Investment theory: good ‘in theory’

Investors should not rely on investment theory because the complex and connected risks in the real world cannot fully be accounted for, says Tim Unger, head of advisory portfolio group at Willis Towers Watson in Australia.

For example modern portfolio theory, for which Eugene Fama won a Nobel Prize, factors in the exogenous risk of changes to underlying fundamentals, but only explains about 20 per cent of the realised market volatility, Unger says.

The theory does not account for endogenous risk, such as the random behaviour of investors who are acting on incomplete information.

According to the theory of rational beliefs by Stanford’s Mordecai Kurz, investors make judgement calls about what will happen to the price of securities based on past and present data, but because not every investor will have access to the same information, and this will cause some to overestimate the price and others to underestimate. Based on these rational beliefs investors will take actions, and this in turn causes things to be more volatile than they otherwise should be. Kurz’s research shows once you take this into account, 95 per cent of market volatility can be explained.

“Turns out that we need more than just one theory,” Unger says.

“The world is complex and there is no single overriding theory that does a good job of describing the real world that we live in. It’s just much more complex and changes more quickly than we expect. We can however use and draw on a number of theories to help us get a better understanding of the world, rational belief being one, but there are others.”

Because no one investment theory is sufficient, Unger said institutional investors should be taking actions to account for this, including developing stronger and deeper investment beliefs; allocating more to alternatives as equity markets will always have bad periods; and either being truly long-term or truly short-term, as a portfolio cannot simultaneously capture the benefits of both.

“In all of this, good beliefs are critical … And by having a better mental map of how those [investment theories] can impact security prices and asset classes, you can actually reflect those in your portfolios and generate better outcomes.”

Stronger and deeper investment beliefs

According to Unger, in an ideal world there is a hierarchy of beliefs, starting at the board and running down to those implementing the portfolio.

The board sets the high-level views and beliefs that frame the organisation and the investment portfolio. However, as there is no settled theory on the more detailed aspects of financial markets, the closer you get to those implementing the actual portfolio, the deeper and richer those beliefs need to become to help in the navigation of decisions.

“Embedded in every single investment decision you make is a set of beliefs. And so what we are arguing for, is that judgement and beliefs need to become a bigger part of the investment process, and those beliefs need to be richer and deeper.”

Another suggestion on how to achieve a better performing portfolio was for asset owners to use those fund managers who had sophisticated mental maps and were already capitalising on a deeper understanding.

“Those managers that can do that are clearly worth paying fees for because they generate excess returns. But other ways you can exploit better understanding is either through thematic investing or through dynamic asset allocation (DAA).”

What thematic and dynamic asset allocation require from an investor is the ability to identify where markets have mispriced and then the patience to wait for those to be realised.

“I’m not going to suggest that any of these are easy – none of them are – but they are all doable, that’s the important part.”

Allocate to alternatives, even if it is difficult

Recently Willis Towers Watson has increased its emphasis for investors not to rely on risk premia that are macro sensitive, as most portfolios are too reliant on credit and equity market risk.

“While Australia has led that charge in terms of increasing allocation to alternative assets, more recently they’ve slowed down and the rest of the world has actually overtaken them.

“The question is, why is that? Have they reached the point where they have the right allocation to alternative assets? Or are there factors that are limiting greater uptake of diversity?”

A straw poll of the delegates at the consultants Ideas Exchange in Sydney revealed that headline fees were not the constraint; rather it was a desire not to increase complexities in portfolios.

“But the fact that there isn’t greater conviction in the equity risk premia is also interesting. I think what it says is there is still appetite to take on greater diversity, it’s just that there are things that are making it harder to do; [that] there are higher hurdles to get new assets in your portfolio and that marries with our experience.”

Exploiting endogenous risk

Unger added asset owners need to have a truly long-term view.

“It’s too difficult and it’s too unrealistic to expect that we can build portfolios to do well in the short-term and the long-term,” Unger said.

“We have to adopt a portfolio that will do better over the long-term, partially because while we may well have a belief in mean reversion, we just don’t know when that is going to apply.

“Most of the changes in markets in the short-term are not due to changes in the fundamentals, it’s due to noise, so the best way to outperform with stock selection or asset allocation is to have a truly long-term view.”

However, it was possible to outperform by being truly short-term by exploiting endogenous risk that dominates the financial system, but which is largely noise when looked at from the longer term perspective.

Unger suggested some strategies that exploit endogenous risk were non-price weighing schemes and smart beta.

“There are also some very short-term oriented strategies that seem to do that, but I would argue they are probably not as easy to do as the longer term fundamental stuff, but still doable.”