GUIDETOINVESTMENTSTRATEGY

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Contents

ListoffiguresListoftablesAcknowledgementsForewordIntroduction

Part1Thebigpicture

1 SettingthesceneThinkaboutriskbeforeithitsyouTheMadofffraud

BetrayalaversionHowmuchriskcanyoutolerate?

AttitudestoriskandthefinancialcrisisKnowyourniche

WarchestsandumbrellasBasecurrency

2 UnderstandyourbehaviourInsightsfrombehaviouralfinanceInvestorbiasesInvestorpreferences

LossaversionThe“fourfoldpattern”ofattitudestogainsandlossesMentalaccountingandbehaviouralportfoliotheory

Investmentstrategyandbehaviouralfinance

ParameteruncertaintyandbehaviouralfinanceTraditionalfinance,behaviouralfinanceandevolution

3 MarketinvestmentreturnsSourcesofinvestmentperformanceAregovernmentbondsrisk-free?

Sovereignriskand“acountrycalledEurope”SafehavensthatprovidedifferentkindsofshelterWhichgovernmentbondswillperformbest?

Isthebreak-eveninflationratethemarket’sforecast?Whatpremiumreturnshouldbondinvestorsexpect?

Theplaceofsafe-harbourgovernmentbondsinstrategyTheequityriskpremiumEquityrisk:don’tbankontimediversifyingrisk

4 Howshouldandhowdoinvestorstrategiesevolve?Modelinvestmentstrategies

Risk-takingandportfoliorebalancingTheevolutionofwealthanditsinvestmentsince2002

Whatisasovereignwealthfund?Liquidalternativeinvestments

5 Thetimehorizonandtheshapeofstrategy:keepitsimpleAnappropriateroleforstrategymodels

Assetallocationmodels:anessentialdisciplineShort-terminvestmentstrategies

Howsafeiscash?Noall-seasonsshort-termstrategyDobondsprovideinsuranceforshort-terminvestors?

Areyouinitforthelongterm?Timehorizonforprivateandinstitutionalwealth

Long-terminvestorsFinancialplanningandthetimehorizon“Safehavens”,benchmarking,risk-takingandlong-termstrategiesThedangerofkeepingthingstoosimple

DeclinesinpricesaresometimesgoodforyouUnexpectedinflation:yetagainthepartypooper“Keep-it-simple”long-termassetallocationmodelsShouldlong-terminvestorsholdmoreequities?Inflation,againLadderedgovernmentbonds:ausefulsafety-firstportfolioBond ladders, tax and creditworthiness: the case of US municipal

bondsMunicipalbondladders:theimpactofthecreditcrisisandultra-low

interestratesWhat’sthecatchinfollowingalong-termstrategy?

Markettiming:anunavoidableriskSome“keep-it-simple”concludingmessages

Thechanceofabadoutcomemaybehigherthanyouthink“Modelsbehavingbadly”

Part2Implementingmorecomplicatedstrategies

6 SettingthesceneAhealthwarning:liquidityrisk

Investinginilliquidmarkets“Liquiditybudgets”

IlliquidityinnormallyliquidmarketsBehaviouralfinance,marketefficiencyandarbitrageopportunitiesBarrierstoarbitrage

FundamentalriskandarbitrageHerdbehaviourandarbitrageImplementationcosts,marketevolutionandarbitrage

Institutionalwealthandprivatewealth:taxation

7 EquitiesTherestlessshapeoftheequitymarket

ConcentratedstockpositionsinprivateportfoliosStockmarketanomaliesand the fundamental insightof thecapitalasset

pricingmodel“Smallcap”and“largecap”Willitcostmetoinvestethicallyorsustainably?Don’tgetcarriedawaybyyour“style”

ValueandgrowthmanagersShouldcautiousinvestorsoverweightvaluestocks?

Fashionableinvestmentideas:lowvolatilityequitystrategiesEquitydividendsandcautiousinvestorsHomebias:howmuchinternational?Whoshouldhedgeinternationalequities?Howmuchinemergingmarkets?

Fashionableinvestmentideas:frontiermarkets

8 CreditCreditqualityandtheroleofcredit-ratingagenciesPortfoliodiversificationandcreditrisk

Localcurrencyemerging-marketdebtSecuritisation, modern ways to invest in bond markets and the credit

crunchMortgage-backedsecuritiesThe role of mortgage-backed securities in meeting investment

objectivesInternationalbondsandcurrencyhedging

Whatdoesitachieve?Whatdoesitcost?Howeasyisforeignexchangeforecasting?

9 HedgefundsWhatarehedgefunds?Alternativesourcesofsystematicreturnandrisk“Dohedgefundshedge?”ThequalityofhedgefundperformancedataWhatmotivateshedgefundmanagers?Arehedgefundfeestoohigh?Theimportanceofskillinhedgefundreturns

TheshapeofthehedgefundmarketHedgefundreplicationand“alternativebetas”Directionalstrategies

GlobalmacroEquityhedge,equitylong/shortandequitymarketneutralShort-sellingorshort-biasedmanagersLong-onlyequityhedgefundsEmerging-markethedgefundsFixed-incomehedgefunds:distresseddebt

ArbitragestrategiesFixed-incomearbitrageMergerarbitrageConvertiblearbitrageStatisticalarbitrage

Multi-strategyfundsCommoditytradingadvisers(ormanagedfuturesfunds)

HedgefundriskMadoff,hedgefundduediligenceandregulationOperationalrisksIlliquidhedgefundinvestmentsandlongnoticeperiodsLies,damnliesandsomehedgefundriskstatistics“Perfectstorms”andhedgefundriskManaginginvestorrisk:theroleoffundsofhedgefunds

Howmuchshouldyouallocatetohedgefunds?Questionstoask

YourhedgefundmanagerYourhedgefundadviserYourfundofhedgefundsmanager

10 Privateequity:information-basedinvestmentreturnsWhatisprivateequity?PrivateequitymarketriskListedprivateequityPrivateequityportfolios

PrivateequityreturnsPrivateinvestments,successfultransactionsandbiasesinappraisal

valuations

11 RealestateWhatisrealestateinvesting?Whataretheattractionsofinvestinginrealestate?

DiversificationModernrealestateindicesandassessingthediversifyingroleofreal

estateIncomeyieldInflationhedge

StylesofrealestateinvestingandopportunitiesforactivemanagementWhatisapropertyworthandhowmuchreturnshouldyouexpect?

RentalincomeGovernmentbondyieldsasthebenchmarkforrealestateinvestingTenantcreditriskPropertyobsolescence

PrivateandpublicmarketsforrealestateInternationaldiversificationofrealestateinvestment

Currencyriskandinternationalrealestateinvesting

12 ArtandinvestmentsofpassionHow monetary easing probably inflated the prices of fine art and

collectiblesPsychicreturnsfromartandcollectibles

Wealth,inequalityandthepriceofartArtmarketindices

Priceindicesforotherinvestmentsofpassionor“collectibles”Investinginartandcollectibles

Sharedcharacteristicsoffineartandotherinvestmentsofpassion

Appendices

1Glossary

2Essentialmanagementinformationforinvestors3Trustingandaligningwithyouradviser4Sourcesandrecommendedreading

NotesonsourcesIndex

Listoffigures

1.1 Ifitlookstoogoodtobetrue,itprobablyis1.2 Risktolerancescoresandequitymarketreturns3.1 Incomeyieldfrom10-yearUSTreasurynotesand3-monthTreasury

bills3.2 Incomeyieldfrom10-yearUKgiltsand6-monthTreasurybills3.3 Incomeyieldfrom10-yeareuro-zoneAAATreasurybondsand3-

monthTreasurybills3.4 USTreasuryconventionalandrealyieldcurves3.5 UKTreasuryconventionalandrealyieldcurves3.6 Euro-zoneAAAratedTreasuryconventionalyieldcurve3.7 USTreasury20-yearyields3.8 US20-year“break-even”inflation(differencebetween20-year

TreasuryandTIPSyields)3.9 UK20-yeargiltyields3.10 UK20-year“break-even”inflation3.11 UScash,governmentbondsandstockmarketcumulative

performance3.12 UKcash,governmentbondsandstockmarketcumulative

performance3.13 Cumulativeperformanceofequitiesrelativetolong-dated

governmentbonds3.14 Therearenofreelunches:cumulativeperformanceofequities

relativetolong-datedgovernmentbondsinleadingmarkets3.15 20-yearequityriskpremiumoverTreasurybills

3.16 20-yearequityriskpremiumovergovernmentbonds3.17 Frequencyofequityoutperformanceofbonds,overlapping5-year

periods3.18 Frequencyofequityoutperformanceofbonds,overlapping20-year

periods4.1 VIXindicatorofUSstockmarketvolatility4.2 Tobin’sQ:ratioofthemarketvalueofUScorporateequityto

replacementcost4.3 S&P500“Shiller”price/earningsratio4.4 SpreadbetweensingleAcreditindicesandhighest-ratedgovernment

bondindices4.5 USTreasury10-yearconstantmaturityyields5.1 Stylisedsurplusriskandopportunityforlong-terminvestors,stylised

approach5.2 ComparisonofmunicipalandUSTreasurylong-datedbondyields5.3 Long-datedmunicipalbondyieldsasapercentageofUSTreasury

yields5.4 USstocks,bondsandcash:“efficientfrontier”andmodelallocations

for“short-term”investors7.1 CumulativetotalreturnofUSsmallcapandlargecapstocks7.2 10-yearrollingaveragereturnsforUSsmallcapandlargecapstocks7.3 Ethicalinvesting,cumulativereturns7.4 CumulativetotalreturnperformanceofUSgrowthandvalueequity

indices7.5 VolatilityofUSgrowthandvalueequityindices,36-monthrolling

standarddeviationsofreturn7.6 USvalueandgrowthequityindices,5-yearrollingperformance7.7 USandinternationalequities,5-yearrollingequityperformance7.8 UKandinternationalequities,5-yearrollingperformance7.9 Volatilityofdomesticandglobalequitiesfromalternativenational

perspectives

7.10 Whoneedsinternationalequitydiversification?VolatilityofequityinvestmentsfromaUS,ChineseandIndianperspective

7.11 CorrelationsbetweenUSequitymarket,internationalequitiesandemerging-marketequities

7.12 CorrelationsbetweenUKequitymarket,internationalequitiesandemerging-marketequities

7.13 Internationalequityvolatilityfromtheperspectiveofdifferentcountries,annualisedstandarddeviationofreturns

7.14 USperspectiveonimpactofhedginginternationalequities,36-monthrollingstandarddeviationofreturns

7.15 UKperspectiveonimpactofhedginginternationalequities,36-monthrollingstandarddeviationofreturns

7.16 Volatilityofworldandemerging-marketsequities,5-yearrollingannualisedstandarddeviationsofreturns

7.17 Performanceofemerging-marketequitiesinbestupmonthsforworldequities

7.18 Performanceofemerging-marketequitiesinworstdownmonthsforworldequities

7.19 5-yearrollingbetabetweenemerging-marketandworldequities7.20 10-yearrollingreturnsfromdevelopedandemerging-marketequities7.21 World,emergingandfrontiermarkets,36-monthrollingcorrelations8.1 DefaultrateofFitch-ratedissuersofcorporatebonds8.2 UScorporatebondspreads8.3 CumulativeperformanceofUSunder10-yearTreasuryand

corporatebonds8.4 YieldsonUSmortgagesecurities8.5 Cumulativeperformanceofagencymortgage-backedsecuritiesand

commercialmortgages8.6 USgovernmentbondmonthlyreturnscomparedwithmortgage-

backedsecurities8.7 Germangovernmentbondperformanceineuros

8.8 GermangovernmentbondperformanceinUS$,unhedged8.9 GermangovernmentbondperformancehedgedtoUS$9.1 Hedgefundindustryassetsundermanagement9.2 Cumulativeperformanceofhedgefundindexandequities9.3 Hedgefundassetsundermanagementbytypeofstrategy9.4 Monthlyperformanceofarbitrageandmulti-strategyhedgefund

indices10.1 Volatilityofpublicandprivateequity,proxiedby3isharepriceand

FTSE100index10.2 Volatilityofprivateandpublicequity,proxiedby60-dayvolatility

of3irelativetoUKstockmarket10.3 Volatilityoftotalequityasprivateequityincreases10.4 Cumulativeperformanceofgloballistedprivateequitycompanies

andglobalequities11.1 Thefourquadrantsofrealestateinvesting11.2 Valuation-basedandtransaction-basedmeasuresoftotalreturnfrom

realestateinvestmentsintheUS11.3 Valuation-basedandtransaction-linkedmeasuresofcommercialreal

estatepricesintheUK11.4 Valuation-basedandtransaction-linkedmeasuresofcommercialreal

estatepricesintheeurozone11.5 CumulativeperformanceofUSequitiesandREITs11.6 VolatilityofUSequityREITsandUSstockmarket,rolling36-month

standarddeviationsofreturn11.7 IsitcheapertobuyrealestateonWallStreetorMainStreet?US

REITs’sharepricecomparedwithGreenStreetestimatesofpropertynetassetvalue

12.1 Returnsfromfineart,stamps,violins,goldandfinancialassets12.2 Worldwidefineartauctionhousesales12.3 Calendaryearperformanceofglobalequitiesandclassiccars12.4 Monthlyperformanceofworldequitiesandclassiccars

12.5 BritishRailPensionFundrealisedratesofreturnfor2,505individualworksofartacquiredbetween1974and1980

Listoftables

3.1 Long-runmarketperformanceandrisk3.2 LongestperiodsendingDecember2012ofequitiesunderperforming

long-datedgovernmentbonds3.3 Doestimediversifyawaytheriskofdisappointingequitymarket

performance?4.1 Indicatorsofglobalinvestableassets4.2 Patternofassetallocationbyglobalinvestors5.1 Unaggressivestrategy:negativereturnriskvariesasinterestrates

move5.2 Bonddiversificationinmonthsofequitymarketcrisis5.3 Bonddiversificationinyearsofextremeequitymarketperformance5.4 Stylisedmodellong-termstrategies,withonlystocks,bondsandcash5.5 Modelshort-terminvestmentstrategies,withonlystocks,bondsand

cash:historicalperspective5.6 Modelshort-terminvestmentstrategies,withonlystocks,bondsand

cash:forward-lookingperspective5.7 USandglobalcapitalmarkets:volatilityandexcesskurtosis6.1 Theimpactoftaxationontaxableinvestmentreturnsandwealth

accumulation8.1 Governmentbondandequitymarkets8.2 Long-termratingbandsofleadingcredit-ratingagencies8.3 Corporatebondaveragecumulativedefaultrates8.4 UScorporatebondyields,spreadsandperformance8.5 USinvestmentgradecreditspreadsandexcessreturns

8.6 PerformanceofselecteddebtmarketsinmonthsofextremeUSequityperformance

8.7 UScorporatehigh-yieldandemergingdebtmarketssummarystatistics

8.8 PerformanceandvolatilityofcomponentsofBarclaysUSAggregatebondindex

9.1 Hedgefundperformanceduringcalendarquartersofequitymarketcrisis

9.2 Hedgefundindustry:assetsundermanagement9.3 Hedgefundperformanceduringcalendarquartersofequitymarket

crisis9.4 Selectedhedgefundstrategies:correlationswithglobalequity

market9.5 Equityhedgefundperformanceduringcalendarquartersofequity

marketcrisis9.6 Emerging-markethedgefundperformanceduringcalendarquarters

ofequitymarketcrisis9.7 Fixed-incomehedgefundperformanceduringcalendarquartersof

equitymarketcrisis9.8 Arbitragehedgefundperformanceduringcalendarquartersofglobal

equitymarketweakness9.9 Multi-strategyhedgefundperformanceduringcalendarquartersof

equitymarketcrisis9.10 Managedfuturesfund(CTA)andcommodityindexperformance

duringcalendarquartersofequitymarketcrisis10.1 GeographicalspreadofStandard&Poor’sListedPrivateEquity

index11.1 Directrealestateinvestmentbytypeofproperty11.2 US,UKandeurozonerealestatemarketindices:volatilityand

correlationswithstocksandbonds11.3 IncomeyieldfromREITs,quotedequitiesandbonds11.4 Directrealestateinvestmentbytypeofproperty

Acknowledgements

I OWEADEBTOFGRATITUDE tomany individualswhohelpedmewith thisbook. First and foremost tomywife,Alex, for her continued support andpatience through this edition’s labour. Elroy Dimson and Steve Satchellprovided invaluable advice and suggestions (as for the previous editions).StephenCollins provided important advice, suggestions and introductions.Colleagues at Delmore Asset Management and the Financial PlanningCorporationhavebeenparticularlypatientasIhavebeenpreoccupiedwiththe book. Many former colleagues have also been generous with theirsuggestions.IalsooweasubstantialdebttothetrusteesandprincipalsofthefundsthatIhavebeenprivilegedtoworkwithovertheyears.

I have been privileged to attend a number of seminars organised byNorway’sGovernment Pension Fund (Global) in the past few years. Thisbook has benefited considerably from the insights gained at these world-classmeetings,whichdebate the interfacebetween academic research andpracticalinvestmentissues.

Generous and insightful contributions on particular issues or chapterswere provided by Victoria Barbary, Paul Barrett, Jörg Behrens, NickBucknell,JeffBryan,EwenCameron-Watt,ForrestCapie,NormanDeitrich,Robin Duthy, Hugh Ferry, Geoffrey Fiszel, Charlie Goldring, HowardGoldring, Dietrich Hatlapa, Arzu Huseynov, Tim Lund, Yoram Lustig,Cesar Murillo, Arlen Oransky, Steve Piercy, Mark Ralphs, John Pullar-Strecker, Max Rayner, Christof Schmidhuber, Paul Stanyer and JamesWyatt.Iammostgratefultoeachofthem,butanymistakesaremyown.

I am also indebted to those firms whose data I have used in thenumerous tables and charts.Without their support the book could not bepublishedinthisform.IwouldalsoliketothankStephenBroughatProfile

Booksforhisencouragement,suggestionsandsupport.MythanksarealsoduetoPennyWilliams,whoskilfullyandpatientlyeditedthebook.

This book aims to help inform the process of seeking and givingprofessionaladvice,butitcannotbeasubstituteforthatadvice.Itdrawsonand summarises research and investor perspectives on a wide range ofissues, but it is not punctuated with footnotes citing sources for facts oropinions.Althoughimportantareasofdebateareflaggedwithreferencestoleading researchers, in other areas ideas which are more commonlyexpressedarepresentedbutnotattributed.SourceswhichwereparticularlyimportantforeachchapterarelistedinAppendix4.

Pleasenotethat theviewsexpressedinthisbookaremyownandmaynot coincide with the views of the investment funds on whose boards orcommitteesIamhonouredtoserve.

In conclusion, let me say how privileged I am that Elroy Dimson,Emeritus Professor of Finance at London Business School, has agreed towriteaforewordforthisthirdeditionofthebook.Althoughmyappreciationofmarkets owes a great deal to the economics that I learnt atCambridgeUniversity, particularly from the late Michael Posner and from MichaelKuczynskiatPembrokeCollege,theLondonBusinessSchool’sInvestmentManagementProgrammegavemean invaluablebridgefromeconomics tomodernfinance.

Foreword

INTEREST RATES HAVE COLLAPSED. Savers who put aside money now, tospendinthefuture,willearnlittlebywayofinterest.Toaccumulateatargetlump sum, they need to savemore than they once planned.Retirees,whowish to liveon their savings, cannowexpect to receive a smaller incomefromtheir investments.Theymustadjust tohavinglesstospendthantheyexpected.

Of course, low interest rates and low bond yieldswere for some timeclear for all to see. It was less obvious that low interest rates imply lowprospective returns on all assets, including equities. Because investorsrequire some compensation for the higher risk of the stockmarket, equityreturnsmustbeequal to the interest rateplusa“riskpremium”. It followsthat,otherthingsbeingequal,aworldwithlowinterestratesmustalsobeaworldinwhichstockmarketinvestorsreceivelowerreturns.

What are the implications of this dramatic change in the financialenvironment?PeterStanyer’sresponseisthateverysaverneedsacoherentinvestment strategy.Strategymust beunderpinnedby anunderstandingofhow markets move, how risk should be judged, how markets rewardinvestorsandhowinvestorsbehave.Inthis thirdeditionofhisoutstandingbook,PeterStanyeraddresses these issuesandelegantlysurveys theentirefieldofinvestment.

He helps us to formulate an investment strategy that is realistic. Theprojectionsmadebymanyassetmanagers,retailfinancialproductproviders,pension funds, endowments, regulators and governments are optimistic.Overlyoptimisticestimatesoffuturereturnsaredangerous,notonlybecausetheymislead,butalsobecausetheycanmasktheneedforaction.

Investors vary in their need for liquidity, their tolerance for risk, and

their capacity to follow a disciplined investment strategy. They thereforeneed to devise a strategy that reflects their salient characteristics. Thestrategyshouldbefoundedonthreepillars.Thefirstpillarisfinancialtheory–howfinancialmarketscanbeexpectedtobehave;thesecondisempiricalevidence–howmarketsactuallydobehave;andthethirdistheinvestmentenvironment–thecurrentconditionoffinancialmarkets.

PeterStanyerreviewstherelevantaspectsoffinancialtheoryinahighlyaccessibleway.Heextendsourknowledgewithoutresortingtocomplicatedmathematics, explaining the central concepts ofmodern finance in a clearexpositionof theargumentsforandagainstdifferentapproaches.Tobetterunderstand markets, he turns to the evidence of financial history, ofteninterrogating the long-term, global dataset that my colleagues and I havecompiled.Heallows the recordofsecuritiesmarkets toenlightenusabouteventsinthepastandtounderpininformedjudgmentsaboutthefuture.

Tointerpretthecurrentinvestmentenvironment,PeterStanyerpresentsuswithawealthofdata.Drawingtogethertheory,evidenceandinformationon the financial environment, he does not flinch from expressing a firmopinion. He presents valuable advice on how to construct a fixed-incomeportfolio,how to thinkabout liquidity,whatquantumof risk is acceptablefor different investors, what factors influence investment performance,whether investmentsofpassionarea storeofvalue, andwhatbehaviouralbiasesinvestorsshouldguardagainst.

There is something foreveryone in thisbook. It is comprehensive,butneverforbiddingoropaque.Thesurveysofeachofthemainassetclasses–equities and risky debt, alternative assets like hedge funds and privateequity, and tangible assets like real estate and artworks – are highlyinformative and the complexities of modern investing are explained withgreat clarity. This bookwill help youmeet the challenge of investing foryourfuture.

ElroyDimsonDecember2013

Introduction:lessonsfromtheglobalfinancialcrisis

THE YEARS SINCE THE CREDIT CRISIS of 2007–9 have seen a number ofrefreshingly simple investment messages gain traction that should enableinvestors toweather future storms in better shape. Thesemessages are asrelevant to individuals managing their own retirement savings as to themanagersofthelargestinvestmentfunds.

One, emphasised by Antti Ilmanen, is that the timing of investmentvolatilitymatters asmuch as itsmagnitude. AndrewAng stresses this byasserting that the twomost importantwords in investing are “bad times”.Thisisathemerunningthroughthiseditionandithasseveralaspects.Oneis that past performance patterns can easily give a falsely reassuringimpressionofthelikelihoodof“badtimes”.Anotheristhatinvestorsshouldinitiatediscussionsabouthowaninvestmentproposalmightperforminbadtimes. If the investmentwill helpmitigate lossesof incomeor capital andgive flexibility inbad times, itwillbeanattractive investment; if itmightamplify them,and impose inflexibility, investorswillneed tobe rewardedamplyforthatandtounderstandwhytherewardisexpectedtobesufficient,given their circumstances. This applies with particular force to the costsimposedbyilliquidinvestments.

Almostallinvestmentproductsofferanalluringcombinationofriskandreturn. When these offer a better prospect than normally offered by themarket,investorsshouldalwaysask,how?Betterthanmarketperformancemust reflect some combination of rare skill; exploiting amarket anomaly(butseeChapter6);orarewardforrisk-taking(seeChapter7).Thevictimsof the Madoff fraud suffered because they or their advisers accepted thedescription of past apparent good performance with low volatility of his

fraudulent funds as descriptions of how they did, and sowould, perform.Thevictims’sufferingwasalltheworsebecausetheirtrustwasbetrayedbyMadoff(seeChapter1).

Allinvestorsneedtoaskforexplanationsofattractiveperformance.Lowvolatilitystrategiesinequitiesandcreditarealwayspopular,andChapters7and 8 encourage investors to suspect that obscure risk-takingmay be theexplanation. If it is, investors are forewarned that the attractive risk-returntrade-off, which is a characteristic of normal times, might provide littleprotectionin“badtimes”.ThiswasamessageofJohnCampbellandTuomoVuolteenaho’s (2004) article “BadBeta,GoodBeta” (seeChapter7). It isalso themessage thathedgefundsandprivateequityare riskassets,andausually reliable short cut is to see themas typesof equity investing.Theywillprobablynotprovidemuchhelpin“badtimes”,butmightneverthelessprovideinterestingopportunities(Chapters9and10).

After 2008, some complained that the poor diversification offered bystrategiesof risk assets couldnot reasonablyhavebeen anticipated.Theseinvestorshadoftenbeenencouragedby theprospectof superior returns toabandon the safety of high-quality government bonds. In the event theyprovided the security of income and, largely, the diversification of capitalvaluesthatwouldbeexpectedofasafeharbourinatimeofcrisis.AsAndréPeroldwrotein2009:“Riskisachoiceratherthanafate.”

Among those investors who emerged least scathed from the financialcrisis were many whose strategy comprised an allocation to cash orgovernmentbonds(whosesizewasdictatedbytheinvestor’sriskaversion),offset with an allocation to diversified equities. This approach echoes theportfolio separation theorem of the late JamesTobin (seeChapter 5), andmany financial advisers (and some institutional investors) served theirclientswellbyadheringtothissimpleapproach.However,theeraofultra-lowinterestratesintheyearsafter2008,andthepurchaseofone-thirdoftheUSnationaldebt(andalsolargequantitiesofhigh-qualitymortgages)bytheFederalReserveandofone-quarteroftheUK’snationaldebtbytheBankofEngland, forced cautious investors to take more risk and to scale backholdings of increasingly expensive government bonds. The dilemma ofchoosing between credit risk and interest-rate risk has hung over income-

seeking investors of all types in the years since 2009. This dilemmaunderlies the debates aboutwhether investors can hope to “time”marketsandtheroleoffixedassetallocationmodelsinChapters4and5.

Negligibleinterestrateshavehadanall-pervadingimpact.InChapter4,surveyevidence is reportedofsubstantialholdingsof liquiditybyhighnetworthindividualsacrossdifferentwealthbands.Thelossofinterestincomeby these wealthy families will have significantly lowered the opportunitycostof indulging in investmentsofpassion.This almost certainlyhelps toexplain the buoyancy of markets ranging from classic cars, stamps andvintage wine to fine art (see Chapter 12). The far-reaching influence onthesemarketsoftheFederalReserve’sresponsetotheglobalfinancialcrisiswasreflectedinanarticleintheNewYorkTimesinearly2013:“Whetherheintendeditornot,orevenrealisesit,BenS.Bernankehasbecomeapatronofthearts.”

Iwouldwelcome any feedback and can be contacted at the followingemailaddress:peter@peterstanyer.com.

PeterStanyerDecember2013

PART1

Thebigpicture

1 Settingthescene

ThinkaboutriskbeforeithitsyouRiskisaboutbadoutcomes,andabadoutcomethatisexpectedtoarriveatabadtimeisespeciallydamagingandrequiresparticularlyattractiverewards.Investors and their advisers have typically judged the riskiness of aninvestment by its volatility, but in the words of Antti Ilmanen, author ofExpectedReturns:AnInvestor’sGuidetoHarvestingMarketRewards,notallvolatilitiesareequal,andthetimingofbadoutcomesmattersforriskasmuchasthescaleofthosebadoutcomes.Athemethroughoutthisbookisthat investors should think about how investments might perform in badtimesas thekey tounderstandinghowmuchrisk theyare taking.There islittle discussion of what constitutes a bad time, which will vary frominvestor to investor,but it isbestcapturedbyIlmanen,whodefines itasatimewhenanextradollarofreadycashfeelsespeciallyvaluable.

Whatconstitutesabadoutcomeisfarfromsimple.It isdeterminedbyeach investor (and not by the textbooks). It varies from one investor toanother and from investment to investment. If an investor is saving for apension, or to pay off amortgage, or to fund a child’s education, the badoutcomethatmattersistheriskofashortfallfromtheinvestmentobjective.This is different from the risk of a negative return. In Chapter 5, thedistinctionisdrawnbetweenthreatstofutureincome(whichisofconcerntoa pensioner) and threats to the value of investments (which matter to acautiousshort-term investor).This shows that theshort-termriskof losingmoneyisinadequateasageneralmeasureofrisk.

Riskisaboutfailingtomeetparticularobjectives.Butitisalsoaboutthechanceofanythinghappeningbefore thenwhichunderminesan investor’sconfidence in that future objective beingmet. Since thoseworking in the

investment business are uncertain about market relationships, it isreasonableforinvestorstobeatleastasuncertain.It isalsoreasonablefortheirconfidencetobeshakenbydisappointingdevelopmentsalongtheway,even if those developments are not surprising to a quantitative analyst.Investors’ expectations are naturally updated as time evolves and as theirown experience (and everyone else’s) grows. So far as the investor isconcerned, the perceived risk of a bad outcome will be increased bydisappointments before the target date is reached, undermining confidenceintheinvestmentstrategy.

Thepatternofinvestmentreturnsalongthewaymatterstoinvestors,notjustthefinalreturnatsometargetdateinthefuture.Thisfocusontheriskofsuffering unacceptable losses at any stage before an investor’s target datehashighlightedthedangersofmismeasuringrisk.Aninvestormightacceptsomelowprobabilityofaparticularbadoutcomeoccurringafter,say,threeyears. However, the likelihood of that poor threshold being breached atsomestagebefore theendof the threeyearswillbemuchhigher than theinvestor might expect. The danger is that the investor’s attention andjudgmentareinitiallydrawnonlytothecompletethree-yearperiod.Astheperiodisextended,theriskofexperiencingparticularlypoorinterimresults,atsometime,canincreasedramatically.

The insights frombehavioural finance (seeChapter2)on investor lossaversion are particularly important here. Disappointing performancedisproportionatelyunderminesinvestorconfidence.Theriskofthis,anditsrepercussions for the likelihood of achieving longer-term objectives,representsissuesthatinvestorsneedtodiscussregularlywiththeiradvisers,especiallywhentheyareconsideringmovingtoahigher-riskstrategy.

Research findings from behavioural finance emphasise that investorsoften attach different importance to achieving different goals. The risk ofbadoutcomesshouldbe reduced,as faraspossible, forobjectives that theinvestor regards asmost critical to achieve, and, ideally, any high risk ofmissing objectives should be focused on the nice-to-have but dispensabletargets. Investors may then be less likely to react adversely to thedisappointments that inevitablyaccompanyrisk-basedstrategies.Theywillknowthatsuchtargetsarelesscriticalobjectives.

Risk is about the chance of disappointing outcomes. Risk can bemanaged but disappointing outcomes cannot, and surprising thingssometimeshappen.However,measuringthevolatilityofperformance,asacheckonwhatthestatisticalmodelssayislikely,canbehelpfulincomingtoanindependentassessmentofrisk.Butitwillalwaysbebasedonasmallsample of data. Thuswe can attempt tomeasure riskswe perceive.Risksthatexistbutthatwedonothavetheimaginationorthedatatomeasurewillalwaysescapeourmetrics.Thereisnosolutiontothisproblemofmeasuringrisk,whichledGlynnHoltontowriteinFinancialAnalystsJournalin2004:“It ismeaningless to ask if a riskmetric captures risk. Instead, ask if it isuseful.”

More often than not, the real problem is that unusual risk-taking isrewarded rather than penalised. We need to avoid drawing the wrongconclusions about the good times aswell as the bad times. This theme iscaptured by a photograph at the front of Frank Sortino and StephenSatchell’s bookManaging Downside Risk in FinancialMarkets. It showsKarenSortinoonsafariinAfrica,pettinganintimidatingrhino.Thecaptionunderneath reads: “Just because you got away with it, doesn’t mean youdidn’ttakeanyrisk.”

TheMadofffraud

If risk isaboutbadoutcomes, tobeavictimof fraud isaparticularlybadoutcome.Butwhenwelookafterourownsavingsandinvestmentsweareoftenourownworstenemies.Manypeopleexpectsavingsandinvestments,inwhich they have no particular fascination, to be a difficult subject thattheydonotexpecttounderstand.Anyopportunitythatpresentsitselftotakea short cut and, in the words of Daniel Kahneman, a Nobel laureate ineconomics and Eugene Higgins emeritus professor of psychology atPrinceton University, to “think fast”, which easily leads to avoidablemistakes, rather than “thinking slow”, which requires some concentrationandeffort,willbetempting.Ourlazyinclinationto“thinkfast”(seeChapter2)isreadilyexploitedbyfraudsterswhoareattractedtoourmoneyandourbehavioural weaknesses like bees to a honey pot. The enormous Madoff

fraudthatunravelledinDecember2008providessalutarylessonsforusall.AttheendofNovember2008,theaccountsoftheclientsofBernardL.

