Successful Investing Is a Process E-Book

Jacques Lussier

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 736

Veröffentlichungsjahr: 2013

Beschreibung

A process-driven approach to investment management that lets you achieve the same high gains as the most successful portfolio managers, but at half the cost What do you pay for when you hire a portfolio manager? Is it his or her unique experience and expertise, a set of specialized analytical skills possessed by only a few? The truth, according to industry insider Jacques Lussier, is that, despite their often grandiose claims, most successful investment managers, themselves, can't properly explain their successes. In this book Lussier argues convincingly that most of the gains achieved by professional portfolio managers can be accounted for not by special knowledge or arcane analytical methodologies, but proper portfolio management processes whether they are aware of this or not. More importantly, Lussier lays out a formal process-oriented approach proven to consistently garner most of the excess gains generated by traditional analysis-intensive approaches, but at a fraction of the cost since it could be fully implemented internally. * Profit from more than a half-century's theoretical and empirical literature, as well as the author's own experiences as a top investment strategist * Learn an approach, combining several formal management processes, that simplifies portfolio management and makes its underlying qualities more transparent, while lowering costs significantly * Discover proven methods for exploiting the inefficiencies of traditional benchmarks, as well as the behavioral biases of investors and corporate management, for consistently high returns * Learn to use highly-efficient portfolio management and rebalancing methodologies and an approach to diversification that yields returns far greater than traditional investment programs

Leseprobe

Table of Contents

Series Page

Title Page

Copyright

Acknowledgments

Preface

Note

Introduction

Note

Part I: The Active Management Business

Chapter 1: The Economics of Active Management

Understanding Active Management

Evidence on the Relative Performance of Active Managers

Relevance of Funds' Performance Measures

Closing Remarks

Notes

Chapter 2: What Factors Drive Performance?

Implications of Long Performance Cycles and Management Styles

Ability to Identify Performing Managers

Replicating the Performance of Mutual Fund Managers

Closing Remarks

Notes

Chapter 3: Outperforming Which Index?

Purpose and Diversity of Financial Indices

Building an Index

Are Cap-Weight Indices Desirable?

Alternatives to Cap-Weight Indices and Implications

Closing Remarks

Notes

Part II: Understanding the Dynamics of Portfolio Allocation and Asset Pricing

Chapter 4: The Four Basic Dimensions of An Efficient Allocation Process

First Dimension: Understanding Volatility

Second Dimension: Increasing the ARI Mean

Third Dimension: Efficiently Maximizing GEO Mean Tax

Fourth Dimension: Accounting for Objectives and Constraints

Closing Remarks

Notes

Chapter 5: A Basic Understanding of Asset Valuation and Pricing Dynamics

Determinants of Interest Rates

Determinants of Equity Prices

Historical Returns as a Predictor

Other Predictors

Review of Predictors

Closing Remarks

Notes

Part III: The Components of an Efficient Portfolio-Assembly Process

Chapter 6: Understanding Nonmarket-Cap Investment Protocols

Risk-Based Protocols

Fundamental Protocols

(Risk) Factor Protocols

Comparing and Analyzing Protocols

Bridging the Gaps and Improving on the Existing Literature

A Test of Several Investment Protocols

Closing Remarks

Notes

Chapter 7: Portfolio Rebalancing and Asset Allocation

Introduction to Portfolio Rebalancing

The Empirical Literature on Rebalancing

A Comprehensive Survey of Standard Rebalancing Methodologies

Asset Allocation and Risk Premium Diversification

Volatility and Tail Risk Management

Volatility Management versus Portfolio Insurance

Closing Remarks

Notes

Chapter 8: Incorporating Diversifiers

Fair Fees

Risk Premium and Diversification

Commodities as a Diversifier

Currencies as a Diversifier

Private Market Assets as a Diversifier

Closing Remarks

Notes

Chapter 9: Allocation Process and Efficient Tax Management

Taxation Issues for Individual Investors

Components of Investment Returns, Asset Location, Death and Taxes

Tax-Exempt, Tax-Deferred, Taxable Accounts and Asset Allocation

Capital Gains Management and Tax-Loss Harvesting

Is It Optimal to Postpone Net Capital Gains?

Case Study 1: The Impact of Tax-Efficient Investment Planning

Case Study 2: Efficient Investment Protocols and Tax Efficiency

Closing Remarks

Notes

Part IV: Creating an Integrated Portfolio Management Process

Chapter 10: Understanding Liability-Driven Investing

Understanding Duration Risk

Equity Duration

Hedging Inflation

Building a Liability-Driven Portfolio Management Process

Why Does Tracking Error Increase in Stressed Markets?

Impact of Managing Volatility in Different Economic Regimes

Incorporating More Efficient Asset Components

Incorporating Illiquid Components

Role of Investment-Grade Fixed-Income Assets

Incorporating Liabilities

Incorporating an Objective Function

Case Study

Allocating in the Context of Liabilities

Closing Remarks

Notes

Chapter 11: Conclusion and Case Studies

Case Studies: Portfolio Components, Methodology and Performance

Conclusion

Bibliography

Index

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Copyright © 2013 by Jacques Lussier

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Library and Archives Canada Cataloguing in Publication Data

Lussier, Jacques

Successful investing is a process : structuring efficient portfolios for outperformance / Jacques Lussier.

Includes bibliographical references and index.

Issued also in electronic formats.

ISBN 978-1-118-45990-4

1. Investments. 2. Portfolio management. 3. Finance, Personal.

I. Title.

HG4521.L8627 2013 332.6 C2012-906769-5

ISBN 978-1-118-46478-6 (eBk); 978-1-118-46479-3 (eBk); 978-1-118-46480-9 (eBk)

John Wiley & Sons Canada, Ltd.

