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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Links theory and practice for investment professionals and portfolio managers, demonstrating why some portfolios consistently perform better than others Investing well, like any other business, depends on competitive advantage. Some portfolios reliably generate greater returns than others because they simply are better positioned to benefit from strengths and avoid weaknesses. Building and using competitive advantage becomes central to the daily work of the best mutual funds, hedge funds, banks, insurers and virtually every other type of portfolio. But competitive advantage commonly is overlooked in most written work for investment professionals. The literature often varies between abstract formal treatments and pragmatic workbooks with little in between. Competitive Advantage in Investing fills the gap by integrating modern portfolio theory with actual practice in one comprehensive volume. This innovative book guides investment professionals on building and sustaining competitive advantage and helps policymakers and researchers apply theory in a wide range of practical settings. Author Steven Abrahams--Senior Managing Director at Amherst Pierpont Securities and former Adjunct Professor of Finance and Economics at Columbia Business School--draws from his experience in both academic theory and real-life strategic investing to bridge the two worlds. This valuable resource: * Connects the formal literature on investing to the actual work of most institutional portfolio managers * Examines core strengths and weaknesses that drive portfolio behavior at mutual and hedge funds, banks and insurers, at other institutions and for individuals * Demonstrates how linking portfolio theory and practice can increase competitive advantage * Offers a robust description of investing, markets, and asset value Competitive Advantage in Investing: Building Winning Professional Portfolios is a must-have book for any investment professional, policymaker, or researcher.
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Table of Contents
Cover
Preface
Acknowledgments
Part I: Theory
1 Welcome, Harry Markowitz
In the Beginning
Choose Wisely
All Cash Flow Includes Risk
Risk Is the Mirror to Return
The Surprising Power of Diversification
The Sources of Risk and Correlation
Markowitz's Open Questions
2 A Sharpe Line
Finding a Place on the Efficient Frontier
Traveling Along the Capital Market Line
Putting a Price on Assets Along the Capital Market Line
The Power of Leverage, the Price of Equity, the Value of a Good Manager
A Theory that Changed Investing
3 The Counsel of Critics
Putting Theory to the Test
A Problem with Alpha
Performance Turns on More Than Beta
Seeds of New Approaches
4 Toward a New Capital Asset Pricing Model
A New Focus on Leverage
Limits to Leverage
More Betting-Against-Beta
A Natural Experiment
Limits on More Than Leverage
5 The Local Capital Asset Pricing Model
Shopping in the Neighborhood
Local Markets for Investing
Implications of Local Markets
Appendix
6 Creating Competitive Advantage
Constrained Optimization
7 Building a Portfolio on Competitive Advantage
Navigating Future States of the World
Return and Risk Goals
Anticipating Future States of the World
Choosing Among Feasible Investments
Putting the Pieces Together
From Theory to Application
Part II: Practice
8 Investing for Total Return: Mutual Funds
The Structure of Mutual Fund Investing
Constraints on Mutual Funds
Role of Performance Benchmarks
Role of the Investment Covenant
Mutual Fund as Intermediary
Sources of Comparative Advantage
Predictions of Local CAPM
Pursuit of Scale
Narrower and Broader Benchmarks
Investing Outside of Benchmarks
Relative Value Investing
The Quality and Cost of Capital
Other Findings
Conclusion
9 Investing for Total Return: Hedge Funds
The Structure of Hedge Fund Investing
A Relative Lack of Constraint on Hedge Fund Investing
Role of Performance Benchmarks and Investment Covenants
Peculiarities of Reported Hedge Fund Returns
Publicly Traded Hedge Funds
Sources of Comparative Advantage
Predictions of Local CAPM
The Formal Literature
Conclusion
10 Investing for Banks, Thrifts, and Credit Unions
The Structure of Bank Investing
Basics of Disintermediation
Duration of Equity
Duration of Leverage
Duration of Net Interest Income
Other Forms of Equity
The Unique Role of a Bank Investment Portfolio
Sources of Comparative Advantage
Predictions of Local CAPM
Evidence for Local CAPM
Differentiation
Retail Rather Than Wholesale Funds
Loans Rather Than Securities
Low- and High-Quality Assets
Short- Rather than Long-Maturity Assets
Floating- Rather than Fixed-Rate Debt
Conclusion
Appendix: A Few Special Topics in Bank Balance Management—The Duration of Regulatory Leverage
11 Investing for Property/Casualty and Life Insurers
The Structure of Insurance Investing
The Basics of Insurance
Sources of Comparative Advantage
Predictions of Local CAPM
Evidence of Local CAPM
Conclusion
12 Investing for Broker/Dealers
Broker Market Structure
Revenues for Brokers
The Volcker Rule
The Role of Broker as Financial Intermediary
Sources of Comparative Advantage
Predictions of Local CAPM
Informal Findings
Conclusion
13 Investing for Real Estate Investment Trusts
REIT Market Structure
Sources of Comparative Advantage
Predictions of Local CAPM
Informal Evidence
Conclusion
14 Investing for Sovereign Wealth Funds
The Structure of Sovereign Wealth Funds
The Challenges of Governance and Public Support
The Issue of Government or Individual Control
Sources of Comparative Advantage
Predictions of Local CAPM
Informal Evidence
Conclusion
15 Investing for Individuals
The Structure of Individual Investing
Sources of Comparative Advantage
Predictions of Local CAPM
Informal Results
Conclusion
Part III: Markets
16 Turning the Tables: Investor Impact on Asset Values
The Yield Curve Conundrum
European Demand for Highly Rated Assets
The Effects of Quantitative Easing
Bank Liquidity Rules Shift Investment Portfolio Holdings
Other Cases
The Competitive Portfolio Response
References
About the Author
Index
End User License Agreement
List of Tables
Chapter 6
Table 6.1 Examples of portfolios with different amounts and types of leverage
Table 6.2 The impact of shifting rates depends on leverage
Table 6.3 Candidates for hedging
Table 6.4 Assets with sensitivity to different risks
Chapter 7
Table 7.1 The level of a risk can take on a different value in each future st...