MadoffInvestmentSecuritiesLLC,aninvestmentadviserregisteredbytheUSSecuritiesandExchangeCommission(SEC),hadasupposedaggregatevalue of $64.8 billion invested in the supposedly sophisticated investmentstrategy run by BernieMadoff. His firm had been in operation since the1960sanditisthoughtthathisfraudstartedsometimeinthe1970s.Itlasteduntil 11th December 2008 when he was arrested and his business wasexposedasahugescam,probablythelargestsecuritiesfraudtheworldhaseverknown.

The amounts that Madoff’s investors thought they owned had beeninflated by fictitious investment performance ever since they had firstinvested, and the amount that Madoff actually controlled was furtherreducedbecauseearlyinvestors,whothenwithdrewmoney,werepaidtheirinflated investment values with billions of dollars provided by laterinvestors.Thecourt-appointed liquidatorhasestimated theactual losses toinvestors of money they originally invested to be around $17.5 billion.Nevertheless, atone stage investorsbelieved that theyhadassets–which,unknownto them,weremostlyfictitious–worth$65billion investedwithMadoff.BySeptember2013, the liquidatorshad recoveredor entered intoagreements to recover, often from early beneficiaries of the fraud, $9.5billionor54%oftheestimatedlossesofamountsinvestedwiththefirm,andactual distributions to investors totalled $5.6 billion. It is likely that thetrusteefortheliquidation,IrvingS.Picard,willsucceedinrecoveringmuchmore than was initially feared of the amounts originally invested.Nevertheless, investors havebeen left nursinghuge losses fromwhat theybelievedwastheirwealth.Unlesstheyremainalert,othersareindangerofrepeating the mistakes that led so many to lose so much. So how caninvestorsprotectthemselves?

Madoff’s investment strategy seemingly offered the attractivecombinationofalong-runperformancecomparabletothestockmarketbut,supposedlythankstocleveruseofderivatives,withlittlevolatility.

FIG1.1Ifitlookstoogoodtobetrue,itprobablyisMadoff’s fictitious cumulative performance compared with market indices, Dec 1990–Nov

2007,Dec1990=100

Sources:Barclays,FairfieldSentryclientreports;MSCI

Marketingmaterial fromfunddistributorspresented the trackrecordofMadoff’s fraud in theway shown inFigure 1.1 forFairfieldSentry, a so-calledfeederfundwhichwasentirelyinvestedinMadoff’sscam.Itshowedtheseductivecombinationofapparentlylowriskandhigh,butperhapsnotoutrageous, returns. But an experienced adviser or investor shouldimmediatelyrecognisethatthetrackrecordshownforFairfieldSentrylooksodd.Itisalwayssafetoassumethatnoinvestmentstrategycandeliversuchsmooth returnswell inexcessof theguaranteed rateonTreasurybillsandthattherearenolow-riskroutestoreturnswellabovethereturnoncash.

Madoff’sstrategywasasimplePonzischeme,wherebyafraudulentrateof return ispromised, seeminglyverified in this caseby theexperienceofthose early investorswhohadbeenable towithdraw inflated amounts.Solong as only a few investors demand theirmoney back, they can be paidwhattheyhavebeentoldtheirinvestmentisnowworth.Butwhattheyhadbeen told was a lie, and the inflated returns were delivered to a few byredirectingcashfromthemostrecentinvestors.AswithanyPonzischeme,MadoffreliedonrobbingPetertopayPaul.

PonzischemesarenamedafteranAmericanfraudsterofthe1920s,andthey are usually built around a plausible-sounding investment story.

However,thesescamsalwayscollapseassoonasthedemandsofinvestorswho want to sell their investments outweigh the cash provided by newinvestors.TheMadofffraudgrewsolargebecauseitsurvivedmanyyears.Itsundoingwas thecredit squeezeof2008when toomany investors,whowere presumably happy with Madoff’s reported investment performance,had to withdraw funds tomeet losses elsewhere. This caused theMadoffhouseofcardstocollapse.

ThevictimsweremostlybasedintheUnitedStates,buttherewerealsomany fromaround theworld.They includedwealthy individuals, charitiesandanumberofwealthmanagers,butrelativelyfewinstitutionalinvestors.ManywereintroducedtoMadoffthroughpersonalrecommendations,whichwouldhavestressedhis respectablecommunityandbusinesspedigreeasaformerchairmanoftheNASDAQstockexchangeandphilanthropist.

Alargepartoftheproblemisthatsomanypeoplecanbeseducedbythebeliefthattheyhavefoundalow-riskwayofperformingsurprisinglywell.Andyet,surprisinglygoodinvestmentperformancealwaysinvolvesrisk.

Madoffisnottheonlyinstanceoflarge-scalefraudorsuspectedfraudofthepastfewyearsandtheseepisodesprovideimportantlessonsforinvestorsand for their advisers. Some of Madoff’s investors were following therecommendationsofinvestmentadvisers,whoappearedtotakeprideintheirprofessional diligence in identifying good managers. The advisers couldoften point to the name of one of the leading accountancy firms as theauditor of the third-party so-called feeder fund that was the conduit toMadoffInvestmentSecurities,butthisprovidednoprotectionforinvestors.

Howwassomeonewhohadfollowedtherecommendationofanadviserorafriendsupposedtoidentifytherisks?Tenoldlessonsre-emerge:

1. Theoldandseeminglytrivialsayingthat“ifitlookstoogoodtobetrue,itprobablyis”remainsoneofthemostvaluablepiecesofinvestmentadviceanyonecangive.

2. Returnsinexcessofthereturnofferedbythegovernmentcanbeachievedonlybytakingrisk.

3. Riskismostobviouswhenaninvestmentisvolatileandisleastobviouswhenariskyinvestmenthasnotyetshownmuchvolatility.

Thisisrarelymentionedinbooksoninvestment.

4. Investorsshouldbeparticularlyquestioningwhenanadviserrecommendsalowvolatilityinvestmentthatofferssuperiorreturns.

5. Donotinvestinsomethingyoudonotunderstandsimplybecauseagroupofyourpeersisdoingso.Adesiretoconformcanexplainmanydecisionsthatwewouldotherwisenottake.

6. Whateveryouradvisersays,makesurethatyourinvestmentsarewelldiversified.Butkeepinmindthatdiversificationismostdifficulttoassesswhenriskyinvestmentsarenotobviouslyvolatile.

7. Payparticularattentionifanadvisergivesyouinconvenientcautiousadvice(suchasarecommendationtoavoidsomethingthatyouwouldliketoinvestin).

8. Socialstatusmaynotbeagoodindicatorofhonesty.

9. Donotassumethatbecauseaninvestmentfirmisregulatedbytheauthoritiestheyhavebeenabletocheckthateverythingisallright.

10. Theabilitytorelyongoodduediligenceoninvestmentmanagersisthekeytominimisingexposuretoriskoffraud.Anauthoritativepost-mortemreportontheMadoffaffairiscalled“Madoff:ariotofredflags”.Mostprivateinvestorswouldnotspottheseredflags,butitwasnotbychancethatfewinstitutionalinvestorslostmoneywithMadoff.Achallengeforprivateinvestorsistoensurethattheyalsohaveaccesstogood-qualitymanagerduediligence.

BetrayalaversionTheMadofffraudputsaspotlightontherelationshipbetweenadvisersandclients.Investorsareattheirmostvulnerableintheirdealingswithadvisers,andyetestablishingabondoftrustwithoneormoreadvisersisprobablythemostimportantingredientforthesuccessfulmanagementofwealth.IrisBohnetandRichardZeckhauser,respectivelyprofessorofpublicpolicyandRamseyprofessorofpoliticaleconomyatHarvardUniversity’sKennedySchoolofGovernment,havefoundthatindividualssystematicallyrequireapremiumreturntocompensatefortheriskthattheymightbebetrayedbyanagentwhoissupposedtobeworkingforthem.Thispremiumisgreaterthanthepremiumthatwouldbeaskedtoacceptthesameprobabilityofapooroutcomewherethereisnolikelihoodofbetrayal.AsBohnethaswritten:

Peoplecarenotonlyaboutoutcomes,butabouthowoutcomescametobe…thatdoesn’tstrikeanyonebutaneconomist–likeme–asasurprise.

Thishighlightstheimportanceoftrustintheadviser–clientrelationship,andthepsychologicalgainsthatflowwhereitispresentandthepsychologicalandpossiblyfinancialdamagethatresultswhenitisnot.

Howmuchriskcanyoutolerate?Theassessmentofinvestorrisktoleranceisafundamentalstepindesigninganyinvestmentstrategy,butadvisersandacademicsapproachitindifferentways. Academic economists use mathematical assumptions to model riskaversion.Theseassumptionsareattractivetotheminpartbecausetheycanbe used in models (and also because they can be tested empirically).Meanwhile, behavioural finance stresses the importance of loss aversionratherthanriskaversion,andtheasymmetryofresponsebetweengainsandlosseswhichisrevealedinbehaviouriststudies(seeChapter2).

Wealthmanagershaveforalongtimeusedquestionnairestocategorisetheirclientsby theirattitudes torisk-taking.Thesequestionnaires typicallycover investors’ circumstances (age, family, income, wealth, expenditureplans, and so on) as well as their attitude to risk. One problem is thatquestions posed by wealth managers about risk may use language andconcepts that are unfamiliar to non-experts. Anecdotal evidence suggeststhat people who are not familiar with investments often expect a riskquestionnaire to be difficult to complete. They may therefore ask theiradviserstohelpthemanswerthequestions.Thisintroduceserrorsandalsoseemstointroducesystematicbias,asinvestmentadvisersappeartobemoretolerant of risk than their clients. For these reasons, conventional riskquestionnairesmayfailstandardcriteriaforassessingpeople’sattitudes.

FIG1.2RisktolerancescoresandequitymarketreturnsJan2002–May2013

Sources:FinametricaPtyLtd;MSCI

In recent years psychometric profiling services have developed toaddresstheseconcerns,makinguseoffocusgroupstomakesurethattheirquestions are easily understood. For example, Finametrica, an Australianconsultancy,hasbuiltupadatabaseofover520,000responsesfromaroundthe world to its questionnaire, which itself grew out of research bypsychology academics in the United States. These responses reveal someinteresting patterns. For example, Finametrica reports that the pattern ofresponsesdoesnotvarymuchbycountry;individuals’toleranceforriskis,on average, fairly stable over time;women tend to bemore cautious thanmen (which is important for investing family wealth); and investmentprofessionalstendtobemoretolerantofriskthantheirclients(whointurntendtobemarginallymoretolerantofriskthanthepopulationasawhole).Thedatabasealsoshowsquiteawidevariationofresponsesforindividualsaroundtheseaveragecharacteristics.

Thefinding(whichisrepeatedlyfound)thatinvestmentadvisersareonaveragemoretolerantofriskthantheirclientsmayhelptoexplaininstancesof investors saying to their advisers: “I didn’t realisewewere taking thatmuchrisk.”Thisgreatertoleranceofriskmightbeinterpretedasreflectingadvisers’greaterunderstandingofinvestmentriskthanthatoftheirclients.Separate survey findings (also from Australia) suggest that investoreducation(forexample,throughattendanceatseminars)haslittleimpacton

therisktoleranceofinvestors,eventhoughitcanbeeffectiveinpersuadingemployees to save more for retirement. This suggests that investmentadvisersmaythinkit reasonable to takemoreriskthanmostpeoplewouldwish,notbecause theyhaveabetterunderstandingof investment risk,butbecause theirnature is toenjoy theproximity tovolatilemarkets. It seemsthatcautiouspeopleprobablycannotbeeducatedoutoftheirdispositiontobecautious,anditalsoseemslikelythatwell-designedpsychometrictestingmay help to categorise the risk appetite of investors better than ad hocquestionnaires.

However,asinglescoreonarisk-tolerancequestionnaire,evenawell-designedone,willnotbeanadequateguidetoaninvestor’swillingnessorcapacity to take risk. An investor is likely to have different financialaccountsfordifferentpurposes:oneormoremaybecriticaltoachieveandanother purely aspirational; one may be for a short-term objective andanotherforalong-termone(suchaspensionsaving).Awell-designedriskscoremightprovideastartingpointfordiscussingrisk-taking,butitwillnotgive the differentiated answers that are probably needed, nor will it copewiththedifferentwaysthatinvestorsrespondtotheexperienceorthreatoflosses,sometimesbyincreasingrisk-taking(seeChapter2).

AttitudestoriskandthefinancialcrisisAsuggestionthatinvestorsbecamemuchmoreriskaverseduringthefinancialcrisisof2008wouldbeacceptedasself-evidentbymanyeconomists.Riskassetpricesdeclinedbecauseinvestorswerenolongerascomfortableholdingthem;inotherwords,theybecamemoreriskaverse.Analternativeexplanationisthatpricesfellbecauseearningsexpectationsdeclined,justifyinglowerstockprices(andalsowiderspreadsbetweentheratesatwhichcompaniesandcreditworthygovernmentsborrow).ButthespikeintheVIXindexofstockmarketvolatilityin2008(seeFigure4.1)indicatesthatthestockmarketbecamemorerisky,andsoinvestorswithagivendegreeofriskaversionmightreasonablyfeeluncomfortablewiththeirexistingallocationstoriskassetsunlesstheyhadastrongviewthattheincreaseinriskwasatemporaryphenomenon.Thesealternativeperspectivesareimportantforinvestors,andthosewhohavebenchmarkallocationstoriskyandcautiousassetswilltypicallyfindthemselvesunderweightriskassetsafteradeclineinequitymarkets.Theseinvestorsmaythenrebalancebacktobenchmarkweights,butiftheydothistheywillbetakingonmoreriskwhenotherswishtotakeless(seeChapter4).

Theseconsiderationscontrastwiththedatathatemergefrompsychometrictests,whichsuggestthatinvestors’toleranceforriskwas,onaverage,surprisinglystableduringthefinancialcrisis,althoughthereareindicationsthattheirassessmentofstockmarketriskwasincreased.(Inotherwords,theymightbeequallywillingtotoleraterisk,butlesswillingto

increased.(Inotherwords,theymightbeequallywillingtotoleraterisk,butlesswillingtotoleratestockmarketrisk,becauseithadincreased.)

Aswithmuch in finance, the relationship between assessments of risktolerance, risk aversion and loss aversion (see Chapter 2) remains anunresolvedissue.

Knowyourniche

The styleof involvement indecision-making is oneof themost importantthings that investors need to decide. How hands-on or hands-off do theywish tobe, andwhat are theirpreferences and special areasof investmentexpertise? This is a natural starting point for discussions between anyinvestorandanewinvestmentadviser.

Some investors like to devote much time and personal effort to theirinvestments.Othersprefertodelegateasmuchaspossibletosomeonetheytrust.Neither policy is inherently superior, so long as keen investors havegrounds forbelieving that their interventionsare likely toaddvalue (or tosavevalue),anddisinterestedinvestorsaresurethattheiradvisersproperlyunderstandtheirinvestmentobjectivesandthatareliableprocessofreviewhasbeenestablished.

Successful entrepreneurs often have specialist skills that put them in aprivilegedpositionintheassessmentofnewbusinessopportunitiesintheirspecialist areas.This role as potential informed investors is likely to opendoorstoinvestmentopportunitiesthatarenotavailabletoothers.Butitwillbe unclear how these investments should fit into an overall investmentstrategyandhowtheentrepreneurshouldweightherisks.

Suchinvestorsneedtoconsiderwhetherandhowfartodiversifyawayfromtheirnicheareatoprovideadownsidelayerofprotection(seeChapter2), or a safety net for at least part of their wealth. Howmuch should beallocatedtosuchrainy-dayinvestmentsdependsonpersonalcircumstances,preferences and willingness to tolerate extreme disappointment. Forexample, there is great scope for disappointment from individual venturecapital investments, even when skilfully selected. For successful venturecapitalists, it is likely that the risk of an individual investment failing is

greaterthanthelikelihoodofthatinvestmentbeingarunawaysuccess.Butonerunawaysuccesswillmorethanpayforseveralfailures.Onetemptationforspecialistinvestorswillbetotrytodiversifyintorelatedareas.Inthesecases, a quiet review of the behavioural biases that commonly affectdecision-making could prove invaluable (see Chapter 2). Investors shouldaskthemselvesthefollowingquestions:

AmImovingawayfrommynaturalhabitatwhereIamconfidentofmy“edge”?

Domyskillsandspecificexpertisetranslatetothisnewmarket?

WillIhavethesamedegreeofcontrol?

DoIhavethesamedegreeofconfidenceinmyaccesstoinformationandinmyfeelforthesenewbusinesses?

If an investor cannot be confident of replicating the ingredients ofsuccess thatwere successfully used in the original niche, therewill be nobasisforexpectingtheextraperformanceneededtojustifytheriskthatgoeswith this pattern of concentrated private investments. In any event, aninvestorshouldaskwhetherthisnewventureprovidesthediversificationofriskthatisbeingsought.Itmaybebettertoseekaprofessionallymanagedapproachtofinancial investmentsforpartof theoverallwealth. Ifallgoeswell, it is most likely that the “natural habitat” investments will performbetter than the diversified investments. But this simply reflects the oldsayingthat tobecomewealthy, it isnecessarytoconcentrateexpertise,butthat to conserve wealth, it is necessary to diversify. However, riskconcentrationwherethereisnoinformationadvantageisarecipeforruin.

Wealthy individuals are often entrepreneurs, and their own businesseswill often represent the bulk of their wealth. Although the risks andopportunities of each business will vary considerably, when consideringoverallinvestmentrisk,itisusuallyappropriatetotreatthebusiness,whichwill typically be a private company, as if it represents a concentratedexposure to equity market risk. A mistake that is often made is to allowfamiliaritywithabusiness to cloudperceptionsof thatbusiness’s intrinsicrisk.Justbecauseitisnotpossibletoobservethevolatilityofthestockprice

of a private company does not mean that its value is not highly volatile.Whetheracompanyisquotedorunquoted,aninvestor’sfamiliaritywithit–eventheknowledgethat thecompanyiswellmanaged– isnoguide to itslackofvolatilityorriskasaninvestment.

Successful entrepreneurs often have such investments dominating theirriskprofile.Allowancesneed tobemade for thiswhen setting investmentpolicy for financial investments thatareheldseparately from thebusiness.Typically, anddependingupon financial needs, thiswill result in cautiousrecommendations for such investments, even if the investor is tolerant offinancial uncertainty. Not surprisingly, most investors are concerned toconserveaswellastoaccumulate,tohavealayerofdownsideprotectionaswellasupsidepotential.

WarchestsandumbrellasWhere financial investments are being managed alongside businessinvestments,theymayconstitutealiquidwarchesttohelpfundfuturenewopportunities,whichmayariseatshortnotice.Inthiscase,thetimehorizonis likely to be short, with a premium put on liquidity and the stability ofcapitalvalues,nomatterhowtolerantofrisktheinvestormightbeinothercontexts.

Alternatively,a familywithavolatilebusinessmaywish tobuilduparainy-day umbrella fund, either to help the business through tough timeswhich the family expects to be short-lived, or to provide an alternativesourceof incomeshould thebusiness fail.Many family-business investorshavelearnednottotrusttheumbrellaofloanfacilitieswillinglyextendedbybanksduringgoodtimestobeavailablewhenitstartsrainingseriouslyandhave thereforearrangedfinancial“umbrellas”fromtheirownresources. Insuch cases, a low-risk umbrella investment strategywould be expected toinclude a significant allocation to investment grade bonds, nomatter howrisk-toleranttheirriskprofileassessmentmightbe.

Basecurrency

Mostinvestorshavenodifficultydefiningtheirbasecurrency.Thisisthecurrencyoftheirhomecountry:thecurrencyinwhichtheymeasuretheirwealthandinwhichtheyformulatetheirexpenditureplans.Anythingoutsidethisbaserepresentsforeigncurrencyandentailsariskofadversefluctuationsagainstthebasecurrency.

Thepositionismoreambiguousformanyinvestors.MostprivateinvestorsinLatinAmerica,theMiddleEastandpartsofEastAsiausetheUSdollarastheaccountingcurrencyfortheirinvestments.Butaconvenientaccountingcurrencyisnotnecessarilyabasecurrency.Formanyoftheseinvestors,theroleoftheUSdollarwillbedifferentfromtheroleitplaysforapurelydomesticUSinvestor.Meanwhile,therearenowtensofthousandsofexpatriateinternationalexecutives,manyofwhomhaveearningsandresidencyinonecurrencyandnationalityandperhapsalsoretirementplansinanother.Thisambiguityaltersthebenchmarkformeasuringsuccessordisappointmentfrominvestmentreturns.Itisalsoparticularlyimportantinconstructingappropriateinvestmentstrategiestomeetparticularcommitmentsindifferentcurrencies.Consider,forexample,aEuropeanworkinginNewYork,subjecttosevereearningsvolatilityandwithalimonypaymentsineuros,orafinanciallyconstrainedfoundationwithcommitmentstosupportprojectsinmorethanonecountry.Inbothcases,theconceptofbasecurrencyandcurrencyriskmanagementneedaddressing.

DiscussionswithinternationalinvestorswhoseinvestmentsaretypicallyaccountedforinUSdollarssuggestthatthiscurrencyambiguityisrarelyconsideredanimportantissueinLatinAmericaorAfrica,butitisrecognisedasapotentialissueintheMiddleEastandisregardedasamaterialconcernbymanyinvestorsinAsia.AsianinvestorsmayhavetheirinvestmentsreportedandmeasuredinUSdollars,buttheyareconcernedbyanymarkeddepreciationoftheUSdollaragainsttheyen,thewonorotherAsiancurrencies.Onepracticalandeasywaytoaddressthisistodiversifyholdingsofcashacrosscurrenciesinawaythatapproximatelymeetstheirparticularneeds.Forexample,theMonetaryAuthorityofSingaporehasformanyyearspursuedapolicyofstabilisingthevalueoftheSingaporedollaragainstabasketofcurrenciesofSingapore’smajortradingpartnersandcompetitors.Inotherwords,accountistakenoffluctuationsintheyen,theeuro,sterling,otherAsiancurrenciesandtheUSdollar.Likewise,internationalfamiliesmayfeelmorecomfortablewiththeirsafe-harbourinvestments,especiallycash,spreadamongcurrenciesinwhichthefamilyhasobligations,ratherthanexclusivelyintheUSdollar.

2 Understandyourbehaviour

Insightsfrombehaviouralfinance

During the past 30 years research by experimental psychologists hasenormouslyenrichedeconomists’understandingofhowwetakedecisions.These insights havedifferedmarkedly from the assumptions that underlaythetraditionalmodelsofeconomistsandfinanceacademics.Theymatterfora range of reasons, of which the most important for this book is theprediction that inmany instanceswe are inclined to takeworse decisionsthan themodels of traditional financewould predict.An understanding oftheseweaknessesoughttohelpustotakebetterfinancialdecisions.

These advances led to the development of behavioural finance, whichprovides a framework that enables us to explore and understand investorpreferences,and todelve into thebiases thataffecthowwe takedecisionsand how thesemay cause us to deviate from the textbook assumptions ofhowrationalinvestorsoughttobehave.Anappreciationoftheseinfluencesisaprerequisiteformakingsurethatinvestorsadoptappropriateinvestmentstrategies.

Traditionally, economics and finance have focused on models thatassumerationality.Thereisanoldstoryabouteconomiststhathighlightsthedifferencebetweenthetwoapproaches:

Aneconomist[was]strollingdownthestreetwithacompanion.Theycomeupona$100billlyingontheground,andasthecompanionreachesdowntopickitup,theeconomistsays:“Don’tbother–ifitwereagenuine$100bill,someonewouldhavealreadypickeditup.”

The economist’s theoretical prior belief tells him that the anomalousobservationmustbeadataproblem.Thebehaviourist,however,wouldwantto examine the evidence, in otherwords to conduct an experiment beforeconcluding that the billwas probably a fake,without any prior belief oneway or the other. This is a profound difference in approach which hasimportantimplicationsforinvestmentadvice.

Traditionalmodelsinfinancecanbecaricaturedasfollows:“Ifinvestorsarerational,andifmarketsareefficient,theninvestorsoughttobebehavingas follows.” Almost all investors have been shown these models, forexample in the “risk” and “return” tradeoffs of an “efficient frontier”analysis, which implicitly assume that markets are “well behaved” and“efficient”, that investors should prefer diversified to undiversifiedportfoliosofriskyinvestments,andthattheyshouldviewtheriskoflossesconsistently with their attitude to the opportunity for gains. Since thefinancialcrisisof2007–09suchmodelshavebeenthesubjectofincreasedcriticism, but they remain useful (and are used to provide illustrations ofpolicy alternatives in Chapter 5). However, investors should have someunderstanding of their potential weaknesses. A simple illustration willsuffice.Manypeoplebuylotterytickets;theyexpecttolosemoney,buttheyhope to gain riches. Traditional finance implicitly finds this behaviourinefficient.Nevertheless,itcanberationalasitprovidesthebestlegalwayto have at least some chance (however remote) of securing riches in theshort term.Ifyoudonotbuya lottery ticket, it iscertain thatyouwillnotwin. An understanding of our willingness to gamble in some predictablecircumstancesandtooverpayforinsuranceinotherscanhelpustomanageourfinancesbetter(seebelow).

Behavioural financeuses research frompsychology thatdescribeshowindividualsactuallybehave,andapplies those insights to finance.Thishasled to two major streams of research. The first concerns how investorbehaviour might not accord with the textbook concept of the efficientrational investor. The other is how less than fully rational investors maycause market prices to deviate from their fundamental values. The firststrand of work, how investors behave, is used to look at how investmentstrategy should accommodate what investors want. The second, how

investors’behaviourmayaffecthowmarketsfunction,isusedinChapter6tolookatwhetheractiveinvestmentmanagersarelikelytofinditeasiertooutperform(forwhichtheshortansweris“no”).

Recognition of the contribution that behavioural analysis ismaking infinancialeconomicswasreflectedin2002withtheawardoftheNobelPrizeinEconomicstoaprofessorofpsychology,DanielKahneman(whowonitjointlywithVernonSmith).Thiswork,muchofitdevelopedjointlywiththelate Amos Tversky, a cognitive and mathematical psychologist, has beensummarised and updated in Kahneman’s retrospective tour de force,Thinkingfastandslow.Itdevelopedfromaseriesofexperimentsthatledtostrongconclusionsabout thebiasesof intuition thataffecthowindividualstake both instinctive and even thoughtful decisions and how they formpreferences. A good understanding of investor preferences is critical ingiving investment advice, and an understanding of investor biases isimportant inunderstandinghowinvestorsmayrespondtoparticulareventsordevelopments.Ifbiasesareweaknessesthatcouldinjuretheinterestsofan investor, investmentadvisersshouldnotpander to them.This indicates,forexample,aneedforinvestoreducation.Butinvestorsandtheiradvisersshouldbeawareofthesebiasessincetheywillhelpdeterminereactionstoarangeofpredictablemarketdevelopments.

Investorbiases

Psychologists have documented systematic patterns of bias in how peopleformviewsandtakedecisions,whichKahnemanhasdescribedas“biasesofintuition”.Although theprimary researchdidnotusually involve investorsorinvestmentdecisions,itisdirectlyapplicabletoinvestments.Thesebiasesinfluence how we form investment opinions, and then how we takeinvestment decisions. For example, the observation that most car driversthink that they are better-than-average drivers reflects a generalcharacteristicofoptimismandwishful thinking.Itwouldbenaive to thinkthat this characteristic did not affect our investment views. Furthermore,people are systematically overconfident, tending to put too much faith intheirownintuition.Overconfidenceinturnisreflectedinconfirmationbias,

wherebyweshowtooreadyawillingnesstoacceptasproofanyinformationthat reinforcesour existingviews, andalso in self-attribution, for exampleattributing toourown innate ability andunusual skill any success thatwemayenjoy. Individualswhoareunusuallywellpaidmight interpret thisasevidenceoftheirownunusualability,forinstance.

Correspondingly,self-attributionleadstoanaturaltendencytoattributeany disappointment to bad luck rather than a lack of skill. Investmentexamples of this would be provided by most accounts of investmentmanager underperformance that an investor might have heard:outperformance reflects skill, while underperformance reflects bad luck.This is also associated with hindsight bias, whereby individuals are sure,after the event, that they expectedwhatever happened to happen: “It wasobvious itwasgoing tohappen,wasn’t it?”Or, if theoutcomewas abadoutcome:“Itwasadisasterwaitingtohappen.”Unfortunately,thefutureisrarelysoclear.

Asimilarbiasisrepresentativeness,orstereotyping,wherebyindividualsaretooquicktoconcludethattheyunderstanddevelopmentsonthebasisoftoo little information.Forexample, in100yearsofstockandbondmarketperformancehistory,fiveseparate(non-overlapping)20-yearperiodscanbeobserved (which is a small sample).Subject to theperiodicityof thedata,any number of overlapping 20-year periods can also be constructed – forexample,20years to lastyear,20years to theyearbefore last,andsoon.Thiswillhelptosliceanddicethedatamorefinelyandenablemorefancystatisticalanalysis.Despitethis,theinescapablefactisthatwedonothavemany20-yearobservationsofperformancetoconcludemuch(purelyusingperformance numbers) about, for example, the likelihood of stocksoutperformingbondsover20-yearperiods.

Therearemoresophisticatedtechniquesthatcanbeusedtogetahandleonthesameissue,butitremainscommontodrawstrongconclusionsfromsmall data sets when that is the only evidence available. In suchcircumstances, it is safer to be circumspect about any conclusions drawnfromlimiteddata.

Another bias (probably just displayed) is conservatism, which ariseswhen it is widely recognised that the available data are insufficient to

support strongconclusions. In this case, it is a commonerror toplace toolittleweight on the available evidence, or even to disregard it and to relysolelyonpriorexpectations.

Yet another bias is “anchoring”, whereby we gravitate towards aquantitythathasbeensuggestedbeforeaddressingtheappropriateanswerinour particular case. One common example would be the proportion offinancial wealth that an investor ought to invest in the stockmarket;inevitablytheanswerwillbestronglyinfluencedbywhattheinvestoristoldthe norm is. This is understandable (though often not appropriate).Anchoringisasurprisinglywidespreadphenomenon,anditcaneasilyleadtousbeingmisled.

Afurtherbias isbeliefperseverance,whichconcerns theevidence thatpeople cling to prior opinions for too longwhen confrontedwith contraryevidencethatwouldbesufficienttoconvinceequallytalentednewcomerstothe field. In this way, individuals demonstrate a reluctance to search forevidencethatcontradictstheirpreviousviews,becausetheyarereluctanttowriteoffpastinvestmentsintheirownhumancapital,despiteitbeingclearthattheyarepartlyobsolescent.

Biases often represent mental shortcuts (called “heuristics” byacademics), which we use to avoid having to process large quantities ofinformation.Theseshortcutsmayderivefromanestablishedopinionofhowmarkets work. For example, many investors expect to be able to identifygoodmanagerswhowilloutperform.Sceptics,however,aremorelikelytoascribe outperformance to transient luck, andmaybe puzzled by apparentevidence of good managers. These differences in “received wisdom” canlead to shortcuts which cause some to think that much more analysis isneeded before a decision is taken and others to readily conclude that theappropriatecourseofactionisself-evident.This typeofshortcutwillhaveled some to feel comfortable that they had found a good manager infraudsterBernieMadoff.

Increasing complexity (for example of investment products) makes itmorelikelythatdecisionswillrelyonshortcutsbecauseofthedifficultyofprocessing all the available information. The practical alternative to usingshortcutsmayoftenappeartobeindecision.Butwhereadecisionappearsto

havereliedonsuchashortcutandthedecisiongoeswrong,hindsightcanbeembarrassing. An alternative, increasingly common among institutionalinvestors,istheadoptionofasetof“investmentbeliefs”,widelysupportedby the fund’s decision-makers, which summarises a coherent view of theopportunities offered by markets and whether the fund is well-placed toexploit them(seeAppendix3).Thiscanfacilitateconsideredandcoherentdecision-making.All investors, large and small, need to considerwhethertheir own views of how markets function might lead to shortcuts andwhether they might compromise or improve their own chances ofinvestmentsuccess.