6045 Freemont Blvd.

Mississauga, Ontario

L5R 4J3

Acknowledgments

I always say Successful Investing Is a Process is the one book I wish I could have read a long time ago, although even with the intent, I doubt it could have been written prior to 2007. So much relevant research has been completed in the last decade. Sadly, it also took the hard lessons learned from a financial crisis of unprecedented proportion in our generation to allow me to question some of my prior beliefs and thus enable and motivate me to write it over a period of more than two years. This book is not about the financial crisis, but the crisis did trigger my interest in questioning the value and nature of services provided by our industry with the hope that some changes may occur over time. It will not happen overnight.

Like most books, it is rarely completed without the help and encouragement of colleagues, friends and other professionals. I must first thank Hugues Langlois, a former colleague and brilliant young individual currently completing his Ph.D. at McGill University, for helping me identify the most relevant academic articles, review the integrity of the content and execute some of the empirical analyses that were required. His name appears often throughout the book. I must also thank Sofiane Tafat for coding a series of Matlab programs during numerous evenings and weekends over a period of eight months.

As I was completing the manuscript in 2012, I was also lucky enough to have it evaluated by a number of industry veterans. Among them, Charley Ellis, Nassim Taleb, Rob Arnott, Yves Choueifaty, Vinay Pande, Bruce Grantier, Arun Murhalidar, as well as several academicians. Some of these reviewers also provided me with as much as ten pages of detailed comments, which I was generally able to integrate into the book. Most of all, I considered it significant that they usually agreed with the general philosophy of the book.

I must not forget to thank Karen Milner at Wiley and Stephen Isaacs at Bloomberg Press for believing in this project. I probably had already completed eighty percent of its content before I initially submitted the book for publication in early 2012. I must also thank other individuals at Wiley that were involved in the editing and marketing: Elizabeth McCurdy, Lucas Wilk and Erika Zupko. Going through this process made me realize how much work is involved after the initial unedited manuscript is submitted. I was truly impressed with the depth of their work.

Finally, a sincere thank you to my wife Sandra, who has very little interest in the world of portfolio management, but nevertheless diligently corrected the manuscript two times prior to submission and allowed me the 1800 hours invested in this project during evenings, weekends and often, vacations. I hope she understands that I hope to complete at least two other book projects!

Preface

In principle, active management creates value for all investors. The financial analysis process that supports proper active management helps promote greater capital-allocation efficiency in our economy and improve long-term returns for all. However, the obsession of many investors with short-term performance has triggered, in recent decades, the development of an entirely new industry of managers and researchers who are dedicated to outperforming the market consistently over short horizons, although most have failed. Financial management has become a complex battle among experts, and even physicists and mathematicians have been put to the task. Strangely enough, the more experts there are, the less likely we are to outperform our reference markets once fees have been paid. This is because the marginal benefit of this expertise has certainly declined, while its cost has risen. As Benjamin Graham, the academician and well-known proponent of value investment, stipulated in 1976: “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities . . . in light of the enormous amount of research being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost [1].” If these were his thoughts 35 years ago, what would he say now?

Forecasting the performance of financial assets and markets is not easy. We can find many managers who will attest to having outperformed their reference markets, but how do we know that their past successes can be repeated, or that their success was appropriately measured? How many accomplished managers have achieved success by chance and not by design, or even have achieved success without truly understanding why? Much of the evidence over the past 40 years says that:

there are strong conceptual arguments against consistent and significant outperformance by a great majority of fund managers and financial advisors (especially when adjusted for fees);

many investors do not have the resources to do proper due diligence on fund managers and/or do not understand the qualities they should be looking for in a manager; and

conflicts of interest, marketing prerogatives and our own psychological biases are making it difficult to exercise objective judgment when selecting and recommending managers. For example, what if a manager that should be considered for an investment mandate underperformed for the last three years? Is he likely to be recommended by advisors? Is he less likely to be selected than managers who recently outperformed?

I have worked 10 years as an academician, and more than 18 years in the financial industry. In my career, I have met with approximately 1,000 traditional and hedge fund managers, and have been involved in almost all areas of research that are relevant to investors today. Some managers should never have existed, a majority of them are good but unremarkable and a few are incredibly sophisticated (but, does sophistication guarantee superior performance?) and/or have good investment processes. However, once you have met with the representatives of dozens of management firms in one particular area of expertise, who declare that they offer a unique expertise and process (although their “uniqueness” argument sometimes seems very familiar), you start asking yourself: How many of these organizations are truly exceptional? How many have a unique investment philosophy and process, and a relative advantage that can lead to a strong probability of outperformance? I could possibly name 20 organizations that I believe to be truly unique, but many investors do not have access to these organizations. So what are investors supposed to do? There has got to be a more reliable and less costly investment approach.

One of the few benefits of experiencing a financial crisis of unprecedented scope (at least for our generation) is that all market players, even professionals, should learn from it. As the 2007 to 2008 credit/subprime/housing/structured product crises progressed, I reflected on what we are doing wrong as an industry. I came up with three observations. First, the average investor, whether individual or institutional, is not provided with a strong and coherent investment philosophy. In 2009, I read an investment book written by one of the most well-known financial gurus, someone whom is often seen on American television and covered in magazines and newspapers. The book was full of details and generalities, so many details that I wondered what an investor would actually do with all this information. What those hundreds of pages never offered was a simple investment philosophy that investors could use to build a strong and confident strategic process.

Second, there is the issue of fees. The financial and advisory industries need investors to believe that investing is complex, and that there is significant value added in the advisory services being provided to investors. If it were simple, or perceived as simple, investors would be unwilling to pay high advisory fees. Investing is in fact complex (even for “professionals”), but the advice given to investors is often the same everywhere. Let's first consider individual investors. They are usually being offered about six portfolio allocations to choose from, each one for a different investment risk profile. Some firms may offer target date funds, funds where the asset allocation (i.e., the mix between less risky and more risky assets) is modified over time (it gets more conservative). Some will also offer guarantees, but guarantees are never cheap. There are several investment concepts, but in the end, they all seek to offer portfolios adapted to the economic and psychological profile of an investor and his goals. These may be good concepts, but even if we accept the argument that investing is complex, paying a high price to get similar advice and execution from most providers makes no sense. I often say that fees on financial products are not high because the products are complex, but that the products are complex because the fees are high. I could spend many pages just explaining this statement.

