs to be a sustainable competitive advantage
-and the greatest beneficiaries of new technologies are the insiders including the innovators and founders of the businesses, but also consumers and societies – but not necessarily the investors.
One way of demonstrating this is to look at the returns of companies from the time of their initial public offer (IPO).
Looking at market adjusted returns for IPOs in the US reveals that on the first day they trade at +17.9 per cent and for the next three years trade at -18.6 per cent.
Similarly in the UK on the first day, IPOs trade at +8.5 per cent, for the next two years trade at -9.4 per cent and for the next five years trade at -31.6 per cent.
Further, the returns improve with the years of seasoning since IPOs.
Dimson, Marsh and Staunton looked over the period 1980-2014, and £1 invested in a strategy that holds companies that are more than 20 years old since the IPO of the company would generate £61.
If the strategy was to hold companies which at the start of each calendar year had been listed for 8-20 years since their IPO, they would have generated £49. In contrast £1 invested in a strategy with companies that had 4-7 years since the IPO would return £33, and £1 invested in companies with less than three years since the IPO would generate £20.
“The older the company being purchased the better the performance. The long-term record is very striking,” Dimson says. “In general IPOs create new industries which on average underperform in their early years.”
In a bid to assess the performance of new technologies over the long term, and in fact whether backing new technology is a recipe for good performance, the analysis shows that railroads were the only transportation industry to outperform the market in the period 1900-2014.
“$1 invested in railroads in 1900 generated $62,019 against the market of $39,134, compared to roads that produced $10,436 and air that produced $7,194,” he says.
Dimson goes on to say that weighting of industries by country in the FTSE International shows there are many countries that are dominated by a couple of industries. In fact there are many countries that have less than 50 per cent in three industries.
“To diversify across industries, investors need to invest globally,” he says.
Taking sector analysis and applying it to responsible investing, Dimson shows the outperformance of “sin” industries since 1900.
In the US, tobacco beat the market with a return of 14.6 per cent versus 9.6 per cent, and in the UK tobacco beat the market by a similar margin.
While tobacco was the best performer in the US, in the UK alcohol has been the best performer since 1900.
Similarly taking the FTSE index, it shows the return on markets ranked by their corruption tendency showed that 21st Century returns had been highest in the most corrupt countries.
While there are a number of strategies for implementing responsible investing – including exiting companies and engaging with companies – Dimson argues that exiting companies may depress stock prices and raise the expected returns from vice stocks.
He says engaging with companies improves corporate behaviour which tends to be followed by share price gains. And says a strategy may be to buy the shares of irresponsible companies, clean up the business and then move on to the next “clean-up” opportunity.