Evenwhen investors are able to sit back and consider potential biasesdispassionately,thereisnoescapefromthedangerofregretrisk.Regretistheemotionindividualsfeeliftheycaneasilyimaginehavingactedinawaythatwouldhaveledtoamorefavourableoutcome.Earlybehaviouralstudiesemphasisedthatregretfromtakingactionthatwassubsequentlyunprofitableisusuallyfeltmoreacutelythanregretfromdecisionstotakenoactionthatwere subsequently equally costly.A typical investment examplewould bethedifferentreactionstoafallinthepriceofinvestments.Ifitisarecentlyacquired investment, there is generally more regret than if it is a long-standing investment. For investors, this leads to the common (almostuniversal) dilemma of how and when to implement new investmentdecisions, even if investment risk arguments point to the desirability ofimmediate implementation(seeChapter5foradiscussionabout the issuesinvolvedinimplementinginvestmentstrategychanges).

Athemeofsomeresearch is that regretaboutadisappointingoutcomefollowingachangeinstrategymaybereducedifthedecisionwasjustified.Thismayleadtoadistinctionbetweenregretaboutbaddecisionsandregretabout bad outcomes. These do not always go together: sometimes baddecisions do not lead to bad outcomes. Other research also indicates atendencytomoveawayfromdecisionsthathaverecentlyhaddisappointingoutcomes. Nevertheless, if an unprofitable investment decision wasunjustified,theinvestorwillblamehimself(ortheadviser).However,ifaninvestmentdecisionwasjustified,theinvestormayregretthedecisionoritstimingbutshouldatleastunderstandwhyitwastaken.

Thus good process should not only lead to more considered (and,hopefully,better)decision-making,butalsosupportstabilityandconfidenceintheexistenceofa“steadyhandatthetiller”.Thisshouldhelpcontrolthepotentially harmful effect of some of the biases that can influenceinvestmentdecision-making.Oneofthebestwaystomanagetheimpactofthesemay be to draw attention to them and discuss their potential impactbeforeimportantinvestmentdecisionsaretaken.

Investorpreferences

If investor biases should be managed, investor preferences should berespectedandreflectedininvestmentstrategy,insofarasitisbothfeasibleandsensible.

There are two particular areas of investor preference that have beenhighlighted by behavioural finance. The first (perhaps not surprisingly) isloss aversion, which Kahneman has described as “the most significantcontribution of psychology to behavioural economics”. In behaviouralfinance, loss aversion fills the role of risk aversion in traditional finance.Thesecondismentalaccounting,whichreflectsthewayinwhichinvestorsassignsumsofmoney todifferentactualornotionalaccounts fordifferentpurposes with varying degrees of risk tolerance depending upon theimportance of achieving the particular objective. For example, anindividual’s summervacationmoneywill be in adifferentmental account(andprobablyadifferentactualaccount)frompensionsavings.

LossaversionTraditionalfinanceassumesthatinvestorsbehaverationallyandevaluatetheriskandpotentialreturnof investmentstrategies in termsof theirexpectedutilityorsatisfaction.Therearedifferentwaysofcalibratingutility,buttheyall have the characteristic that they represent assumptions about howinvestors should be expected to express preferences. They have theadditionalcharacteristicthattheycanbemodelledmathematically,whichisconvenientformodellers.Muchlessconvenientisthewidespreadevidencethattheserationalutilitymodelsdonotreflecthowpeopleviewtheprospect

offinancialgainsorlosses.This has been reflected in prospect theory,which is built upon awide

rangeofexperimentsshowingthatpeoplewilltakequitelargeriskstohavesomechanceofavoidingotherwisecertainlosses,butthattheyarequicktobank any winnings. Investment banks tap into this investor preferencethrough sales of highly profitable principal-protected structured products,whichprovidedownsideprotectionwith theprospectofsomecombinationof leveraged positive returns. In other words, they offer a seductivecombination of “little fear andmuchhope”.This relationship between thedisutility or dissatisfaction that comes from losses and the utility orsatisfactionthatcomesfromgainsiscapturedintheso-calledcoefficientoflossaversion,whichacrossawiderangeofexperimentshascomeoutatavalueofaroundtwo.Thismeasureshowmuchmorehighlyinvestorsweighlossesthantheyweighgains.Lossaversionismostcommonlyexpressedinterms of a comparison of absolute gains and losses, but it also applies togainsandlossesrelativetoabenchmark.

Theseexperimentshavehighlightedtheimportanceofhowaquestionisframed or asked as a determinant of the reaction to it. The choice of abenchmarkbecomesofgreatimportancebyhelpingto“frame”expectationsforperformanceandwhetheraninvestorshouldbepleasedordisappointedwith an investment result.An investor, for example,may be disappointedthat a fund has lagged well behind the performance of the stockmarket,whereasthemanagermaytrytopersuadeclientstobehappythatthefundhasshownsomegrowthinvalue.Howexpectationsaresetattheoutsetforan investment can become as important as the subsequent performance indeterminingwhetheraninvestmentisjudgedtobesuccessful.

A related challenge arises from the inconsistency between thewish tohavestable,oratleastprotected,investmentvalues,andthedesiretohaveastable incomethat is financedbythose investments(seeChapter5).Thesewishesareincompatible,becauseonlylong-dated,high-qualitygovernmentbonds, which are volatile, can guarantee a stable income over time. Thishighlightstheneedforinvestorstobeeducatedaswellasaskedtherelevantquestions,framedinanappropriateway.

The“fourfoldpattern”ofattitudestogainsandlosses

KahnemanandTversky’sprospecttheory,whichisbasedonexperimentsintohowindividualschooseamongriskyalternatives,iscommonlyrepresentedbyaquadrantsuchtheonebelow.

Biggains Biglosses

Highprobability

Sellwinnerstolockinsubstantialbutsmallerthanexpectedgain

Rejectopportunitytocrystalliseexistinglosses,runriskofevenlargerlossestohaveatleastsomechanceofavoidinglikelybigloss

Lowprobability

Buylotterytickettohavechanceofbigwin

Buyinsurancetoavoidsmallchanceofbigloss

Thetopleftquadrantindicatesapreferencetoacceptlessthantheexpectedvalueofasuccessfulgambletolockinacertaingain.Intheinvestmentworld,thistranslatesintosellingwinninginvestmentsafterarunofgoodperformance.

Thebottomleftquadrantisthetemptationtobuylotterytickets,eventhoughthemostlikelyresultbyfaristhelossofthecostoftheticket.Intheinvestmentworld,thistootranslatesintothesurprisinglylargedemandforstructuredproductsthatofferlargepayoutsintheeventofplausiblebutunlikelyevents.

Thetoprightquadrantisthetendencytoholdontolossmakinginvestmentstoavoidthepainofrealisinglosses.Thisofferssomehopeofrecoupinglosses,attheriskofincurringevenbiggerones.InKahneman’swords,whenconfrontedwithonlybadoptions,“wewerejustasriskseekinginthedomainoflosses,aswewereriskaverseinthedomainofgains”.

Thebottomrightquadrantiswhereinvestorsopenlybuyinsurance,toavoidthesmallriskofsomeloss.

MentalaccountingandbehaviouralportfoliotheoryA division of investments between safety-first, cautious accounts to meetbasic needs, and more aggressive “aspirational” accounts to meet lesscritical or simply more distant objectives is one of the predictions of thementalaccounting frameworkofbehavioural finance.Thisapproach isnotfoundanywhereinthetraditionalfinancetextbooksbutitiscommon(somewould say common sense) in everyday experience, as the following

examplesillustrate.

ThesubsistencefarmerSubsistencefarmersoftengrowtwotypesofcrops:foodforthefamilyandcash crops with volatile prices. Growing food represents the safety-firstportfolio.Theallocationoflandtogrowingfoodisdeterminedfirstbybasicneeds,suchasfamilysize.Theremaininglandisallocatedtothecashcrop,whichisthemorespeculativeopportunitytoraiselivingstandards–inotherwords,theaspirationalportfolio.

ThechampionpokerplayerGreg “Fossilman”Raymer gave this account of howhe and hiswife kepttheir“aspirationalaccount”separate fromtheiressential“safety-first”cashwhenhestartedoutonhissuccessfulcareeratthepokertable:

Istartedgettingsteadywins,butIwasnowmarried,and[mywife]wasbecomingincreasinglyconcernedaboutthetimeIwasspendingonit.She’dalsohearhorrorstoriesaboutplayersbankruptingtheirfamilies.Intheendwemadeadeal:Iwasalloweda$1,000pokerbankrollonconditionitstayedseparatefromoursavings.AndifIlostitall,I’dneverplayagain.Itnevergottothat.

ThecentralbankforeignexchangereservemanagerEvencentralbanksdemonstrate this layeringof investment resources.Thefirst purpose of a central bank’s foreign exchange reserves is to fundwhatever market intervention might be necessary to defend the exchangerate of the national currency.Thismeans investing in high-quality, highlyliquid,short-datedsecurities,inparticularUSTreasurysecurities.Thisisthesafety-first portfolio. Central banks also often hold substantial reserves ofgold bullion. These are intended to have a different, longer-term capitalpreservationandconfidence-buildingrole,whichsetsthemapartfromshort-termliquidreserves.

In recent years a number of central banks accumulated unprecedentedlevels of foreign exchange reserves, far in excess of the likely need tosupporttheircurrenciesintheshortterm.Theseexcessreserveshaveoften

been separated from the short-term liquid reserves and been used to fundgovernment-owned sovereignwealth funds (seeChapter4).The long timehorizon for investing sovereignwealth funds gives them a different set ofobjectivesandattitudetoriskfromcentralbankreserves.Sovereignwealthfunds represent a national aspirational portfolio.The investmentof centralbank foreign exchange reserves and the accompanying sovereign wealthfundparallelsthelayeredpyramidofbehaviouralportfoliotheory.

Investmentstrategyandbehaviouralfinance

Eachoftheseexamples,fromthechampionpokerplayertothecentralbank,shows a natural process of segmentation of risk-taking, with separateallocations to different accounts, each with distinctive risk tolerances andtimehorizonsdictatedbyparticularobjectives.Aboveall,thissegmentationprovides an easy-to-monitor, keep-it-simple management informationsystemforindividualsandinstitutions.

This mental accounting also helps to discipline future behaviour byhighlighting deviations from decisions that have already been taken. Forexample,inafamilycontext,someonemightsay,“no,wewillnotusethatmoneytobuyanewcar,it’sourpensionsavings”;or,inaninstitution,“no,wecan’tusethatcashtofinanceaprivateequityopportunity,itisourreadycashtopaypensions”.

Traditionalfinancedoesnotsegmentfinancial resources in thisway.Ittreatsallafamily’sfinancialresourcesorallapensionplan’sresourcesasaunifiedwholeandseeksatotalwealth-efficientsolutiontoconsideringrisk,returnandinvestmentstrategy.Italsoconsidersmoneytobefungible(cashinthisaccountisthesameascashinanotheraccountifit isownedbythesamepersonandhasthesametaxstatus).Furthermore,andthisisofgreatimportance, traditional finance takes into account the relationships, forexample, correlations, that may exist between the investments and theobjectivesorobligationsofthedifferentaccounts.Separateaccounting,withseparate strategies designed independently for each account,would ignorethese relationships. This can be a major inefficiency in the widespreadpracticeofmentalaccounting.Mentalaccountinghelps financial resources

tobetargetedfordifferentpurposes.Eachpersonwillhaveadifferentrisktolerance for achieving different objectives. Some goals are critical, butothersarejustnicetohave.Decisionswillbeinfluencedbyregulationsthatimpingeontaxedandtax-exemptaccounts,current-generationresourcesandtrustorothertax-efficientaccountsforfuturegenerations,andphilanthropicaccounts.

A more general example of mental accounting is quoted by MeirStatmanandVincentWoodinInvestmentTemperament,whentheydescribethepatternofresponsestothefollowingquestionintheFidelityInvestmentsAssetAllocationPlanner:

Ifyoucouldincreaseyourchancesofimprovingyourreturnsbytakingmoreriskwouldyou:

1. Bewillingtotakealotmoreriskwithallofyourmoney

2. Bewillingtotakealotmoreriskwithsomeofyourmoney

3. Bewillingtotakealittlemoreriskwithallofyourmoney

4. Bewillingtotakealittlemoreriskwithsomeofyourmoney

Overwhelmingly,therespondentsindicatedawillingnesstotakeeitheralotoralittlemoreriskwithsomeoftheirmoney.Thisindicatesapreferencetosegmentorlayerrisk-taking,whichisgenerallyconsideredtobeatoddswith the traditional risk-return tradeoff commonly presented to investors.Thisaddressestheperformanceandriskofthetotalportfolio,whichwouldpresume taking either a little or a lot more risk with all of the money.However,ifatraditionalefficientportfoliocomprisesamixtureofaholdingof risk-free assets and an allocation tomarket risk, these responseswouldmakesenseintermsofbeingwillingtoshiftsomeresourcesoutofasafe-haveninvestmentandintoamarketriskportfolio(seeChapter5).Inotherwords,theresponsescouldbeconsistentwithtraditionalfinanceaswellasbehaviouralportfoliotheory.

ParameteruncertaintyandbehaviouralfinanceInvestors often like to test the reasonableness of major decisions from

differentperspectivesbeforecommittingthemselves.Thisisarationalwayto proceed with decision-making when faced with uncertainty about thereliability of models or approaches. One of the themes that pervades thisbook is that theparametersused in financialmodelsaresubject tomarkeddegrees of uncertainty, with some elements more uncertain than others.Thereisnothingnewaboutthis.

Eveninthetraditionalmodelofrationalmarketsandrationalinvestors,investors have not generally faced a unique solution to their investmentproblems, although that may be what they were offered. Quantitativeanalysis may provide supposedly unique answers to asset allocationproblems,but theinvestmentmarketshaverarely(seeChapter3)providedsuchclearanswers.Instead,ourunderstandingoftheuncertainrelationshipsbetween markets has always involved a tradeoff between broadlyappropriatealternative investment strategieswhichappear to liewithin therangeofwhatisbestdescribedasthe“fuzzyfrontier”.

Thismeansthatinanyparticularsituationtherewillalwaysbestrategiesthataredemonstrablyinefficientorthatinvolveaclearlyinappropriateriskprofile. There will also be a range of strategies that are each broadlyappropriate,givenourcurrentstateofknowledgeofmarketsandinvestors’attitude torisk.Thiscangiveasurprisinglywidescopefor the investmentpreferencesofprincipalsorfiduciariestobereflectedininvestmentstrategy,while still staying consistent with the overriding desire to adhere to theirgoalsandobjectives.Italsomakesitmorelikelythatinvestorswillfindthatindependent ways of presenting strategy, such as the behaviourist-layeredpyramid approach, provide intuitively attractive cross-checks on thetraditionalquantitativeapproach.

Theideaofafuzzyfrontiercanbetracedbacktoworkonuncertaintyinscientificmeasurement dating from the 1960s.Much of the uncertainty inmeasurement that we know exists cannot be adequately captured bystatistics.Thishaspotentialapplicationsinmanydifferentfields.Oneofitsstarting points is that we often do not know precisely how to categoriseitemsthatarebeinganalysed.Thiswasreflectedinadebateover20yearsagoaboutwhetherUSquotedmultinationalcorporationswithUSboardsofdirectorsbutextensiveoverseasoperationswerereallyUScompanies.This

was captured in the title of a 1990 article in Harvard Business Review,“Who IsUs?”, byRobertReich, a formerUS labour secretary. In reality,thisisanissuethatthestaffofanyinvestmentfirmwrestlewitheveryday.Mechanical rules have to be applied, but rules differ from one investinginstitutiontoanother,ofteninwaysthatpuristswoulddispute,resultinginapparent arbitrary differences in investment allocations. Leading indexproviders have disagreed aboutwhether SouthKorea is an emerging or adevelopedmarket.InvestorsbuyUKstockstogainexposuretoadevelopedmarket,butisaKazakhminingcompanyoranIndonesiancoalminerlistedin London a UK exposure, or is an Israeli technology company listed onNASDAQaUSexposure?Inhigh-levelsummariesofportfolioallocations,should a convertible bond be classified as debt or as equity? In finance,these classification issues are routinely put to one side in investmentanalysis, and yet they undermine the precision with which policyconclusionscanbedrawn.

Traditionalfinance,behaviouralfinanceandevolutionIn recent years steps have been taken towards synthesising traditionalfinancewiththeinsightsfrombehaviouralfinance,butthereismuchfurtherto go before an integrated approach is agreed which combines both therigour and comprehensiveness of “traditional” finance and evidence-basedassumptionsaboutinvestorbehaviourfrombehaviouralfinance.

Some things are already clear. First, it is important for investors andtheir advisers to benefit from the insights of behavioural finance tounderstand better the influences on their own decision-making andpreferences.Adviceandstrategycanthenbeadaptedtoaccommodatethat.Thisdoesnotprovideanexcuseforignoringthefundamentalprinciplesofdiversification, correlations between different investments or the need totailorpoliciestothetimehorizonofinvestmentobjectives.Equally,itwouldbe arrogant to suggest that it is always poor practice for individuals topurchase the investment equivalent of lottery tickets, as this may be anefficientwayofmaximising the chances of acquiring riches.Furthermore,behavioural finance helps advisers gain a better understanding of howinvestorstakedecisions,whyinvestors’portfoliosarestructuredastheyare,

how investors are likely to respond to any instance of disappointingperformanceandthenatureoftheirstrongpreferences.

As Statman writes in Behavioral Portfolios: Hope for Riches andProtectionfromPoverty:

Wemightlamentthefactthatpeopleareattractedtolotteries,orwemightacceptit,andhelppeoplestrikeabalancebetweenhopeforrichesandprotectionfrompoverty.

AndrewLo,Harris&HarrisGroupprofessoroffinanceanddirectoroftheLaboratoryforFinancialEngineeringatMIT,putsitmorestarklywhenhewritesinTheAdaptiveMarketsHypothesisthat“forallfinancialmarketparticipants,survivalistheonlyobjectivethatmatters”.

Against this background, themost important first stepmay be to startdiscussions of investment strategy with an assessment of whether aninvestorhassufficientwealthtoguaranteesurvival.Inotherwords,doestheinvestorhavesufficientresourcestohedgeagainsttheriskofshortfallfromcritical objectives by investing in liability-or objective-matching high-quality government bonds? In the years after 2008, the era of ultra-lowinterestratesmeantthattheanswerformanywas“no”.Survival,intermsofmeetingwhat previously seemed reasonable expectations (for example, interms of retirement income or retirement date), cannot be guaranteed andrisk-taking,andthedangerofworseningshortfalls,cannotbeavoided.Howsuchrisk-takingmightbestbestructuredisdiscussedinthenextchapter.

3 Marketinvestmentreturns

THE FINANCIAL MARKETS should be seen as a place to protect and growwealth,not as aplace togrowwealthy.Thischapter looksat expectationsanduncertaintiesforfutureequityandgovernmentbondmarketreturns.Animportantmessage is that the startof this centuryhas set the tone for lessfavourable equity returns than were enjoyed in the 20th century and formodest returns tobeearned fromcreditworthygovernmentbonds.But themain qualification remains that even over long periods of time, we areunclearhowmarketsaregoingtobehave.

Traditionally, domesticTreasurybonds andbills havebeen consideredfree from credit risk and safe havens for investors. This has been acornerstoneofmuchmodernportfolio theory andpractice, but it hasbeenshakenbythegovernmentdebtcrisesthatflowedfromthecreditcrunchof2007–08. Despite this, appropriately interpreted, it is a foundation thatremainslargelyintact(seeAregovernmentsriskfree?below).

Inflation-linkedgovernmentbondsareaninnovationthatcanprovideanimportant degree of security for cautious long-term investors. But theextraordinary monetary easing after early 2009 led to negligible rates ofinterestbeingpaidonalltypesofcreditworthygovernmentbonds.Thishasposedseverechallengesforcautiousinvestors,forwhomthecostofsecurityhasoftenbeentoohigh.Anunwelcomedegreeofrisk-takingandstandard-of-living uncertainty became unavoidable as the security of income fromgovernmentbondsbecametooexpensive.

SourcesofinvestmentperformanceIna countrywitha creditworthygovernment, investmentperformancecanbedescribedascomingfromsixsources:

1. Treasurybillyield.Theshort-term(lessthanoneyear,andtypically1–6months)risk-freerateofinterest.

2. Inflation-indexedgovernmentbondyield.Thelong-terminflation-risk-freerateofinterest.Itisunclearwhethertheseinflation-indexedbondsneedtoofferapremiumreturnoverTreasurybills.

3. ConventionalTreasurybondyield.Thelong-termnominalrisk-freerateofinterest.Thisrateofinterestissubjecttotheriskofunexpectedlyhighinflation.Itshouldincludeapremiumoverinflation-linkedbondstocompensateforexpectedinflation,andprobablyalsoamarginabovethisfortheuncertaintyofthatinflation(butseebelow).

4. Marketriskpremium.Thecompensationthatanyrationalsavershouldseekinreturnforputtingmoneyorfutureincomeatriskofloss.Themarketprovidesthisrewardforbearing“marketrisk”.Thisisreflectedintheequityriskpremium(theamountbywhichequitiesareexpectedtooutperformbondsorcash)andthecreditriskpremium(theextrayieldpaidoncorporatebondstocompensatefortheriskthatacompanymightdefault–seeChapter8).Lessobviously,marketriskpremiumsseemtobeofferedinreturnforacceptingvarioustypesofinsuranceriskandalsofordifferenttypesofequityrisk(forexample,small-companyriskseparatelyfromequitymarketrisk).ThesearediscussedinChapter7(equityinvesting),Chapter9(hedgefunds)andChapter11(realestate).

5. Investmentmanagerskill.Generatesinvestmentperformance(oralpha)thatisseparatefromtheperformanceofthemarket(orbeta).Frequently,investmentperformancethatmanagersattributetotheirskill(whichisanexpensive,scarcecommodity)getsconfusedwithaspectsofmarketperformance(whichcanbeaccessedinexpensively).

6. Noise.Introducedtoinvestmentperformancebyunskilfulmanagersofinvestors’portfolios.Noiseisoftendescribedas“alpha”whenitispositive.(Scepticshavedescribedalphaas“theaverageerrorterm”.)Distinguishingnoisefromskillisoneofthemostdifficult

tasksforinvestors.Therearealwayslikelytobemoreunskilled“noise”managerswithmarketabletrackrecordsthanskilledmanagerswho,inadditiontobeingskilled,alsohaveamarketablerecordatanypointintime.Noisewillnormallybringsomeextravolatility;itwillalsoincurfeesanddistractinvestors,wastingtheirvaluabletime.

Thissummarysimplifiesmattersconsiderably,byignoringcross-borderinvestmentingovernmentbondsandbyassumingthatallinvestorshaveanunambiguousbasecurrency,whichasdiscussedinChapter1isnotthecase.Nevertheless, this provides a useful introduction to the building blocks ofinvestmentperformance.Thefirst threesourcescanbeaccessedeasilyandinexpensivelybyanyone, throughdirectholdingsofgovernment securities(or through funds, including exchange traded funds, which hold onlygovernment securities). Equity market risk can also be accessedinexpensively through index funds or exchange traded funds. Someinvestmentmarketsandsomeaspectsofmarketriskpremiums(forexample,private equity – see Chapter 10) can be accessed only if the investor iswilling to take a viewon investmentmanager skill. The sources of hedgefundperformancearediscussedinChapter9.

Thepatternofreturnsavailablefromexposuretomarketriskcanalsobere-engineeredthrough“structuredproducts”whichcontaincombinationsofembedded options with exposure to particular markets. These do notgenerateperformance,but theycanprovide insurance(whichmustbepaidfor) against the risk of disappointing outcomes in ways that may suitinvestors.

Aregovernmentbondsrisk-free?Theideathatgovernmentbondsarefreeofcreditriskisroutinelyusedasabuildingblockindesigninginvestmentstrategies,butitseemstobeatoddswith ample evidence to the contrary. The highest rating assigned by thecredit-ratingagencies(seeChapter8)isAAA,whichdenotesadebtofthehighest creditworthiness, when in the words of Standard and Poor’s, theissueris“judgedtobeofthehighestquality,subject tothelowest levelof

creditrisk”.Nevertheless,credit-ratingagenciesfrequentlyassignratingstosovereign and other central-government debtwhich imply some degree ofriskthatthegovernment’sobligationswillnotbehonoured;inrecentyearsone or more of the three leading rating agencies has rated the domesticcentral-governmentdebtoftheUnitedStates,Japan,France,theUK,Italy,SpainandIrelandbelowAAA.Furthermore,moderncreditmarketsenableinvestors (or speculators) to buy or sell insurance contracts, called creditdefault swaps,which can give amarket assessment of the likelihood of agovernment defaulting on its debt, and can track fluctuations in marketassessments of a government’s creditworthiness (although the credit crisishighlightedcounterpartyissueswiththesecontracts).Mostobviously,thereis a history of governments defaulting on their international and (but lessfrequently)domesticdebt.

Surveys of the historical experience of defaults by governments (seeAppendix4)havesometimesmisinterpretedmarketrefinancingofsovereigndebt –when a government exploits a contractual opportunity to redeem aloanandrefinanceitatalowerinterestcost–asadejuredefault,whichitisnot.Between 1952 and 2008 there seems to have been no instance of thecentral government of a developed country failing to honour the nominalfacevalueofitsmarketabledebts,althoughtherehavebeenexamplesfromemerging markets (most notably Russia in 1998–99, and the forcibleterminationofUSdollarorinflationindexationofdebtinanumberofLatinAmericancountriesinthe1980s),aswellasGreecein2012.

Debasement of government debt through inflation has been acharacteristicbehaviourofover-indebtedsovereigngovernmentssincetimeimmemorial,anditisariskfacedbyholdersofthedebtofanygovernment.But it is also clear that developed-market (and many emerging-market)sovereigngovernmentscanbecountedontotakehonouringthefacevalueoftheirmarketabledebtextremelyseriouslyand,atleastinrespectoftheirunindexed domestic obligations, they should always have the means toensurethattheycanmeetthoseobligations.

Not surprisingly, when governments do default, there seems to be ahierarchy of risk exposures, with foreign-currency-denominated or linkedandinflation-indexedobligationsmorevulnerablethanunindexeddomestic

debt.Forthisreason,theproportionofsovereigndebtthatisdenominatedinforeigncurrencyorwhichisindexedisausefulcreditriskindicator.

Sovereignriskand“acountrycalledEurope”Animportantfinancialdifferencebetweenasovereignandalocalgovernmentisthat,ifitneedsto,asovereigngovernmentcandebaseitscurrencytomeetitsobligations,whicharefixedinitsowncurrency,butalocalgovernmentdoesnotenjoythisdegreeoffreedom.Thismeansthatanover-indebtedsovereigngovernmenthasthescopetotrytodevalueitswayoutofadomesticdebtcrisisbutanover-indebtedlocalgovernmentdoesnot.

Thisisnotanewinsight,andforsomeEuropeancountries,theopportunitytoreplacethediscreditedtemptationtodevalueandtoaccommodatefastinflation,andthehighinterestrateswhichcamewiththatfreedom,withanewregimewiththedisciplineofafixedexchangerate,apparentlytightfiscal-policyguidelines,andatie-intolowratesofinflationandinterest,wasseenasamajorattractionofEuropeancurrencyunionaheadofitsintroductionin1999.Thisinvolvedsomevoluntaryyieldingoffinancialsovereignty,andthecredibilityofmonetaryuniondependedonanexpectationthatthiswasirreversible.

Forgovernmentbondinvestorsthismeant(thoughscantattentionwaspaidtoitatthetime)thesubstitutionofinflationriskwiththecreditriskthatanationalgovernmentmightbeunabletohonouritsobligations.Intheeurozone,membercountrieshavetheirowngovernmentbondmarkets,andeffortsaremadetoco-ordinatefiscalpolicybetweenmembercountries,butthereisnodominanteuro-zonefiscalpolicyortheissueofcollectiveeuro-zonegovernmentdebt,underwrittenbytheeuro-zonetaxpayer–althoughtherehavebeenstepstowardsthiswithfinancingarrangementsputinplaceafter2009.Foreuro-basedinvestors,itfollowsthatthechoiceofasafe-harbourgovernmentbondismorejudgmentalandnuancedthanforinvestorsfromothercountries.ButthishasparallelswithUSinvestors,whomustweighthetaxandcreditworthystatusofdifferentmunicipalbonds,whichformcorelong-term“safety-first”holdingsinmanypersonalportfolios(seeChapter5).

SafehavensthatprovidedifferentkindsofshelterIfinvestorstakenorisk,theyshouldnotexpecttoreceiveapremiumreturn.Butoneinvestor’ssafe-havenmaybeariskyinvestmentforanother:

Forashort-terminvestor,domesticTreasurybillsrepresenttheminimumriskinvestmentthatprovidescapitalprotectionovertheshortterm.

Foranindividual,abankoraninsurancecompanywantingtosecureanincome,domesticTreasurybondsgivethatsecurityforthelifetimeofthebond.Treasurybillsthatmatureeverythreeorsixmonthsareriskyforthispurposeastheyareimmediatelyvulnerabletocutsin

interestrateswhichaTreasurybond,ifheldtomaturity,isnot.Theriskfromthesebondsisthatinflationmaypickup(and,separately,thatinterestincomemayhavetobereinvestedatloweryields).Figures3.1,3.2and3.3showhowthepre-taxincomeyieldonofferfortenyearstobuy-and-holdinvestorsinten-yearTreasurybondshascomparedwiththeyieldonofferforthenextthreemonthsforholdersofTreasurybillsfortheUnitedStates,theUKandtheeurozone.

Anindividualwhowantsasecureincomethatisalsoprotectedagainstinflationcanuseinflation-linkedTreasurybonds.Theseprovidethelow-riskinvestment,insuringagainstadverseinflationandadverserealinterest-ratesurprises,buttheilliquidityofinflation-linkedmarketsisaconcern.

FIG3.1Incomeyieldfrom10-yearUSTreasurynotesand3-monthTreasurybills%peryear,Sep2004–Oct2013

Source:www.ustreas.gov

FIG3.2Incomeyieldfrom10-yearUKgiltsand6-monthTreasurybills%peryear,Sep2004–Oct2013

Source:www.bankofengland.co.uk

FIG 3.3 Income yield from 10-year euro-zone AAA Treasury bonds and 3-monthTreasurybills%peryear,Sep2004–Oct2013

Source:www.ecb.int

Eachoftheseinvestorshasadifferentsafe-haveninvestment:Treasurybillsfortheshort-terminvestor;conventionalfixed-incomeTreasurybondsfor the investorwho is not concerned about inflation (most commonly aninsurance company with contracts to pay fixed monetary amounts); and

inflation-linked government bonds for the prospective pensioner who isconcerned about inflation. Each investor takes a risk when they ventureoutsidetheirownsafehaven.Oftentheywillfeeltheyhavelittlechoice,buttheyneedtoconsiderhowandwhethertheywillberewardedfortakingthatrisk.

Whichgovernmentbondswillperformbest?In theexamplesabove, the insurancecompanydoesnotneed tobepaidapremiumyieldbythetaxpayertobepersuadedtoholdTreasurybonds,nordoes thepensioner tohold inflation-linkedgovernmentbonds.Thismeansthatitisunclearhowmuchpremiumreturn,ifany,shouldbeexpectedfromgovernmentbonds,whetherindexedornot,overcash.

So different groups of investors have their own separate natural orpreferred habitats in different segments of the government bond market.From time to time this canaffect the shapeof theyieldcurve (that is, thepatternof yieldsofferedongovernmentbondsof varyingmaturities – seeFigures3.4,3.5and3.6).Thiscansometimesmakeithardtorationalisethedifferences in interest rates that a government pays to different groups ofinvestors. The barriers that can limit attempts to arbitrage away apparentpricinganomaliesarelookedatinChapter6.

Thenormalshapeoftheyieldcurvehasbeenanareaofextensive,andoften inconclusive, research in macroeconomics. The historical pattern isclearontwothings.First,therehasnormallybeenanupward-slopingyieldcurve – in other words, longer-dated Treasury bonds have offered higheryields and returns than shorter dated government bonds, in particularTreasury bills. (See Appendix 1 for definitions of Treasury bonds andTreasurybills.)Second,theextentofthispremiumvariesovertime.Thisisoften described as the term premium that short-term investors need to beoffered to tempt them to buy longer-dated bonds (because such bonds aresubjecttopricevolatility).Butinsurancecompaniesdonotneedtobepaidatermpremiumbecauselongermaturitiesprovidetheir“naturalhabitat”,andinvestorsmayinanyeventwishtoholdgovernmentbondsbecausetheyare,oratanyratehavebeen(seeChapter8),thebestandmostliquiddiversifierofequitymarketrisk.