These comments can also be extended to institutional investors. The management concepts sold to these investors have evolved in the last two decades, but most advisory firms were offering similar concepts at any point in time. Investors were advised to incorporate alternative investments in the late 1990s and early 2000s (real estate, hedge funds, private equity, etc.). The focus moved to portfolio concepts that are structured around the separation of Beta and Alpha components, or Beta with an Alpha overlay, and then, as pension plans faced larger deficit funding, to liability-driven and performance-seeking portfolios, etc. Furthermore, investing in private and public infrastructure through debt or equity is now recommended to most investors. All of these initiatives had the consequence of supporting significant advisory/consulting fees, although, as indicated, the asset-management concepts offered to investors are not significantly differentiated among most advisors.

Third, most investors are impatient. We want to generate high returns over short horizons. Some will succeed, but most will fail. The business of getting richer faster through active management does not usually offer good odds to some investors. However, if we cannot significantly increase the odds of outperforming others over a short investment horizon, we can certainly increase those odds significantly in the medium to long term.

This book is not about using extremely complex models. Playing the investment game this way will put you head to head with firms that have access to significant resources and infrastructure. Furthermore, these firms may not even outperform their reference market. Just consider what happened to the Citadel investment group in 2008, one of the premier investment companies in the world, with vast financial resources that allowed it to hire the best talent and design/purchase the most elaborate systems. Citadel is a great organization, but their flagship fund still lost nearly 55%. As I indicated, strangely enough, the more smart people there are, the less likely it is that a group of smart people can outperform other smart people, and the more expensive smart management gets. Smart people do not work for cheap, and sometimes the so-called value added by smart people is at the expense of some hidden risks.

This book is about identifying the structural qualities/characteristics required within portfolio allocation processes to reliably increase the likelihood of excess performance. It is about learning from more than half a century of theoretical and empirical literature, and about learning from our experiences as practitioners. It is about providing statistically reliable odds of adding 1.5% to 2.0% of performance (perhaps more), on average, per year over a period of 10 years without privileged information. We seek to exploit the inefficiencies of traditional benchmarks, to introduce efficient portfolio management and rebalancing methodologies, to exploit the behavioral biases of investors and of corporate management, to build portfolios whose structure is coherent with liability-driven investment (LDI) concerns, to maximize the benefits of efficient tax planning (if required) and to effectively use the concept of diversification, whose potential is far greater than what is usually achieved in most investment programs (because diversification is not well understood). As we progress through each chapter of this book, we will realize that our objective is not so much to outperform the market, but to let the market underperform—a subtle but relevant nuance. Furthermore, this book will help you understand that the financial benefits of what is often marketed to investors as financial expertise can generally be explained through the implicit qualities that may be present in replicable investment processes.

This is why it is so important to understand the relevant qualities within portfolio-allocation processes that lead to excess performance. It will help segregate performances that result from real expertise (which is normally rare) from performances that are attributed to circumstantial or policy-management aspects. It will also help design efficient and less costly portfolio solutions. Thus, what is at stake is not only risk-adjusted expected performance, but the ability to manage, with a high level of statistical efficiency, assets of $100 billion with less than 20 front-office and research individuals.

Much of what I will present has been covered in financial literature (all references are specified), but has not, to my knowledge, been assembled nor integrated into a coherent global investment approach. I have also incorporated new research in several chapters when the existing literature is incomplete. Finally, the approach is not regime dependent nor is it client specific. An investment process adapts itself to the economic and financial regime (even in a low-interest-rate environment), not the other way around. An investment process should also apply similarly to the investment products offered to small retail, high-net-worth and institutional investors. Different constraints, financial means and objectives do not imply a different portfolio-management process. Service providers should not differentiate between smaller investors and larger investors on the basis of the quality of the financial products and the depth of the portfolio-management expertise being offered. However, larger investors should benefit from more adapted (less standardized) and less costly investment solutions. Therefore, this book is specifically designed for either institutional investors seeking to improve the efficiency of their investment programs, or for asset managers interested in designing more efficient global investment platforms for individual investors. It is also appropriate for sophisticated individual investors.

The book is divided into four parts and eleven chapters. Part I seeks to demystify the fund management industry and the belief that superior performance can only be obtained with superior analytical abilities. Chapter 1 makes the traditional argument that investing is a negative-sum game (after all fees) for the universe of investors, but also that it is likely to remain a negative-sum game even for specific subsets of investors (for example, mutual fund managers versus other institutional investors). Furthermore, the likelihood of outperforming the market may have declined over the past 30 years, as management fees and excessive portfolio turnover have increased. Chapter 2 illustrates that excess performance by asset managers is not proof of expertise, that successful managers may attribute their success to the wrong reasons (an argument that will be further developed in Chapter 6) and finally that some managers maintain systematic biases that explain much of their performance. Therefore, some investors could replicate those biases at a low cost. Finally, Chapter 3 discusses the inefficiency and instability of capitalization-based equity indices.

Part II introduces the four dimensions of the investment process, as well as basic notions and concepts about asset valuation and forecasting that are helpful in supporting the remainder of the book. For example, Chapter 4 emphasizes the importance of understanding that portfolio structural characteristics lead to more efficient diversification. It makes the argument that many idiosyncrasies of the financial world can be explained, at least in part, by a proper understanding of volatility and diversification. For example, why some studies support the existence of a risk premium in commodities while others do not, why low-volatility portfolios outperform in the long run, why equal-weight portfolios often perform very well, why hedge fund portfolios could appear attractive in the long run, even if there is no Alpha creation, etc. Finally, Chapter 5 explains why it is difficult to make explicit return forecasts and that investors should put more emphasis on predictive factors that can be explained by cognitive biases, since those variables are more likely to show persistence.