Table 7.2 Examples of risk levels in hypothetical future states
Chapter 8
Table 8.1 Rules for including securities in the Bloomberg Barclays US Aggrega...
Table 8.2 Grinold and Kahn's estimate of information ratios across managers
Table 8.3 The Bloomberg Barclays Aggregate US Credit Index is a subset of the...
Table 8.4 Regressing a more diversified index such as the Bloomberg Barclays ...
Chapter 9
Table 9.1 Corrections for survivor and backfill bias lower average hedge fund...
Table 9.2 Hedge fund alpha and systematic beta estimates January 1995–2008
Table 9.3 Fung-Hsieh seven-factor model January 1995–December 2009
Chapter 10
Table 10.1 The aggregate US bank balance sheet
Table 10.2 A stylized example of a bank balance sheet
Table 10.3 Bank risk weights for selected assets
Table 10.4 Accounting classifications for fixed income securities
Table 10.5 A range of US bank business models as of early 2019
Table 10.6 A sample of bank balance sheets
Table 10.7 A simple bank balance sheet invested in mark-to-market securities
Table 10.8 A simple bank balance sheet after a shift in rates
Chapter 11
Table 11.1 Average insurer balance sheet (1999–2009)
Table 11.2 A simple insurance example
Table 11.3 Components of insurer risk-based capital, or RBC
Table 11.4 Contributions to life insurer RBC
Table 11.5 Asset risk requirement
Table 11.6 RBC and target ROE lead to minimum acceptable asset yields
Table 11.7 Asset accounting treatment
Chapter 12
Table 12.1 Broker ROE shows aleveraged return to fixed income (2.51x) and a d...
Chapter 13
Table 13.1 REITs have to meet asset, income, and ownership requirements
Chapter 14
Table 14.1 The world's largest sovereign wealth funds in 2019
Chapter 16
Table 16.1 Europe invested heavily in corporate debt and structured products ...
List of Illustrations
Chapter 1
Figure 1.1 Markowitz's approach leads to a limited combination of securities...
Figure 1.2 The periodic returns on different assets can vary together, with ...
Figure 1.3 Markowitz also showed that risk in a portfolio falls as the corre...
Chapter 2
Figure 2.1 In Markowitz's world, every risk-averse investor would make a dif...
Figure 2.2 Borrowing and lending at the riskless rate allows any investor to...
Figure 2.3 Steady investment in portfolios along the capital market line rai...
Chapter 3
Figure 3.1 On stock portfolios that vary in their beta, realized returns are...
Chapter 4
Figure 4.1 CAPM critically assumes unlimited leverage.
Chapter 5
Figure 5.1 Investors can operate, and assets can trade, in separate local ma...
Figure 5.2 Local investors hold the market portfolio along local capital mar...
Figure 5.3 The aggregate market portfolio is a simple average of local marke...
Figure 5.4 Investors free to diversify outside local markets move along the ...
Figure 5.5 The global capital market line is always steeper than local capit...
Chapter 8
Figure 8.1 The market value of mutual funds since 1980 has grown at an annua...
Figure 8.2 Independents and bank and insurer affiliates make up the 25 large...
Figure 8.3 Diverse asset allocation in the largest US fixed income mutual fu...
Figure 8.4 Alpha generated by the largest mutual funds benchmarked against t...
Figure 8.5 Relationship between alpha and the deviation of fund asset alloca...
Chapter 9
Figure 9.1 Rapid growth of assets under management at hedge funds.
Figure 9.2 Growth in number of hedge funds and funds-of-funds has lagged gro...
Figure 9.3 Hedge fund liquidations accelerated into the financial crisis, ex...
Figure 9.4 A rising percentage of hedge funds have chosen public listings....
Figure 9.5 Year-by-year hedge fund alpha and systematic beta returns 1998–20...
Chapter 10
Figure 10.1 Private depositories' share of US debt has fallen since the 1970...
Figure 10.2 Steady consolidation in US commercial banking since the early 19...
Figure 10.3 Banks stand between users and suppliers of funds.
Figure 10.4 Key forms of bank funding
Figure 10.5 Estimated average lives for demand deposits run longer than OTS ...
Figure 10.6 Projected price premiums for core deposits at selected depositor...
Figure 10.7 Bank liability structures across major economies and regions...
Figure 10.8 Banks hold an outsized share of US lending.
Chapter 11
Figure 11.1 Top 25 property and casualty and life insurers
Figure 11.2 US P&C insurers' asset balance and asset mix
Figure 11.3 US life insurers' general account asset mix
Figure 11.4 Fewer life insurers and rising employment point to consolidation...
Figure 11.5 Life insurance in force has failed to keep up with US GPD.
Figure 11.6 P&C insurers' combined ratio can vary significantly from year to...
Figure 11.7 More volatility in paying for annuity surrenders than for life b...
Figure 11.8 Sources of funding for life-and-health insurers
Figure 11.9 Types of risks hedged with derivatives by insurers
Figure 11.10 Life insurers tend to invest in debt with long maturities.
Figure 11.11 Life insurance portfolios hold a larger share of illiquid secur...
Figure 11.12 P&C insurers hold more than a quarter of their portfolio in mun...
Figure 11.13 Both life and P&C insurers hold a majority of assets in fixed i...