FIG3.4USTreasuryconventionalandrealyieldcurves%peryear,October21st2013

Source:www.ustreas.gov

FIG3.5UKTreasuryconventionalandrealyieldcurves%peryear,October18th2013

Source:www.bankofengland.co.uk

FIG3.6Euro-zoneAAA ratedTreasury conventional yield curve%per year,October18th2013

Source:www.ecb.int

Since the introduction of the markets in inflation-linked governmentbonds (see below), there has been growing emphasis on the premium inconventional government bond yields as an inflation risk premium.Pensioners should not normally buy conventional bonds unless they offercompensationnotonlyfortheexpectedrateofinflation,butalsofortheriskthattheactualrateofinflationmightbehigherthantheratethatisexpected.This is the inflationriskpremium.(This ignores taxation issues,whichareimportantindecidingbetweendifferenttypesofgovernmentbonds.)Long-terminvestorswhoareprimarilyconcernedwithsecuringastablestandardoflivingwillfeelmorecomfortableholdingconventionalgovernmentbondswhentheyhavegreatestconfidenceininflationbeingkeptwithinthetargetset by the central bank. If not, they will need to believe that there issufficient premium in the yield on conventional government bonds tocompensate for the threat to their standardof livingposedbyanuncertaininflationrate.

Amarket expectation for inflation canbe deduced from the differencebetweenyieldsonconventionalgovernmentbondsand theyieldson theseindexedbonds.Thisistheso-called“break-even”inflationrate.(Ifinflationturns out at this rate, an investorwill get, approximately, the same returnfromholdingindexedgovernmentbondsasfromconventionaltreasuriesofthe same maturity.) But whether the break-even rate really is a marketforecastforinflationiscontroversial.

Isthebreak-eveninflationratethemarket’sforecast?Inflation-indexedgovernmentbondsarenowavailableineachmajorfinancialmarket.TheywereintroducedintheUKin1981andsincethentheyhavebeenmadeavailableinAustralia(1985),Canada(1991),Sweden(1994),theUnitedStates(1997)andJapan(2004),withgovernmentissuesintheeurozonefromFrance(1998),ItalyandGreece(2003),andGermany(2006).Anumberofemergingmarkets,includingIndia,Brazil,IsraelandSouthAfrica,havealsomadeuseofinflation-linkedbonds.Theynowrepresentaninstrumentwhosecharacteristicsinvestorsineachcountryshouldunderstand.IntheUnitedStates,thesebondsareknownasTreasuryInflationProtectedSecuritiesorTIPS,andthatacronymisusedheretorefertoanyinflation-linkedgovernmentbond,notjustthoseissuedbytheUSgovernment.Thepatternof20-yearinflation-linkedandconventionalUSandalsoUKTreasurybondyieldsandtheimplied20-yearbreak-evenratesofinflationareshowninFigures3.7–3.10.

FIG3.7USTreasury20-yearyields%peryear,Jul2004–Oct2013

Source:www.ustreas.gov

FIG 3.8US 20-year “break-even” inflation (difference between 20-year Treasury andTIPSyields)%peryear,Jul2004–Oct2013

Source:www.ustreas.gov

FIG3.9UK20-yeargiltyields%peryear,Sep2004–Oct2013

Source:www.bankofengland.co.uk

FIG3.10UK20-year“break-even”inflation%peryear,Sep2004–Oct2013

Source:www.bankofengland.co.uk

Thoseunfamiliarwithinflation-indexedbondsareadvisedtocheckthedifferenceinyieldsfromconventionalandindex-linkedissuesofgovernmentbonds.Break-eveninflationratescanbededucedfromanytableofgovernmentbondpricesandyields(andareregularlypublishedintheFinancialTimes).TIPSareindicatedbytheletter“i”intablesofUSTreasurybondyieldsandthesameclassificationruleisused,forexample,forFrenchandGermangovernmentissueslinkedtoinflation.Thebreak-evenrateofinflationisaffectedbyanumberoftechnicalfactors,whichmaymeanthatitisnotatruemarketforecastforinflation.Theseincludethefollowing:

Aninflationriskpremium.Thiswouldcause,ifitexists,thebreak-evenratetobehigherthanthemarket’sforecastforinflation.

IntheUnitedStatesandothercountries,butnottheUK,TIPSprovideaninsuranceagainstdeflationasthebondswillberedeemedatthehigherofparorthatvalueplustheiraccumulatedindexation.Intimesoflowinflationordeflation,thiscancausedifferencesinbreak-eveninflationratesimpliedbynewissuesandlong-standingbondseveniftheyhavethesamematuritydate.(IntheUK,persistentdeflationcouldcauseanissuetoberedeemedatlessthanpar.)

Taxationdifferences.Thesecandistorttherelationshipbetweeninflation-linkedandconventionalgovernmentbonds.Taxtreatmentofinflation-linkedbondsdiffersamongcountries.IntheUnitedStates,forexample,taxableinvestorsmustpaytaxonboththerealyieldandtheinflationaccrual.Sowheninflation(orexpectedinflation)increases,afallinTIPS’pricesisneededtokeeptheafter-taxrealyieldunchanged,andviceversaforreductionsininflationexpectations.Bycontrast,intheUKincometaxisleviedonlyonthecouponofinflation-linkedgovernmentbonds,notontheinflationcompensationontheoutstandingprincipal.SoUKtaxableinvestorsmayhaveanincentivetoholdshorterdatedindex-linkedbonds,astheirtaxtreatmentismorefavourablethanthatofshort-datedconventionalbonds.Tothe

extentthatthepricesofinflation-linkedbondsaredrivenbytaxableinvestorsratherthantax-exemptinvestors,thiscaninfluencethebreak-eveninflationrate.

Liquiditydifferences.Inflation-linkedgovernmentbondmarketsaregenerallylessliquidthanconventionalgovernmentbondmarkets.Investorsvaluetheoptiontobeabletobuyandsellinvestmentsatnegligiblecost,whichisavailablefromliquidgovernmentbondmarkets,andsotheinflation-linkedbondyieldmaycontainapremiumtocompensateforitscomparativeilliquidity.Thispremiumislikelytovaryovertime,andmayattimesbestronglyinfluencedbythedemandoflong-terminvestors,whodonotintendtotradetheirholdings.

Regulationandvaluationrulesfortax-exemptpensionfundsandinsurancecompanies.Thesecancauseconcentrationsofdemandforparticularsegmentsoftheconventionalandinflation-linkedmarkets,leadingtovaluationanomalieswhichrequireparticularlylongtimehorizonstoarbitrage.Thiscanbereflectedindifferencesinbreak-eveninflationratesoverdifferentmaturities(andcanrepresentinvestmentopportunitiesforlong-terminvestorswhoareguidedbytheirownfinancialneedsratherthanarbitraryrulesorbenchmarks).

Biasesinthemeasureofinflationusedtoindexindexedbonds.Suchbiasesarereflectedinthebreak-evenrateofinflation.Forexample,intheUKindex-linkedgiltsarecompensatedforchangesintheretailpriceindex(RPI),andacombinationofadifferentindexweightingmethodologyanddifferentcoveragecausestheRPItoincreasebyaround1%peryearonaveragefasterthantheinternationallycomparableconsumerpricesindex,althoughthedifferenceisquitevolatile.Aconsultationwithinterestedparties(largelyinvestors)togaugesupportforamovetowardsinternationalstandardsofmeasuringinflationfound,notsurprisingly,littlesupportforchange,whichwouldhaveledtoafallininvestmentvalues.Asaresult,intheUKgovernmentbondmarketrealinterestratesaremateriallyhigher,andthebreak-evenrateofinflationmateriallylower,thantheyappeartobe.

Thesefactorscancausethebreak-evenratetodifferfromaninflationforecastandthesedifferencesvarybetweencountries,overtimeandevenbetweenmaturitiesofbonds.Thebreak-evenrateisareadilyavailable,crude“ruleofthumb”foramarketforecastofinflation,buttheseotherfactorsneedweighingbeforetakinganinvestmentdecision.Ifalong-terminvestorhasstrongviewsthatdifferfromtheapparentmarketrateofinflation,theseviewscaninfluencehowtheinvestormovesawayfromthesafetyofinflation-linkedgovernmentbondsinimplementingstrategy.Investorswhosesafe-harbourinvestmentisaninflation-linkedgovernmentbondshouldhaveastrategicpositioninconventionalgovernmentbondsiftheyexpectconventionalbondstoprovideanadequaterewardforexpectedinflation,includingamarginforuncertainty.

Whatpremiumreturnshouldbondinvestorsexpect?It is not normally in doubt that creditworthy governments will make thepayments that are due on their debt, but how these payments on differenttypesofgovernmentdebtrelatetoeachotherisstillunclear.

Weknow from the international comparisonof 22markets undertakenby Elroy Dimson and PaulMarsh, both emeritus professors of finance atLondonBusinessSchool,andMikeStaunton,directoroftheLondonSharePriceDatabaseatLondonBusinessSchool,thatfrom1900to2012USlong-datedbondsdeliveredapremium(geometric) returnoverTreasurybillsof0.8%ayearandthattheaveragefor21countriesoutsidetheUnitedStatessince1900was0.5%peryear.However,itisunclearhowmuchpremium,ifany, should be expected from inflation-linked government bonds overTreasurybills.Theexperiencetodateisstronglyinfluencedbythemonetarypolicybackgroundandthetaxregimeinthecountriesconcernedandistooshorttobeconclusive.

JohnCampbell,MortonL.andCaroleS.Olshanprofessorofeconomicsat Harvard University, Robert Shiller, Arthur M. Okun professor ofeconomicsatYaleUniversity,andLuisViceira,GeorgeE.BatesprofessoratHarvardBusinessSchool, in their 2009 study “Understanding Inflation-IndexedBondmarkets”highlightanumberofdifferent factors influencingthe relationship between conventional and inflation-linked governmentbonds.Althoughtherearegoodreasonstoexpectconventionalgovernmentbonds to outperform index-linked over long periods, there are contraryinfluences that could cause them to underperform. Campbell, Shiller andViceira conclude that the experience of recent years ofmarked short-termvolatility and very low yields for inflation-linked government bonds does“notinvalidatethebasiccaseforthesebonds,thattheyprovideasafeassetforlong-terminvestors”.

Theplaceofsafe-harbourgovernmentbondsinstrategyTheconclusionsinderivingassumptionsformodellinginvestmentstrategy(developedfurtherinChapter5)canbesummarisedasfollows:

Inflation-linkedbondsshouldprovideabenchmarkforlong-terminvestorsjustasTreasurybillsprovideabenchmarkforshort-terminvestors.

ItisreasonabletoassumethattheywillprovidenopremiumreturnoverTreasurybillsinthemediumterm.

In the absence of inflation surprises, conventional bonds are likely toprovide some inflation risk premium over inflation-linked bonds, but thismay average no more than 0.25% per year. However, there may be anilliquiditypremiuminyieldsoninflation-linkedbondswhichoffsetsthis.IntheUK,biasesintheofficialmeasureofinflationmeanthatUKrealinterestratesappearunusually low incomparisonwithothercountriesbut,despitethis, conventional gilts (UKgovernment bonds)mayoutperform inflation-linkedgiltsbyonlyasmallmargininthefuture.

Themost cautious long-term investorsmayhave an anchor holdingofinflation-linkedbonds,butattimesoflesserinflationuncertainty(orgreaterconfidenceinthemonetaryauthorities’abilitytorestricttherangeoffutureinflation), high-quality conventional bonds are likely to replace inflation-linkedbondsasthecoreholdingsofmanylong-terminvestors.Thisreflectsboththeirgreaterliquidity(andsolowertransactioncostsandflexibility),apossibleinflationriskpremiumandtheconvenienceoftheirgreaterregularincomedistribution.

Theequityriskpremium

TheTriumphof theOptimists is the title thatDimson,MarshandStauntongave the first edition, published in 2002, of their path-breaking review ofreturnssince1900fromstocks,bondsandcashin17countries(whichhassince been extended to 22 countries). Their message was that equityinvestors had done better than they should reasonably have hoped in the20thcenturyandthattheyshouldexpectthe21stcenturytobelessgenerousforlong-termequityinvestors.Asifoncue,thenewcenturystartedterriblyforequityinvestors,anddespiteastrongrecoveryafter2008,byDecember2012 the total return on world equities in US dollars, after allowing forinflation,wasjust1%aheadoftheend-1999level,andformost investors,after allowing for fees, trading costs and, for many investment accounts,taxation,would have been significantly behind.According to theDimson,MarshandStauntondata,2008’stotalreturn,beforefeesandexpenses,of–37%forUSequitieswas thesecondworstcalendar-yearperformanceeverrecorded for the United States; and for the world excluding the United

States,2008’sperformanceof–43%wastheworstonrecord.(Rolling12-monthdataforthe1930sindicatemuchworseexperiencesin1932.)Fortheten years to December 2008 the return, again before expenses and alsobeforeallowingforinflation,fortheUSmarketwas–0.6%ayear,thefirstnegativeten-yearreturnsincethe1930s;itwasnotuntil2010thattheten-yearreturnwaspositiveagain.

So what performance should equity investors expect and how does itrelate to the performance from bonds and cash? This is an area of greatcontroversyandthereforeuncertainty.Thisuncertaintymattersandneedstobereflectedinthedesignofinvestmentstrategy.

The starting point is history. In recent years much academic researchintohistoricmarketperformancehasbeenpublished.Theoriginalpioneersin thiswereRoger Ibbotson, aprofessor in thepracticeof financeatYaleSchool of Management, and Rex Sinquefield, co-founder of moneymanagersDimensionalFundAdvisors,whoin1976jointlypublishedlong-rundatabasesofcarefullyconstructedreturnsdatafortheUnitedStatesbackto1926.Shillerhasextendedthisbackto1871.InthepastfewyearsthisUSworkhasbeensubstantiallyextended,mostnotablyby theDimson,MarshandStauntoninternationalresearch.

Thedataconclusivelyshowthat,apart fromtwonotableexceptions, inallcountriescoveredbyDimson,MarshandStaunton’sworkequitieshave,over the longest periods measured, outperformed both government bondsandTreasurybillsandsorisk-takinghaseventuallybeenrewarded.ThetwoexceptionsareRussia,where investors instocksandbondseffectively losteverything in 1917, and mainland China, where investors lost almosteverythingin1949.ThemoregeneralandfamiliarpatternishighlightedinFigures3.11and3.12,whichshowhistoricinvestmentmarketperformancefrom the perspective of investorswith theUS dollar or theUK pound astheirbasecurrency.Table3.1givesasummaryoftheperformanceandriskasrevealedbytheDimson,MarshandStauntonannualdatafor22countriesfrom1900to2012,showingresultsfortheworld(asmeasuredbythese22countries) and the United States and the UK, the two most importantnationalmarketsoverthepastcentury.InTable3.1thedataincorporatetheimpactofthelossesinRussiaandChina(Russiarepresentedaround6%of

worldequitymarketcapitalisationin1899,whileChinawasmuchsmaller).

FIG3.11UScash,governmentbondsandstockmarketcumulativeperformancea$,afterinflation,1900–2012,Dec1899=1

aPerformancebeforeallcosts,feesandtaxes.Source:DimsonE.,MarshP.,StauntonM.,2013

FIG3.12UKcash,governmentbondsandstockmarketcumulativeperformancea£,afterinflation,1900–2012,Dec1899=1

aPerformancebeforeallcosts,feesandtaxes.Source:DimsonE.,MarshP.,StauntonM.,2013

TABLE3.1Long-runmarketperformanceandriskaAfterinflationbutbeforeallfeesandexpenses,1900–2012

aAfterinflationbutbeforefeesandexpenses.bGeometricannualisedreturns.Includingimpactofinflationonvolatilityofreturns.cWorldbondindexisweightedbyGDP;worldequityindexisweightedbycapitalisation;worldindexreturnsandvolatilityareshownindollars.

Source:Dimson,E.,Marsh,P.andStaunton,M.,2002and2013

Recent experience and a close examination of the data reveal that thispatternofequityoutperformancehassometimestakenalongtimetoassertitself.Figure3.13 shows therehavebeen longperiodswhenequitieshavenot outperformed cash or bonds.This applies not only to individual smallmarkets,whicharenotwelldiversified,butalsototheUnitedStatesandtherestoftheworld.

FIG3.13Cumulativeperformanceofequitiesrelativetolong-datedgovernmentbonds1899–2012

Source:Dimson,E.,Marsh,P.andStaunton,M.,2002and2013

Figure3.13 showsunderperformancebyequities relative to long-datedbondsfrom1980to2012fortheUSequitymarket,from1986to2012fortheUK,andfrom1968to2012fortheworldinaggregate.Thesearelong-term periods in anyone’s lifetime. Figure 3.14 shows the cumulativeperformance of equities relative to government bonds for a range ofcountries; there is nothing unusual in government bonds failing tooutperformequitiesover longperiods.Figures3.15and3.16showthe20-yearexcessreturnsfromequitiesovercash(Treasurybills)andlong-datedTreasurybondsfromtheUnitedStates,theUKandtheworld,asmeasuredby the22countriescoveredby theDimson,MarshandStaunton research.The figures indicate that the long-term underperformance by equitiesrelativetogovernmentbondsinrecentyearshadparallelsinthe1930sand1940s

FIG 3.14 There are no free lunches: cumulative performance of equities relative tolong-dated government bonds in leading markets

Source:Dimson,E.,Marsh,P.andStaunton,M.,2002and2013

FIG3.1520-yearequityriskpremiumoverTreasurybills%perannum,1919–2012

Source:Dimson,E.,Marsh,P.andStaunton,M.,2002and2013

FIG3.1620-yearequityriskpremiumovergovernmentbonds%perannum,1919–2012

Source:Dimson,E.,Marsh,P.andStaunton,M.,2002and2013

Table 3.2 shows performance of equities, government bonds and cashseparately for the longest periods to 2012 over which equities haveunderperformedgovernmentbonds.This shows that these instances reflectnotthe weakness of equity market performance but the unusual, and surelyunrepeatable, performance of government bond markets. Equity marketperformance has not over these periods been unusual relative to cash nor inabsolute terms (after inflation). A repeat of such performance over similarnumbersofyearsbygovernmentbondsfromthelowlevelofbondyieldsinlate2013 is almost inconceivable, and although the returns from equity marketsshowninTable3.2aremostlyhigherthanwouldonaveragebeexpected,theyarecomfortablywithintherangeoflikelyoutcomes.

TABLE3.2LongestperiodsendingDecember2012ofequitiesunderperforminglong-datedgovernmentbondsa

Geometricreturn

%peryearExcessovercash

%peryear

US:Dec1980–Dec2012

Cash 1.6

Treasurybonds 7.2 5.4

Equities 7.1 5.3

UK:Dec1986–Dec2012

Cash 2.5

Treasurybonds 5.8 3.2

Equities 5.5 3.0

World:Dec1968–Dec2012

Cash 0.9

Treasurybonds 4.9 4.0

Equities 4.6 3.6

aAfterinflationandbeforefees,transactioncostsandtaxes.Source:DerivedfromDimson,E.,Marsh,P.andStaunton,M.,2002and2013

Somuchforhistory:whatmattersforsettingstrategyiswhatweexpectforthe future. The majority view is that the 20th century was kinder to equityinvestorsthantheyshouldreasonablyhaveexpected,andthatthe21stcenturyislikelytobepay-backtime(becauseamarginoflastcentury’sperformancewasbrought forward or “borrowed” from the future). The broad story is that asignificantpartof theoutperformanceofstockmarkets in the20thcenturywasbecause they started cheap and ended expensive, and that the process ofbecoming more expensive explains a significant part of their historicoutperformanceofbothcashandbonds.Translatingthisintoexpectationsforthefutureisimpededasthereisdisagreementaboutthenormallevelofthemarket,forexampleinrelationtocompanyearnings.

Some look for valuationsof the stockmarket to revert towards the averagefromthepast(seeChapter4).However,otherssuggestthatweshouldexpectthestockmarkettobepricedmoreexpensivelythanonaverageinthepastbecauseinvestorscannoweasilyinvestat lessriskandlessexpensivelybecauseof thewider use of pooled funds, and especially index funds and well-diversifiedexchangetradedfunds.Ifinvestorscanaccessthemarketlessexpensively,thatraises theequityriskpremiumfor thoseinvestors.There isapparentconsensusthatbondreturnsinrecentdecadeshavebeenunsustainable,asyieldshavebeendriven tohistoric lowlevels,and thatgoingforwardbondperformancewillbedisappointing, either because bond yields will recover (as the markets arepredicting)andsopriceswill tendtofall,orbecauseyieldswillstaylowforalong period and so provide a modest return. There is a range of views as towhere government bond yieldswill stabilise. In the interim, for equities to beexpected to perform poorly relative to bonds, they would need to be thoughtexpensivein2013.

At the turn of the century finance experts differed on prospects for thesuperior return that should be earned from equity investing, and thosedifferences show no sign of abating. There is increasing (but not consensus)agreementthatmedium-termprospectsneedtotakesomeaccountofwhetherthe

market is cheap or expensive at the outset. A variation on this is that sincemarketriskevidentlyfluctuates,investorsshouldwantandexpectahigherriskpremiumwhen themarket ismorevolatile.Thismaycoincidewith times thatthemarketislessexpensive,butitmightnot.Althoughthissoundslikecommonsense,thereisalsoagreementthatitisdifficulttoexploitvaluationindicatorstoearnhigherreturns,andtherewouldbequitewidesupportfortheideathatitisfruitless to adjust expectations used in long-term planning except when thestockmarket appears to be either unusually expensive or unusually cheap.Anothercomplicationisthattherelevantexpectedequityriskpremiumwillvaryfromoneinvestortoanother.Forexample,ifthemarginoverTreasurybillsorbondsatwhichinvestorscanborrowforamortgageincreases,theymayfinditmoreattractive toprepay theirmortgage rather than invest inequities for theirpension.

Lowerestimatesof future returnsareproducedby researcherswhobelievethat the stockmarket is expensive. A survey of the future geometric averageannualreturnsfromequityinvesting(measuredasapremiumovertherisk-freerate)in2001rangedfromzeroto7%,withanaverageofjustbelow4%.Thereisincreasingagreementthatatsometimestheriskpremiummaybehigherthanatother times. A more recent range of projections would be similar, with theaveragecloseto4%.But this isbynomeansuniversallyagreed.In2011,RobArnott,chairmanofResearchAffiliates,aninvestmentmanager,wrote:

Thisbriefhistorylessonilluminatesthatthemuch-vaunted4–5%riskpremiumforstocksisunreliableandadangerousassumptiononwhichtomakeourfutureplans.Inourview,amorereasonableanalysiswouldsuggest2–3%,whichisthehistoricriskpremiumabsenttheriseinvaluationmultiplesinthepast30years.

Dimson,MarshandStaunton,intheir2013CreditSuisseGlobalInvestmentReturns Yearbook, say “we infer that investors expect an equity premium(relativetobills)ofaround3–3½%”asageometricaverageforworldequities,andconcludethatareasonablepremiumforinvestinginlong-datedgovernmentbonds is close to 1% per annum. This would mean that they infer that theexpectedequitypremiumreturnovergovernmentbondsisabitover2–2½%.Bycontrast, a rather more optimistic prospect is offered by Peng Chen of

Morningstar Investment Management, who in 2011 projected a 20-yeargeometricaveragereturnfromUSequitiesof7.6%,apremiumof3.3%peryearabove 20-yearUSTreasury bonds and 5.0%per year ahead ofTreasury bills.These approaches involve various ways of projecting the different sources ofreturn that comprise the equity market return, and adjusting for factors thatcannot be relied on in the future (such as the market becoming ever moreexpensive).

Corporatefinanceasksadifferentbutrelatedquestion:whatmarketrateofreturnabovetherateguaranteedbythegovernmentisrequiredbybusinessestotemptthemtoinvest?PabloFernandezandJavierAguirreamalloa,togetherwithLuis Corres, all of IESE Business School at the University of Navarra inBarcelona, have published the results of internet surveys of assessments ofrequired rates of return from academics, investment analysts and businessexecutives.Their2012surveyproducedover7,000responsesfrom82countries,ofwhich52%werefromfivecountries:theUnitedStates,Spain,Germany,theUK and Italy. These show a noticeable pattern: the median responses fromdevelopedcountriestendtobegroupedbetween5%and6%,whileforemergingmarketstheymostcommonlyliebetween7%and9%.

The standard MBA corporate finance textbook, Principles of CorporateFinance, by Richard Brealey, Stewart Myers and Franklin Allen, provides ascepticalviewofthisdebate.Astheauthorspointout:

Manyfinancialmanagersandeconomistsbelievethatlong-runhistoricalreturnsarethebestmeasureavailable…outofthisdebateonlyonefirmconclusionemerges:Donottrustanyonewhoclaimstoknowwhatreturnsinvestorsexpect.

This perspective reflects a view that the pattern of stockmarket returns isessentiallyarandomwalk–thatis,amatterofrollingthedicefromoneperiodtoanother.Asmentionedabove,thereisthoughincreasingsupportfortheviewthatthelevelofthestockmarket(andthelevelofbondmarketprices)cantelluswhetherreturnswillbehigherorlowerintheperiodahead.Thisisconsideredinmoredetailinthenextchapter.

Thisdebatedoesnotmuchaffectthelikelihoodofnextyear’sequitymarketperformancebeingdisappointing.However, itdoeshavea large impacton the

prospectsforwealthaccumulationfromequitiesover longperiods,particularlythe potential for disappointing returns from equity markets over extendedperiods.Theonethinganyinvestorcandotoraise theirexpectedreturnsfromequityinvestingistobevigilantaboutthefeesthattheypay;thisalsohasalargeimpactonwealthaccumulationoverextendedperiodsoftime.

Equityrisk:don’tbankontimediversifyingriskThesizeoftheequityriskpremiumwouldbeoflessconcernifitwastruethatequities are “less risky” for long-term investors than for short-term investors.This is a separate area of debate with strong differences of opinion – andthereforemuchconfusion–amonginvestors.Butwhataretheexpertssaying?

Thelongerthetimehorizonthemorelikelyitisthatstockmarketindiceswilloutperform bonds or cash, simply because on average stocks are expected toperformbetter.Furthermore,thelongertheperiodthemorelikelyitisthatthiscumulativeoutperformancewilltranslateintoanincreasinglylargeproportionoftheinitialinvestment.Long-terminvestorsinequitiesshouldexpecttodobetteronaveragethaninvestorsinbondsorcash,andthelongertheperiodoftime,thebetterinmonetarytermstheyshouldexpect,onaverage,todo.Solongasequityinvestors are offered a positive risk premium,whichmore than outweighs theextrainvestmentmanagementfeestheypay,thisshouldbeuncontroversial.

Therealissueistheriskofdisappointingresultsoverlongerperiodsoftimeand how this can compound into an increasingly large shortfall, and howstronglyinvestorsshouldbeassumedtowanttoavoidthepaincausedbysuchshortfalls. This has always been a central focus of finance, and it has beenbroughtintoevensharperfocusthroughtheworkonlossaversioninbehaviouralfinance.TheexperimentalworkonlossaversiondiscussedinChapter2suggeststhatinvestorsareprobablytwiceassensitivetotheprospectoflossesastheyaretogains.

Forlongperiods(upto20yearsorso),therisksofequitiesunderperforminglong term bonds and cash are not negligible, even though equities are, onaverage,expected tooutperformbondsandcashbyawidecumulativemargin.Figures3.14,3.15and3.16showthisvividlyandmorepersuasivelythanwoulda quantitativemodelwhose assumptionswill always be subject to debate, andthereforedoubt.

Table3.3showstheresultsofjustsuchamodellingexerciseinwhich2,000possible outcomes for equity markets have been simulated by replicating thesummary characteristics of how theUSmarkets have behaved since 1900.Ofcourse, actual experience is only one of many possible outcomes. The tableshows a range of outcomes, from the disappointing 5th percentile outcome,throughthemedianor50thpercentileoutcometothefavourable95thpercentileoutcome, and it shows these simulated results over5, 10 and20years. It alsoshows that in at least half of the modelled scenarios equities far outperformbonds and cash over each period, with the potential in strongly favourablemarkets for substantial outperformance. Nevertheless, the 5th percentileunfavourableoutcomeforequitiesisshownlaggingbehindcashandbondsovereachperiod.

TABLE3.3Doestimediversifyawaytheriskofdisappointingequitymarketperformance?

a50thpercentileoutcomesforbondsandTreasurybillsshown.bUsingtheNorthAmericanconventionofcountingpercentilesfromthemostdisappointingoutcomes.

Source:Author’scalculationsbasedonhistoricalvolatilitiesandreturnsusingDimson,MarshandStauntondataforreturns,afterinflation,forUSstocks,bondsandcash,1900–2012

Inrecentyears,therehasbeengrowingagreementthatthestandardstatisticalassumptions underlying Table 3.3 understate short-term risk (crashes happenmoreoftenthanthemodelsassume)andmightoverstatelong-termequityrisk.Thisisbecauseabodyofacademicresearchsupportsthewidelyheldviewthat,to some extent, markets “overreact” (in relation to the standard assumptions

underlyingthetable).Ifthisistrue,thenifinvestmentreturnshavebeenaboveaverage,theyarelikelysubsequentlytocomedown,andiftheyhavebeenbelowaverage, they are likely to increase. This process of overreaction,where goodmarketperformanceisexpectedtobefollowedbypoorerperformance,iscalled“mean reversion”.A result of this is that equitymarketswouldvary less overtimethantraditionalmodelswouldsuggest.Ifthisistrue,stockmarketvolatilitymeasuredover,say,decadesor20-yearperiodswouldbe“less”thanwouldbeexpected if we were simply to extrapolate short-term volatility. However, thedegree to which it is the case is controversial, particularly among academicresearchers.

The simple, easy-to-use modelling that underlies Table 3.3 (and manysavings planning exercises) has been widely criticised. But these approachescontinue to be used, partly because there is no agreement on how to replacethem. However, the weakness of these models needs to be reflected in howwealthplanningispresented.Anexpectationthatarisk-basedstrategyislikely,butnotcertain, toachieveanobjective isoften reassuringenough. If investorswant more certainty (for their “safety-first” portfolio – see Chapter 2), theunderlying investment strategy needs to be based on hedging using tailoredinflation-linkedorconventionalgovernmentbonds.Oftenthehonestmessageisthatthepriceofsuchinsuranceistoohigh,andmanyinvestorshavelittlechoicebuttolivewithasignificantdegreeofuncertainty.

At present, the best guide to the risk of equities underperforming cash orbonds is given by examining the historical data. As discussed above, theprevailingviewoffinanceacademicsisthatthe21stcenturyislikelytobelessfavourabletoequitymarketsthanthe20thcenturywas.Furthermore,allowanceneeds to be made for the drag of investment fees and transaction costs and,whererelevant,fortax.Soareasonableassumptionwouldbethattheincidenceofdisappointingequitymarketswillbehigherinthe21stcenturythanitwasinthe20th.Thefirstdecadewascertainlyconsistentwiththis.

The international pattern for equities underperforming bonds over rollingfive-yearand20-yearperiodsisillustratedinFigures3.17and3.18.TheseshowthatforUSandworldequitiesoverthepast109years,stockshaveoutperformedbondsinjustover70%ofrollingfive-yearperiods.Forperiodsof20years,thefrequencyofequitiesoutperformingbondsrisesto95%forUSequitiesand89%

forworldequities,althoughitislowerthan80%inalmosthalfoftheindividualcountrieswithafulltrackrecord.Asrecentexperienceshows,theriskofequitystrategies underperforming safe-haven investment strategies over long periodsneeds to be taken seriously. These are not remote events to be dismissed asexceptionalbadluck:thesethingshappen.

FIG 3.17 Frequency of equity outperformance of bonds, overlapping 5-year periods %,1900–2012

Source:Dimson,E.,Marsh,P.andStaunton,M.,2002and2013

FIG 3.18 Frequency of equity outperformance of bonds, overlapping 20-year periods%,1900–2012

Source:Dimson,E.,Marsh,P.andStaunton,M.,2002and2013

4 Howshouldandhowdoinvestorstrategiesevolve?

Modelinvestmentstrategies

The debate aboutwhat returns to expect from the stockmarket is partly adebatebetweenthosewhothinkthatstockmarketperformanceovertimecanbest be explained as a statistical “random walk”, where forecasting ispointlessbutonaveragerisk-takinggetsrewarded,andthosewhothinkthatmarket returns aremean reverting,with higher than average returns beingfollowedbyperiodsofdisappointingreturnsandviceversa.Thisdebatehasimportantimplicationsforthedesignofinvestmentstrategyandtheroleoflong-term model allocations between stocks, bonds, cash and other assetclasses.Thesearesometimescalled“strategicassetallocations”or“policyportfolios”. The role of such models, and how they help to differentiatebetween investors with different appetites for taking risk, is discussed inChapter 5, but an important feature is that they anchor actual investmentsaroundthemodelallocations,nomatterwhatishappeninginmarkets.