Part III explains how we can build portfolio components and asset-allocation processes that are statistically likely to outperform. It also discusses how taxation influences the asset allocation and asset location decision (for individual investors only). Thus, Part III introduces the core components of the proposed approach. Chapter 6 implicitly makes the argument that an equity portfolio is more likely to outperform if its assembly process incorporates specific structural characteristics/qualities. It also makes the argument that the portfolios of many successful managers may incorporate these characteristics, whether they are aware of it or not. Thus, if we have a proper understanding of these characteristics, we can build a range of efficient portfolios without relying on the expertise of traditional managers. Chapter 8 makes similar arguments, but for commodities, currencies and alternative investments. It also makes the argument that the performance of several asset classes, such as commodities and private equity, are exaggerated because of design flaws in the indices used to report their performance in several studies. The same may be true of hedge funds. Chapter 7 illustrates different methodologies, from simple to more sophisticated, that can be used to improve the efficiency of the asset-allocation process. It compares and explains the sources of the expected excess performance. All of these chapters provide detailed examples of implementation. Part III also incorporates a chapter on taxation (Chapter 9). Among the many topics covered, three are of significant importance. First, postponing/avoiding taxation may not be in the best interest of investors if it impedes the rebalancing process. Second, the tax harvesting of capital losses may not be as profitable as indicated by a number of studies. Third, equity portfolios can be built to be both structurally and tax efficient.

Finally Part IV integrates all of these notions into a coherent framework. It also illustrates the powerful impact on risk, return and matching to liabilities of applying the integrated portfolio-management philosophy discussed in this book. Chapter 10 describes how to build portfolios that are structurally coherent with LDI concerns. It explains that many of the concepts discussed in Chapters 6, 7 and 8 will lead to the design of portfolios that implicitly improve liability matching. Finally, Chapter 11 is a case study that incorporates many of the recommendations presented in this book. It shows that a well-designed investment process can significantly and reliably enhance performance and reduce risk. Furthermore, the book provides the foundations that can be used to build more performing processes.

However, it is important to recognize that most of the recommendations in this book are based on learning from the evidence already available, and that significant efforts are made to link the literature from different areas of finance. We have access to decades of relevant financial literature, and an even longer period of empirical observations. We have more than enough knowledge and experience to draw appropriate and relevant conclusions about the investment process. We simply have not been paying enough attention to the existing evidence.

Note

1. Graham, Benjamin (1976), “A conversation with Benjamin Graham,” Financial Analysts Journal 32(5), 20–23.

Introduction

Investing has always been a challenge. It is only possible to understand the relevant “science” behind the investment structuring process once we understand that investing is also an art. Artwork takes different shapes and forms, and we can often appreciate different renditions of the same subject. Fortunately, the same is true of investing. There is more than one way to design a successful investment process, and, like artwork, it takes patience to fully appreciate and build its value.

However, investors in general have never been so confused and have never encountered the kind of challenges we face today: low interest rates in a dismal political, fiscal, economic, demographic and social environment. All this is occurring in the most competitive business environment we have ever known. We live in a world of sometimes negative real (inflation adjusted) returns and of unprecedented circumstances. Therefore, we do not have an appropriate frame of reference to truly evaluate risk and to anticipate the nature of the next economic cycle. Defined benefit pension funds are facing huge deficits, and some are considering locking in those deficits at very low rates, while others are searching for all sorts of investment alternatives to improve their situation. At the same time, it seems that they are timid about making appropriate changes, and these changes do not necessarily involve taking more risk, but taking the right risks at a reasonable cost. Small investors are faced with exactly the same difficulties, but simply on a different scale.

There are at least two other reasons why investors are so confused. The first reason is benchmarking with a short look-back horizon. The obsession with benchmarking as well as ill-conceived accounting (for corporate investors) and regulatory rules are increasingly polluting the investment process. For example, plan sponsors know their performance will be monitored and compared every quarter against their peer group, whether the comparison is truly fair or not, since the specific structure of liabilities of each investor is rarely considered in this comparison. Furthermore, under the US Department of Labor's Employee Retirement Income Security Act (ERISA), they have fiduciary responsibilities and can be made liable if prudent investment rules are not applied. But who establishes the standards of prudent investment rules? In theory, the standard is utterly process oriented [1]. Nevertheless, to deflect responsibility, and because of unfamiliarity with the investment process, plan sponsors will retain the services of one or several portfolio managers. However, because selecting the right managers is also a responsibility that many plan sponsors do not want to take on alone, consultants will be hired with the implicit understanding that hiring a consultant is in itself indicative of prudence and diligence. Since the consultant does not want to be made liable, it is unlikely that he or she will advise courses of action that are significantly different from the standard approach. Therefore, this entire process ensures that not much will really change, or that changes will occur very slowly.

It may also be that managers and consultants lack, on average, the proper conviction or understanding that is required to convince plan sponsors and other investors to implement a coherent and distinctive long-term approach. A five- to ten-year track record on everything related to investing is only required when we are dealing with intangible expertise and experience, since we cannot have confidence in any specific expertise without proven discipline. And the passage of time is the only way we can possibly attest to the discipline or expertise of a manager. However, a well-thought-out process does not require the discipline of a manager, but simply the discipline of the investor. It is the responsibility of the investor to remain disciplined. Furthermore, investing is not a series of 100-meter races, but a marathon. There is more and more evidence that the fastest marathon times are set by runners who pace themselves to keep the same speed during the entire race. Ethiopia's Belayneh Dinsamo held the world marathon record of 2:06:50 for 10 long years. He set the record by running nearly exact splits of 4:50 per mile for the entire 26 miles, even if the running conditions were different at every mile (flat, upward or downward sloping roads, head or back wind, lower or higher altitude, etc.). We could argue that an average runner could also improve his or her own personal time using this approach. The same may be true of successful investing. The best performance may be achieved, on average, by those who use strategies or processes designed to maintain a more stable risk exposure. Yet, when investors allocate to any asset class or target a fixed 60/40 or 40/60 allocation, they are allowing market conditions to dictate how much total risk they are taking at any point in time. Traditional benchmarking does not allow the investor to maintain a stable portfolio risk structure.

