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The Freebie We Always Forget
Last weekend, I came across a fascinating discussion in the New York Times that gave me pause for thought. The topic at hand was “evolutionary economics”, also known as “the economics of innovation” – a field of economic research that I never knew existed. But as Richard R. Nelson of Columbia University explained it, it’s the study of how knowledge becomes accepted practice or conventional wisdom in societies.
This line of thinking attempts to address the “if we can send a man to the moon, then why can’t scientists eradicate(fill in the blank) ?” problem. According to economists like Nelson and also Daniel Sarewitz at Arizona State, the problem is not so much an issue of lack of knowledge or knowing what should be done - but rather, one of finding the trigger whereby society aligns itself enough around the technical insight to adopt it.
Nelson uses the example of Cotton Mather, the 18th century New England minister/community leader who had advocated a widespread smallpox inoculation program for children to keep the disease in check. While today, we view such a policy as commonsensical, it would take nearly 100 years for the policy to become embraced as conventional wisdom.
So what does it take to translate “knowledge” into accepted “know-how”? In theory, any technology or practice that can be reliably standardized and improved on over time can lead to robust know-how. But the key trigger occurs when stakeholders with very diverse agendas can find a point of convergence. If people perceive that all interests are advanced when people rally around a specific concept, then that “go” quality is generally assured.
You may well wonder why I am telling you about this – particularly when people paid a lot of money to come and hear about all the sexy new alpha generating ideas available in asset allocation.
It’s as simple as this:
One of the most value-enhancing strategies available to investors has been well understood, in fact, since as far back as 1914, when US Supreme Court Justice Louis Brandeis wrote about it in his book “Other People’s Money”, a scathing condemnation of the self-serving financial management industry.
And yet even today – a little more than 100 years later - consumers and providers of financial services have still failed to align themselves behind what should have become “conventional wisdom” in the world of financial services.
The concept introduced by Brandeis, and then later re-introduced in a 2005 FAJ article by John Bogle entitled “The Relentless Rules of Humble Arithmetic”1 (a phrase he lifts directly from Brandeis’s book), is known as: The Cost Matters Hypothesis. At its most basic, it is the reality that controlling costs down to a level that at least equates to the potential value-add of a strategy, is essential if investors are going to benefit in any way from the long term investment process
Bogle points out the considerable paradox of an investment community that is prepared to churn out untold research around whether a concept such as “efficient markets” really exists and what the implications are for active management and the quest for alpha, and yet provides precious little debate or call for action in relation to a concept that is widely accepted as irrefutable: Costs do matter.
To quote Bogle: “How can we talk about “creating positive alpha without realizing that after intermediation costs* are deducted, the investment system as a whole has negative alpha?2
While Bogle is unable to rigorously quantify the impact of costs on long term investors in aggregate, he does go so far as to make the following summation:
“In the US, the investor who puts up 100% of the capital, assumes 100% of the risk receives only 21% of the return. By contrast, financial intermediaries who put up 0% of the capital and assume 0 %of the risk, walk away with as much as 79% of the financial benefit.”
In Bogle’s view, “So long as money-making activity simply shifts returns from the pedestrian to the brilliant, or from the unlucky to the lucky, or those that trust the system to those that work on the margins – it has profoundly antisocial effects
Readers of Mindfields will recall that in a previous edition, we approached the discussion of cost vs. value-add from a slightly different perspective when we posed the question: how much skill does a manager need to have to compensate investors for the fees charged on active management.
The answer provided by Richard Ennis3 was particularly disheartening
In theory, asset allocation is supposed to be one of the very few “free lunches” in the investment management game. Create a robust investment strategy by diversifying
among a range of un-correlated asset classes, and the long term resilience to economic shocks more than rewards investors seeking out long term real returns.
The quest for alpha through the blending of uncorrelated asset classes has become such a compelling focus that the financial service industry is positively bursting in growth in new and far flung asset classes: hedge funds, private equity, currency overlay strategies, international property, infrastructure funds, distressed debt…the list goes on and on.
But one has only to look back on an already dated study by Keith Ambactsheer and his KPA Associates to recognize the problem. While the chart is but a memory now, I can still provide a vivid description of its gist.
Ambachtsheer’s chart essentially examines the following characteristics of different asset classes. A summary of his conclusions are highlighted at the bottom of the chart in red.:
Here’s the problem in a nutshell:
As one moves into progressively less mainstream asset classes, picking the right manager is that much more critical, given the extreme variability in performance from top and bottom managers. At the same time though, you now have less dependable valuations and reporting on performance; less transparency of process and portfolios from which to derive insights into a manager’s true alpha generation abilities; – and worst of all, greater costs – both implicit and explicit – that need to be overcome to justify venturing into the asset class.