In2003PeterBernsteinwroteanarticleintheEconomicsandPortfolioStrategynewslettertitled“Arepolicyportfoliosobsolete?”Thisquestionhasprobablybecomemorerelevantwiththepassageoftime.In2008,adherencetofixedlong-termassetallocationmodelsledmanyinvestorstoexperiencedeclinesininvestmentvaluesthatexceededtheirworst-caseexpectations.In2003Bernsteinwrote:“Investmentpolicyintoday’senvironmentshouldbeopportunistic,tobeplayedmorebyearthanbyrigidpolicyallocations.”HewentontoquoteKeynes,whowrotein1924:

[The]longrunisamisleadingguidetocurrentaffairs.Inthelong

runwearealldead.Economistssetthemselvestooeasy,toouselessataskifinthetempestuousseasonstheycanonlytellusthatwhenthestormislongpasttheoceanwillbeflat.

Underlying the criticism of fixed long-term investment strategies is abeliefthatanalysiscantelluswhethermarketsarecheaporexpensive,andthatwhenamarketisexpensivetheriskoflosingmoneyisincreased.Fewclaimtobeabletopredictwhenamarketwillcorrect,buttheydonotdoubtthat markets do eventually correct, or that they revert to their averagerelationships.Asimilarbutslightlydifferentcriticismoflong-termstrategymodels is that markets experience different regimes or environments andthat investment policy ought to respond to the differentmarket conditionsthattheyrepresent.

Thenotionofdifferentmarketclimatescanbestbeillustratedbylookingathowstockmarketvolatilityhasfluctuatedovertheyears,andofhowthepricing of the stockmarket has evolved. Figure 4.1 shows the leadingindicatorandmeasureofstockmarketvolatility,VIX,from1990to2013.Ithighlightsboththeextraordinaryincreaseinstockmarketvolatilityin2007–09 and also howbenign themarket environment appears to have between2003and2007.SinceVIXreflectsoptionpricing,itindicatesfluctuationsinthecostofinsuringagainstastockmarketcrash,thisbeinglowwhenVIXislow and high when VIX is high. Figure 4.1 also shows what would bedescribed as regime changes.Almost any investment strategy had amuchhigherriskofexceedingsomethresholdtolerancefornegativereturnsinthemore volatile environment of 2008–09 than when it was more moderate.This suggests that investors who are particularly sensitive to the risk oflosing money should attempt to return towards their safe haven ofgovernment bonds or cashwhenmarket volatility increases.One practicalissuewiththisisthatasuddenincreaseinmarketvolatilityislikelytohavebeencausedbyasuddenfallinprices,makingsucharesponseareactiontorecentlosses.

FIG4.1VIXindicatorofUSstockmarketvolatilityJan1990–Oct2013

Source:www.cboe.com

Risk-takingandportfoliorebalancingAttimesofmarketturmoil,measuresofvolatilityincreaseandthevalueofriskassetsfalls.Anyinvestorwhohasbenchmarkallocationstoriskassetsandconservativeassets(seeChapter5)willthenbeunderweightriskassetsbutoverweightsafeassets.Inthesecircumstances,investmentadvisers–who,asdiscussedinChapter1,mayenjoytakingriskmorethantheirclientsdo–oftenrecommendrebalancingbacktowardsthestrategicallocationsand,forexample,takingprofitsongovernmentbondsandreinvestingtheproceedsinriskassets.Attimesofgreatstressinmarkets,opportunitiestorebalancewillbegreatest.Atsuchtimes,thiscounter-cyclicalpolicyisnotforthefainthearted.Itprovidesliquiditytodistressedsellersandincreasesrisk-takingin“badtimes”whenriskpremiumsmaybeunusuallyhigh.Ifmarketstendtooverreactand“meanrevert”,thisaddedrisk-takingwillbeasourceofaddedvalue

Automaticrebalancingisanaturalroleforalong-terminvestor,butitisawayoftakingmoreriskwhenotherswishtotakeless(oravoidtakingmore)asmarketvolatilityincreases.Itisamechanismforsellinggovernmentbonds(andliquidity)whentheirpriceishighandbuyinggovernmentbonds(andmaintainingliquidity)whenothersareincreasingtheirexposuretoilliquidassets.Itisalsoawayforinvestorstoanchorpolicytoapreviouslyagreedstrategythatwasjustifiedwithreferencetopastlong-termaveragesformarketrisks,whichareunlikelytoreflectthecircumstancesatthetimeoftherebalancing.

The argument thatmarkets overreact and then revert towards trend orevenovershootintheoppositedirectioniscloselyrelatedtotheargumentsinfavourofavaluestyleofequityinvesting(seeChapter7).ApersuasiveanalysisinthistraditionisthatdevelopedbyAndrewSmithers,chairmanof

Smithers & Co, and Stephen Wright of Birkbeck College London. Theyhave built on the analysis of the late James Tobin, formerly the Sterlingprofessor of economics at Yale University, who suggested that thestockmarket valuation of a company should be related to the replacementvalueofitsassetsminusitsliabilities.

Figure4.2shows thismeasure,calledTobin’sQ,of stockmarketvaluesince 1900. The horizontal line shows its average value, highlighting anunprecedentedpeakattheendofthe1990sandasharpdeclinein2000.Thedipbetween2007and2008islessthanmighthavebeenexpectedbecauseofthesubstantialwrite-offsofcapitalinthedominantfinancialsectorduringthe credit crisis.This is onlyone indicator, but it provides awarning signthatwhenQhasbeenwellaboveaverage,subsequentperformanceismorelikely to be disappointing, and when Q has been well below average,subsequentperformanceismorelikelytobegood.Ifthisisaccepted,modelallocations to equities should reflectmarket valuations and not be cast instone.Overthetenyearsaftertheratioreachedthethreemostextremelowssince1900,theUSequitymarketperformedstrongly,whereasfollowingthepeaksof1929and1999performancewaspoor.

FIG4.2Tobin’sQ:ratioofthemarketvalueofUScorporateequitytoreplacementcost1900–Mar2013

Sources:Wright,S.,Smithers,A.,Shiller,R.;USFederalReserve,updated

Figure 4.3 shows Robert Shiller’s cyclically adjusted price/earningsratio,alsoknownasCAPE,orthe“ShillerPE”.TheShillerPEistheratioofthe inflation-adjusted level of theS&P composite stock price index to theinflation-adjusted ten-yearmoving average of the reported earnings of thecompanies in the index. Shillermade considerable use of this indicator ofstockmarket value in his book Irrational Exuberance, the publication ofwhichinearly2000coincidedwiththepeakovervaluation,asindicatedbyFigure4.3,sincestockmarketrecordsbegan.TheShillerPEfocusesonthevaluation that the stockmarket places on the ten-year historic stream ofcorporate earnings, whereas Tobin’s Q is measuring the relationshipbetweenacompany’sstockmarketvaluationanditsnetworth.Nevertheless,thetwomeasuresshowessentiallythesamestory(compareFigures4.2and4.3). Shiller and Smithers both use their metrics to describe stockmarketoverreaction and reversion to the mean. Shiller, for example, includes achart relating the value of the Shiller PE to the subsequent ten-yearperformanceofthestockmarket:forwellover100years,highlevelsoftheShiller PE have tended to be followed by relatively poor stockmarketperformance, and low levels of the Shiller PE by better-than-averageperformance.

FIG4.3S&P500“Shiller”price/earningsratio1881–2013

Source:Shiller,R.,IrrationalExuberance,asupdated,www.econ.yale.edu/~shiller/data.htm

Withhindsight,fewwoulddisputetheimportanceofthemessagethesetwo indicators give at extremes of valuation, and this emphasises thebenefitsofbeingabletoadjuststrategy.Intheinterestsofdesigningamoreprofitable forecasting tool, somehavesuggestedadjustments (forexample,in calculating the Shiller PE, by taking account of the trend in earningsratherthantheiraveragelevel,afterinflation).Otherslookforreasonswhythenormalvalueofthestockmarketmightbehighertodaythaninthepast(for example, as discussed in Chapter 3, since investors can much moreeasily and cheaply acquire a diversified exposure to the market, thestockmarketmaybealessriskyplacetoinvest).Nevertheless,atextremesofmarketvaluation,Tobin’sQand theShillerPEhavebothproved tobereliableindicatorsofsubsequentstockmarketperformance.

The equity market is not alone in showing valuations revert towardstrend.Figure4.4showsfortheUnitedStates,theUKandtheeurozonethedifference between the yields on single A-rated investment grade debtindices (see Chapter 8) and indices of government debt (Germany in thecase of the euro zone). Differences between the indices mean that thecomparisons in Figure 4.4 are indicative rather than exact measures, butcorporatebondyieldsprovideanotherindicatorofvaluethatseemstorangebetweenperiodsofofferingtoolittlerewardforrisk-taking(asimmediatelybefore the credit crunch) and periods of offering the prospect of generousrisk-adjustedreturns.ThisisdiscussedfurtherinChapter8.

FIG4.4SpreadbetweensingleAcredit indicesandhighest-ratedgovernmentbondindices%peryear,Dec1998–Sep2013

Source:DerivedfromBarclaysindexdata

Figures 4.1–4.4 reflect the incidence of booms and busts in risk assetmarkets. Advice to avoid speculative excess is easier to give than toimplement successfully. In practice, success does not come easily toprofessional investment managers who seek to time markets, and someconsultantshaveattimesgivenuptryingtoidentifymanagerswhocanaddvalue in this way. The equity bear market of 2008–09 was much moresevere than thatof2000–02,whichfollowedaboomin technology,mediaandtelecomsstocks,butwithafewnotableexceptions,the2008–09equitybearmarketwasmuchlesswellanticipatedinadvance.Thebuoyantcreditmarketsin2005–07weremuchmorecommonlyseenasofferinginadequateprospectivereturnsthanwereequitymarkets.Thedifficultyofanticipatingevents presents amajor challenge for investors, and it echoes a commentmadeinAugust2002byAlanGreenspan,thenchairmanoftheUSFederalReserve. Looking back on the unwinding of the late 1990s equitymarketboom, which he had anticipated by publicly voicing concerns about“irrational exuberance” over three years prior to themarket peak in early2000,atalevel80%higherthanwhenhegavehiswarning,Greenspansaid:

Aseventsevolved,werecognisedthat,despiteoursuspicions,itwasverydifficulttodefinitivelyidentifyabubbleuntilafterthefact–thatis,whenitsburstingconfirmeditsexistence.

Greenspan’s comments should encourage people to be modest abouttheirabilitytocallmarketssuccessfully.Thissenseofmodestyencouragessome to argue that long-term investors should stickclose to their strategicasset allocations and buy-and-hold equities through thick and thin. Thereasoning behind this recommendation is that market timing is hazardousand,formanyadvisers,equitiesarelessriskyforlong-terminvestors.JohnCampbellandothersagreethatequitiesseemtobelessriskyoverlongtimehorizons than is suggested by their short-run volatility because equities“mean revert”. If this is correct, Campbell argues that investors shouldoverweightequitieswhentheyareexpectedtoperformbetter thanaverageand underweight themwhen they are expected to doworse than average.Manywouldsaythatthisis“easiersaidthandone,exceptaftertheevent”.

Following 2008, the more usual concern was the dilemma of how toreact to unusually low government bond yields. “Quantitative easing” bycentral bankswas initially designed to relieve financialmarket distress in2008–09 and then evolved into supporting the economy (and, in the eurozone,ofrelievingthecrisisinperipheralgovernmentbondmarkets).TheUSFederalReserveandtheBankofEnglandacquiredinexcessofone-quarterof theUSandUKnationaldebts respectively (while theEuropeanCentralBankandtheBankofJapangreatlyfacilitatedtheirlendingtobanks).IntheUnitedStatesandtheUK,thesebond-buyingprogrammes(includingintheUnitedStatespurchasesofmortgagesbytheFederalReserve)wereintendedtoreducetheyieldsonlow-riskassetsandsolowerthecostofborrowing,whether formortgages or for business. In the process, existing holders ofTreasury bonds were enticed to sell, and presumably to buy higher-riskassets instead.Quantitative easingwas a policy intended to force cautiousinvestors to take more risk than they would normally wish to, and in sodoingTreasurybondpriceswere forcedhigher.Figure4.5 shows ten-yearUSTreasurybondyieldsoverthe51yearsafter1962:betweenApril2012andApril 2013, these averaged 1.8%, comparedwith an average of 6.7%overtheprevious50years.CentralbankpurchasingoflargesegmentsoftheTreasury market was an evident distortion that was to some degreeresponsible for these extraordinarily low bond yields. The dilemma forinvestorswashowtorespondtothisdistortion,andhowlongwouldittake

tounwind.

FIG4.5USTreasury10-yearconstantmaturityyields%peryear,Jan1962–Sep2013

Source:USFederalReserve

Set against this background, Bernstein’s criticisms of buy-and-holdapproachestowealthmanagementlookevenmorerelevant.Thepriceofaninvestment shouldmatter, and there is a price atwhich itmakes sense toexchange the assurance of a high-quality government bond for a cheaper,lesswell-suitedorlesssecuresubstitute.Thefirststepsmaybetheeasiest,asportfoliorebalancingleadstosalesofgovernmentbonds.However,manyadvisers will suggest going beyond this and scaling back considerablyexposuretothesecurityofgovernmentbonds.Oneofthebiggestproblemsfacing investorswhoaccept this is thatnooneknowshowmuchTreasuryyields have been influenced by central bank purchases (though variousestimatesexist)orhowmuchcontinuinginfluenceonyieldswillbefeltbythepresenceoftheUSFederalReserveandBankofEnglandaslong-termholdersofTreasurybonds. Inotherwords,noone reallyknows the “fair”priceforaTreasurybond.Thisisamajordifficultyforthoseinvestorswhowere persuaded to sell their core holdings of government bonds, becausethey were too expensive, but who need to decide when to return to theassuranceofTreasurybonds.

Theyearssince2007haveradicallyalteredtheinvestmentenvironmentforanyinvestor.Bernstein’scallforinvestmentpolicytobe“opportunistic,tobeplayedmorebyearthanbyrigidpolicyallocations”surelyappliestosuchachangeintheinvestmentlandscape.Inpractice,thebroadestpatternsof asset allocation have not changed markedly for different groups ofinvestors in the five years after 2007, although there have been importantchanges indetail, often continuationsof trendswhichwere evident beforetheglobalfinancialcrisis,ratherthanarisinginresponsetoit.

Theevolutionofwealthanditsinvestmentsince2002Table4.1showsestimatesofthewealthofselectedcategoriesofinvestorin2002, 2007 and 2012; Table 4.2 shows their allocation to different broadcategoriesof investment.Table4.1 isnotcomprehensive– forexample, itdoesnotincludeinsurancecompanies–andsomeofthedata(forexample,for global private clients) unavoidably involve a significant degree ofestimation,exchangeratefluctuationscandistortthedata,andthereissomeoverlapbetweenthecategories.Nevertheless,Table4.1givesanindicationofbroadtrendsintheevolutionofwealth.

The highlight of Table 4.1 is the contrast between the rapidaccumulation of wealth by all categories of investors in the five years to2007anditsslowgrowth,formost investors, in thesubsequentfiveyears.The shortfall from previous expectations will have been worse thansuggested by the change in value of investment funds. The reduction inlong-terminterestratesbetween2007and2012willhavehalvedtheincomethey could safely withdraw without undermining their fund’s capital.Allowance for inflation would have reduced this still further. In thisenvironmentinvestorswillhavefeltseverelyconstrained.Bythesummerof2013,arecoveryinbondyieldshadnoticeablyincreasedsustainableincomelevelsforinvestors.Thetwocategoriesofinvestorwhosewealthincreasedsubstantially in the five years to 2012 were sovereign wealth funds (seebelow) and central foreign-exchange reserves (which in aggregate weretwicethevalueofSWFsattheendof2012).TheincreaseinassetsofSWFswasdrivenbybuoyantoilandgasrevenues.Theimpactofthequitesuddenarrival of a new, rapidly growing groupof substantial investorsmayhave

been to support the prices of those assets theyparticularlywished to hold(listed equities and alternative investments, see below). This is turn willhavebroughtforthadditionalinvestmentopportunities.

TABLE4.1Indicatorsofglobalinvestableassets

Sources

Globalhighnetworthfinancialinvestments:CapgeminiandMerrillLynchWealthManagement“WorldWealthReport”2003;CapgeminiandRBCWealthManagement“WorldWealthReport”2013.“Highnetworth”referstoindividualswithatleast$1mfinancialwealth

Globalpensionfunds:TowersWatson“GlobalPensionAssetStudy”2012.Datarefertoa

Globalpensionfunds:TowersWatson“GlobalPensionAssetStudy”2012.Datarefertoasub-sampleofthesevenlargestpensionfundmarkets,Australia,Canada,Japan,Netherlands,Switzerland,UK,US

USemployer-definedcontributionpensionplansandindividualretirementaccounts:TheInvestmentCompanyInstitute,www.ici.org/research/stats

USendowments:NACUBO-CommonfundStudyofEndowments2012;NACUBOEndowmentStudy2002,2007

Sovereignwealthfunds:InstitutionalInvestor’sSovereignWealthCenter,www.sovereignwealthcenter.com

Centralbankforeign-exchangereserves:IMF,“CompositionofForeignExchangeReserves”.Goldholdingsareexcludedfromthesetotals

Bondyields:USFederalReserve

Whatisasovereignwealthfund?Sovereignwealthfunds(SWFs)aregovernment-ownedinvestmentfunds,andtheytypicallyarisefrompersistentbalance-of-paymentsandbudgetsurpluseswhenacountry’sforeignexchangereservesbecomemuchlargerthannecessarytomeettheirtraditionalrole,whichisthemaintenanceofforeignexchangestability.SomeinvestmentfundsthatareownedbyregionalgovernmentsarealsocommonlyclassifiedasSWFs.

SWFsareoftenfundedfromthesaleofnon-renewablemineralwealth,suchasoilandgas.TheinvestmentstrategyofaSWFhasamuchlongertimehorizonthanthatofacountry’sforeignexchangereserves.Reservemanagementtypicallyfocusesonhighestqualityshort-ormedium-termgovernmentsecurities,whereasSWFsinvestforthelongertermandseektoearnariskpremiumbyinvestinginabroadspectrumofbothriskyandmorecautiousinvestments.

OnecharacteristicofSWFsisthattheyhaveshownthattheycangrowfrommodestbeginningstoalargesizeoverarelativelyshortperiodoftime.Thisdifferentiatesthemfromotherinstitutionalinvestors,suchasinsurancecompaniesandtraditionalpensionfunds,whoseimportanceinaneconomytendstoevolvemoregradually.

TABLE4.2Patternofassetallocationbyglobalinvestors

%

aMarch.bExcludesprimaryresidences.cAlsoknownasbalancedfunds;theyincludeequitiesandbonds.Sources:AsforTable4.1

Table4.2givesabroadindicationofassetallocationofprivateclients,pension funds, endowments and sovereign wealth funds in 2012 or early2013andindicationsofchangesinallocationsbetweenmarkets in thefiveyearsbeforetheglobalfinancialcrisis,andinthefiveyearsafteritsonsetin2007–08.Beforedrawingconclusionsaboutthedegreeofchangesuggestedbythetablerecallthatallinvestmentshavetobeowned:whenoneinvestordecides to sell, another buys, although it might take a change in price tocomplete a transaction. Thismakes it unlikely that aggregated investmentdatasuchasthoseinTable4.2willshowmarkedshiftsinallocations,exceptasareflectionofpricechanges,orovertime,asthesupplyofdifferenttypesofinvestmentchangesinresponsetomarketdemand.

Table4.2showsmovesbefore2007intolistedequitiesbypensionfundsandUSindividualretirementsavingsplans(wherethemovewasfocusedoninternational equities) and then away from listed equities by the sameinvestors in the following five years. The data for the asset allocation forwealthy individuals are taken from the Capgemini, RBC WealthManagement and Scorpio Partnership Global HNW Insights Survey ofMarch 2013.The broad pattern it reveals,which is consistentwith earlier

surveyscarriedoutbeforethefinancialcrisisusingadifferentmethodology,is thewell-diversified and generally cautious deployment ofmuch privatewealth. In early 2013, cash and deposits represented over 20% of thefinancialwealthofmillionairesworldwide,withsuchcautioncharacterisinginvestorsofalllevels.

Onecommonthemeacrossdifferentcategoriesofinvestors,whichwasevidentbefore2007,istheincreaseinallocationstoalternatives,thecatch-allcategoryforunlistedinvestments includingrealestate,hedgefundsandprivate equity. US university endowments have led theway in this trend,andtheirimportance(particularlythatoftheHarvardandYaleendowments)insettingtrendsinglobalassetallocationfarexceedstheirsize(comparableto many large pension or insurance funds). David Swensen, the long-standingchief investmentofficer atYaleUniversity, publishedPioneeringPortfolio Management: An Unconventional Approach to InstitutionalInvestment in2000,highlightingtheattractionsofinvestinginalternatives.This provided a reference book for what has become known as the“endowment model” for asset allocation, with the prospect of superiordiversificationenablingenhancedreturnsforthesamelevelofrisk.Thishasbeenanimportantinfluenceonadvicegiventoinstitutionalinvestorsaroundtheworldbothbeforeandsince thefinancialcrisis.Theexperienceduring2008–09 of investors in illiquid alternatives highlighted the potential forlargeadverseswingsincashflowfromprogrammesinilliquidinvestmentsin“badtimes”(whenthedemandtomeetcommitmentsmaybesurprisinglyhigh, and the cash flow generated by the investments surprisingly low).Nevertheless, the prospect of earning attractive excess returns fromalternative investments continues to be reflected in growing allocations toalternativesbyallcategoriesof investors,with the“endowmentmodel”ofasset allocation havingmorphed in some consultants’ recommendations toboth institutional and private clients into multi-asset or hybrid funds,sometimes called “diversified growth funds”, which embrace a growingrangeofalternativeandmainstreamassetclasses.

LiquidalternativeinvestmentsMuchprivatewealthhasashorterandlesspredictabletimehorizonthaninstitutionalwealth.Thishelpsexplainwhyprivateinvestorsarelikelytobelesswillingthaninstitutional

Thishelpsexplainwhyprivateinvestorsarelikelytobelesswillingthaninstitutionalinvestorstomakelong-termcommitmentstoilliquidinvestments.AsonewealthmanagerquotedintheMoneyManagementInstitute’s2012annualreportputit:

Wedon’tuseprivateequitymuch.ThisisgreatforYaleorHarvard.Butitisilliquid,andclientsjustdon’tgetit.Deathanddivorcearetoodisruptive.

Manyprivateinvestorsareneverthelesspersuadedofthemeritsofaliquid,marketablevariationonthe“endowmentmodel”ofassetallocation,andanumberofalternativeassetsareavailableinhighlyliquidinvestmentvehicles.Theseincludeanewbreedof“hedgedmutualfunds”,whichhavegrownrapidlyinpopularityinNorthAmericaandEurope.Thesetypicallyfocusonliquidhedgefundstrategies,includinglong-shortequities,currencystrategies,andcommodityormanagedfuturesfunds(seeChapter9)andcompriseliquidunderlyinginvestments.Furthermore,inrealestateandprivateequity,althoughtheunderlyinginvestmentsareilliquid,realestateinvestmenttrusts(REITs)andlistedprivateequityfundsgiveinvestorsreadyaccesstothesemarkets,butwiththescopeforlargevariationsinthepremiumordiscountofthemarketpricetotheassessedvalueoftheunderlyinginvestments(seeChapters8and9).Inaddition,Chapter9discussesthedevelopmentofliquidhedgefundstrategies,whichseektoreplicate,atlowcostandwithhightransparency,theriskandreturncharacteristicsoftheaveragehedgefund.Theycanalsobeusedtotargetsourcesofriskandreturnwhicharenotavailableinequityandbondmarkets,andwhichprovideoneofthetraditionalreasonsforinvestinginhedgefunds.

Alternativeassetsdonotneedtobeilliquid,andarenottheexclusivepreserveofinstitutionalinvestors.AccordingtotheMoneyManagementInstitute,USmutualfundsandexchangetradedfunds(ETFs)thatfocusonprovidinghedgefundorcommodity-basedinvestmentstrategiesgrewfrom$117billionin2007to$368billionbyMarch2012.

The opportunity for improved diversification by accessing differenttypesof systematic risk (seeChapter9) is oneof the expectedbenefits ofinvestinginalternativeassets,andisaprincipalinsightofthe“endowmentmodel” that should be available to investors in “liquid alternatives”.However,threeofthefurtherbenefitsinstitutionshopetogainbyinvestinginalternativesmaynotbereadilyavailabletoinvestorsintheirmarketablealternatives.The first isa liquiditypremium:when investorsbuyaprivate(that is, unlisted) investment they should do so on the understanding thattheyareacquiringitonbettertermsthaniftheinvestmentwashighlyliquid.Readily marketable versions of the endowment model should not beexpectedtoofferthisbenefit(althoughtheymight,particularlyiftheytradeatadiscount).Asecondadvantagethatinstitutionalinvestorshopetosecureis access to unusually skilledmanagers, forwhom theremaybe restrictedaccess.A third, andmost important, benefit is that large investment funds

oughttohaveanadvantageinsecuringadvantageousfeeterms,whichwillnotbeavailabletoamuchsmallerinvestor.

However,oneofthecentrallessonsof2008wasthatin“badtimes”thecorrelations between risk assets increase noticeably, and that althoughalternatives – whether liquid or illiquid – may offer some diversificationfromequities,despitetheincreaseincorrelations,thatisscantconsolationin“badtimes”.Ifyoureallywanttodiversifyperformanceriskinbadtimes,orto hedge your liabilities, keep a significant part of your wealth ingovernment bonds. Risk assets do not achieve either of these objectives:theyareriskassets.

In subsequent chapters other significant trends in asset allocation arehighlighted. There is a global trend to lessen the home bias in equityinvesting; there has been a rapid move away from investing in funds ofhedgefunds;andmostofall,manyinvestorsaroundtheworld,havingsoldUS Treasury and mortgage bonds to the Federal Reserve and UKgovernment bonds to the Bank of England at historically high prices, arewonderingatwhatyield tobuyback theassuranceofferedbygovernmentbonds.

5 Thetimehorizonandtheshapeofstrategy:keepitsimple

AnappropriateroleforstrategymodelsThis chapter discusses investment strategy models for investors withdifferent tolerances for shortfall risk and with different time horizons forinvesting.Oneofthegreatinsightsofmodernportfoliotheory,whichshouldbe used in designingmodel portfolio strategies, is the portfolio separationtheoremofthelateJamesTobin.Tobinsuggestedthatthedegreeofinvestorrisk aversion only influenced the allocation of an investment strategybetween risky and cautious investments. As Willem Buiter, global chiefeconomist at Citigroup, wrote in 2003 in an appreciation of Tobin’scontributiontoeconomics:

Thisisanimportantandbeautifulresult,whichisnotdonejusticebyTobin’sownsummary:“Don’tputallyoureggsinonebasket”.Indeed,Tobin’sremarkableresultisbettersummarisedas“regardlessofyourdegreeofriskaversionandcaution,youwillonlyneedtwobasketsforallyoureggs”.

A great deal of damage was done to investors’ wealth in 2007–09because investment advisers lost sight of this essential principle, partlybecause they thought they had discovered new and improved ways ofdiversifying investment portfolios which falsely offered the benefits ofsecurityathigherratesofreturn.(SeeAppendix4forfurthercommentsonthe portfolio separation theorem.) One dilemma facing investors in thesecond decade of the 21st century is how to benefit fromTobin’s insightwhilemakingsomeadjustmentstoallowforthehistoriclowratesofinterest

paid on high-quality government debt. Cautious advisers choose to stayquiteclosetoTobin’sinsight.

Assetallocationmodels:anessentialdisciplineChapter4openedwithacriticismbythelatePeterBernsteinoffixedassetallocationpolicymodels.Bernstein’spolicyportfoliosarewhatotherscallstrategicassetallocationsorhigh-levelbenchmarks.Hearguedthattheusefulnessofsuchmodelallocationsisunderminedbyfluctuatingmarketvolatilityandchangesininvestmentopportunitiesasmarketpriceschange.Despitethis,manyinvestors–includingthelargestsovereignwealthfunds,universityendowmentsandpublicpensionfunds,aswellaslargeinvestmenthouseswhichadviseawiderangeofinvestorsandmanyboutiqueinvestmentfirms–makeuseofformalorinformalpolicyportfolios.Theseprovideaframeworkagainstwhichthemanagementofinvestmentsisanchored,oftenwithinpre-agreedlimits.Theyhelptoexpressanattitudetorisk-taking(eventhoughitisknownthatmarketvolatilityfluctuates),andinparticularanattitudetothedivisionofinvestmentsbetweensafe-harbourandriskassets.Theyalsoexpressanattitudetoliquidityandprovideacontextforareviewofinvestmentsandinvestmentopportunitiesaswellasperformance.

Theroleofanchoringisparticularlyimportant:aninvestmentadvisermaythinkthatsafe-havengovernmentbondsareundesirablyexpensive,andmayrecommendmovingquitealongwayfromtheallocationanddurationofthebenchmarkallocationintootherassets.Thesedifferentinvestmentswillintroducenewrisks,but,iftheadviser’sforecastiscorrect,theyshouldreducetheexposureofacapitallossbeingincurredonexpensivebonds.Thepolicyportfolioprovidesabenchmarkagainstwhichtomeasurethatdecision.Italsoprovidesananchortodraginvestmentsbacktowardsthemodelifthepricing“anomaly”subsequentlycorrects.Policyassetallocationmodelsprovideanimportantdisciplineforanyinvestortokeepinvestmentsinlinewithapreviouslyagreedapproach,tojudgemovesawayfromthatagreedapproachandsometimestoanchorlimitsbyinvestmentmanagersfromthatpolicyinpursuitoftacticalmarketopportunities.

This chapter discusses investment strategy models for long-term andshort-term investors with different tolerances for disappointment risk. Ineachofthesemodels,governmentbondsorTreasurybillsprovideananchorforthestrategy.Theweightgiventothemisdrivenbytheappetiteforriskof the investor. Risk assets are represented by allocations to equities.Whetherequitiesalonerepresentthemostefficientwayofgainingaccesstopremiumreturnsneedstobeassessedinthelightofmarketvaluationsandexpectations for performance, risk, and correlations from different assetclassesataparticularpointintime.Itwillbenormaltoinvestinarangeofriskassetsincluding,forexample,credit.TheseopportunitiesarediscussedinPart2.Butnomatterwhatanadviserbelievesaboutthepredictabilityof

marketreturnsorwhichassetclassischeapordear,acautiousinvestorwillbe keener on having safe-haven assets than an aggressive investor, and acautious long-term investor will be more interested in government bondsthanashort-terminvestor,whowillwantmorecash.

When safe-haven investments are themselves expensive, cautiousinvestors faceaparticularproblem.Theyneed todecidehowmuch topayforwhatisineffectinsuranceandhowmuchrisktoincurbymovingawayfromthesafehaven.Forcautiouslong-terminvestors,bondladderscanbeparticularlyuseful inthesecircumstances(seeLadderedgovernmentbondsbelow).

Short-terminvestmentstrategiesFor short-term investors, the safest strategy is to have 100% of theirinvestments inTreasurybills, or highest qualitymoney-market funds.The“warchest”or“umbrella” fundmightbeconsideredashort-termportfolio(see Chapter 1). Short-term investors are absolute return investors. Theirfocus is immediate and they have no need to hedge against risks in thefuture.Although the textbookbenchmark againstwhich success shouldbejudged is the performanceofTreasurybills, the reality is that achieving apositiveinvestmentreturnprovidesalineinthesandthatmattersaboveallelsetoshort-terminvestors.

Moving strategy away from the safe haven of cash (Treasury bills)bringsboththehopeofabetterperformanceandthefearofadisappointingoutcome. Initially, it is simplest to constrain investment choices to thetraditionalareasofstocks,bondsandcash.

Howsafeiscash?Theanchor investment for short-term investors is cash.Cautious investorswhowantmoresecurityshouldholdmoreofit.Investmentbooks,suchasthisone,oftenproceedasifcashwasalwaysinvestedinTreasurybills.Thisisrarelythecase.Oneofthemostshockingfeaturesofthecreditcrunch’searly stages in 2007–08 was the sudden erosion of confidence in cashinvestments held at banks and in money-market funds. This was coupledwithuncertaintyabouttheattitudeofgovernmentstobankfailuresandthe

extentofgovernmentdepositinsurance.Itwasaripeenvironmentforcrowdbehaviour by savers as they responded to rumours of impending bankfailures.