However, the other reason why investors are so confused is that the relevant factors leading to a return/risk-efficient portfolio management process have never been well explained to them. How can we expect investors to confidently stay the course under those circumstances? Investors' education is key, but then we still need to communicate a confident investment philosophy, and to support it with strong evidence. Does the average industry expert understand the most important dimensions of investing? I think not. What do we know about the importance or relevance of expertise and experience in asset management, or about the type of expertise that is truly needed? Whenever a manager is attempting to sell his or her services to an investor, the presentation will incorporate a page that explains how many years of experience the portfolio management team has. It will say something like, “Our portfolio management team has a combined 225 years [or any other number] of portfolio management experience.” Is it relevant experience? Do these managers understand the true reasons for their successes (or failures)? Some do. Many do not. This book offers the arguments that an investor needs to manage distinctively and more efficiently. It answers many of the questions that are puzzling investors. Among them:

Should we index, be active or passive and why?

Can we identify the best managers?

Even if we can, do we need them?

Are traditional benchmarks efficient?

What can we reasonably forecast?

What aspects or qualities are truly required in an investment process?

Is it the same for equities, commodities, currencies, hedge funds, asset allocation, etc.?

How many asset classes or risk premiums are enough?

Do we need alternative investments?

How do we structure a portfolio and maintain its balance?

Do we truly understand the impact of taxation on the allocation process (for individuals)?

What is this concept of Beta and Alpha, and would we really need Alpha if we had a better Beta?

How much risk can we really afford to take, and how do we answer this question?

What are the risks we should be worried about?

How do we incorporate liabilities into this analysis?

Can we create a global portfolio assembly and allocation process that incorporates all of these concerns?

This is a fairly long list of questions, but having reflected for two years about what is relevant and what is not, what works and what does not and what is sustainable and what is not, I have never been so comfortable with my convictions. When I look at asset managers, I no longer think in terms of their expertise and experience, or their so-called forecasting abilities, but in terms of whether or not the investment process offers the necessary underlying structural qualities that can lead to outperformance. By the end of this book, most investors will have a much clearer understanding of investment dynamics, and will be able to assemble the right components to build an efficient and appropriate portfolio that is resilient to almost any context.

Note

1. Monks, Robert A.G. and Nell Minow (2011), Corporate Governance, John Wiley & Sons, Inc.

Part I

The Active Management Business

Chapter 1

The Economics of Active Management

Active management is at best a zero-sum game. It means that, collectively, we cannot beat the market, since the collectivity of all investors is the market. Therefore, as a single investor among many, we can only beat the market at the expense of someone else. It becomes a negative-sum game once we incorporate the fees required by active managers, and other costs imposed by active management, such as trading and administration. The more money we collectively pour into expensive active management, the more likely we are to collectively get poorer.

Imagine a group of four individuals, each wanting to share an apple pie. We could agree initially that each individual deserves a slice of equal size (i.e., a form of neutral indexed position), but one individual wants a bigger serving. He can only do so at the expense of someone else. The pie will not get bigger simply because he wants to have more of it.

In order to have a chance to get a bigger slice of the pie, our individual must be willing to risk losing a portion of his slice, and find at least one other individual who is willing to do the same thing. These two individuals will play heads or tails. Whoever wins the coin toss gets a bigger portion, and the loser gets a smaller portion. The same goes for active management. It is at best a zero-sum game.

Now let's assume these two individuals want to increase their chances of winning a bigger slice, and each hires an expert at tossing coins. They will pay these experts by giving them a portion of their slice. Since our two betting individuals have to share their two slices of the pie with others, the portions left for these two individuals are smaller than two full slices. Much like active management, the presence of a new player and his or her fees have transformed this situation into a negative-sum game, and to be a winner, you have to win in the coin toss a portion of the pie that is bigger than the one you are giving to your coin-tossing expert.

How much of their returns are investors giving to the financial industry? No one really knows for sure, but according to John C. Bogle, founder and retired CEO of The Vanguard Group, the wealth transfer in the United States in 2004 from investors to investment bankers, brokers, mutual funds, pension management, hedge funds, personal advisors, etc. is estimated at $350 billion (excluding investment services of banks and insurances companies) [1]. This represents nearly 3% of all US GDP a year! Some intermediation is obviously essential, but if we consider the management fees that actively managed products require, the costs related to excessive trading activity and the significant distribution costs of many financial products, it could be shown that unnecessary intermediation is reducing the wealth of all investors (or is transferring this wealth to a small select group) by 15% in present value terms, possibly more. Excessive intermediation could even become a drag on the overall economy. As investors, we have to make better decisions than just betting on which active manager will be the next winner, and whether or not there is such a thing as a reliable coin-tossing expert. Furthermore, investors cannot necessarily rely on advisors for that purpose, because advisors are often biased in favor of offering the most recent winners, and thus are not always objective or often knowledgeable enough to make an informed recommendation. There are obviously exceptions, but this is often true.

Therefore, the purpose of this first chapter is not to determine if we can identify managers or strategies that can outperform the market. It is simply to make the argument that more than half, perhaps two-thirds, of assets being managed will underperform whatever the asset category or investment horizon. Finally, although the discussions in Chapter 1 are sometimes supported by the finance literature related to individual investors, who often pay significantly higher management fees than institutional investors, the investment principles that are presented, the questions that are raised and the implications of our assumptions are relevant to both individual and institutional investors.