Chapter 12
Figure 12.1 The number of FINRA-registered firms has steadily declined.
Figure 12.2 A small share of brokers control most revenue, assets, and capit...
Figure 12.3 Broker return on equity has varied significantly with returns in...
Figure 12.4 Brokers hold substantial net positions in fixed income assets....
Figure 12.5 Trading gains and losses can be the most volatile part of broker...
Figure 12.6 The average broker has held between $5 and $35 of assets for eve...
Figure 12.7 Share of trading captured by the top five brokers varies signifi...
Chapter 13
Figure 13.1 Equity REITs grew aggressively from 1985–1995 and again after 20...
Figure 13.2 The market tracks at least 18 different types of US REITs.
Chapter 14
Figure 14.1 Launch date, sponsor, and objectives of world SWFs to 2008
Figure 14.2 Foreign exchange reserves in Asia have built up since the mid-19...
Figure 14.3 Foreign sovereign portfolios hold most of their US exposure in T...
Chapter 15
Figure 15.1 Most US household wealth is tied up in bank accounts, vehicles, ...
Figure 15.2 Transactions costs for retail run up to four times the cost of b...
Figure 15.3 Earnings vary with GDP especially for very high or low earners....
Figure 15.4 Younger workers bear more GDP risk than older workers.
Figure 15.5 The impact of GDP on earnings varies across industries.
Chapter 16
Figure 16.1 Liquidity rules have shaped bank appetite for liquid assets....
Guide
Cover
Table of Contents
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Competitive Advantage in Investing
Building Winning Professional Portfolios
Steven Abrahams
This edition first published 2020.
Copyright © 2020 by Steven Abrahams
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Library of Congress Cataloging-in-Publication Data
Names: Abrahams, Steven, 1959- author.
Title: Competitive advantage in investing : building winning professional portfolios / Steven Abrahams.
Description: First Edition. | Hoboken : Wiley, 2020. | Includes index.
Identifiers: LCCN 2019056753 (print) | LCCN 2019056754 (ebook) | ISBN 9781119619840 (cloth) | ISBN 9781119619857 (adobe pdf) | ISBN 9781119619864 (epub)
Subjects: LCSH: Investments. | Portfolio management.
Classification: LCC HG4521 .A216 2020 (print) | LCC HG4521 (ebook) | DDC 332.6—dc23
LC record available at https://lccn.loc.gov/2019056753
LC ebook record available at https://lccn.loc.gov/2019056754
Cover Design: Wiley
Cover Image: © ChubarovY/Getty Images
To Maryann and Stuart,
who got me started,
and to Valerie, Ben, Margot, and Jake,
who kept me going.
Preface
Take a little time at some point to look over the public portfolios of a few larger investors. Pick a mix of mutual funds or hedge funds or banks or insurers, for example. It could include almost any professionally managed portfolio. It should start to become clear that investing takes place over a wide and diverse landscape.
Each portfolio will differ from others in ways large and small. Each manager will describe the business in different terms. Some will talk about stocks, some about bonds, some about things different altogether. Some will emphasize income, some will emphasize price. Some will talk stability, others not. Issues important to one will barely show up in the notes for another. Each portfolio will seem to run like a separate business. And that is true for the thousands of portfolios that come into the markets every day.
Similar to any other business, investment portfolios compete to make the best out of opportunities that flow through the markets daily. Similar to any other business, the most successful assess themselves and others up and down the line and create and sustain competitive advantage. Plenty of good work has challenged the ability of any investor to consistently beat the competition. But practitioners and students of finance increasingly realize some portfolios simply are better positioned than others to generate quality returns. The reasons vary, but the best investors know their relative strengths and weaknesses and try to anticipate circumstances where their strengths might capture returns unavailable to others in the market. The competitive landscape constantly evolves. Investing is a competition, but not everyone is playing the same game.
Most of the written work on investing barely reflects the diversity of portfolios and the competition between them. The daily press and most magazines, journals, and books usually offer an eclectic mix. There's the daily drama of winners and losers. There's nuts-and-bolts advice for practitioners. There are formal treatments of finance that abstract away from the institutional details of the markets. Between these islands of information is a sparse archipelago. This book tries to build a bridge from daily headlines to the actual work of most institutional portfolio managers and on to the formal literature on investing.
The formal literature does capture an important strand of institutional investing in its emphasis on balancing risk and return. This strand tends to view investing as a world of assets with particular expected risks, returns, and correlations. In the version of this world that has dominated formal finance since the 1950s, all investors see the future in just the same way and share the same expectations of asset performance. In its strongest form, the formal work in finance largely rules out the possibility of portfolios with sustainable strengths and weaknesses. This line of work has produced important insight into the best ways to trade off return against risk in both individual investments and portfolios. It has put an important spotlight on the value of diversification. And it has led to valuable tools for breaking investor performance into the part likely due to simply taking risk and the part due to the managers' skill. At some point, practicing institutional investors do balance the relative value of different assets and try to add something to portfolio performance.
Still, some of the most widely taught tenets of modern investing seem oddly distant from the concerns and activity of investors in the market every day. Some theories imply investors should largely hold portfolios of similar assets, but few do. Some theories imply little room for investors to generate performance much better than the broad market, but investors nevertheless go into the market looking for it every day. Some theories imply that investment risk, return, and correlation is all that matters, but the daily work of professional investors seems consumed by so many other things.
The formal literature on investing often assumes away the institutional constraints that set boundaries for portfolios managing most of the world's capital. These constraints create the strengths and weaknesses that enable different portfolios to look at the same assets and see different opportunities. Only in the last decade or so have some of the best students of finance at universities and investment portfolios started to weave these constraints into explanations of asset returns and market behavior. Work that explains the origin of institutional constraints and their impact on investment and asset value offers a better theory of the markets. It explains more of investors' observed behavior.