ThefirstmajorcollapsewasthatofaBritishretailbank,NorthernRock,in September 2007. Its online cash withdrawal service was overwhelmedandcustomersformedlonglinesinthestreettoremovetheirsavings.ItwasthefirstrunonaBritishretailbanksince1866.Oneyearlater,inSeptember2008,a$64billionUSmoney-marketfund,ReservePrimaryFund,“brokethebuck”bymarkingdownitsunitpriceto97centsfollowinglossescausedby the failure of Lehman Brothers, a global financial services firm. As aresult,withindays investorswithdrewoverhalf theassetsmanagedby thefund,andtheUSauthoritiesmovedtoshoreupconfidenceinmoney-marketfunds by providing a temporary guarantee to underpin their value. Therewere other signs of sudden loss of depositor confidence in banks. Butconcerns about the security of bank deposits were allayed by theclarificationofdepositguaranteeschemes,andinparticularbythegrowingunderstanding shortly after September 2008 that deposits at major bankswould be protected, not least by the steps taken to bolster bank capital. Itremains thecase thatunguaranteedcash investments inbanksneedcarefulduediligence.

Noall-seasonsshort-termstrategyA focus on managing short-term negative return risk has to respond tochanges in the level of interest rates. The rate of interest provides aperformancecushionwhichisreducedwhenratesarelow.Thusshort-terminvesting is made easier by higher interest rates when (somewhat) moreaggressive strategies can be pursuedwith no increase inmeasured risk ofincurringanegativereturn.Inthisparticularcontext,investingismademorehazardousbylowinterestrates,whenitwillbenaturaltostayclosertothesafetyzone(cash).

TABLE5.1Unaggressivestrategy:negativereturnriskvariesasinterestratesmove

%

aCalculatedprobabilityofanegativereturninacalendaryearforanunchanging,unaggressive(“capitalprotection”)strategy,asdescribedinTable5.6.Seecommentsintextaboutriskofunderperformance.

Source:Author’scalculations

Thismeans that there is a tension between standard “one-size-fits-all”model asset allocations and the focus of short-term investors on theirabsolute performance.The problemwith the standard approach is not thatgroups of clients do not face similar investment risks and opportunities –they normally do. It is rather that a one-size-fits-all approach takes noaccountofmarketconditions.Athigherratesofinterest,itisappropriateforanunaggressiveshort-terminvestor toconsideracceptingmore investmentvolatility. This means that the illustrative short-term stylised modelallocations should be seen for what they are: allocations which might beappropriate if bond yields are around 3.0%, but otherwise they should beconsideredsubjecttorevision,particularlyforunaggressiveinvestors.

Dobondsprovideinsuranceforshort-terminvestors?Theanswerissometimesyesandsometimesno.Thenormalpatternisforequitymarketsandbondmarketstobepositivelycorrelatedwitheachother.Whenequitiesdowell,bondstendtodoatleastquitewell.Attimesofcrisisandflighttoquality,however,therelationshiphasoftenbrokendownasinvestorsfleetogovernmentbonds.Duringthestockmarketdeclinesof2008,thevolatilityoflong-termgovernmentbondsprovidedaninvaluablelevertooffsetthedeclinesinequitymarkets.Butthescaleoftheinsurance“payout”dependedcriticallyonthesizeoftheallocationtobondsandthedurationofthosegovernmentbonds.Cash,thesafehavenforshort-terminvestors,providedlittlehelp.Thisparalleledtheexperiencesofthe2000–02equitybearmarket.Butatothertimesinthepast,forexampleduringthesustainedincreaseininflationexpectationsduringthe1960s,equitiesdidwellwhilebondswereerodedbyinflationandsufferedagradualincreaseinyields.Therehavebeenseveralyearswhenfixedincomesufferednegativereturnswhileequitiesperformedstrongly.

Intimesofcrisis,bondsnormallyappreciate,but(evenforlongermaturities)notnecessarilybymuch,andnotbyasmuchasequitiesfall.Aspectsofthehistoricrecordsince1987aresummarisedinTables5.2and5.3.ItisevidentfromtheexperienceofthemonthsofOctober2008andFebruary2009thatequitymarketsetbacksdonotnecessarilycoincidepreciselywithstrongperformancebytheUSTreasurymarket(seeTable5.2).However,Table5.3,whichrecordstheworstcalendaryearexperiencesofUSequities,showsthatin

thoseyearstheUSTreasurymarketperformedstronglywith,asexpected,long-datedbondsperformingstrongest.

TABLE5.2BonddiversificationinmonthsofequitymarketcrisisTotalreturnperformance,%

Note:DatasortedbyworstmonthlyperformanceofMSCIUSequityindex,January1987–September2013.Sources:Barclays;MSCI

TABLE5.3BonddiversificationinyearsofextremeequitymarketperformanceTotalreturnperformance,%

Note:USequityandbondperformanceduringthebestandworstthreeyearsfortheMSCIUSequityindexbetween1987and2012.Sources:Barclays;MSCI

Table5.3looks“quitegood”forsupportingtheinsuranceroleofbonds.However,theoverallmessageregardingtheinsuranceroleforbondsisthatitsometimesworksbutnotalways,andfurthermorethatUSTreasuriesprovidebetterinsurancethancorporatebonds

andothercomponentsoftheBarclaysAggregateIndex(seeChapter8).Theothermessageisthattherelationshipbetweendifferentmaturitiesofbondsis

generallypredictable,withthelongestdated(andmostvolatile)USTreasuriesappreciatingmostinperiodsofstockmarketcrisis.Butthisdoesnotalwayshappen.Whenitdoesnot,theshapeofthebondyieldcurvecanshiftmarkedly,whicharguesfordiversifiedexposuretobondmaturities.Long-datedbondsareunquestionablymuchfurtherawayfromashort-terminvestor’ssafetyzonethanshort-termbondsandsoaremuchmorerisky.Butthepayoutofshort-termbondsismuchlesswhenfixed-incomemarketsareprovidinginsurance.

Sotheprocessforshort-terminvestorsshouldbefirsttodecidehowmuchrisktheywanttotake,andthentomakesurethatrisk-takingisitselfdiversifiedacrossassetclasses.Offsetequityexposurewithatleastsomefixed-incomeexposure,notinthiscaseforincomebutforinsurance.Butdosoknowingthatthisisoneofthoseinsurancepolicieswithloopholesinthesmallprint.

Areyouinitforthelongterm?Thepurposeofwealth,howeverlargeorsmall,istofundexpenditureinthefuture.Thismightbetomorroworitmightbein40years’time,butthetimehorizon formost investment objectives cannot be described as short term.Forlong-terminvestorswhoareconcernedtotargetaminimumstandardofliving, or, for an endowment, a minimum level of disbursements, thestrategyshouldnottargetaparticularlevelofwealth.Wealthisameanstoanend,butnottheendinitself.Thesufficiencyofwealthisbestexaminedfromtheperspectiveofthelevelofincomeordisbursementsthatthewealthcansupport.

TimehorizonforprivateandinstitutionalwealthTheincomethatadefined-benefitpensionfundoraninsurancecompanyisobliged to disburse can bemodelled by actuaries years in advancewith areasonable degree of accuracy. There are issues with the uncertaintysurroundingtheseprojectionsandwhetherthishasincreasedwithcorporatechangeandwithgreaterlifeexpectancy.Buttheseissuesareofanorderofmagnitudedifferentfromtheuncertaintysurroundingthespendingofmuchprivatewealth.

Theobligationsofendowmentsandcharities(andalsosovereignwealthfunds)areagaindifferent innature.Their spending isconstrainedbywhattheyhave,bythebequestsor inflowsthat theyreceive,andbytheneedto

balance the interestsof today’sbeneficiarieswith thoseof tomorrow.Thisneed toensureequitable treatment inmakingallocationsbetweendifferentgenerations of beneficiaries is a particular concern for “perpetual”endowments,suchascollegefoundations,andsomesovereignwealthfunds,whoseinvestmentstrategyneedstoassumethatthefoundationwilllast“forever”.

The increase in wealth of tax-exempt endowments with bothprofessional investmentmanagementandsuccessful fund-raisingoffers theprospectofaccumulationthat isboundedonlybytheirendowments’fund-raising capacity. David Swensen of Yale University gives a revealingaccount of the differing evolution of the Yale, Harvard and CarnegieInstitutioninvestmentfundssincetheearly20thcentury.In1911,CarnegieandHarvardhad fundsof around$23mwhileYale had around$12m.ByJune 2012, the Carnegie Institution’s investment portfolio, which devotesitself to supporting scientific research, had more than kept pace withinflation, with an endowment of $989m. However, this was dwarfed byHarvard’s$30.7billionandYale’s$19.3billion.Thereasonforthisscaleofdifference is not superior investment management but the much greateraccessoftheuniversityfoundationstonewbequests.

Private wealth is different. Families continue from generation togeneration, but family wealth gets spent. There is little scope for theintergenerational exponentialwealth accumulation thatmaybe enjoyedbyeducationalfoundations.Privatewealthisconsumed,dissipatedinfees,paidin taxes, or donated (as with the Carnegie family wealth) to charitablefoundations. If this did not happen, the parsimonious among the wealthycould become stupendously wealthy. For example, in the 113 years toDecember2012,thecumulativereturnfromUSequitiesafterinflation,butbefore all costs, taxes and fees,was6.3%ayear.This implies that averywealthyfamilywithperhaps$20min1900,equivalenttoaround$500mintoday’sprices, couldhave an inherited fortuneof almost$500billion if ithadbeeninvestedinthediversifiedUSstockmarket,andifthatfamilyhadconsumednothingapartfromwhattheyearnedindependentlyofthatwealthandhadcontrivedtopaynotaxesorinvestmentmanagementcosts.Suchascaleofinheritedwealthdoesnotseemtoexist.Wealthisinherited,butitis

alsospentordisbursed.There is often little predictability in the spending plans of individual

family members. This creates asset-planning issues that do not affectinstitutions.Bycontrast,thepurposeandstrategicdirectionofendowmentsand institutions are legally fixed by trust deeds or equivalent documents.With families, strategic objectives and actual disbursement of wealth canevolve at short notice, sometimes in surprising directions. This introducesuncertainty into the time horizon for the management of private wealth,whichhasfewparallelsforendowmentsorinstitutionalinvestors.However,a change in regulations for pension funds and insurance companies (therehavebeenmanysincethelate1990saroundtheworldandmoreareunderconsideration)canhaveasuddenimpactonthetimehorizonofinstitutions.

Insettingstrategy,theimportanceofdifferentpointsonthetimehorizonforaninvestorneedstobeclarified.Forfamilywealth,theobjectiveisnotnormallypreciselydefined.Sometimestherearecleardatesassociatedwithparticular financial goals which can easily be benchmarked usinggovernment bonds; in other cases, wealth is explicitly needed foropportunities (or contingencies) which may arise in the short term. Butusuallythisisnotthecaseandplansoftenneedtoevolveascircumstanceschange and asmore information becomes available.However, this shouldnot beused as an excuse for assuming that such investors are, bydefault,short-terminvestors,astheadoptionofamedium-orlonger-terminvestmentstrategycouldwellhelpprotectthepurchasingpoweroftheirinvestments.

Long-terminvestorsLong-terminvestorshavemuchgreaterflexibilitythanshort-terminvestorsto make adjustments to improve the likelihood of meeting financialobjectives.Long-terminvestorsarenot justat themercyof the investmentmarkets and their initial choice of investment strategy. Depending on theinvestor’s circumstances, financial disappointment “along the way” oftenleaves time to elicit a response, which provides extra degrees of freedomthatreduceriskintheabilitytomeetobjectives.Forexample,theremaybetime for a revision to the investment strategy, or for an individual topostpone retirement or to reduce current expenditure. For an endowment,

theremaybetimeforadrivetoraiseadditionalbequests,andforapensionfund,timetoraisethelevelofregularpensioncontributions.Theseoptionsprovide flexibility for the long-term investor that is not available to theshort-term investor. For any individual or foundation (or perhaps pensionplan) that relies on a regular injection of savings or contributions to fundfuture financial needs, variations in these sources of income are often amuchbiggersourceofriskandopportunitytomeetexpectedcommitmentsthanaremarketconditions.

FinancialplanningandthetimehorizonShort-term investorshaveaclear focuson total returnasameasureof thesuccessoftheirinvestmentstrategy.Long-terminvestorswilloftenfocusonthesamemeasure.However,asdiscussedinChapter3thisisunderstandablebutwrong.For example, it is common for individuals tohave a target foraccumulated savings before they feel able to retire.Over quite short timeperiods an amount thatwas broadly appropriate can become inadequate iflong-terminterestratesfall.Thekeyisnottheabsoluteamountofsavings,buttheabilityofthatamount,ifcautiouslyinvested,tosupporttheintendedlevelofretirementincome.Thisleadstoafocusonshortfallriskratherthanthe risk of generating a negative return. The benchmark for measuringshortfallistheperformanceoftheappropriate“safety-first”,strategy,andsoshortfallriskistheriskofunderperformingthatstrategy.

This is well understood and reflected in financial advice and the“laddered” bond portfolios of many cautious private investors in NorthAmerica.It ismuchlesscommon,however, in thegenericadvicegiventoinvestors elsewhere. Internationally, it is common for private wealthholdingsofbondstobeofshortduration.Oftenthisreflectsconcernsaboutthepotentialimpactofinflationandadesiretoavoidtheriskofshort-termnegative returns from volatile assets, even if they are government bondsguaranteedtodeliverasetamountatagivendateinthefuture.

OutsidetheUnitedStates,itiswidelybelievedthatlong-termbondsareinappropriate as investments for cautious private investors for whom theemphasisshould,itisargued,beoncontrollingabsolutevolatilityandshort-term capital preservation. However, this is the appropriate focus only for

cautious short-term investors. An error that often accompanies failure todesign risk-takingstrategiesappropriate toan investor’s timehorizon is toconfuse this time horizon with risk tolerance. The two should be treatedseparately.Therearecautious long-term investorsand thereareaggressiveshort-terminvestors.

“Safehavens”,benchmarking,risk-takingandlong-termstrategiesThe ability of government bonds to “lock in” objectives (by avoiding thedangerofhavingtosufferlessfavourableinterestratesatalaterdate)meansthat they have a benchmarking role in setting strategy for long-terminvestors. Where financial objectives can be precisely specified, thebenchmarkisaseriesofgovernmentbondsthatwouldprovideastreamofincometomatchtheobjective.Wheretheyarelongterm,butnotspecified,thebestbenchmarkand“safehaven”isalong-datedgovernmentbond.

A “safe-haven” investment strategy quantifies how much wealth isneededtodaytosecureorto“hedge”withreasonablecertaintyaparticularobjective at a chosen date in the future.Alternatively, it can tell youhowmuchcan,withconfidence,beaccumulatedbythatdatewithagivenlevelofinitialinvestment.

For cautious long-term investors, long-term bonds should normallydominate the investment strategy. However, when interest rates are verylow,cautious investorsneed toventureoutof their comfort zoneand takemore risk than usual. For more aggressive investors, the holding may bemuchsmaller,butgovernmentbondswillstillprovideareferencepointforcomparativemeasurementofthechoseninvestmentstrategy.

Thiscorereferenceroleforlonger-datedhighestqualitybondsisneededbecause theyenablecautious long-term investors tohedge the risk to theirfuture income and standard of living from adversemovements in interestrates.Reductionsininterestratesshouldbeoflittleconcerntoapensioner,orsomeoneapproachingretirement,whohasfollowedasufficientlyfundedandproperlyimplementedcautiouslong-terminvestmentstrategy.

ThedangerofkeepingthingstoosimpleHowever, formany investors,anoverridingdesire to“keep thingssimple”

may encourage them to indicate that they are content to be considered asshort-term investors, even though their objectives are longer term. This istheoption tobe treated as “absolute return” investors, forwhom the safe-haveninvestmentstrategyistobe100%investedincash.

The danger is that these investorswillmiss two important differencesbetweenshort-termandlong-terminvesting.Thefirstisthefocusthatlong-term investorsmust have on the price level and inflation uncertainty. Thesecondisthatsuchinvestorswillalsofailtodistinguishbetweenareductionin the price of future security (a fall in government bond prices) and areductioninthemarket’sassessmentofaninvestment’squality.

DeclinesinpricesaresometimesgoodforyouSometimesyoucanbesurethatafinanciallosscanbereversed.Pensionersliving off the income generated from a well-constructed ladder of high-qualitygovernmentbondscanrespondtoafallinthemarketvalueoftheirinvestmentportfoliofollowinganincreaseinbondyieldswithcomposure.Itshouldbeofnoconcern.Acreditworthygovernmentissuerwillkeeptheminthestyletowhichtheyareaccustomed.However,individualswhosuffera similar fall in investment value as a result of a downgrade in thecreditworthinessofacorporateorevengovernmentbond,onwhichtheyarerelying for pension income, might reasonably suffer sleepless nights,becausethereislessassurancethattheywillgetpaid.

For a short-term investor whowishes to realise objectives in the nearterm, either reversal should be viewed as if it might be a permanent losswhich could need to be realised. For a long-term investor, only the creditdowngrade should be of concern. Itmight be said that it is not the creditdowngradethatshouldconcernthepensioner,sinceitisonlyadefaultthatleads to a loss of income. But this is a classic case of the dangers ofmismeasuring risk. Investors lose sleep over their ability to support theirfuture standard of living a long time before most downgraded corporatebondsdefault.Abondladdercomprisingcorporatedebtthatstretchesmanyyearsintothefutureismorelikelytosufferworryingcreditdowngradesatsomestagethanactualdefault.

Volatilitywhich is reflected in a reduction in government bond prices

reducesthecostofbuyingfutureincome.Thisisunambiguouslygoodnewsforanyone saving forapensionoracollegeeducation, foranendowmentinvestingnewmoney tomeet futureneeds,or fora sovereignwealth fundtrying to balance the interests of today’s beneficiaries with those oftomorrow.Foralltheseinvestors,higherrealinterestratesmeanbothlowerbondpricesandbeingabletomeetmoreoftomorrow’sneedswitheachnewinvestment.

To achieve success as a long-term investor, this distinction betweengood and bad price declines should be accepted and reflected in how aninvestor responds to financial reverses. This is invaluable for privateinvestors, who often regard any loss as if it is bad news, when it mayrepresentanopportunitytolockinaccesstohigherfutureincome.

Alackofclarityaboutfinancialgoalscanencourageinvestorstofocuson inappropriate timehorizons.Theonepredictableconsequenceof this isinefficiencyintheimplementationofstrategy.Anexampleofthisoccursifprivate investors, whose appropriate focus is on the long term, behave asshort-term investors. They will fail to appreciate their vulnerability tochanges in long-term interest rates and to the gradual erosion of inflation.Any change in long-term interest rates is likely to bemisinterpreted,withpositive performance arising from only partial exposure to falling interestratesbeingseenas“goodperformance”(itisnot,itispoor,becauseitonlypartiallyhedged the fall in interest ratesandshouldhavebeenbetter),andnegativeperformanceowingtopartialexposuretorisinginterestratesbeingseenas“poor”,whenunderexposure to the safehavenof long-termbondsmay(dependingontheinterest-ratesensitivityofexistinginvestments)offeranopportunitytosecureahigherfutureincomewithexistingresources.

Afinanciallydisciplinedendowment fundor institutionmanagingcashflowobligationsoveranumberofyearsislesslikelytomaketheseerrors.The issue is that where the financial constraints are not naturally tight,market competition is not available to ensure that wealth is efficientlymanaged. Instead it requires deliberate decision-making and appropriategovernancetomakesurethataproperfocusismaintainedontheobjectivesthataresuitableforthetimescaleofeachinvestor.

Unexpectedinflation:yetagainthepartypooperThedistinctionbetweengoodandbaddeclinesinprices,whichdrawsonacademicresearchonequitymarketsdiscussedinChapter7,isausefuldevicetohelplong-terminvestorsunderstandtheimportanceofthepassageoftimeforthesuccessoftheinvestmentstrategy.Italsohelpsdifferentiatebetweenshort-termandlong-terminvestors.Strictly,so-calledgooddeclinesinpricesreferprimarilytothepricesofgovernmentinflation-linkedbondyields,suchasTIPS(TreasuryInflationProtectedSecurities).Thereasonisthatafallinconventionalgovernmentbondpriceswhichreflectsanincreaseininflationexpectations(ratherthananincreaseinrealinterestrates)isnotgoodnewsforaninvestor,foritindicatesanexpectedirrecoverabledevaluationintheworthofallnominalbondinvestments.Thisistheprocessthatexplainswhy,inmostcountriesforwhichtherearedata,bondsprovideddisappointingreturnsinthe20thcentury.

“Keep-it-simple”long-termassetallocationmodels“Diversify,diversify”assetallocatorsoftensay.However,indesigninglow-riskstrategies,whichshouldalwaysbethestartingpointforassetallocation,thefirststepshouldbetodesignthebesthedgetoneutraliserisksoffailingtomeet objectives. For some investors it is conceivable that this could beachieved through a single holding in a particular government bond. Anexample would be the acquisition of a long-term inflation-linkedgovernmentbondwhosematuritydatecoincideswithwhenayoungchild’suniversityexpensesareexpectedtobepayable.Diversificationbecomesanissue as an investormoves away from this “best hedge”.Any suchmoveneedstobemadeefficiently,whichwillcallfordiversificationofavoidablerisks.

Theshort-termassetallocationmodels(seeTables5.5and5.6attheendofthischapter)arerootedintheintellectualbreakthroughsofthe1950s,andgiven the flood of advances in finance since then could be described as“antediluvian”.Theyprovide an easy shortcut to thinking aboutmanagingthe risk of losing money. They assume that markets are “well behaved”(which they are not), they dealwith a single period (which is an unusualfocusforaninvestor),andtheyassumethatwealthisagoalinitselfandnotameanstoanend.

Sowhatdoesalong-terminvestmentplanlooklike,andhowshoulditbestructured?Itisnotawealthplan–itisalong-termincomeorspending

power plan. An income plan needs to take account of your financial andother assets, your likely earnings, your financial obligations and yourspendingplans.Thefirststepwillbe toestablishabasecase tosee ifyouare able to “hedge out” your obligations and plans, given your currentresourcesandcurrent levelsof interest rates.Todo this, financialadvisersneedtobeabletoaccesssophisticatedmodellingtoolsthatenableinvestorstomatch the profile of their investmentswith the likely schedule of theirpaymentobligationsinawaythathighlightsthelowrisk(buthighexpense)of followinga“fullyhedged” investmentstrategy. It shouldshowhowtheexpected cost may fall (with an accompanying danger of accumulating ashortfall from financial objectives) as strategymoves away from the fullyhedgedposition.

A flavour for thedifferences in strategy from the short-termmodels isshowninTable5.4andFigure5.1.Thefocusisnowontheriskofshortfallsfrom the fully hedged strategy instead of the risk of negative returns. Soinsteadofshowingtheexpectedreturnanditstrade-offwiththevolatilityofthat return, the focus is on the expected surplus or deficit in meetingobjectives,ascomparedwiththeminimumriskofafullhedginginvestmentstrategy.The“modelstrategies”forlong-terminvestorsareshowninTable5.4. Note that Figure 5.1 assumes that even a most cautious long-termstrategyislikelytoinvolveariskoffallingshortoffinancialobjectives.

TABLE5.4Stylisedmodellong-termstrategies,withonlystocks,bondsandcash

Source:Author

FIG 5.1 Stylised surplus risk and opportunity for long-term investors, stylisedapproachExpectedsurplus,%peryear

Source:Author’scalculations

Shouldlong-terminvestorsholdmoreequities?The discussion about stockmarket bubbles in Chapter 4 reintroduces thequestionofwhetherstockmarketriskisreducedwithtime.Forifboomsandbustsinthestockmarketpredictablyfolloweachother,itmaybepossibletoprofit from thispattern.However, ifwedoubtourability to timemarkets,eventhoughwebelieveinmarketcycles,thispredictablecyclicalnatureofequity returnswill reinforce the case for a somewhat higher allocation toequitiesforlong-terminvestors(whichisincorporatedinTable5.4).

Anumber of studies, notablyby JeremySiegel inStocks for theLongRun,havesuggested thatover longholdingperiods(forexample,30yearsormore)aninvestormightbemoresure,oratleastlessuncertain,ofwhatafter-inflationperformance to expect fromequities than fromconventionalgovernmentbonds.Thisbuildsontheexperienceofthe20thcentury,whentheimpactofunanticipatedinflationmadecashandbondsmuchriskierforholding wealth over long periods than shorter-term experience wouldsuggest.TheevidencethatSiegelusestosupportthiscomesprimarilyfromthe United States, but it also appears to be supported, almost without

exception, by international data. Taken together, these would suggestskewing,atleasttosomeextent,theinvestmentstrategyallocationforlong-terminvestorstowardsequitiesandawayfrombondsforcautiousaswellasaggressiveinvestors.

However,hemakesclearthatalthoughthismodeldoesreflecttheeffectthat unanticipated 20th century inflation had on the investments inconventionalgovernmentbondsandcashofcautious investors, itdoesnotincorporatethepotentialroleofinflation-linkedgovernmentbonds.

Theintroductionof inflation-linkedgovernmentbondshaschangedtheground rules for long-term investment strategy in the 21st century. Long-terminvestorsmayhavemedium-termaswellaslong-termobjectives,andoften, especially with private wealth, unexpected opportunities orrequirements to draw down investments arise. Taken together with theinsightsofbehaviouralfinanceintolossaversion,thissuggeststhatitisnowneither necessary nor desirable to recommend high equity allocations forlong-termcautiousinvestors.However,iflong-termcautiousinvestorshaveconfidenceintheequitymeanreversionstory,especiallyiftheyhaveaccesstoothersourcesof income, theymight reasonablyholdmoreequities thanwouldberecommendedforcautiousinvestorswithashorttimehorizon.

Inflation,againThere is no role for cash in the long-term models in Table 5.4. This isbecause cash is volatile relative to the safe haven (inflation-linked bonds)and it normally offers no performance advantage. At the same time, thefuture relationship between inflation-linked bonds and conventionalgovernmentbonds is sensitive toviewson inflation. It shouldbe assumedthattheseinflationriskscannotbeproperlyreflectedinanysetofmodellingassumptions, and that it will be necessary to rely heavily on judgmentalopinions. Furthermore, the judgments of “experts” should probably notcount for more than the views and experiences of informed investors onissues such as inflation expectations. However, the apparent views of thefinancialmarketsonthebreak-evenrateofinflationshouldalwaysbeusedasapointofcomparison.

Views on expected inflation and the uncertainty about future inflation

shouldbereviewedfromtimetotimewiththehelpofsomesimple“what-if” illustrations for the price level at different dates in the future. In thestylisedmodel for long-term investors shown inTable 5.4, a keydecisionwillbetheextenttowhichtheholdingsofgovernmentbondsshouldbeintheformofinflation-linkedorconventionalbonds.

Ladderedgovernmentbonds:ausefulsafety-firstportfolioA bond ladder is a portfolio of bonds with staggered maturity dates. Itsecuresastreamofincomeforyearsahead,anditreducestheriskofsuddenchanges in that income resulting from interest-rate changes.As eachbondmatures, it will need to be reinvested at prevailing interest rates and thisexposes the income from the ladder to a margin of uncertainty. But thisreinvestment risk applies only to an individual rung of the ladder as itmatures.Itcantakejudgmentoutoftimingmovementsinlong-terminterestrates and reduce uncertainty in a pensioner’s future income. Spreadingmaturities allows more reinvestment opportunities and less exposure toregretatthetermswithwhichanyparticularbondwasreinvested.Agreaternumberofbondissuesalsoenableseffectivemanagementofdifferenttypesofriskexposure(seebelow).

The danger of having to reinvest at lower interest rates than prevailedwhen thematuring bondwas purchased could have been avoided if a lifeannuity had been purchased instead of a bond ladder (though complicatedtaxissuesariseiftheannuityispurchasedwithtaxablesavings).However,the laddered approach is more appealing to many investors than a lifeannuityas itgivesgreatercontrolover theirwealthandavoids theneedtolockinasinglelong-termrateof interestonthedaytheypurchasethelifeannuity. Although a ladder does involve reinvestment risk, it also offersreinvestmentopportunity,namelythechancetoreinvestatmorefavourableinterestratesatalaterdate.

Thiscanprovideanelementofinflationprotectiontoretirementincome.Ifindividualsdecidetobuyafixed-incomelifeannuityratherthaninvestina bond ladder, theywill bewholly exposed to anyunexpected increase ininflation for the rest of their lives.However, if an increase in inflation isexpected to persist, bond yieldswill be higher, and the rungs on a fixed-

incomebondladderwillbereinvestedat thenewhigherrateof interest.Ifan investor expects interest rates to rise, but is not sure when they will,having to reinvest maturing bonds allows income to be “averaged up” ifrates do rise over time. If the objective is to secure a steady income, thisprospectofsecuringahigherincomeshouldmattermorethanthetemporarydipsincapitalvalueoftheexistingbondsasratesriseaheadofmaturity.

This degree of inflation compensation is incomplete and less effectivethan what could be offered by inflation-linked government bonds.Furthermore,reinvestingaconventionalmaturingbondwillalways,iftherehas been any inflation, support a lower standard of living than when thebond was first purchased. Nevertheless, this partial element of inflationcompensation in a bond ladder, in conjunction with the flexibility anddiscretionthat it leaves the investor,willbeanappealingfeatureformanyinvestors.

A bond ladder is designed to mitigate interest-rate risk and it shouldencourageaproperunderstandingof thedistinctionbetweengoodandbaddeclinesinprices.Thisisbecauseaninvestorwillfinditeasiertorespondtoafallingovernmentbondpricesasanopportunitytolockinhigherincomewhen the next rung on the ladder matures. However, if the cause of thedecline in investment values was a downgrade in the credit quality of acomponentrung, theresult is likely tobe,at least,aworried investoruntilthebondmatures.

For this reason, ladders should be constructed from government(including high-quality municipal) bonds. With good-quality longer-termcorporatebondsthereisalwaystheriskofadeteriorationincreditquality,and this risk obviously increases with longer maturity bonds. Whenconstructing a long-term bond ladder designed to provide dependableincome, it is safest to assume that there is no such thing as a blue-chip,entirely reliable corporate credit risk. For example, a US dollar corporatebond ladder built up in the initial years after 2000 would probably haveincluded largeexposures to several thenhighly rated financial institutions,including banks as well as AIG, an insurance company which had to berescuedby theUSgovernment in2008. (SeeChapter8 forhowcorporatecreditriskevolvesovertime.)Aninvestorwhowishestotakeadvantageof

the higher yields available from assuming credit risk should follow aprofessionallymanaged approach to investing in credit risk and forgo theconceptofabondladder.Investorscanseesampleportfolios(forexample,mutualfundportfolios)ofthemosthighlyrespectedfixed-incomeportfoliomanagers.Thesewill show that credit risk iswell diversifiedwithmodestexposures to individual institutions. A bond ladder gives much lessopportunityforsuchdiversification.

Inpractice, buildingabond ladderofhigh-qualitybonds togenerate asecure flow of income stretching over a number of years is mostlyassociatedwiththeUSmunicipalbondmarket.Thisimmediatelyintroducescredit-qualityconcerns.Buildingabondladderinvolvesaseriesofchoices(whichmaybemore limited thanwouldbewished)andusually trade-offsbetweenwhatisdesirableforabuy-and-holdapproachtoinvestingandwhatisavailable.Bondladdersneedtobeconstructedwithcare, takingaccountofthetaxstatusofdifferentissues,creditrisk,theexistenceofcalloptionsthat enable the issuer to repay the bond early, and the costs that may beincurrediftheinvestordecidestosellthebondbeforeitsfinalmaturitydate.

Bondladders,taxandcreditworthiness:thecaseofUSmunicipalbondsAt the end ofMarch 2013,US state and local authorities had outstandingobligationsintheformofdifferenttypesofmunicipalbondsof$3.7trillion,making the “muni”market approximately one-third of the size of theUSTreasurymarket. Themarket is highly diverse with, according to a 2012Securities and Exchange Commission (SEC) report, close to 44,000 stateand local issuers and over 1m different municipal bonds outstanding in2011.Thisheterogeneitycontributestoilliquidityinthemarket(seebelow).The municipal bond market is attractive to US taxable investors becauseinterestonmunicipalbondsisgenerallyexemptfromfederalincometaxandfrom state and local tax in the issuing state. (Interest onUSTreasury andgovernmentagencybondsissubjecttofederalincometaxbutexemptfromstateincometaxes.)Thismakesthemunicipalbondmarketanaturalhabitatfor the taxable savings of US private investors. According to the SEC,individuals owned around 75% of outstanding municipal bonds in 2011,

witharound50%helddirectlyand25%heldthroughmutualfunds(orotherinvestment vehicles, such as closed-end funds or exchange traded funds –ETFs).

There are the twomain types of tax-exemptmunicipal bonds: generalobligation bonds and revenue bonds.General obligation bonds are backedby the full faith and credit of the issuer and are usually supported by theissuer’s tax-raising powers. By contrast, revenue bonds are serviced fromspecific projects or businesses that have been funded by the bonds. If theproject fails to generate sufficient income to service the debt, thebondholders have no access to other sources of revenue of the issuingauthority. Other highest quality municipal bonds include those where theoriginalissueis“refunded”orcollateralised,forexamplewithUSTreasurysecurities.