Understanding Active Management

Active management is a complex issue. We want to believe that our financial advisor can identify skilled managers, or that we are skilled managers. We buy actively managed products because we hope the management fees that are being paid to investment professionals will help us outperform the market and our peers. However, before we even address the particularities of active managers' performances and skills, we have to realize that active management is globally a negative-sum game. It basically means that even before we have hired a manager, our likelihood of outperforming the market by investing in an actively managed product is almost always much less than 50%. Why is that?

First, we live in a world where the market value of all assets within a financial market is simply the sum of the market value of all single securities in that market. For example, the market value of the large-capitalization (large-cap for short) equity segment in the United States is equal to the sum of the market value of every single security in that particular segment (i.e., Exxon, IBM, Johnson & Johnson, etc.). This is true of all financial markets, whether they are categorized according to asset classes (equities and fixed income), size (large capitalization, small capitalization, etc.), sectors (financial, industrial, etc.), style (growth, value) or country (United States, Canada, etc.). Second, all of these securities have to be owned directly or indirectly by investors at any moment in time, whether these investors are institutions such as pension funds and endowment funds, corporations such as life insurance companies, hedge funds, mutual funds, individuals or even governments or government-related entities. Even central banks are investors. Investors as a group collectively own the market. What is the implication of this for active management?

To illustrate, we will use a simple example. We will assume an equity market is only comprised of the securities of two companies, X and Y. However, the conclusion would be the same if there were 1,000 or 10,000 securities. The first company, X, has a market value of $600 million, while the second company, Y, has a market value of $400 million. Thus, the entire value of the market is $1 billion. Consequently, X accounts for 60% of the value of the entire market, and Y the other 40%. Now, let's assume the returns on the shares of each company are respectively 30% and 0% during the following year. What will be the weight of each company in the market?

After one year, X is worth $780 million, while Y is still worth $400 million. The market value of both companies, and thus of the entire market, is now $1,18 billion (+18%), and their respective market weights are now 66.1% (780/1,180) and 33.9% (400/1,180). This is illustrated in Table 1.1.

Table 1.1 The Structure of a Hypothetical Equity Market

In this example, the entire value of the market is initially $1,000 million, while it is $1,18 billion one period later. The performance of the market was 18%. Who owns this market? As we already indicated, it is owned by all investors, either directly or indirectly (through products such as mutual funds).

Let's assume that among all investors, some investors are passive investors who are indexed to this market. This means they are not betting on which security (X or Y) will perform better. They are perfectly content to invest in each company according to the same proportion as in the overall market. Their initial investment was $300 million, or 30% of the entire market. What was the performance of these passive investors? It was 18% before fees, the same as the market. If passive investors realized an 18% return, what was the aggregate performance of all active investors that owned the other $700 million in securities, or 70% of this market? It had to be 18% in aggregate before fees for all active investors, or the same as passive investors. It cannot be otherwise. Once we have removed the assets of all indexed investors who received a performance equivalent to the market, what we have left are the collective assets of all active investors who must share a performance equal to the market. It is that simple.

Now, let's imagine there are thousands of active managers out there. Since the sum of their aggregate performance cannot be more than that of the market, we can safely assume that investors and managers that represent 50% of all money invested actively in a market will underperform that market, and investors and managers that represent 50% of all money invested actively in a market will outperform that market. It cannot be otherwise. Therefore, we have shown that active management is, at most, a zero-sum game. It simply redistributes existing wealth among investors, whether individual or institutional.

When I mention that active management is a negative-sum game and not a zero-sum game, it is because of fees: management fees, advisory fees, trading fees, etc. In aggregate, active and passive managers alike will not realize the performance of the market because they both pay fees, although fees for active management can be significantly higher. In the previous example, if the average of all fees paid by investors is 1.0%, the aggregate performance of all investors net of fees will only be 17.0%. The performance drain could be slightly less, since investors could recuperate part of this wealth transfer through their ownership of the financial sector, but it could only amount to a small fraction of the drain. Thus, the greater the fees paid to advisors, the lower the probability that investors can match or outperform the market.

To illustrate further, let's assume an investor has a choice between two products to invest in the US large-capitalization equity market. One product, which is indexed to the market, is relatively cheap. The total expenses related to this product are 0.2% yearly. The second product, an actively managed product, is more expensive. Its total expenses are 1.0% per year. Thus, in order for this investor to achieve a higher performance with the actively managed product, the active manager must outperform the indexed product by about 0.8% per year (assuming the index product is an accurate representation of the market), and this must be done in a world where all active investors in aggregate will do no better than the market return before fees. If 0.8% in fees per year does not seem so important, maybe you should consider their impact on a 10-year horizon using some assumptions about market returns. Table 1.2 shows the cumulative excess performance (above the market) required from an active manager over 10 years to outperform an indexed product when the difference in management fees is as specified, and when the gross market return is either 0%, 2.5%, 5%, 7.5% or 10% yearly.

Table 1.2 Impact of Fees on Cumulative Performance (%)

The example illustrates that the impact of fees on performance is not independent of market returns. The greater the market performance, the greater the cumulative excess performance required from an active manager to match the performance of a cheap index alternative, because investors not only pay fees on their initial capital, but also on their return. At a low 5% average annual return, the manager must outperform a cheap index product by 11.8% over 10 years. At 7.5% average annual market return, he must outperform by 14.6%. This requires a lot of confidence in your active manager, and what we have indicated about active management being a zero-sum game before fees is true for any investment horizon, one year, five years, ten years, etc. How likely is it that an active manager can outperform the market adjusted for fees over a long period of time, such as 10 years? It all depends on two factors. First, what is the level of fees, and second, what is the usual range of performance for all active managers against the market. For example, if all managers were requiring 1% yearly fees, we need to have some managers that outperform the market by at least 1% yearly on average (before fees) to be able to calculate a positive probability of outperforming the market. If not, the probability is nil.