Although the formal literature rarely deals with the institutional constraints, the literature for practitioners at times seems to deal only with these constraints. Part of the practitioners' literature lays out the definitions and conventions of securities markets. Part focuses on accounting, tax, and regulation. Part focuses on ways to finance investments. Part outlines ways to manage assets against liabilities. These are necessary and practical topics, but they do not point the way toward building a competitive investment business. Among other things, the work for practitioners rarely links back to the genuinely valuable framework that ties risk to reward and highlights the powerful implications of diversification.
Competitive advantage shapes the business of investing as much as it does any business. Some portfolios find themselves better equipped to expand into new areas or respond to investment opportunity. Some find themselves better able to leverage, deleverage, or tailor the risk and return in existing assets. Some portfolios find themselves better informed, better able to hold assets under different accounting or tax treatments, better able to navigate regulations and politics. These things and others create configurations of competitive advantage.
Portfolios that recognize strengths and weaknesses improve their chances of earning sustainable returns beyond those of broad market averages. In practice, most portfolios specialize in their strengths. This usually gets little attention in formal theory, which often relies on the simplifying assumption that all investors have the same information and investment capacities. Of course, this also implies that no investor can deliver consistent excess return and that no portfolio can sustain advantage.
Competitive advantage also figures in anticipating the plausible future states of the world, which is central to good investing. After all, future economic growth, interest rates and lending terms, hedging, information flow, taxes and accounting rules, political and regulatory changes, technology, and so on all shape investment returns. Some portfolios have comparative advantage in anticipating this kind of change. And, empirically, the time and effort spent by investors on forecasting attests to the importance of anticipating a probabilistic future.
Finally, competing portfolios shape the value of different assets all the time. Formal finance acknowledges the idiosyncrasies of preferred risk and return across investors. But once institutional constraints lead large blocks of capital to adopt similar preferences, then the idiosyncrasies of individual portfolios coalesce into systemic influences on asset value. Investors will demand compensation for these systemic influences. Among other things, the value of the US Treasury market, the agency mortgage-backed securities market, and the corporate debt market, among others, have been shaped in the last few decades by episodes of major institutional capital flow responding less to return, risk, and correlation than to policy and regulation.
This book brings together investment theory, practice, and markets to explain the differing goals of professional investment portfolios, the sources of competition between them, and the impact of competition on asset value. For theorists, it adds to the list of systemic factors that drive asset value by breaking global asset markets into local ones. For practitioners, it frames the business of investing as a competition with other portfolios operating under similar constraints. For market analysts, it details the ways that scale, leverage, funding, hedging, information, tax and accounting, and regulation and politics can suddenly shift the playing field.
The book starts with the ideas that brought investing into the modern era. Harry Markowitz revolutionized investing by changing it from an exercise in calculating present value into one of balancing risk, return, and diversification. William Sharpe and his peers then built on work by Markowitz and others to develop the capital asset pricing model, or CAPM. CAPM would offer a beautiful theory of investing but arguably one that hid as much as it revealed.
In the half-century after CAPM's debut, its critics would steadily pile up one piece of evidence after another showing shortfalls in the model's description of markets. Analysts at universities and across Wall Street would offer expanded versions of CAPM to explain the anomalies. The local capital asset pricing model, introduced here, is one such version. Local CAPM explicitly builds in competitive advantage and disadvantage across portfolios and their impact on asset value. The sources of advantage and disadvantage are specific and their impact unique.
From investment theory, the book swings into analysis of the broad investment platforms and special vehicles that dominate markets. Mutual funds and hedge funds compete to generate total returns. Banks and insurers manage asset portfolios against a series of specific liabilities. Broker/dealers stand between investors but still extract investment return and shape markets. Real estate investment trusts and sovereign wealth funds reflect the impact of mixing public policy with investment portfolios. And the potential advantages that individual investors might have in highly competitive markets get treatment here as well.
This guide is for researchers who want a better model for the observed behavior of investors. This is a guide for practicing investors who want a better, formal framework for managing the investment process and building a competitive business. This is also for students of markets who want to understand how the behavior of investors can shape the value of assets.
Kurt Lewin, the psychologist, noted that there is nothing so practical as a good theory. A good theory organizes facts and simplifies and explains an otherwise complex landscape without diminishing its most important features. The book you are about to read takes a resolute step in that direction.
Steven Abrahams
September 9, 2019
Acknowledgments
The 2008 financial crisis planted the seeds for this book. I was at Bear Stearns watching everything going on around me in the markets and covering much of it as part of Bear's fixed income research team. My job let me range across different markets and talk to different investors in the US and abroad. It had been the case throughout my Wall Street career that advantages and disadvantages mattered in investing, and the crisis made it especially clear. When Bear collapsed, I decided to try to relay some of what I had learned to a new generation.
Glenn Hubbard, dean at the Columbia Business School, and Galen Hite, who organized the adjunct faculty for him, warmed to the idea of a course that would focus on ways that different institutional portfolios dealt with markets. They gave me the chance to design and offer the course, and I took it. I've been grateful ever since.
From that first semester, the students at Columbia Business School taught me as much as I taught them. There was no precedent for the course, much less a book, so I started doing the background work and developing the materials that evolved over the years into these pages. The students contributed excellent ideas, challenged me to hone my own, and taught me that a good lecture is as much a performance as anything else. I thank them for the education.
