1. Markets are Efficient
Our core belief is that markets are “efficient”, meaning that prices reflect the knowledge and expectations of all investors. Though prices are not always correct, the availability of information and its rapid dissemination means that markets are so competitive that it is highly unlikely that any single investor can routinely profit at the expense of all other investors.
Many investment managers believe that they can actively exploit market miss-pricings by stock-picking or market-timing – the traditional activities of active fund management. If markets were not efficient then the brightest, hardest-working and most highly paid fund managers would be able to beat a simple buy-and-hold strategy over time. But nearly forty years of academic research has shown that traditional investment managers are unable to outperform markets by anything more that the amount we would expect by chance. Indeed a multitude of studies has reached the same general conclusion: the average actively managed fund does no better than the market after fees, transaction costs and taxes.
Before fees, the track records of traditional fund managers are similar to what would be expected from a room full of orang-utans throwing darts at share and bond listings. After fees, the expected distribution of results is better for the orang-utans because they are assumed to work for bananas.
David Booth “Index & Enhanced Index Funds”, 2001
Investing is not a zero sum game where one investor must lose so another can win. Therefore any investor has the chance to capture the same capital market rates of return. Over the long run, markets reward investors for taking risk and providing capital. If they did not, the capitalist system would have collapsed long ago. Indeed, the only people who still appear to believe to the contrary are the governments of Cuba and North Korea – and Active Fund Managers.
2. Risk and Return are Related
Risk is one of the most avoided, least quantified and comprehensively misunderstood subjects by those working in the financial services industry. This is unfortunate because the primary purpose of investment professionals is the intelligent management of financial risks and the alignment of an investor’s risk capacity with the appropriate exposure to financial risk and the uncertainty of future returns. The relationship between risk and return was first described by Nobel Laureate, Harry Markowitz, in his 1952 paper “Portfolio Selection” which gave birth to the concepts known as Modern Portfolio Theory.
It comes as a surprise to many investors that the potential for financial loss is also the reason that they earn a return. We face risk because nobody can reliably predict the future – but risk, return and time are interconnected. Higher exposure to the right risk factors leads to higher expected returns, but is no guarantee of them. The bottom line is that risk must be taken to achieve a return. Risk is therefore the currency of return, in that a greater return can be considered a payment to investors for subjecting their capital to greater uncertainty.
Without the uncertainty of gain or loss, there would be no logical reason for investors to earn money. Therefore, if risk is the currency that is used to purchase returns, the questions that then arise are: what are the risk factors and how are they priced? The answers were provided in 1992 by Professors Eugene F. Fama of the University of Chicago Graduate School of Business and Professor Kenneth R. French of the Tuck Business School at Dartmouth College.
Fama and French’s analysis of the sources of investment risk and return has reshaped portfolio theory and greatly improved investors’ understanding of the factors that drive equity performance. The three factors are:
The notion that equities behave differently from fixed interest is widely accepted. However, within equities as a whole, Fama and French find that the differences in share returns are due to company size and price characteristics. Taken together, these three factors explain more than 90% of the variation in average equity portfolios.
Because they are riskier, financially less-healthy “value” companies have higher costs of capital than financially healthier “growth” companies. For example, if a “value” company and a “growth” company each approach a bank for a loan, the “value” company will pay a higher interest rate because the bank will charge additional interest for taking on the risk that the loan might not be repaid.
Similarly, when they issue shares, the price of a “value” company’s shares is lower because the market perceives the stock to be riskier. The market drives down the price so that the expected return is high enough for investors to hold it, in spite of the extra risk. The market sets the price at a discount so the expected return is higher. This ensures the stock will be purchased even though “growth” companies have better earnings prospects and generally appear safer.
The three factor model defines risk with a precision that has made it the modern investment research standard. Size and price characteristics, along with broad stock market exposure, are the major explanatory variables in equity returns as illustrated below:
3. Diversification is Key
Risk can be broadly classified in two ways:
Loss of capital comes from investing in securities whose value fluctuates due to systematic risk, unsystematic risk, or both. Non-systematic risk is the risk associated with one individual shareholding. Because the risk can be easily eliminated with diversification, the market does not reward investors with a return premium for this type of risk. So, when investors concentrate their investments they are increasing their risk with no added benefit of higher expected return. Systematic risk, on the other hand, cannot be diversified away as it is the risk common to the market as a whole. Investors require an extra return – known as the risk premium – to bear this risk.
Diversification in investing refers to the process of spreading out risk. The most prudent approach to minimise risk and maximise the probability of achieving a market rate of return is to hold the entire index. In this way the specific risk of holding each individual stock within the index is diversified down to near zero leaving investors with the systematic risk of the market the index is designed to track.
Global diversification is beneficial because it applies the same rationale as above. There are now more risk factors in international markets that can both smooth out volatility and increase expected returns. For example, in 1970 the United States represented 68% of world market capitalisation whereas Asia represented just 7%. By 2004, the United States’ share had decreased to 46%, whereas Asia had increased to 22%. Clearly, investors cannot ignore the global dimension in constructing portfolios.
The three factors or dimensions that explain equity market risk and return (market, size and value) are clearly observable in international markets, as shown in the illustrations below:
4. Structure Explains Performance
In addition to the three factors or dimensions that explain equity market risk and return, Fama and French added a further two dimensions which explain fixed interest returns. They are:
Whilst the Term Factor provides higher expected returns, the excess returns diminish significantly beyond a term of five years, so bonds with terms in excess of five years are generally avoided.
Fixed interest investments are an important component of investment portfolios because they dampen portfolio volatility due to their low correlation to the movements in share prices. Fixed interest investments (i.e. Gilts and Bonds) also provide investors with short-term liquidity where cash distributions may be required from the portfolio over a two to four-year period.
Equipped with the three risk factors of equities and the two risk factors of bonds, it is possible for investors to select from a wide array of risk and return combinations when building efficient portfolios. The resulting trade-off is known as the “eat well/sleep well dilemma.” If investors want to eat well and earn higher returns with stocks they need to be prepared to take more risk and accept the roller-coaster ride of fluctuations in the value of their portfolio. If they want to sleep well, they must take less risk and invest in fixed-income investments such as bonds and accept that they will earn lower returns.
The blending of these components in an investment portfolio is called Asset Allocation.
I want to thank you for your time, input and advice over the years over my pension and retirement. I enjoyed working with you and would not hesitate to recommend you and your services.
What you need to know about looking for a care home Funding and sourcing Long Term Care is becoming a major concern not just for those about to require Long Term Care and navigating the pitfalls of the State system, but also for children forced into sourcing what they hope will be suitable care for […]Read more →
Here’s one final word on the recent volatility in Global stock markets. As always, Carl Richards put this into context with one of his graphics and a few words… Normal Can Feel Scary… Imagine being in a boat in the ocean on a very still day. No wind. No swell. The water is as flat […]Read more →
There’s no doubt hyperbolic headlines depicting the recent falls on the world’s financial markets are potentially anxiety-inducing. With the FTSE 100 Index falling to its lowest level since April 2017, the effect of the headlines is to promote a sense of uneasiness; we’re here to remind you that this shouldn’t be the case. Instead of […]Read more →
It is often said that Inheritance Tax is an avoidable tax, but many of us somehow fail to avoid it. Why is this? In our experience, clients’ failure to plan effectively is a result of the following perceived problems: Speed – How often will the thought of having to survive 7 years from the date […]Read more →