Several studies have looked at this issue from different angles. Iwill initially reference only one study and come back with more evidence later. Rice and Strotman (2007) published very pertinent research about the fund-management industry [2]. Their research analyzed the performance profile of 1,596 mutual funds in 17 submarket segments over a 10-year time frame ending on December 31, 2006. The authors used the range of performance (before fees) observed for all managers against their respective markets over this period to estimate the likely probability of any manager outperforming the market in the next 10 years. The study shows that about two-thirds of managers in their entire data set have performances that range between −2.14% and +2.14% compared to their respective markets. Based on this information, Table 1.3 presents the approximate probability that the average manager can outperform the market after fees.

Table 1.3 Fees and Probability of Outperformance (%)

Total Yearly Fees

Probability of Outperforming the Market

0.5

41

1.0

32

1.5

24

Source: Rice and Strotman (2007).

We can conclude that an investor paying annual fees of 1.0% would have less than one chance out of three of outperforming the market, and two out of three of underperforming. This is an approximate estimate that relies on assumptions about the range of performance of active managers, and does not adjust for the particular portfolio structure of an investor, or for the style of a manager. Although institutional investors are likely to pay even less than 1.0% fees on most equity products (although significantly more on hedge funds), their likelihood of outperforming the market still remains well below 50%. Therefore, it is difficult to argue against the fact that fees reduce your probability of outperforming the market to less than 50%, and that higher fees will reduce your probability even more.

Evidence on the Relative Performance of Active Managers

The statement that active management is a negative-sum game is based on all active managers in aggregate. However, asset managers may cater to specific investors (retail, high-net-worth, institutional, etc.), and some large institutional investors have their own internal management teams. Therefore, if active management is globally a negative-sum game, it could, in theory, be a positive-sum game for a specific group of investors (such as mutual fund investors), but this could only happen at the expense of other groups of investors. More specifically, it could happen if, for example, mutual fund managers were not only better than the other active managers out there, but also good enough to compensate for their own fees.

However, I doubt very much that this could be the case in aggregate for the larger, more efficient capital markets. There is much evidence that supports a contrary view. Let's start with the common-sense arguments with a specific look at mutual funds. First, in the United States, institutional investors, defined as pension funds, insurance companies, banks, foundations and investment companies (that manage mutual funds), owned 37.2% of all equities in 1980, while the number grew to 61.2% by 2005. During the same period, the share of equities owned by mutual funds grew from 2.3% to 23.8%, and then reached a peak of about 29% prior to the 2008 liquidity crisis [3]. Therefore, in this active-management game, institutional investors who can afford the best expertise are playing against other institutional investors who can also afford the best expertise on a large scale. Furthermore, mutual funds are no longer a small player, but a very large component of the market. It becomes more and more difficult to assume that as a group they could be expected to consistently outperform other groups of investors, at least in the US market and other developed markets, since they have become such a significant segment of the entire market themselves. But do not forget, they must not only outperform other groups of investors, but also outperform enough to cover excess costs (compared to a cheap alternative) related to their own products.

In 2006, researchers completed a study on the issue of mutual fund fees around the world [4]. It covered 46,799 funds (86% of the total as of 2002) in 18 countries. The study compared total annual expense ratios for all funds (balanced, equity, bonds and money market). These observations are presented in Table 1.4.

Table 1.4 Fees Around the World (%)

Country

Total Annual Expense Ratio

Australia

1.60

Canada

2.68

France

1.13

Germany

1.22

Switzerland

1.42

United Kingdom

1.32

United States

1.42

Source: Khorona, Servaes and Tufano (2006).

Individual investors in the US and in several other countries benefit from a lower level of fees while Canada has among the highest fees. It seems, according to the authors, that the more concentrated a banking system is in each country, the higher the fees are. Canada has, in fact, one of the most concentrated banking systems in the world. Thus, even if we assumed that, in Canada, mutual fund managers as a group were better than other active managers, considering the much higher level of fees they require, they would have to be significantly better than US managers on average.

This study was obviously the subject of criticism in Canada. Some have argued that the methodology of the study overestimates the fees paid in Canada and underestimates those paid in the United States. However, even if we agree with the precise arguments that were raised against this study, they would only justify a fraction of the difference in fees between the two countries.

Furthermore, while competition among institutional managers has become fiercer, management expense ratios (MERs) have gone up in the United States since 1980, from an average of 0.96% to an average of 1.56% in the mid-2000s (although competition from low-cost alternatives is now improving this matter) [5]. Why? In an industry that has grown so much in size, the investors should have expected some economies of scale. Instead, the industry has delivered more specialized and complex products that have considerably added to the confusion of investors. However, fund-management expenses are not the only factors detracting from performance. A 2009 study by Kopcke and Vitagliano [6] looked at the fees of the 100 largest domestic equity funds that are used within defined contribution plans (US 401(k) plans). The horizon of the study was short, but it provides an interesting look at total expenses including costs related to trading within the industry. From the information within their study, we can determine the weighted average MER, sales load fees and trading-related costs for the 100 funds. Remember that 401(k) plans are usually employer-sponsored plans, and thus investors within these plans should benefit from lower MER than the average mutual fund investor. These funds had weighted average MER, sales load and costs related to trading of 0.51%, 0.11% and 0.67% respectively. Costs related to trading, an item that is usually invisible to the average investor, are significant, and can, in some cases, be even greater than the MER.