Drawing from a more recent piece by Ambachtsheer on the future of investing, he raises serious questions as to whether this current rush to engineering products that identify potential new sources of alpha for investors is entirely in investors’ best interests, (although they do certainly help keep asset managers profitable.):
“Adam Smith’s invisible hand may give a minority of money managers a competitive edge but it cannot improve the lot of investors as a group. – that can only be don’t by the slashing of financial intermediation costs.”
In essence, Ambachstsheer argues, that investors would be far better served if the fire power of intellectual capital found in the industry turned it sights, rather, to thinking more about a “value for money” philosophy.
Let’s first find agreement on some fundamental principles relating to asset allocation (although we’re certainly open to debating any of these principles):
The answer may not be as far from our grasp as we fear. But to get to that answer, we need to ask some tough questions about our expectations for our more esoteric (but wonderfully diversifying) asset classes.
First. Do we genuinely believe that asset managers that move into areas such as hedge funds, private equity, currency overlay strategies, etc. are so much more skilful than other asset managers that they can:
In a recent edition of Collective Insight which covered the topic of “Alternative Views of Alternative Investment Strategies” Rowan Williams-Short addressed this precise question. He starts by pointing out that globally, an excellent manager – upper quartile – is typically one who can reliably outperform the market index benchmark by 2% pa. Contrast that to our expectations that hedge fund managers should be able to deliver double digit performances.
One of two things is possibly wrong with this picture: either the benchmark is inappropriate for truly assessing manager skill (can tens or thousands of investors be that much smarter?) or…and this is a variation of the first point…we are failing to recognize that much of this double digit performance may well be a function of the “market” contribution to performance, much as we see with their traditional manager counterparts
Williams-Short concludes that hedge fund managers aren’t really that much more skilful – it just turns out they play in more fertile fields. He uses the following example to illustrate the point:
Assume your hedge fund manager manages a long/short equity strategy. Most typically, that means going long smaller cap under-researched shares and selling short over-researched, but more liquid (easier to borrow) large caps. This process is then repeated across a diversified portfolio of holdings.
Williams-Short argues that you can replicate this exact strategy by buying Russell 2000 futures and selling S&P 500 futures, an exercise which effectively costs next to nothing.
A similar low cost strategy for “synthesizing” fixed income arbitrage strategies of hedge fund managers by using derivatives to capture corporate bond vs gov’t bond spread.6
Effectively if you can passively replicate a number of hedge fund managers (and research by Jaeger and Wagner shows that 88% of hedge fund returns can be explained by the methodology)7 then surely this element of return in a hedge fund must be deemed as much a “beta” contribution as the equity market’s return is a “beta” component of a traditional long-only active manager’s return.
Now here’s the surprise: subtract this “beta” from hedge fund strategy returns and low and behold, a top quartile hedge fund manager is likely to earn somewhere around 2% returns in addition to the underlying “beta” – or passive market component of their strategy – not so different from our traditional manager experience.
The good news is that these astonishing insights are now leading to two encouraging outcomes:
The extraordinary thing about our industry is that the more we learn how to properly assess manager skill, the less we discover really exists. But, should that be troubling? –
Not as long as I am not paying performance eroding fees that pretend it does exist.
What I really want – back to my asset allocation quest – is to gain low cost exposure
In a nutshell – access to strategies that may well be nothing more than less constrained variations of traditional active management processes – but still provide better diversification benefits than an exposure to equities or bonds alone - may well be within reach of the investors’ pocketbook. And we don’t even have to worry about trying to determine (much less reward) whether managers are truly skilful.
Unfortunately, a similar spurt of synthetic hedge fund index product development has yet to unfold in South Africa. But this has more to do with the fact that South Africa still lacks a viable hedge fund index rather than lacks the know-how of how to replicate the beta component of hedge funds. We watch this space with interest.
Another asset class to make headlines in the “increased diversification / significant alpha generation” space is currency overlay strategies. Unlike traditional global asset allocation strategies that saw currency as yet another dimension of the global equity vs. bond allocation decision, currency overlay strategies recognize that there are factors driving currency returns that are independent of price drivers for global equities and global bonds. Because currency overlay strategies can typically incorporate short term trading strategies that capture changes in volatility; arbitrage strategies capture pricing anomalies that are a function of the currency markets unique array of different participants; and momentum strategies that can capture any speculative fever reflected in the market - all in addition to valuation differentials that might be a function of interest rate or inflation differential between countries, currency overlay strategies tend to have more in common with hedge fund strategies than traditional global asset allocation strategies. For many investors, currency overlay strategies are even regarded as another class of hedge fund management strategies. The key characteristic that we are looking for, though, is their low correlation to other asset class strategies – which indeed exists.