The clients and colleagues that explained the way different portfolios work, or just showed me by analyzing the same markets in such different ways for such different reasons, also deserve thanks. My list of contacts, which I've kept carefully since my first day on the Street, runs into the thousands. They all deserve some credit. The job of analyst has always seemed an extraordinarily good place to satisfy curiosity. Morgan Stanley, Bear Stearns, Deutsche Bank, and Amherst Pierpont have given me the opportunity. I've taken full advantage.
Some friends in the business deserve specific mention for carefully reading sections of this book and offering thoughtful comments. Richard Dewey, Albert Papa, Glenn Perillo, and Robert Thompson kindly read parts of the manuscript on tight deadline. Of course, any shortfalls or errors in this book are entirely mine.
Kevin Harreld, Michael Henton, and Richard Samson at John Wiley & Sons have encouraged me throughout the drafting of this manuscript and worked with me patiently to get all the details right for publication. To my partners at Wiley, thank you.
As for my family, I thank them for the time on nights and weekends I needed to work through the book, for their support and encouragement, and for the beautiful spot by the lake in New Jersey where much of the writing took place and where all good things happen.
Steven Abrahams
September 9, 2019
Part ITheory
1Welcome, Harry Markowitz
In the Beginning
Imagine a simple beginning. You have some spare cash. You have covered your daily cost of living and other bills, and it's rattling around in your pocket. You start thinking about what you might do with it. Other than spend it, that is. That is the beginning. With that thought, you have become an investor.
Or imagine that you are sitting at a bank or insurance company or mutual fund. Or a hedge fund or some other place that invests professionally. In front of you is a number with the cash you have to invest. You have work to do.
You start penciling out a list. It's short at first. Maybe you think about putting the money in a drawer just because it's convenient. Perhaps you think about putting the money in a bank. Or you think about making a loan to someone or some company somewhere in the world. You think about investing as an owner of a business or several businesses. You imagine a budding international empire of businesses. The list has only started.
You could buy a bond from a government or from a company somewhere in the world. You could buy stock. You could buy an option, where someone takes a payment today and agrees to either buy or sell something at a certain price in the future. You could buy insurance or a contract that works like insurance, where someone takes a payment today and agrees to cover losses or damage in the future. You could buy gold or silver, wheat or orange juice, oil or other commodities. You could buy an apartment or an apartment building, an office building, or other commercial property. That's a lot to consider, but the list goes on.
You could buy shares in funds managed by professional investors—even if you are a professional investor yourself. The fund would invest on your behalf in any or all of the available markets. You could buy shares in funds that make loans, buy and sell private companies, buy and sell bonds or equity, own options or commodities or real estate, or any combination of these and other things. You could own funds that trade their investments all the time or almost never. The list continues.
It you printed this list out and watched the pages tick off of the printer and slide onto the floor, it would likely run longer than the longest list you have ever seen. It would fill up the room, spill into the hallway, out the front door, and down the street. It would keep going from there. You could follow it to the ocean and watch it start to fill up the deepest parts. The list would literally be endless.
Now that you have this infinite list, choose. Build your portfolio.
Choose Wisely
The challenge of investing becomes a challenge of choice and choosing wisely.
If you avoid the temptation to put the infinite list aside and do nothing, you may start to notice something common to all of these investments. Something that unifies them. Something that simplifies them. Something that enables you to compare each item on your infinite list to every other.
Start with the money in the drawer. You put the money there, and time passes. One day, you open the drawer and take the money out. You spend it.
Consider another simple investment: depositing money in a bank. You put the money in the bank, and time passes. The bank pays interest on your deposit. One day, you take the deposit and the interest out of the bank. You spend it.
Now consider another investment: a loan. You give the borrower cash. The borrower makes interest payments on a certain schedule and then returns the cash. The investment ends. You spend it.
Consider a related investment: a bond. You buy a bond with cash. The cash goes to a government or company. The government or company pays interest on a certain schedule and then repays the cash. The investment ends.
Consider buying a company or making an investment in common stock or some other form of ownership. The investor buys the stock or the ownership stake with cash. The company uses the cash to operate its business, taking in revenues and paying expenses. Whatever is left over after expenses either gets reinvested in the business or returned to investors as a dividend. The investor never gets back the original cash, although the investor can sell the stock or the ownership stake to another buyer.
Then consider options, insurance, commodities, real estate, and funds. It's a couple of lifetimes' worth of considering.
One thing unifies all of these investments: cash flow. All investing in all of its various forms starts and ends with cash flowing in and cash flowing out of an investment. The world has endless notes, articles, books, and guides to the particular ways that cash flows in and out of different kinds of investments. The investments may seem very different, but underneath the complexities and nuances of different investments is the flow of cash or value into and out of an investment over time. Look through the different names and details to the cash flow. Cash flow is investing stripped to its essentials. Cash flow is all that matters.
Different forms of investment simply entitle investors to different cash flows. The money in the drawer only generates cash in and cash out. A bank deposit generates cash and interest. A loan or bond typically gets principal and interest. Equity gets whatever cash flow is left after a business pays expenses. An option gets the chance to buy debt or equity or something else at some future date. Premiums paid for insurance get the right to recover future damages or losses.
Even when investment advice never mentions cash flow—when it focuses on buying low and selling high, or timing or not timing the market, or momentum or value investing, or the like—it still involves putting something of value in and taking something of value out. If that's not the case, then it's not an investment. It's the purchase of goods or services. Or it's a donation.
All Cash Flow Includes Risk
Both before Harry Markowitz and since, investment theory and practice has followed the thread of cash flow that runs through every item on the infinite list and has woven a broad fabric. Different investments generate cash flow over different time lines. Cash flow can come tomorrow, the next day, or years later. The frequency or circumstances of future cash flow can be easy or hard to predict. Value invested today produces expected value tomorrow. Reasonable people will disagree about the timing or magnitude of return, but the value of any investment ultimately ties back to cash in and cash out.