The study also showed the average annual turnover of securities within these funds to be around 48%, and only 30% if turnover is weighted by the size of the fund. Bigger funds have much lower trading volume. The average turnover level in this study is not entirely consistent with other estimates for the overall industry, but there is little doubt that the turnover is significant. The 2009 Investment Company Institute Factbook [7] shows a weighted average annual turnover rate for the industry of 58% from 1974 to 2008. The level was 58% as well in 2008, but much closer to 30% in the 1970s. Although Maginn and Tuttle (2010) [8] estimate the range of turnover for equity value managers to be between 20% and 80%, they also estimate the range for growth managers to be between 80% and several hundred percent. By comparison, many indexed equity products have turnover rates in the 6% to 10% range. A higher turnover means more trading and market impact costs, but also more tax impact costs related to the early recognition of capital gains. According to John C. Bogle, the turnover in US large-cap equity funds may have reduced the after-tax return of investors by 1.3% yearly between 1983 and 2003. When compounded over many years, this is incredibly significant.

So the common-sense argument is that institutional investors are all trying to outperform one another with their own experts, that many products have fairly significant management fees and that the level of trading required by active management imposes significant trading costs. Under these circumstances, outperforming a passive benchmark in the long run appears to be improbable for a majority of active managers. This common-sense argument should be convincing enough, but for those who are skeptical, there are many studies on the issue. In the interest of time and space, I will concentrate on a few. However, I can already indicate that after more than 35 years of research, going back 60 years in time, the main conclusion that these studies have reached is not ambiguous: active managers in aggregate underperform indexed products after fees.

Chen, Hong, Huang and Kubik (2004) looked at the performance of mutual funds according to size. [9] Their study on 3,439 funds over the period 1962 to 1999 concluded that the average fund underperformed its risk-adjusted benchmark by 0.96% annually. Furthermore, the underperformance was 1.4% adjusted for fund size, indicating that bigger funds underperformed even more. They also found that the typical fund has a gross performance net of market return of about 0%. In their study, funds were categorized into five distinct group sizes. All groups underperformed after fees. These conclusions do not only apply to the US markets. For example, Table 1.5 presents the scorecard of US, Canadian and Australian mutual funds for a five-year period ending in 2010.

Table 1.5 Percentage of Funds Outperforming their Benchmark (2006–2010)

It is probably no coincidence that Canada has the lowest scorecard and among the highest mutual fund fees in the world. We could cite other studies, but they all point to the same general conclusion: a one to one tradeoff, on average over time, between performance and expenses (i.e., more fees equal less return).

Relevance of Funds' Performance Measures

The issue being raised is not the accuracy of the performance measures of funds, but of their usefulness to the investment-decision process. We will address three types of performance measures: performance against other funds, fund rating systems and performance against benchmark indices.

One methodology often used to evaluate managers is to rank them against their peers for horizons such as one, two, three, five and even ten years. For example, is my manager a first-quartile manager (better than 75% of managers), a median manager (better than 50% of managers), etc.? I never gave much thought to this ranking approach until I realized that the mutual fund industry, like most industries, has a high degree of concentration. For example, in 2008, the largest 10 sponsors of mutual funds in the United States controlled 53% of all assets in that group. Also, in 2007, a study by Rohleder, Scholz and Wilkens was completed on the issue of survivorship bias of US domestic equity funds. [10] We can conclude from this study, which covered most of the industry, that the largest 50% of funds accounted for more than 99% of the assets of US domestic equity funds.

Although I will not specifically address the issue of mutual fund survivorship, extensive literature has demonstrated that an industry-wide performance bias is created by the tendency to close or merge funds that performed poorly, causing their track record to be removed from the existing universe of funds. [11] Thus, if we do not take into account the performance of these funds, the surviving funds paint an inaccurate picture of the performance of the industry. This would be equivalent to an investor earning a 10% return on 90% of his allocation, and a negative 20% return on 10% of his allocation, stating that if we ignored the allocation on which he lost money, he had a 10% return!

Furthermore, we know that smaller funds have a wider range of return around their benchmark, since larger funds are more likely to maintain a more prudent investment policy. They are more likely to protect their asset base and reputation, while small funds are more likely to take more aggressive active investment positions. They do not have the marketing budgets of large funds, and their managers know they have to outperform large funds to attract new capital. Thus, it is likely that we will find a greater number of smaller funds than large funds whose performances are below and above the median of managers, if even by chance, and also because there are more small funds than large funds.

Under such circumstances, quartile rankings have a lesser meaning. If smaller funds have a wider range of performance and are greater in number, we could expect that smaller funds (many of them unknown to most investors) accounting for much less than 50% of all assets would dominate the first two quartiles in the long run. This is reinforced by Bogle's argument that excessive size can, and probably will, kill any possibility of investment excellence. [12] Furthermore, the industry is not stable enough to make such performance measures useful. According to the Rohleder, Scholz and Wilkens study, there were 1,167 mutual funds in the United States in 1993. In December 2006, there were 7,600 funds, but 3,330 funds had closed during this period. The average life of a fund was 71 months. Finally, only 658 funds were operational for the entire period, but they were the biggest, with 52.5% of all assets by the end of the period. What is the true significance of a first- or second-quartile ranking when this measure is applied to an unstable population of funds, and when chance may account for the excess performance of many managers in the short term? The situation has not improved in later years. Thirty percent of large-capitalization managers operating in 2006 were no longer operating by the end of 2009.

Another rating approach is the scoring system. Better-known systems are Morningstar and Lipper Leaders. Although these systems are designed to rank the historical performance of funds on the basis of different risk-adjusted methodologies, investors have been relying on these systems to allocate their investments to mutual funds. The authors of an Ecole des Hautes Etudes Commerciales du Nord (EDHEC) paper on this issue [13] referenced different studies showing that funds benefiting from high ratings receive a substantial portion of new inflows [14]. However, as I will start to explain in Chapter 2, past performances in mutual funds are only an indicator of future performance in very specific circumstances. Furthermore, other studies [15] have shown that a significant percentage of funds have performance attributes that are not consistent with their stated objectives. If these funds are classified within these scoring systems according to their stated objectives, these rankings may not be relevant or useful, since the benchmarks may not be appropriate to the investment approach or policy of the managers.