Once again, what we really care about is whether this asset class can generate the kind of double-digit excess returns and the commensurate high fee structures that prevail in all of these alternative asset class strategies. And once again, academic research is beginning to unearth the fact that this asset class also has a strong beta component to it that can be replicated synthetically at significantly lower costs. The launch of a fully automated currency fund by Barclays Capital that can significantly undercut the cost structure of established actively managed currency funds highlights the fact that beta exists in this asset class as well because of the preponderance of trading by non-profit maximisers such as central banks and companies in cross-border trades – 11.7 % after charges – 85 bps - Deutsche ETF 81 bps vs 2% and 20%.
Over the last six months, no alternative asset class has attracted as much debate and controversy as private equity. As with hedge funds, there is massive variability between top and bottom performing private equity funds. As with hedge funds, the fees charged by managers in this space are typically four to five times greater than traditional active equity manager fees. But significantly more confounding, are the issues surrounding how these funds are meaningfully valued through time. This lack of transparency and timeliness in valuation is what creates the illusion that private equity is a powerfully diversifying asset class with significant alpha generating potential.
Private equity: A different dynamic at play
The question at stake goes back to the heart of what John Bogle and Keith Ambachtsheer were trying to address: to what extent to financial activities actual improve the lives of all stakeholders or simply contribute more “anti-social” outcomes?
A recent flood of submissions on private equity to Collective Insight brought these insightful comments:
“This article aims to show, that like Paris Hilton, private equity has a glamorous façade, but is quite empty inside. In fact, this somewhat stretched analogy is a bit misleading: we can prove that private equity, as it is being sold at the moment, is a triumph of form over substance. In Paris Hilton’s, case we are just guessing - but we wouldn’t mind trying to find out!
“This is where the story goes full circle: due to the fact that interest rates are at very low levels, leverage can be introduced on a grand scale.
This leverage comes at no risk to the private equity fund: it merely extracts the equity in the form of a dividend from the target company (post buy-out, of course) and substitutes it with low interest rate debt. Net cost of the investment: 0. Using this financial alchemy, PE funds can buy low quality businesses and stand a chance of making quite high returns. In the regulated, listed market, there is no way to compete with this. The fact that finance theory shows that adding debt to an asset does not increase its value, matters not.
Here’s the thing. The institutional investor, who has moved money from an old school long only fund, to a cool new PE fund, broadly ends up owning the same asset – just in a more risky, leveraged form. This investor is also paying much higher fees for the privilege. Giving up low cost transparency and liquidity for high cost opaqueness and illiquidity does not look like a fair trade, but it is the price for escaping low yielding, highly regulated assets.”
“Private equity is unique among alternative in that it is not actually a diversifying asset class in the traditional sense but forms part of the equity continuum.” (liquidity premium)
But there’s a far more serious debate that is decidedly SA specific:
In contrast to the ideal of providing capital and skills to growing enterprises, PE funds are more recently known in South Africa for leading the charge to buy-out public companies with low gearing and predictable cash flows. This is anti-developmental as such companies are starved for research and capex in favour of debt-service.
The Private Equity Model: A Plethora of Problems
PE has a potentially vital role in supporting medium sized enterprises and developmental projects while offering the potential for sound risk adjusted returns. However, for PE funds to gain greater support from the retirement fund market will require a reconciliation of the positive nature of the asset class with practices and methods of PE funds.
Steven Brown and William Goetzmann in the Journal of Investment Management point out that the performance fee component in funds of hedge funds may under certain circumstance exceed the realized return on the fund. Worse, the more diversified the fund of funds is, the more likely the likelihood that the investor will incur a performance fee regardless of overall performance – in fact, there is a significant probability that the incentive fee will be so large that it absorbs all of the annual fund return. The key for investors is to ensure that the FoF manager absorb underlying performance fee in exchange for charging such a fee at the FoF level.
Joseph Gerard Paul of Alliance Bernstein makes these additional points about the selection of hedge funds:
1 Bogle, John, “The Relentless Rules of Humble Arithmetic” Financial Analysts Journal,
2 Costs: advisory fees, marketing expenditures, sales loads, brokerage commissions, legal and transaction costs, custody fees, security processing expenses.
3 Richard Ennis
4 Daniel Polakow
5 London Business School and ABN AMRO conducted studies on absolute return strategies. When strategies attempted to limit falls to 1% to 2% maximum in the US equity market returns fell from 11.6% to 0.6% before costs. More importantly though, Sharpe ratios turned negative – suggesting a worse risk/return outcome than if you invested in government bonds. Broadening the drawdown limit to -5% produced marginally positive Sharpe ratios. Effectively, downside protection eroded returns by more than risk is reduced. Attempts to eliminate equity risk will also eliminate the equity risk premium.
6 Rowan Williams-Short
7Jaeger and Wagne
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