Before the 2007–08 credit crisis, as well as having tax advantages,investment in municipal bonds was aided by the role of the insurancecompanies,withjustunder60%ofthevalueofnewissuesin2004–07beinginsured, according to the SEC. Following the credit crisis, insurancecompanieshavegreatlyreducedthisserviceandin2009–11theproportionof the value of new issues insured fell to an average of 17%. This hascoincided with growing concerns about the credit quality of issuers,increasing both the burden of due diligence on investment advisers inrecommending specificmunicipal bonds to investors and the attraction ofinvesting inmutual fundsmanagedbywell-resourced teamsofanalysts. Ithas also shifted perceptions of creditworthiness: revenue bondswhich aresecured by predictable high-quality projects or business activities havebecomerelativelymoreattractiveastheroleofinsurancehasdeclinedanddoubts about the “full faith and credit” of some issuers backing generalobligationbondshaveincreased(seebelow).

In 2009–10 a new type ofmunicipal bondwas issued, encouraged byfederalgovernmentsubsidies:the“BuildAmericaBond”orBAB.However,unlikemostmunicipalbonds,BABsarenotexemptfromincometax,andsoareofmoreinteresttoinstitutionalinvestorskeentodiversifytheirexposuretonewissuersthantotaxableprivateclientinvestors.

Rulesofthumbarenormallyusedtocomparetax-exemptmunicipaland

Treasury bonds, such as a comparison of the difference in yieldswith theinvestor’staxrate.(Inaccuracieswiththisapproacharisebecauseofinterestcouponreinvestmentriskandthetaxthathastobepaidonthecouponofthetaxable bond.)A key indicator is the ratio of the yield on highest qualitymunicipal bonds to that on US Treasuries of similar maturity and acomparisonofthatratiowiththeinvestor’staxrate.AnindicationisgiveninFigures5.2and5.3.

FIG5.2ComparisonofmunicipalandUSTreasurylong-datedbondyields%peryear,Jan1992–Sep2013

Source:Barclays

FIG5.3Long-datedmunicipalbondyieldsasapercentageofUSTreasuryyields%,Jan1992–Sep2013

Source:Barclays

In practice, a number of factors need to be assessed for individualmunicipalbonds:

Thecreditworthinessoftheissue.

Theavailabilityofcreditenhancement,suchasinsuranceorcollateralisation.

Liquidityandtheeaseofsellingabondinthemarket.ForTreasurysecuritiesthiswillnotbeafactor,butformanymunicipalbondissuesthetransactioncostscanbeconsiderable.

Whetherthemunicipalbondissuehascallprovisionsthatenabletheissuertorepaythebondearly,atparorataspecifiedpremiumtopar.Callprovisionsunderminetheusefulnessofabondaspartofaladderintendedtosecurefutureincome,becausethebondwillbecalledwhenitsuitstheissuer,nottheinvestor.Callprovisionsalwaysunderminetheinterestsofinvestorsandprovideavaluableoptionfortheissuer,soacallablebondshouldofferinvestorsahigheryieldthananon-callablebond.

Severalofthesefactorshelptoexplainwhythemunicipalbondmarkethasoftentradedathigheryieldsthanmightbeexpectedbysimplymakinga

comparisonwiththeUSTreasurymarketandprevailingtaxrates.Thiswasexacerbatedafter2007(seeFigure5.3).

The dramatic change in the relationship between US Treasury andmunicipalbondyieldsin2008wasoneaspectoftheflighttoliquidityandquality in financial markets. Historically, losses from the municipal bondmarkethavebeenmodest.Moody’s, forexample, reports that theone-yeardefault rate for Moody’s-rated municipal issuers was a low average of0.030%forthefiveyearstoend2012,comparedwithjust0.009%for1970–2007. By comparison, in Chapter 8 research is cited which reports anaverage annual default rate on corporate bonds of around 1.5% over 150years(withactuallosses,afterallowingforamountsrecoveredforinvestors,aroundhalfthatamount).Evenafterthe1994bankruptcyofOrangeCounty,California,municipal bond investorswere repaid in full, with reassurancemeanwhile having been provided to investors by insurance companiesstandingbehindanumberof thebonds thatwouldotherwisehavebeenatrisk.

Thechangedrelationshipbetweenyieldsonmunicipalbondsandyieldson Treasury securities primarily reflects increased concerns about thecreditworthinessofstateandlocalissuers.Italsoreflectsthewithdrawalofinsurance for municipal bonds and increased illiquidity in the municipalbond market. In its initial stages in 2008 and 2009, the spike in yielddifferentials(seeFigure5.3)wasexacerbatedbyforcedsellingbyleveragedinvestors in the illiquidmunicipalbondmarket.Creditworthinessconcernshave been heightened by the well-publicised financial difficulties of anumberofmunicipalities,downgradesbytheratingagenciessince2008andtheJuly2013bankruptcyfilingbytheCityofDetroit,withdebtsinexcessof$14billion.

These issues present challenges for advisers constructing bond laddersthat are intended to provide dependable income over many years forinvestors.Thepreferredwaytoestablishaladderisgradually,overtime,aspartoftheprocessofportfoliodiversification,forexamplebydivertingcashflowfromearningsorassetsalesintheyearsbeforeretirementandbuyingindividualbondsfromtimetotime.Therearealwaysconcernsthatthebestyieldisnotbeingachieved,butthisisnotasufficientreasontodelaylaying

thefoundationsforasecureincome.Inestablishingthebondladder,creditriskcanbemanagedbut itcannotbeavoided(unless,arguably, the laddercomprisesonlyUSTreasuryissues).Itisnormallytaxefficienttofocusonmunicipalbondsissuedbytheinvestor’shomestate,asthesewillbeexemptfromstateaswellasfederalincometax.However,statessuchasFloridaandNevada do not levy personal income tax, making their municipal bondsattractive for out-of-state investors seeking to diversify issuer risk.Furthermore, investorsmaychoose topayout-of-state incometax toallowfurtherdiversificationofissuerrisk.Revenuebondsprovideafurthersourceof diversification, which for more secure “essential revenue issues”(typically tied to utility earnings) can attract high credit ratings. Revenuebondsincludenicheswhereunusuallyattractiveyieldswithlittlecreditriskmaypersistbecausetheissuesaretoosmalltobearbitragedawaybylarge-scaleinvestment,butmaysuitindividualbuy-and-holdinvestors.Thisisanareawhereduediligencebyaskilledadvisercanpaydividends.

Historically, the difference between US Treasury and municipal bondyields has been most marked for longer maturities. As a result, the termstructureofthemunicipalbondmarkethasoftenbeensteeperthanthatforUSTreasuries.Thisisamostattractivefeatureforaladdered,buy-and-holdapproachtoinvestinginmunicipalbonds.

Municipalbondladders:theimpactofthecreditcrisisandultra-lowinterestratesSince2008,investorsintheUSmunicipalbondmarkethavebeenbuffetedbythedemiseofinsurance,concernsaboutthecreditqualityofissuersandultra-low interest rates. Investors have responded to this by altering howtheyinvestinmunicipalbonds.Thefirsteffecthasbeenonunadvisedretailclients,who–whentheybuyindividualbonds–seemincreasinglytohaveboughtshortermaturityhighestquality issues.Asecondeffecthasbeentoencourage reliance on third-party due diligence (particularly following thedemiseofinsuredbonds)andsoagreaterinvestmentinmanagedaccountsandmunicipal bond funds, includingETFs. In turn, themanagers of suchbond funds, conscious of the need to honour redemptiondemands, have astrong preference formore liquid, high-quality – but not necessarily short

maturity – municipal bonds. This has left a significant segment of themunicipal bond market where advised investors can find high-quality,relativelyinexpensivebutilliquidmunicipalbondswhicharebestsuitedforabuy-and-hold-to-maturityinvestmentaspartofabondladder.

At each month-end between September 2012 and April 2013, theredemption yield on the Barclays 20-year municipal bond index was lessthan 3%, and it averaged 2.8%.This posed a challenge for investorswhoneeded to reinvest the proceeds of maturing bonds from a bond ladder.There was anecdotal evidence of investors looking for short-term liquidhomes for their cash, such as short-dated municipal bond mutual funds,while agreeing with their advisers threshold yields at which they wouldconsiderre-enteringthemarkettorebuildadependablesourceofmedium-orlong-termretirementincome.Suchyieldsappearedtohavestartedtobemetinthesummerof2013.However,theoverridingmessagefromtheperiodofultra-lowinterestratesshouldbethatthemechanismofahigh-qualitybondladder is a good way to secure retirement income. The more generousincomeyieldsonofferinpreviousyears,andmaintainedforthelifeofthebonds, would have avoided precipitous declines in investors’ income formanyyears.Thisisthecorevalueofagovernmentbondladdercomprisinghigh-qualityissueswithstaggeredmaturitydates.Manycautiouspensionerselsewhereintheworld,sufferingdiminishedincomefromtheirinvestmentsafter2008,wouldhavebenefitedfromtheadvicegiventolargenumbersoftheirAmericancounterparts,whofacedessentiallythesameissueofhowtosecureareasonablystableretirementincome.

What’sthecatchinfollowingalong-termstrategy?At the time of writing, the “worst” month for the US TIPS market wasOctober 2008. In that month the yield, according to the US Treasury, onlong-dated (ten-year-plus) TIPS increased by 0.6% to 3.4%, and theBarclays Capital index of this part of the market showed a monthlyperformance of –10.7% (in May and June 2013 results almost as “poor”were recorded). For an investor funding a pension plan from regular cashcontributionstoinflation-linkedgovernmentbonds,suchanincreaseinyieldand reduction in price, if taken in isolation, is clearly good news as it

enables each contribution at the lower price to purchase more pensionentitlement. This is at the heart of the distinction between good and badprice declines. For cautious long-term pension investors who werecontinuingtocontributetotheirsavingsplan,theOctober2008increaseinreal yields and fall in bond prices should not have been a concern, eventhoughwith hindsight theymay regret not postponing purchases until thehigheryieldswereonoffer.But it is normallywishful thinking tobelievethattheymighthavebeenabletosucceedatsuchmarkettiming.

However,themostimportantfeatureofshort-termandlong-termmodelsisthatthereisafundamentaldifferenceinstrategydesignforcautiouslong-term investors and cautious short-term investors. These are not smalldifferences that can be ignored: there is an essential difference betweenstabilising the incomethatcanbegeneratedfroman investor’swealth, theobjectiveforacautiouslong-terminvestor,andstabilisingthevalueofthatwealth,theobjectiveforacautiousshort-terminvestor.

Markettiming:anunavoidableriskWhatever strategy is being followed, from time to time it is likely thatinvestorswillbepersuadedoftheneedtochangeinvestmentdirection.Buttheprocessofchangingstrategyisfraughtwithriskfor investors.Thereisoftenlittleadviceavailableonhowtodecidewhentochangestrategy.Forlarger institutional investors, investmentmanagers and consultants providemuch advice on how to insure against bad outcomes and how tomanagetransactions costs once an investor has decided when to change strategy.However,thereislittleprofitforanadviserinansweringthekeyquestion:“When?” But for all investors this is a crucial issue in managinginvestments.

Implementingstrategychangeinvolvesunavoidablemarkettiming.Youknowyouhave toget fromA toB,buthow toget there, andparticularlywhentogetthere,requiresjudgmentsaboutmarkettiming.Thesehavetobebalancedagainsttheknowledgethatyourinvestmentriskprofileisnotwhatyouwantittobe(whichiswhyyouwanttochangestrategy).

Asimpleruletofollowisthatifinvestorsdecidethattheirriskprofileistoo aggressive, they should move to the new, more cautious strategy

promptly, perhaps allowing a small amount of time for trying to predictmarketmovements,butwithlittleconfidencethatthiswilladdmuchvalue.Such investors should not let seeming confidence in short-term marketforecastsextend theperiodduringwhich their riskprofile is inappropriate.This is easily stated and perhaps more easily applied in the case of aninstitutionratherthananindividualorafamily.Thisisbecausediscussionsaboutrisktolerancearerarelyseparatedfromviewsonmarketprospectsindiscussionswithfamilies.

However,forallinvestors,withineachfour-orfive-yearperiodthereisasignificantchancethatcircumstancesmayforceachangeofdirection.Theobviousgroupofinvestorsforwhomthismightnotapplyiswell-resourced“perpetual” endowments (such as some sovereignwealth funds, universityfoundations and charitable endowments). Adjustments to strategy involvetakingviewsonmarketsand,typically,asignificantdegreeofregretrisk.

Therealissueisnotthatmarkettimingcannotbeundertakenskilfullyorprofitably: it can. There are some investment managers whose skill inmarket timing hasmanifested itself over time.But these track records arenotbuiltbyone-off“bettheranch”decisionsonthetimingofcorrectionstoinappropriate risk profiles. They are carefullymanaged and,within limits,diversified. Changing strategy is different. There is normally no way todiversifytheinvestmentdecisionortogivemeaningfultimetoprofitfromthecorrectionofperceivedmarketanomalies.

It is often suggested that phasing implementation of a change ininvestment strategy from one asset class to another is the best way toproceed ifan investorhas tochangestrategy.The investor is likely tofeelmorecomfortablewiththisapproach.Butthestrongargumentinfavourofimmediate implementationofchangeis that ifan investorhasdecidedthatthe risk of the current investment strategy is excessive, any delay extendsunnecessaryrisk-taking.Whenfacedwiththeneedtomakesuchadecision,therearealwaysreasonswhynowisnotthebesttimetoact.

Some“keep-it-simple”concludingmessagesThemodelallocationsdescribedinthischapteraresimplifiedandwilloftenneed tailoring to suit an individual investor’s needs as well as to market

circumstances.Buttheygiveaflavourofwhatstrategymightlooklikeiftheavailable investments comprised only cash, domestic conventionalgovernment bonds, domestic inflation-linked government bonds anddiversifiedequities. Inmanycases, appropriate“keep-it-simple” strategies,consisting only of these investment classes, can be constructed for thefinancial needs of investors. Actual investment holdings can then deviatefrom these to reflect, within agreed limits, views on the cheapness anddearnessofmarkets.

Inpractice,most investorswill spendmuchmore timefocusingon thedetailofimplementation,whichinvolvesdeparturesfromthiskeep-it-simpleapproach. How much should go in hedge funds? Isn’t finding the rightmanagermore important than the right hedge fund strategy? Surely valuewill outperform growth? Is high yield too risky? What about emergingmarkets?Andsoon.

Despite the time that most investors spend on these issues, the mostimportant one is the extent to which obligations or spending plans arehedged and future income secured.Thekeep-it-simple framework ismorethanadequatetoaddressthesefundamentalissues.Whatisoftenthoughttobethemoreexcitingmaterialaboutthedifferentassetclassesiscoveredinthe second part of this book. When reviewing these more exciting andsophisticatedopportunities,akeyquestion tokeepasking is:howwill thisproduct perform in “bad times”when reliable diversificationwill bemostimportanttome?

ThechanceofabadoutcomemaybehigherthanyouthinkWhatisa“badoutcome”or“minimumacceptablereturn”(MAR)forshort-terminvestors?Acautiousshort-terminvestorwillbelesstolerantofshort-termlossesthananaggressiveinvestor.Forunaggressiveshort-terminvestors,ithasbeenarbitrarilyassumedthatthemeasuredriskofanegativereturnofworsethan–5%inanyparticularyearshouldbenogreaterthanonein20.ThisisthetargetMAR.Formoderateriskshort-terminvestors,theMARisassumedtobe–10%andforaggressiveshort-terminvestors–15%.Inprinciple,anyfigurecanbeselected,butwhateveritis,thecalculatedprobabilityofbreachingmaybeonlyonein20inanyparticularcalendaryear;however,overfiveyears,forexample,theprobabilityofbreachingtheguidelineinatleastoneofthesefiveyearswillbemorethanoneinfive.If,asismostprobable,theinvestor’sportfolioismonitoredmorefrequentlythanonceayear,sayattheendofeachmonth,theprobabilityofatleastonebreach,measuredonthebasisofrolling12-monthperiods,willbecloserto50%.(NotethattheMARprobabilityrefers

tothechanceofanoutcomeworsethanthespecifiedparameterinaparticularcalendaryear.)Thesethingshappenandarenotsurprising,evenifyouthinkthataone-in-20riskisaremoterisk.Arealproblemforadvisersisthatinvestorsmaythinkthatsuchapooroutcomeisunlikelytohappen,whichplacesaparticularresponsibilityoninvestoreducation.

Havingselectedthesetolerancesforlosses,intheorywecandesignshort-termmodelstrategiesthatgivethebestprospectforwealthgeneration,giventheseguidelines.Thesewouldbetheconventionalefficientportfoliosthatareoptimalforeachindicatedlevelofrisk-takingbyshort-terminvestors.Efficientportfoliosgivethebestpossibletrade-offofexpectedriskandexpectedreturn.Foranygivenlevelofrisk-takingthereis,intheory,onlyoneoptimalportfolio.Itwouldbeimpossibletoachievehigherexpectedreturnswithnoincreaseinriskanditwouldbeinefficienttopursuethesamereturns,butathigherrisk.Inpractice,theuncertaintiesdiscussedinChapters2and3meanthatthisdoesnotworksincewecannotpreciselymodeluncertainty.Wemayexpectthataparticularoutcomeisunlikely,butwegenerallydonotknowwithanyprecisionhowunlikelythatresultis.

AconsequenceofthisisthattheseindicatedMARriskfigurescansupportarangeofverydifferentstrategies,andtheintentionwouldoftenbetomanagethestrategytoalowerlevelofrisk-takingthanindicatedbytheMAR.Considerthethreeillustrativeshort-termstrategies,usingonlystocks,bondsandcash,showninTable5.5,whichhavestylisedallocationstostocksincreasingfrom20%to50%andthento75%.Theallocationofnon-equityinvestmentsisdividedbetweenover-ten-yearUSTreasurybondsandcash.

TABLE5.5Modelshort-terminvestmentstrategies,withonlystocks,bondsandcash:historicalperspective

aIndicativeallocationsbetweenbondsandcashforshort-terminvestorssensitivetodurationofbondbenchmark.

bGeometricaverages.cSeetextcommentsonriskofmorefrequentoccurrencesofdisappointingreturns.Sources:UnderlyingdatasourcedfromBarclays;Dimson,MarshandStaunton;MSCI

Table5.5showstheaveragereturnforeachstrategybasedonthehistoricalperformanceofmarketindices,beforeallfeesandexpenses,since1900usingdatafromDimson,MarshandStaunton.Italsoshows,basedonhistoricalrelationships,thesortofreturnsthatmightbeexpectedinadisappointingyear.Forexample,themoderatestrategyindicatesthatareturnof–8.4%,orworse,shouldbeexpectedwithnomorethanaone-in-20chanceinanyparticularyear.Theback-testingofresultsusingmonthlydatasince1991showsthatmuchlargernegativereturnswouldhavebeenrecordedintherecentpastwithsucha“moderate”strategy,withmarketindicespointingtoanegativereturnof20.5%inthe12monthstoFebruary2009.

Thisillustratesthatactualexperiencecanfromtimetotimebealotworsethanwouldbesuggestedbythepastaveragestatisticsforoverallreturnsandvolatility.Themorecomfortingfiguresareprovidedbyroutinelyusedmodellingexercises.Thesesufferfromsevereaveragingdifficultieswhichsuggest,forexample,thatstockmarketvolatilitystaysatoneaveragelevel.Itdoesnot,and,as2008demonstrated,theworstnewsarriveswhenthisisleasttrue.Moreparticularly,theriskfiguresareunderminedbythe“surprising”frequencyofextremereturns–bytrendingormomentuminmarkets,andbythefactthatattimesofstress,“normal”relationshipsbetweendifferentmarketsmaynothold.

TABLE5.6Modelshort-terminvestmentstrategies,withonlystocks,bondsandcash:forward-lookingperspective

aIndicativeallocationsbetweenbondsandcashforshort-terminvestorssensitivetodurationofbondbenchmark.

bSeetextforderivationofexpectedreturns.cSeetextcommentsonriskofmorefrequentoccurrencesofdisappointingreturns.

cSeetextcommentsonriskofmorefrequentoccurrencesofdisappointingreturns.Source:Author

Table5.6replacesthehistoricalstatisticswithforward-lookingstatistics,baseduponstandardassumptionsthatflowfromChapter3.Theexpectedreturnsareanchoredontheten-yeargovernmentbondyield,takenas3.0%.(Cashisexpected,overtime,toyield0.5%lessthanten-yearbondsandequitiesareexpectedtoearnanarithmeticaveragereturnof4%aboveten-yearbonds.Correlationsandvolatilitieshavebeenestimatedusingdatasince1900.)

FIG 5.4 US stocks, bonds and cash: “efficient frontier” and model allocations for“short-term”investors

Source:Author’sillustrations

ThelowerslopeofthelineinFigure5.4indicatesaslowerfuturerateofaccumulationoffinancialwealththatisbeinganticipatedbymostfinancialexperts,whereasthehigherslopeshowsaverageperformancesince1900.Thesedifferenceshaveasignificantimpactonthelikelihoodofachievingdistantobjectives.

“Modelsbehavingbadly”Weknowthatweshouldexpectinvestmentmodelstoperformpoorlyfromtimetotime,andthatsurprisingthingshappensurprisinglyoften.Butweknowmorethanthis.Onethingisthatattimesofcrisisandflighttoquality,badnewsinfectsallriskassets,anddiversificationamongriskassetsprovideslessprotectionthanwashoped.Another,againstwhichinvestorsshouldalsobealertedinadvance,isthatstrategieswhichareintendedtohavemodestvolatilitymaybeparticularlypronetodisappointingsurprises.

Everyoneknowsthatthestockmarketisvolatile,andsonooneshouldbesurprisedthatthestockmarketsufferssharpsetbacksfromtimetotime.However,ournotionofapoor

thestockmarketsufferssharpsetbacksfromtimetotime.However,ournotionofapoorinvestmentresultisconditionedbyourexpectationofthelevelofvolatilitythatisbuiltintoaninvestmentstrategy.Ashockingresultforacautiousstrategyisasmallershortfallthanasurprisinglypoorresultforavolatilestrategy.

Acautiousinvestmentstrategyprovidesanaturalhabitatforlowvolatilityriskassetsthatoffertheprospectofasurprisinglyattractiveratioofperformancetovolatility(knownastheSharperatio,seeAppendix1).ThefraudulentdeliveryofstockmarkettyperewardsforminimalapparentvolatilitywasthemainattractionoftheMadoffscam(seeChapter1).Butmanylegitimateinvestmentstrategiesofferattractivepay-offsbetweenmeasuredvolatilityandreward.Thechallengeconfrontinginvestmentadvisersistoassesstheextenttowhichtheyunderstandthesestrategiesandwhetherpastvolatilityadequatelycapturestherisksthatmattertoinvestors.

Manylowvolatilitystrategiesindirectlyofferinsurancetosomeoneelseandareineffectoption-writingstrategies,whichcollectasteadypremiummostofthetimebutthenoccasionallysufferlargelosses.Anumberofhedgefundstrategiesfitthisdescription,andgroupsofhedgefundsoccasionallyperformpoorlytogether(seeChapter9).Lessobviously,corporatebondsalsofallintothiscategory,sinceanindividualcorporatebondcanbeseenasacombinationofagovernmentbondandanoption(forwhichapremiumyieldisreceived)providedbythebondinvestortoothercreditorstoreimbursethemintheeventofdefault.Providingthisinsurancebecomesmoreofaliabilitytoinvestorsasequityvolatilityincreases(asitdidin2007–08,seeFigure4.1),andsoweshouldnotbesurprisedifcorporatebonds,asagroup,performparticularlypoorlywhenstockmarketvolatilityincreases.Generalisedincreasesinriskaversioncanleadtoincreasesinthespreadofferedoncorporatebonds,causingthemtounderperformgovernmentbondsbysurprisinglylargeamountsandbyamountswhichmorethancompensateforthesubsequentexperienceofdefaultoncorporatebonds(seeChapter8).Manycautiousinvestmentstrategies,whichalmostinevitablyreachforyieldbeyondthatofferedongovernmentbonds,includethistypeofexposureanditisareasonwhycautiousstrategiesmaybepronetoperform“surprisingly”poorlyin“badtimes”,whencautiousinvestorswillparticularlyvaluesafety.

Theperformanceofcorporatebondsandmanycautiousinvestmentstrategiesin2008–09fitthispattern.Itisnowconventionalwisdomthatmarketreturnsare“fattailed”andthatsurprisingperformancehappensmoreoftenthanvolatilitynumbersalonewouldsuggest.Oneissueisthatvolatilityitselffluctuates,asnotedinChapter4,andattimesofhighvolatilityitshouldbenosurpriseifthebestandworstperformanceresultslookmoreextremethanwouldnormallybeexpected.Anotheristhatwithagivenlevelofvolatility,therange,or“tails”,ofthedistributionofreturnsismoreextremethanwouldbeexpected(ifitfollowedanormalpattern).Thisiscaughtbyastatisticalmeasurecalled“kurtosis”(seeAppendix1).Excesskurtosishasavalueofzerointhenormaldistributionassumedbymostinvestmentmodels.Table5.7showshowvolatilityandexcesskurtosischangedafter2006forUSmarkets(asimilarpatternisshownbyUKandeuro-zonedata).

TABLE5.7USandglobalcapitalmarkets:volatilityandexcesskurtosis

Note:TRmeanstotalreturn;GRmeansgrossreturn.Source:DerivedfromBarclaysandMSCIindexdata

ThehighlighteddataforexcesskurtosisinTable5.7indicatethatthepatternofextrememonthlyreturnsincapitalmarketswasmuchmore“surprising”intheUSandglobalcorporatebondmarketsthaninequitymarkets,includingthoseofemergingmarkets,eventhoughtheysufferedmuchlargercumulativedeclinesin2008.Thisisconsistentwiththeexperienceofmanyapparentlycautiousormoderateinvestmentstrategiesin2008,whoseinvestorsmightreasonablyhavesaidthattheyhadnoideathattheywererunningsomuchrisk.Onereasonforthisisthatbefore2007thisexposuretokurtosiswasnotevidentinthepatternofmonthlyreturnsofthepreviousfewyears.Thisshouldbeexpected:onethingweknowisthatwearemostunlikelytohavereliabledataontheriskofaninvestmentsurprise.Yetanotherthingweknowisthatsometypesofinvestmentstrategycarrytheriskofsurprisinglypoorperformanceevenifitisnotevidentintheavailabledata(andwillnotbeshowninmarkettrackingrecords).Thisemphasisestheimportanceforinvestmentadviserstothinkthroughhowinvestmentsmightbeexpectedtoperforminbadtimesaswellasgoodandtoaskwhetherinvestorsarebeingadequatelycompensatedforthatrisk.

PART2

Implementingmorecomplicatedstrategies

6 Settingthescene

Ahealthwarning:liquidityriskThe “keep-it-simple” strategies described in previous chapters should beliquidaswellassimple.Almostalways,wheninvestmentstrategygetsmorecomplicateditstartstoembracemoreliquidityrisk.Liquidityisadimensionof risk which is not captured by the off-the-shelf risk models that areroutinely used in managing investments. This is because it is difficult tomodel,notbecauseitdoesnotmatter.Illiquidityhasbeendescribedas“themostdangerousandleastunderstoodfinancialrisk”.

InvestinginilliquidmarketsAcommonerrorisforaninvestortoexpectanilliquidinvestmenttoofferapremiumreturnjustbecauseitisilliquid.Thiscanbeanexpensivemistake.From an investor’s perspective, the appropriateway to look at an illiquidinvestmentopportunityistoseeifitofferstheprospectofapremiumreturnthat is sufficient, given the investor’s circumstances, to compensateadequatelyforgivinguptheflexibilityofferedbyliquidity.Netoffees,andgiventheinvestor’scircumstances,theilliquidinvestmentopportunitymayoftennotpassthetest.

This gives rise to two related questions: How should investors judgetheir appetite for illiquidity, in other words, the trade-off between thepotentialtoearnexcessreturnsinreturnforacceptingthenearcertaintyofadded inflexibility that comes with increasing allocations to illiquidinvestments?Howshouldinvestorsassessthereturnstobeexpectedfromaparticular illiquid investment?A theme from the chapters in this book onhedgefunds(Chapter9),realestate(Chapter11)andprivateequity(Chapter10) is that investors should not assume that they will be able to earn amarket return (whatever thatmight be) in illiquidmarkets unless they canconvince themselves that they have an “edge” which will enable them toperformbetterthanaverage.Otherwise,itissafesttoassumethattheywillunderperform. One hurdle to overcome is the high level of fees, whichappears to be almost a universal characteristic of investing in illiquidmarkets. Another is the series of issues covered by the umbrella heading“agency issues”,which refers to the informationalandotherdisadvantageshandicapping clients in their dealings with investment advisers in privatemarkets.

AndrewAng,AnnF.KaplanprofessorofbusinessatColumbiaBusinessSchool,hasanalysedtheseandotherissuesthatariseintryingtodeterminean optimal allocation to private equity and other illiquid investments. Animmediate problem he identifies is that traditional “mean variance”optimisermodelsusedtoderiverecommendedassetallocationsforinvestorsassumethatinvestorscanrebalancetheirportfoliosatanytime,whichdoesnot applywith illiquid investments. This inability to rebalance investment

allocations imposes real opportunity costs on investors, and can result inunwantedrisk-taking.Aparticularaspectofthis,whichiseasytooverlookin the search for premium returns from illiquid investments, is that theability to rebalance portfolios back to a long-term strategic allocation (seeChapter4)isameansofseekingaliquiditypremiumfromnormallyliquidsecuritiesmarkets by providing liquidity to risk assetmarkets at times ofcrisiswhenothersarefleeingtosafety.Investorswhoareheavilyexposedtoilliquid markets will be much less able to benefit from this liquiditypremium.Angconcludesthat long-horizoninvestorsdohaveanadvantageininvestinginilliquidassetclasses.However, thisdoesnotmeanthatit isoptimalforeachlong-terminvestortoholdilliquidinvestments.

“Liquiditybudgets”One of the lessons to emerge from the credit crunch of 2007–09 is thatinvestors need a policy on liquiditymanagement. This became evident asinvestorsscrambledtorespondtoasituationwhereformerlyliquidmarketsbecame prohibitively expensive to trade in, and illiquid portfolios ofalternative investments generated less cash and made calls on thecommitments investors had already agreed. Against this background itbecameimportantthatinvestorsshouldhaveagoodbalancebetweenliquidand illiquidassets, ifonlyso that liquid investmentscouldbesold toraisecash; it also became evident thatwhen the dust settled investors ought tohaveanexplicitpolicyonallocationstoliquidandilliquidinvestments.

IlliquidityinnormallyliquidmarketsLiquidmarkets give investors theoption to buyor sell an investment at amodest transaction cost at a time they choose at prevailingmarket prices;illiquid markets do not give them this option. Like any option this isvaluable, though some investors will value it more highly than others.Furthermore,thevaluethatinvestorsputonitvariessubstantiallyovertimeandbetween investors. Investorswhoparticularlyvalue liquiditywillneedto be offered a premium rate of return before investing in illiquid assets.Correspondingly,investorsshouldalwayspaylessforanilliquidinvestmentthanforanotherwiseidenticalliquidinvestment.

Liquid investments should provide the natural habitat for short-terminvestors,evenforaggressiveshort-terminvestors.Thisisbecausetheymayneedtorealiseinvestmentsatshortnotice(whichiswhytheyareshort-terminvestors).Long-terminvestorscanmoreeasilyaccommodateilliquidityandwithskill(orluck)mayprofitfromit.

Theliquidityofaninvestmentinstocksorbondsoftenvariesaccordingto the size of the holding. It will normally be possible to buy or sell amarginalholdingofanyquotedinvestmentatorclosetoitspublishedprice.Buttheholdingsoflargeinvestmentfundscanrepresentasignificantpartoftheavailablecapitalisationofasecurity.Anyattempttoestablishorrealisesuchholdings requiresskilland timesoas tomanage theadverse“marketimpact” on the price of the transaction.These are circumstances inwhichlarge investors can be heavily penalised or well-rewarded for demandingliquidityfromorsupplyingliquiditytothemarket.Forsubstantialinvestorsin many markets liquidity is at best an illusion, as the published pricesprovide a reliable guide to realisable transactions for only a small part oftheir holdings in individual stocks. Thismeans that substantial short-terminvestors who really do have a short time horizon must maintain a highdegreeofliquidityintheirinvestments.