Think again about the list of investments. The cash in the drawer is there whenever you need it. The bank deposit is usually there, too, whenever you need it. An investor in a loan or bond usually has to wait to get interest and to have principal returned. The cash flow from a stock or other form of ownership depends on the operations of the business.
The timing of cash flows matters. Cash may not be able to buy as much in the future as it can today, so future cash may not be worth as much as cash in the pocket today. The cash in the drawer may be safe, but it may not be able to buy a loaf of bread, a dozen eggs, and a carton of milk at the same price tomorrow. For professional investors at banks or insurers or other funds, cash in a drawer may not be enough to meet future obligations to customers or partners. If prices go up, that is, if there's inflation, then the money in the drawer loses value. Or for professional investors, if customers' or partners' need for return rises, cash in a drawer may not be enough. Timing of cash flow matters because the longer it takes to get the cash, the greater the possibility that the cash loses buying power or falls short of investment expectations. In that case, time truly is money.
Timing matters, too, because borrowers compete for cash over different horizons. Borrowers offer to pay different interest rates over different horizons. The supply and demand for cash leads to a clearing rate at each horizon, often called the real rate of interest.
Cash flow also may not be certain. The borrower disappears or has a run of bad luck and cannot repay. Banks fail. The bond issuer fails. The company falls on hard times. Earnings rise and fall. Laws and regulations change. Taxes go up and down.
The cash flow from an investment can range from stable and predictable down to the last penny to wildly uncertain. Cash flow is dynamic. It is the fingerprint of each investment.
Investors can pack concern about the future value of cash or its uncertainty into a discount rate for each cash flow and add them all up into the discounted present value of any investment.1 That becomes the first unifying, simplifying feature of all investments: present value. Investments with short cash flows and long cash flows, safe cash flows and uncertain or risky cash flows all get summarized in one number: present value. The infinite list of investments gets reduced to an infinite list of present values. The list of present values gets sorted from highest to lowest. Now, perhaps, choosing from the infinite list looks simple. Just pick the best.
Risk Is the Mirror to Return
It may seem that investing comes down to simply choosing the investment with the highest expected return, a single investment that for every dollar going in delivers the most dollars out. It could be the stock expected to appreciate the most or pay the highest dividend. It could be the bond that pays the highest rate of interest. It could be the piece of real estate expected to bring the highest price or produce the most income. It could be gold or silver, wheat or pork bellies, or anything expected to go up in value. Investors have developed ingenious ways to project investment cash flows and then add them up or calculate a discounted present value to compare them all. Investing may seem like a winner-take-all game.
If every investor knew the exact cash flows of every investment, then a winner-take-all hunt through the investment menu would get each investor to the right place. It would create races and anoint winners. Genius would prevail. David would beat Goliath. It would make for great television, valuable tips from one investor to another. It would venerate the hunters that find winning investments.
This is the stuff that makes up most advice on investing. The daily game of covering the markets usually focuses on winners and losers, surprises and disappointments, the new new thing. It is a rich and repeatable story. But it rarely makes for good investing.
It's 1952, and Harry Markowitz, then a graduate student at the University of Chicago, makes a simple observation about the hunt for a single best and highest rate of return: it is an unrealistic way to build a portfolio (Markowitz, 1952). Almost no portfolio ever gets built that way. An exclusive focus on expected return or even on expected discounted return rules out the possibility of holding more than one security—except for the trivial case of multiple securities that all have the highest expected return. The rational investor in a winner-take-all world of returns simply would hold the best security. Any rule that led to an undiversified portfolio with one or even a handful of securities, Markowitz argues, violates both observed investor behavior and common sense. Few things in the world are certain; most are uncertain. A winner-take-all approach to investing was silly in the best case and hubris in the worst. He rejects it.
Markowitz instead focuses on uncertainty or risk. We might like to think the world follows a determined path, but it varies in small and sometimes large ways every day. It is probabilistic. One day dawns clear, another cloudy. Traffic moves quickly one afternoon, slowly the next. Technology advances and a new business replaces an old. Earnings ebb and flow. Buyers' preferences shift.
At any point, the future state of the world is unknown. Some future states may be more likely than others, of course. As the world evolves, the probabilities of some future states rise and fall. And as possible versions of the future come in and out of view, the timing, magnitude, and certainty of investment cash flows change. The cost of living might go up or down over time, the ability of a borrower to repay may change, the prospects of a company will likely vary.
Risk can shape the estimate of expected cash flow and the calculation of present value.2 All else equal, the higher the risk, the higher the discount rate and the lower the present value of an assumed stream of cash flow. A dividend or interest payment that an investor expects with near certainty may get discounted at one interest rate. A payment at risk from earnings or default may get discounted at a higher rate. Risk can enter the calculation of present value, but that does not address Markowitz's critique.
Whether the investor adjusts the expectations of cash flow or adjusts the discounting rate, neither approach on its own suggests any obvious metric other than judgment for choosing the cash flows or the discounting rate. And once an investor choses a set of cash flows and a set of rates, discounted expected return still points to a single best and highest rate of return. The winner is anointed.
Markowitz offers a transformative idea for building a portfolio of risky cash flows, using variance to measure risk: “There is a rate at which the investor can gain expected return by taking on variance (risk),” he writes, “or reduce variance by giving up expected return” (1952, p. 79).
In other words, risk is the behavior of cash flow from the time it starts flowing into an investment to the time it finally flows out. Some investments may produce very reliable, very predictable cash flows. The cash in the drawer has a predictable cash flow. The US Treasury bond has a predictable cash flow. The safest bank deposit does, too. An investment in a start-up company may not. The history of an investment's cash flow should reflect this, and so should expected cash flow. The safest cash flows vary only a little bit and have low variance; the riskiest vary a lot and have high variance.3
Investments with predictable prices or cash flows will tend to offer relatively low returns, and investments with unpredictable prices or cash flows will tend to offer relatively high returns. It's intuitive.
Imagine two companies: one that always pays a $1 dividend each year and another that flips a coin and pays $2 for heads and $0 for tails. Both produce, on average, $1 a year. Both have expected cash flow of $1 a year. If both investments cost the same, most investors would choose the predictable $1. That would drive up the price of the predictable $1, lowering its expected return compared to the coin-flipping investment. That was Markowitz's intuition.
The simple idea of the reliability or variance of returns makes it easier to compare investment returns, including returns on investments that might otherwise seem wildly different. Almost every investment leaves a trail of returns with an average rate of return and variability around that average. An investor can measure variability by a wide set of measures: variance or standard deviation, the ratio of winning days to losing, the largest loss, and so on. They all get at a different facet of risk. A stock or a portfolio of stocks, a bond or a portfolio of bonds, options, real estate, commodities, mutual and hedge funds, and so on all leave a record. All investments leave a trail of returns as distinct as a fingerprint.
Markowitz's emphasis on risk and return encourages investors to compare investments on these two attributes. An investor could take more risk to get more return. But an investor also could compare investments with roughly the same risk and choose the one with the highest return. An investor alternatively could compare investments with similar returns and choose the one with the lowest risk. And an investor could take a view on the future risk and future return of a menu of investments. Investing suddenly becomes an exercise in trading off risk against return.
Investors trading off risk against return should transform the relative value of different assets. For assets with roughly the same risk, the one with the highest return would attract more investment. Its price would rise relative to others and its return would fall. Returns across assets in that sleeve of risk would tend to converge. For assets with roughly the same return, the one with the lowest risk would attract investment. Relative prices and returns would start to shift.
If an investor could go through all possible combinations of potential investments—all the items on our infinite list—the analysis leads to a set of portfolios that have both the highest return for a given level of risk and the lowest risk for a given level of return. These portfolios are the most efficient. Among all possible portfolios of investible assets, the efficient ones line up along a continuum or border from a point with the lowest risk and lowest return to a point with the highest risk and highest return. This becomes the efficient investment frontier (figure 1.1).
It is easy to miss the genius in Markowitz's formulation of risk and return. By bringing risk into the picture, Markowitz puts the least tangible element of investing on par with the most. Return is tangible, easy to measure and compare. It gets reported every day, every month, every year. Return can actually buy things. Risk, however, only shapes returns over time, has to be imagined in advance, and often is clear only in hindsight. Risk rarely shows up in summaries of investment performance. We tell ourselves stories of likely investment return, and, in an effort to convince ourselves or convince others, we tend to narrow the range of likely risk. Markowitz makes risk and return equals.
Figure 1.1 Markowitz's approach leads to a limited combination of securities that have the highest return for a given a level of risk or the lowest risk for a given level of return.
The Surprising Power of Diversification
Markowitz would have taken an important step if he had only made risk and return equals, but he has another idea that revolutionizes investing: investors can improve risk and return in a portfolio by mixing investments. In other words, investors have something valuable to gain from diversification.
To get an intuition for diversification, think again about a company that flips a coin every year and pays $2 for heads and $0 for tails. Then imagine a second company that flips a second coin and also pays $2 for heads and $0 for tails. Each company would pay $1 a year on average with a variance of $1.4 But because the two companies flip separate coins, they don't always pay on the same schedule. Some years, both will pay and investors will get $4. Other years, both will skip payments and investors will get $0. Most years, one or the other will pay, and investors will get $2. The companies still pay their separate cash flows, but the combination over time is smoother. In other words, the combination of the two companies doesn't reduce their expected return, but it does reduce their risk.
To Markowitz, mixed investment or diversification recognizes the unmeasured aspects of an investment that might make its returns move a little differently or very differently from all the investments around it. Diversification brought humility to investing. By diversifying, the investor would have to acknowledge that he or she would never know the likely timing, direction, or magnitude of returns of all the items on our infinite investment list. Diversification encourages adding a wide range of investments to a portfolio to capture the widest range of possible risks and returns.
Diversification might have sounded like just another nice idea if Markowitz had not provided a powerful example of its benefits. Markowitz measured diversification by the correlation between investment returns, or how much returns on different investments move together. Investments with returns that move proportionately up and down by the same amount at the same time would have a correlation of 1 (figure 1.2). Returns that moved proportionately in opposite directions at different times would have a correlation of −1. Investments with returns that have no relationship would have a correlation of 0, such as the two companies that flipped coins. Two investments with the same risk and same return but with a correlation of less than 1, for example, could combine into an investment with the same return but less risk.5 An investor who put the two coin-flipping companies into a portfolio would end up with an investment that returned $1 a year on average but had less than two-thirds of the risk of holding either company alone. The cash flow from the portfolio would be smoother than from either company alone. This is Markowitz's powerful insight on the benefit of diversification.
Figure 1.2 The periodic returns on different assets can vary together, with the correlation ranging from perfectly positive (1) to perfectly negative (−1) to anywhere in between.
Figure 1.3 Markowitz also showed that risk in a portfolio falls as the correlation between investments drops below 1.
Markowitz's insight leads to a finer appreciation for the ways investors could shape the risk and return of a portfolio by mixing different assets. The expected return from mixing assets would simply add up to the expected return from each investment, weighted, of course, by the share of the portfolio invested in each one. But the expected risk depended on the correlation between assets. Assets with a high positive correlation would simply be a weighted sum of the risk in each investment. But as the correlation fell, risk would fall, too (figure 1.3). And if an investor could add items that tended to spin off positive returns when others were spinning off negative—items with negative correlation—then risk could fall dramatically.
By showing that investors could use diversification to reduce risk without necessarily reducing return or add return without necessarily adding risk, Markowitz moved the investment discussion beyond present value and discounting rates and into modern portfolio theory. Building portfolios becomes an exercise in assembling cash flows that have the right mix of expected return, risk, and diversification.
For an investor staring at an infinite menu of choices, the challenge becomes picking the best set of choices, not just simply the single best choice. Any investment with acceptable risk and return could become part of an efficient portfolio as long as it adds diversification. Investing changed from the evaluation and pursuit of single assets into the construction of portfolios that maximized return for the portfolio of risks taken.
The Sources of Risk and Correlation
For all the insight of Markowitz's approach, he left largely unexamined the building blocks of risk and correlation. We know a good investor needs compensation for risk, and we know that correlation provides the glue that joins the elements of an efficient portfolio, but we do not know how risk and correlation arise. They simply seem to exist, and Markowitz arrived on the scene to tell us how to use them.
To better understand risk and correlation, the idea of companies in different coin-flipping businesses is a good way to start. The coin that each company flips stands for the risk that each company takes to earn a return. One company can flip the same coin as another or a different coin. Another company can earn returns by flipping multiple coins, and those coins may overlap partially or completely with the coins flipped by yet another company. And the payoff or sensitivity to the outcomes from those coins may differ across companies as well.
In the real world, companies do not flip coins to earn returns but they do take risks. Companies can take the same or different risks, those risks can overlap partially or wholly, and the sensitivity to those risks can vary as well. Some companies buy bricks and mortar and lumber, for instance, and turn them into buildings. Some companies own airplanes, trains, trucks, or automobiles and move materials around to different buyers. Some companies buy and sell buildings. Some companies take computer chips and software and make computers. Some companies buy meats and vegetables and make restaurant meals. Some companies do nearly the same thing but in different places. This list of things that companies do is as endless as is the list of companies itself. Sometimes the risks provide good return; sometimes they do not, just like a coin can come up heads or tails.
This idea of flipping coins and taking risks extends beyond companies to all investments. The value of the cash in the drawer depends on inflation, so the owner with the key to the drawer has flipped an inflation coin. The value of a loan or bond depends on interest rates, so those investments flip the interest rate coin. The value of an oil company depends on the supply-and-demand-for-oil coins.
Once it becomes clear that companies or investments flip different risk coins, then building a diversified portfolio becomes a hunt in part for investments that flip different coins and take different risks. Some risks are truly independent, but some are related. Companies in very different businesses, very different locations, or both may show returns that look relatively independent. Companies in the same or similar business may show returns that look related or correlated.
In practice, companies and investments usually take multiple dimensions of risk. And each investment's performance may show different sensitivity to each dimension of risk.6 Items on a menu of investments could show sensitivity to interest rates or corporate profits or the weather or new technologies, and a given investment may be more sensitive to one risk than to another.
Instead of thinking of a menu of investments as a list of instruments or companies or funds, it is better to think of the risk dimensions packed into a given investment—the list of risk coins being flipped or the risks embedded in each item on the menu. Some investments involve the same or similar risks; other investments involve very different risks. Some involve concentrated risks; others involve a broad set of risks. Some risks actually offset others. By looking through the individual items on the infinite list of investments to the underlying risk dimensions, the actual number of choices that an investor has to make goes down dramatically. Even a few risk dimensions can be combined in different amounts to create an infinite list of investments. But the underlying risk dimensions are much smaller, and the investor's challenge much more manageable.
Because each item on the investment menu involves a different set of risks and different sensitivity to each risk, an investor can shape the return, risk, and correlation among elements of a portfolio by combining different items from the menu. The investor can choose which risks to take and which risks to avoid. And as different dimensions of risk come in and out of a portfolio, then performance of the portfolio changes. Rather than choosing from a menu with an infinite set of discrete investments, an investor builds a portfolio from an underlying set of broader risks.
Markowitz's Open Questions
Markowitz also left open an essential aspect of his approach: the best way to determine expected return, risk, and diversification:
To use the E-V (expected return and variance) rule in the selection of securities we must have procedures for finding reasonable (expected returns and variances). These procedures, I believe, should combine statistical techniques and the judgment of practical men. My feeling is that the statistical computations should be used to arrive at a tentative set of (returns and variances). Judgment should then be used in increasing or decreasing some of these (returns and variances) on the basis of factors or nuances not taken into account by the formal computations. (Markowitz, 1952, p. 91)
Despite the investors' essential job of combining risk, return, and correlation into portfolio performance, Markowitz still left open the best way to predict these things. If use of time is a good signal, then performance depends on expectations about asset cash flow and plausible changes in the relevant risk factors. A large block of investors' time goes to anticipating asset cash flow, whether it is earnings or dividends in the case of equity securities or coupons, option exercise, prepayments, or defaults in the case of fixed income securities. Another block goes to anticipating the path of events that might re-price securities such as changes in monetary or fiscal policy, politics, the economy, interest rates or option prices, science or technology, or other factors. These effectively are the risk exposures embedded in available securities. The intersection between probable scenarios and the value of specific security cash flows is the daily work of portfolio construction.
In a Markowitz world, investors may end up with competitive advantage. Some investors may simply have more or different or better information than others. Some may be able to run faster or better analysis. Some investors may be able to consistently anticipate the return, risk, and correlation of assets more accurately than others. Some may be able to consistently build portfolios that perform better than others'. Markowitz would expect a return to investing in research and analysis.