Theglobalfinancialcrisishasshownthatsomemarketsthatareusuallyliquidcanbecomeilliquidsurprisinglyquickly.Wheninvestorswanttosell,whichisthesameassayingwhentheywanttodemandorpayforliquidity,theymaybeforcedtodelaytransactingandsoacceptrisksthattheywould

prefertoavoid,ortheymaybeforcedtoconcededamagingpricesthattheydonotwishtoaccept.Iftheintentionsoflargeinvestorsseekingtounwindorestablishsubstantialpositionsinashortperiodbecomeknowntoothersin themarket, theywill alwaysbecomevictimsofpredatorybehaviourbyothermarketparticipants.Themarketneverbehavesbenevolently in thesecircumstances.

Variable liquidity is both a risk and an opportunity. An alternativedefinitionofashort-terminvestor isan investorwhomayneed todemandliquidity at short notice. Short-term investors should review and limit theallocation of their portfolio to markets that might be subject to markedfluctuations in liquiditybecause in thesemarkets thepriceof liquiditycanbecomeprohibitivelyhighinaveryshortperiod.Thisisaclearthreattotheachievement of short-term financial goals. Long-term investors, howeverlargeorsmall,canprofitfromtheseswingsinliquidity,solongastheyareabletouseskillin“selling”liquidity.However,iftheyhaveusedtheirlongtimehorizon to loadupon illiquidassets, theywillnotbeable todo this,andoftenthebestoutcomewillbetorideoutliquiditycriseswithouthavingtoacceptpenaltermsforbuyingliquiditywhenitismostexpensive.

Itisnotonlyattimesofcrisisthattheseprinciplesapply.Differencesinequity transaction styles between trading desks of different investmenthousesreflectwhether themoneymanagersor tradersdemandandpayforimmediateexecution,whichraises their“execution”costs,orwhether theyare content to bide their time, at the risk of missing out on the potentialadvantages of rapid execution. “Value” equity managers normally pridethemselves on their ability to provide rather than demand liquidity. Theopposite is true ofmomentummanagers, who seek to profit frommarkettrends.

Long-termmanagers with a clear sense of investment philosophy anddisciplinewho,attherequiredtime,havetheassetallocationflexibility,willbe able to exploit the occasional extreme price paid for liquidity. But forwaverers,hesitationwillalwaysbereinforcedbythecertaintythattherewillbe highly reputable commentatorswho argue that prospects have changedfortheworseandthatwhatappearsinexpensiveisatbestfairlypriced.Forlong-terminvestorsforwhomriskassetsrepresenta“naturalhabitat”,who

have the good fortune (or foresight, or both) to have significant resourcesawaitinginvestmentatthemomentofcrisis,theseeventscanpresentaone-off opportunity to significantly improve their finances. But it will be arewardfortakingriskwhenthemajoritywantedsecurity.

Behaviouralfinance,marketefficiencyandarbitrageopportunitiesIlliquidityindicatesabreakdownofmarketefficiencyinsecuritiesmarkets.Anydiscussionofmarketefficiencyshouldstartbyaddressingawidespreadheresy,avariationofwhichRobertShillerhasdescribedas“oneofthemostremarkableerrorsinthehistoryofeconomicthought”.Thisisthenotionthattheveryexistenceofinefficiencyinmarketsisasufficientreasontoexpectoutperformance from skilful managers. This notion is wrong. It does notfollowthattheremustbeeasyrewardsforskilledinvestorssimplybecausemarkets are inefficient.The reason is that inefficiencies canbedifficult toarbitrage.Correspondingly, if there seem to be no easy rewards for activemanagers, this is not necessarily evidence ofmarkets being efficient. Therule of thumb is that if the existence of a market anomaly can easily bedemonstrated,thesafestconclusionisthattheremustbesomedifficultyinprofitingfromtheanomaly.AsAswathDamodaran,professoroffinanceatStern School of Business, New York University, writes in his bookInvestmentFables:“Ifyouseeeasymoneytobemadeinthestockmarket,youhavenotlookedhardenough.”

BarrierstoarbitrageAnomaliesinthepricingofcontractsthatofferthesameeconomicriskscanpersist even inmarketswhich are the natural habitat of investment banksandhedgefunds.Onehistorichighlyvisibleexampleofanevidentarbitrageopportunity is the significant differential that existed between the sharepricesofRoyalDutch(tradedprincipallyinAmsterdamandNewYork)andShell Transport& Trading (traded principally in London). Shares in bothcompaniesgavestrictlycomparableownershiprightsinthesamecompany,but Royal Dutch traded historically as much as 35% underpriced and asmuchas15%overpricedcomparedwithShellTransport&Trading.

TheShellsharepriceanomalydidnotprovideaneasyprofitopportunitybecausetheanomalycouldgetworse.ThispositionwasresolvedonlyafterShellannouncedinlate2004thatthetwoshareclasseswouldfinallymergein 2005. The corporate announcement provided some assurance of aprofitableexitwithinaspecifiedtimeperiod.Oftenthereexistsnosuchexitstrategyfromaperceivedanomalywhichexplainswhyitmaypersist.

The key to the potential persistence of these “anomalies” lies in theimpediments to arbitragewhich can prevent instances of irrational pricingtranslating into easy profit opportunities. These barriers are generallyconsideredtobeofthreetypes.

FundamentalriskandarbitrageThe first barrier is the commondanger (not present in theShell example)that fundamental risk may undermine any effort to arbitrage away ananomaly. An example would be where one company in an industry isthought to be expensive and a similar one to bemore sensibly priced. Ahedgefundmanagermightselltheformerandbuythelatter,butthesizeofthese positions will be limited because the arbitrageur will know thatunexpectedeventscouldcausetheexpensivestocktoappreciateinpriceandthecheapstocktodecline,causinglossestobothsidesofthe“hedge”.

Once in a while a graphic illustration of an apparently good hedgeresulting in large losses for hedge funds is revealed. In May 2005 KirkKerkorian, an American billionaire investor, announced his intention toincrease his holding in General Motors (GM) stock (which increased inprice), and almost simultaneously Standard & Poor’s (see Chapter 8)downgraded thedebtofbothGMandFord from investmentgrade to sub-investment grade, which fell in price. The problemwas that a number ofhedgefundsthoughttheywere“hedging”GMequity(whichtheyhadsold)withGMdebt (which theybelieved tobe cheap, and sohadbought).Theresultwassubstantial losses foranumberofhedge fundsonbothsidesofthehedgewhoseprices,unusually,movedinoppositedirections.

This example illustrates a characteristic of a number of hedge fundstrategies: that they often provide an attractive earnings stream,accompanied by the risk of occasional substantial losses (see Chapter 9).Thesimple lesson from this is tomakesure thatahedge isagoodhedge,andtobecarefulhowmuchmoneyisinvestedtryingtoexploitanapparentanomaly.Themoresubstantivelessonisthateventhebesthedgesmayfail,and the risk of this happening puts a limit on the scale of the arbitragepositionthatwillbeappliedtocorrectapparentmarketanomalies.

To riskmoney on an arbitrage position, an investormust consider thetimehorizon for theposition.Ahedge fund thatcorrectly identified in thelate 1990s that “new economy” (technology, media, telecommunications)sectors of the stockmarket were overpriced relative to so-called “oldeconomy”sectorscouldeasilyhavebankrupteditselfbeforethevalidityof

its analysis was demonstrated by the collapse of “new economy” stockprices. This illustrates that some types of market anomaly, whoseidentificationwillalwaysbesubjecttomarginsofuncertainty,mayrequiresuchlongtimehorizonsthattheinvestorsbestsuitedtotrytoexploitthemwillbe long-term investment funds,nothedge funds.Hedge fundsarenotideallysuitedtocorrectallpricinganomalies.

HerdbehaviourandarbitrageHedgefundsmayinfactexacerbateanomaliesintheshortrun.Thesecondbarrier to arbitrage is that “noise trader risk” may undermine arbitrageefforts by making an apparent anomaly even more extreme. A trend-following hedge fund, or any other short-term “momentum” manager orspeculator, understanding that investors may behave as if recent pastperformance will continue, is more likely to follow and reinforce theanomalythantoholdoutagainstit.Thereiswidespreadsupportfortheideathatshort-termtrendfollowingcanbeaprofitablestrategy.Thiscanbeseenas one application of the “greater fool” theory, namely a confidence thatprofitscanbemadeoutof“hot”overpricedinvestmentsbysellingthematahigherpriceonalaterdatetoagreaterfool(thoughthetrendfollowerwillnotbeinterestedinwhethertheinvestmentisoverpriced,onlythetrendinits price). This type of trading by market insiders is probably as old asmarkets: academicshave identified evidenceof suchprofitable investmentbehaviourbymarketprofessionalsduringtheSouthSeabubbleof1720.

These patterns of investing will exacerbate irrational market trends.Success in this kind of anomaly exacerbating behaviour, like a policy ofdancing by the doorwaywhen you know themusic hallmay burn down,requires the ability to identify and respond more quickly than others toeventsthatmayburstaspeculativebubble.Onaverageforallinvestorsthisis a doomed strategy, but wishful thinking about their own nimblenessencouragesmanytostayonandenjoythepartywhileitlasts.Afewalwaysgetoutintimethroughamixtureofskillandluck.Therandomelementofluckisnormallydownplayed,leadingmanytoconcludethattheymayhavetheskill required toplay thegamenext time.Theonepredictable result isthat the market process of correcting anomalies is undermined and, for awhile,madelesseffective.

Inthesecircumstancesitcanbedangeroustobetagainstsomeapparentirregularitieswithmore thanamodest investmentposition.Anomaliescanpersist for a long time, reflecting the inability of short-term arbitrageurs(suchashedgefunds)toremovethemispricing.

The role of crowd behaviour in driving investment prices away from

their fundamental value requires a particular collective role for what aresometimes known as “noise traders”. This needs a wide interpretation,becauseitdoesnotjustincludetheactionsofuninformedinvestors.Aswellasprofessionalinvestorswhotrytoexploitmomentumtrendsincrowdsofuninformed investors, there are professional investors who feel forced toimplement investmentdecisions that theyviewwithdeepscepticism.Suchinvestmentsshouldberegardedasgenerating“noise”,inthesensethattheremaybelittlefundamentalinvestmentjustificationforthedecision.Thismayarisefromsellingpressureinilliquidmarketscausedbyend-investorswhomayneedtoraiseliquidityorwhoseconfidenceinastrategyisunderminedjustwhentheinvestmentcaseforitmayappeartotheinvestmentmanagertobegreatest.

Occasionally, noise may result from spuriously precise definitions of“prudential”regulations.Morecommon,though,maybetheimpactofpeer-grouppressuregeneratingherdingbehaviouramonginvestors.Thismaybepurelyinformalcommercialriskmanagement,whereamoney-managementfirmdeterminesthatitsbiggestriskistobedifferentfromotherfirms.Oritmay be imposed by formal or informal ruleswhich dictate themargin ofdifference from the market or from other investors (this is often calledrelativeriskortrackingerror)thataninvestmentfundmayrun.Wherefundsormanagersareassessedrelativetoanindexorrelativetocompetitorsthispressurewillbepresent.

The herdmentality is probably reinforced by the legal backing to the“prudent person” rule, which is the benchmark for the assessment of thereasonableness of the actions of fiduciaries in many countries. The 1974Employee Retirement Income Security Act (ERISA) in the United Statesdefinestheobligationsofafiduciaryasbeingtouse:

thecare,skill,prudence,anddiligence,underthecircumstancesthenprevailing,thataprudentmanactinginalikecapacityandfamiliarwithsuchmatterswoulduseintheconductofanenterpriseofalikecharacterandwithlikeaims.

As Shiller points out, this definition tests the reasonableness of afiduciary’s decision against the standard of how a peer might behave. In

otherwords:

Theprudentpersonstandardreferstosomeonewhodoeswhatmostofusthinkissensible.Ultimately,itmustrefertoconventionalwisdom.

It is not clearhow this standardmightbe improved,but the inevitableconsequenceisthatitvalidatesthereasonablenessofcrowdbehaviour.Asaresult,theimpactofthisstandardofcareismorelikelytoreinforcethantocorrect any tendency towards market mispricing. It will encourage tradesthatfollowandsupportmarkettrendsasmanagerscontroltheirdifferencesfrom themarket or the peer group of other reasonable investors,who arebehaving in exactly the same way. The behaviour of pension fundsrespondingtothispressurehasinthepastbeenlikenedtoaparadeofcircuselephants followingeachother round ina circle, joined from trunk to tail.Thehonestconclusionisthatinstitutionalinvestorsnevercompletelybreakfrom this circle. Their fiduciaries are, rightly, always looking over theirshoulder and comparing themselves with comparable funds. For privatewealth there is more flexibility, which brings both more opportunity andmoredanger.

Implementationcosts,marketevolutionandarbitrageThe third potential barrier to arbitrage activities is that “implementationcosts” can be prohibitive. Typically, an arbitrageur needs to sell short aninvestment.Tobeable todo this, ahedge fundneeds toborrow the stockfromanother investorsoas todeliver it to the investorwhohasbought it.Thisworkssmoothlyintextbooksandinliquidmarkets.Inilliquidmarketsit can be a nightmare. This is because it is a process that is subject toadministrative interruptions that can threaten investment positions. Forexample,ifastocklenderwantsthestockreturned,thehedgefund’sbrokerneedstofindanotherinvestorfromwhomtoborrowthestock.Ifitcannot,the hedge fund manager will be forced to buy the stock back before theanomaly has corrected (or, even worse, when it has become moreentrenched).

In2008,clientselling,withdrawalsofborrowingfacilitiesandregulationchanges (such as restrictions on short selling) probably conspired toexacerbateratherthancorrectmarketanomalies.Attimesofcrisisliquiditypressures can force hedge funds prematurely to close positions, therebyexacerbatingtheveryanomaliesthattheyweretryingtoarbitrage.The1998Long-TermCapitalManagement crisis provided earlier vivid testimony tothe reality that fundscannot alwaysafford tomaintain largepositions thatthey may want to sustain for a long period. (Long-Term CapitalManagementwas a largehedge fund that failed in 1998 as a result of thefailureofarbitragestrategiesofenormoussize.)

Theseinfluencesmeanthatthereisnoinevitabletendencyformarketstobecome progressivelymore efficient. The cycles ofmarket liquidity showthat market efficiency is also cyclical. Nevertheless, the pressures toarbitrageawayanomalieswillalwaysbeapowerfulforceinanymarket.Ifaparticularmarketarrangementisabarriertoefficiency,youcanbesurethattherewillbegreatpressuretoremovethatimpedimentbecausetherewillbearbitrage profits available to thosewhohelp remove it.Today’s barrier toarbitragemaynotexisttomorrow,asinstitutionalandmarketarrangementsand instruments are continuously evolving to overcome obstacles andexploit opportunities to make money. Tomorrow there may be otheranomalies, and old onesmay reappear, but itwould be a greatmistake tounderestimate what Robert Merton, the University Professor Emeritus atHarvardUniversity,andZviBodie,theNormanandAdeleBarronprofessorofmanagement atBostonUniversity, refer to as “the financial innovationspiral”thatworkstochipawayatanomaliesandinefficiencies.

Institutionalwealthandprivatewealth:taxationThe three principal differences between private and institutional wealthmanagementare:

theroleoftaxationinprivatewealth;

theroleofcommitteesoffiduciariesinthemanagementofinstitutionalwealth;

thecontrastbetweentheflexiblespendingobjectivesoffamilywealth

andtheprecisepurposesofmuchinstitutionalwealth.

However, thesearegeneralisations.Not allprivatewealth is subject totaxationandnotallinstitutionalwealthisexemptfromtaxation.Investmentcommittees are found in themanagement of both private and institutionalwealth. Some institutions have flexible objectives, while familyphilanthropic foundations have closely defined purposes and mark theboundary at which private wealth becomes institutional. Yet the broadgeneralisations remain valid, togetherwith the further observation that theamountsofmoneyrepresentedbyprivatewealtharenormallymuchsmallerthanthoseofinstitutionalinvestmentfunds.

Some advisers make far-reaching proposals for investment strategy toaccommodatetaxstructures.Othersemphasisethatthebenefitsfrommanytaxdevicesareinpracticemodest.Investorsshouldbeawarethatgiventhesame facts, conflicting advice may be offered. For taxable investors,minimising the overall tax bill makes less sense than trying to maximisepost-taxincome,giventheirtoleranceforrisk,evenifitmeanspayingmoretax.Anytax-managementschemeshouldbeassessedinthislight:ifitisnotexpected to improve post-tax income, after allowing for tax advisory feesand foranyspecialelementsof risk (suchas illiquidity) introducedby theproposal,itprobablyshouldnotbepursued.Itisworthpayingmoretaxifitisassociatedwithevenmoreincome.

Tax doesmake an enormous difference, however, by constraining theevolution of private wealth. Table 6.1 illustrates its potential impact,although the picture is muchmore complicated than this. It assumes thatcapitalgainsandincomearetaxedatthesamerate,whichtheyarenot,andthat each individual stock earns the same return, and ignores any taxallowances thatwould reduceaheadline tax rate to a lower effective rate.But the simple story remains true, that income and capital gains taxesseriously undermine the rate of accumulation of private wealth and thepremium offered for taking risk. In practice, the impact on risk-takingvaries, as income tax particularly affects low-risk assets (bonds and cash)whereascapitalgainstaxparticularlyaffectsequities.

TABLE 6.1 The impact of taxation on taxable investment returns and wealth

accumulation

aAssumingactualreturnequalsexpectedreturnandthattaxrateappliestoannualtotalreturnwithnoallowancesortaxshelters.

Source:Author

Individualtaxpayershavetax-deferredaccounts(forexample,retirementaccounts, which accumulate free of tax but withdrawals from which aretreatedastaxableincome)aswellastaxableaccounts,anddependinguponthe jurisdictionan investormayhave some tax-exempt accounts (accountsfrom which the investor can withdraw funds without incurring a taxpenalty). Investment strategy andwealthmanagement should take accountof the different tax status of different accounts. This starts with anassessment of the sufficiency of wealth to meet future objectives. Forexample, a dollar in a tax-deferred pension savings accountwill beworthless than a dollar in a tax-exempt account. At the same time, investmentstrategyneedstotakeaccountofthetotalityofaninvestor’swealthineachdifferentaccountor“location”,andtheallocationofinvestmentstodifferentlocationsneedstoallowforthedifferencesintheimpactoftaxondifferenttypesofinvestment.

The impact of taxation on risk-taking needs to be kept inmindwhenconsidering the uncertainty surrounding future equity returns. Butuncertaintyalsosurroundsfuturetaxratesandallowances.Thisneedstobe

acknowledged in the degree to which the details of today’s tax rules areallowed to influence the medium-or long-term investment strategy for aninvestor’staxableinvestments.Ifindoubt,keepitsimple(buttakeadvice),butbeparticularlyawareofthecostsofunwindinganarrangementwhichistaxefficienttoday,butmaynotbetomorrow.

For a taxable investor, investment strategy never starts from a blanksheetofpaper.Thereisalwaysalegacytaxpositionthatexistswheneveraninvestorchangesinvestmentmanageroradviser.Thiscanhaveimplicationsfor:

thechoicebetweendifferentstylesofinvestmentmanagement;whethertohavefewerormoremanagersorfunds;

thedesiredaverageholdingperiodsforinvestments;

whethertohaveabiastowardslowturnoveraccounts(thoughtherelationshipbetweenturnoverandtaxationwillnotbestraightforward);

whethertohaveabiasagainststrategiesthatinvolve“topslicing”ofallpositionstorebalanceorimplementassetallocationdecisions.

Tax overlaymanagement services are oftenmade available by privatewealth managers in the United States. They introduce a degree ofconsistencyandrigourintowhatmightotherwisebeajudgmentalprocess.These services are typically model-driven and can help manage the taxconsequencesofamove toanewinvestmentmanager,andcanalsoassistso-called tax-lossharvestingwhenaportfoliohasacombinationofcapitalgainsandcapital losses.Theseapproachescan include themanagementofbothportfolioriskandtaxobligations.

To address these issues, taxable investors should consult a tax-literateinvestment adviser (who may be better placed to advise on strategies tooptimiseafter-tax investment returns)aswellasa taxspecialist (whomayhaveabias towardsminimising taxpayments).However, in responding totax advice, investors should always retain an overall picture of their taxstatusaswell as their investment strategy.This isparticularly important ifthe investor divides savings and wealth between different objectives,

different risk profiles, and a mix of taxed and tax-advantaged accounts.Finally,becautiousbeforeprolonginganyexcessive investment risk (suchas a concentrated stock position) simply because of concern about the taxconsequences of selling down a position which represents a substantialcapital gain. It is better tomake a gain onwhich you pay tax than not tomakeagain.

7 Equities

TherestlessshapeoftheequitymarketAtthestartof the20thcentury,railroadstocksrepresented63%oftheUSequity market and just 0.2% a century later. Russia, India and Austria-Hungarytogetherrepresented25%oftheglobalequitymarketin1899andlessthan1%acenturylater,whichinthepastdecadehasincreasedto2.5%.In the past 30 years in the global equity market, the weights of Japan,technologystocksandbankingstockshaverisenandthenfallen,andintheyearssincethelate1980stheweightoftheemergingmarketshasincreasedfrom around 1% of the globalmarket to around 13%. The scale of thesechangesisapowerfulchallengetoanyonesuggestingthatinvestorsshouldpassively acceptwhatever changesmay occur in themarket.An autopilotapproachtoinvestingineitherdomesticorglobalequitiesoverlongperiodsis not credible. All investors need to be responsive to changes in thestructure,riskandopportunitiesofthemarketplace.

ConcentratedstockpositionsinprivateportfoliosTheanalysissofarhasassumedthatanyequityexposurereflectstheriskcharacteristicsoftheequitymarket.Frequently,though,equityholdingsareconcentratedinawaythatincreasesrisk-taking.Sometimesthisarisesfromanexecutive’ssuccessfulcareerwithalistedcompany.IntheUnitedStates,concentratedpositionsinemployerstockwithincompany-sponsored401(k)defined-contributionpensionplansusedtobecommon,thoughthesehavedeclinedinrecentyears.Accordingtoa2013reportfromMorningstarInvestmentManagement,almost25%of401(k)planassetsforcompanieswithamarketcapofgreaterthan$10billionwereinvestedinthecompany’sownstockin1999;by2011thishadfallento10%.

Theprescriptionsoftraditionalfinanceareclearonthisissue:thereisnopremiumreturn,onlyincreasedrisk,offeredforalackofdiversification.Increasingawareness,legislativechangeandthethreatoflitigationaremovingpracticeinthesamedirection.Nevertheless,theMorningstarreportshowsthatitwasstillcommonin2011for401(k)planstohaveconcentrationsofexposuretoemployerstockthatexceededthemaximumlevels(often5%,

concentrationsofexposuretoemployerstockthatexceededthemaximumlevels(often5%,orperhaps10%forahighlyfocused,activeportfolio)thatamoneymanagerwouldmaintainforamostfavouredstock.

Concentratedholdingswithindefined-contributionpensionaccountsareseparatefromtheconcentratedstockpositionsthatexecutivesmayaccumulateasarewardforsuccessthroughcorporateremunerationschemes.Thepensionplanholdingsreflectadeliberatedecisionbytheindividualtoacquire,ortoretain,thestock.Executives’concentratedstockholdingsreflectinvolvementinbusinessthroughemploymentorentrepreneurship.Theexposurewasacquiredtoaligntheinterestsofanindividualwiththoseofthecompany.Inanexecutivestockcompensationscheme,ifthecompanyandtheindividualhavebeensuccessful,significantwealthmayhavebeenaccumulated.Atthatstageissuesofwealthandriskmanagementbecomerelevant.Theyarenotrelevantattheoutsetoftheprocess.Forthisreason,concernabouthowbesttomanageanexecutive’sconcentratedstockpositionisan“enviabledilemma”.

Anexecutive’sstockpositionisoftensubjecttoformalorinformalsellingrestrictions.Whenarestrictedholdingrepresentsasubstantialpartofaninvestor’swealth,afinancialadvisermayrecommendborrowingagainstthesecurityofthatholdingtoallowinvestingelsewhere.Iftheconcentratedpositionisunhedged,theborrowingwillnotreducerisk-taking.Itwillincreasethepotentialforwealthaccumulationbygearingtheinvestor’soverallportfolio,butatthecostofevengreatervolatilityofthatwealth.Thelikelihoodofasuddendiminutionofwealthisincreased,notreduced,byborrowingagainstanunprotectedconcentratedstockholdingandinvestingtheproceedsofthatborrowinginadiversifiedstockmarketexposure.

Assistinginthetaxandwealthmanagementofconcentratedstockpositionsisanimportantroleformanyfinancialadvisers.Therisksofsuchpositionsneedtobetakenintoaccountwhenallocatingotherfinancialinvestments.Thisisbecausethetotalwealthisdominatedbytheirvolatileexposuretotheequityoftheirbusiness.

StockmarketanomaliesandthefundamentalinsightofthecapitalassetpricingmodelDespitetheextraordinarychangesintheshapeoftheglobalequitymarket,anannuallyrebalanced,passiveapproachtoinvestinginUS,UKorglobalequities,ifithadbeenavailable,couldhaveperformedextremelywelloverthepast 11decades (seeChapter 3).However, thebelief that it shouldbepossibletodo“better”thantomatchtheperformanceofthestockmarketissupportedbyawidebodyofresearch(eventhoughsimplearithmetictellsusthat this cannot be true for all stockmarket investors). This research hasfocusedonextensiveanalysisofstockmarket“anomalies”,whicharewell-established patterns of stockmarket performance that do not conformwiththe predictions of the original simplified theory called the capital assetpricingmodel(CAPM).

In itsoriginal form, theCAPMsaid that theperformanceof any stockshouldbeexpectedtoreflect twothings: theextent towhichthestockisageared or a diluted “play” on the market as a whole; and a considerableamount of company-specific volatility. The first represents a stock’sexposure to systematic risk (measured by its “beta”) for which investorsshouldexpecttobecompensated.Anexampleofastockwhichwouldbea“gearedplay”onthestockmarket,ora“highbeta”stock,wouldbethestockof an equity money manager whose fee income, reflecting assets undermanagement, would rise and fall in line with the stockmarket and whoseprofitabilitywouldbehighlygearedtothisinfluence.Systematicriskcannotbe diversified away in an equity portfolio. The second is “noise”, oridiosyncratic or diversifiable risk. This should cancel out in a well-diversified portfolio, but it reflects the scope for an individual stock, or aportfolio of stocks, to perform differently from the market (or, moreprecisely,fromthebeta-adjustedmarketreturn).

TherehavebeennumerousrefinementstotheCAPMtoreflectresearchindicating that there are a numberof sources of risk for a particular sharepriceinthestockmarketwhichcanhelptoexplainsharepriceperformance.These include interest-rate and foreign exchange exposure, corporatebalance-sheet data, income and dividend information, aswell as companycapitalisation,industryandgeographicallocation.Anunderstandingofthesesourcesofriskcanhelpintheconstructionofequityportfolios,particularlyifan investorhasaview thataparticular sourceof risk-taking is likely toproducegoodresultsintheperiodahead.

However, the fundamental insight of the CAPM – the division ofportfolio risk intoundiversifiable, systematicmarket riskanddiversifiable,idiosyncratic risk – has stood the test of time. It provides an invaluableframeworkforunderstandinghowtheactivitiesofportfoliomanagersalteraportfolio’s systematic and idiosyncratic risk exposures and so affect theperformanceandriskof thatportfolio.Anunderstandingof this insight,aswellasitsstrengthsandweaknesses,isanimportantaspectoftheinterfacebetweenfinancetheoryandpracticalinvestment.

Among the weaknesses of CAPM is that it is now accepted that theoriginalsimplifiedtheorydoesnotfullyexplainthepatternofperformance

betweendifferentstocks.Lowbetastocks,withsupposedlydilutedexposureto themarket, do not systematically underperform the stockmarket as theoriginaltheorysuggestedthattheyshould.Furthermore,stockswithsmallermarketcapitalisation,certainmeasuresof“value”stocksandevenrecentlysuccessful, “momentum”, stocks have shown an apparent persistence ofsuperior performance that is inconsistentwith the simplest versions of thetheory.

Therearetwopossibleexplanations:

Thesepatternsreflecttheimpactonmarketpricesofirrationalinvestorbehavioursuchasinvestorfashionsandawidespreaddesiretoownsharesin“good”companiesandtoavoid“dogs”(forexample,historicstockmarketunderperformers).Ifso,theanomalieswoulddisappearonlyifsufficientweightoflong-terminvestormoneyrecognisedtheirrationalbehaviourofotherinvestors,leadingthe“rational”investorstoreorganisetheirportfoliostoprofitfromtheseanomalies.Thiswouldbidupthepricesthathadbeenexpectedtooutperform(removingtheoutperformance)anddepressthepricesofexpectedlaggards(improvingtheirsubsequentperformance).Ifenoughinvestorsrespondedinthisway,theanomalieswoulddisappear.Butiftheypersist,“informed”investorswhoareawareoftheanomaliesshouldadjusttheirportfoliostoprofitfromthem.

Theoldmeasuresofrisk-takingmaybewrong.Ifthisiscorrect,thosewhoseektoexploittheanomaliesmaysimplybegearinguptheirrisk-taking.Forexample,smallcap(seebelow),somecategoriesof“value”stocksandemerging-marketstocksmayberiskierthantheyappeartobe.Ifso,itmayberationalthattheyshouldtradeatadiscountedpricetoleaveroom,onaverage,forsuperiorperformancetoreflecttheextramarginofrisk.

If the first explanation is correct (that groups of stocks tend to beunderpriced), cautious long-term investorsmight reasonably increase theirexposuretothesegroupsofstocks.Butifthesecondexplanationiscorrect,this would be inappropriate. Investors need to know that there is no

agreement among finance experts on this and that when faced withuncertainty, it is reasonable for cautious investors to err on the side ofcaution.

John Campbell of Harvard University and TuomoVuolteenaho of theNational Bureau of Economic Research have argued that the traditionalmeasure of market risk exposure, beta, is clouded by combining twodifferent measures of risk. The first is the responsiveness of a stock to achange in the market’s discount rate. As explained in Chapter 5 in thediscussionof “good” and “bad”price declines, a fall in price causedby arise in the market discount rate should be recouped by faster subsequentperformance.Foracautiouslong-terminvestorthisisnotamajorsourceofconcern.Thesecondelementistheresponseofastockpricetoachangeinexpectationsforcorporateearnings.Thisiswhathasbeendescribedas“badbeta”, because there is nomechanism for ensuring a recovery of the lostperformanceinresponsetoadowngradeofearningsgrowthexpectations.

InstudiesofUSequityperformance,itwasfoundthatvaluestocksandsmall-company stocks are more sensitive than the market as a whole tochangesinmarket-wideearningsexpectations(badbeta)thangrowthstocksand large-company stocks, which are more sensitive to changes in themarket’s discount rate (goodbeta).Any investor shouldwant to receive apremiumreturnforincurringbadbetarisk,anditseemsthatnormallysuchapremiumhas eventuallybeenpaid tovalue and small cap investors, but itshouldnotbetakenforgranted.

“Smallcap”and“largecap”In the early 1980s, Rolf Banz published research which highlighted thesurprisingsuperiorperformanceofsmallercompaniescomparedwithlargercompanies.ThisresulthasbeenreplicatedonnumerousoccasionssincefortheUnitedStates,theUKandothercountries,withageneralpatternthatthesmallest,ormicro-companies,haveoutperformedsmallcompanies,whichinturn have outperformed large companies. The historic outperformance ofsmaller companies is the “small cap effect” or the “small cap anomaly”,because, although small companies tend to be more volatile than largecompanies, the degree of outperformance could not be explained by the

originalsimplifiedCAPMmodel.A sense of the small stock “anomaly” is gained by looking at the

historicalperformanceofsmallandlargecapitalisationcompanies.Figures7.1 and 7.2 make use of the comprehensive database maintained by theCenterforResearchinSecurityPricesattheUniversityofChicago’sBoothSchoolofBusiness.Theycontrasttheperformancefrom1925toearly2013ofthelargestUScompanies(representedbythelargest10%ofNewYorkStockExchange listeddomesticcompanies,aswellascompaniesfromtheotherleadingUSexchangeswhichareallocatedtothesamesizebands)withtheperformanceof small companies, indicatedby those companies fallingwithin the sixth to eighth decile bands of the same grouping. At end ofMarch2013marketvalues,thissmallcapbandcoveredUScompanieswithamarketcapitalisationofbetween$584mand$2.2billion,while the largecapbandincludedallcompanieswithamarketcapitalisationofgreaterthan$20.1 billion. The cumulative outperformance of small cap since 1925 isimpressive, with an initial $1 investment growing (before allowing forinflation,or expenses and taxes) to$13,800byMay2013, comparedwith$2,250foraninvestmentinthegroupoflargestcompanies.(Overthesameperiod, consumer prices increased 13-fold.) This translates into anannualised performance of 11.5% per year for the small cap stocks,compared with 9.2% for the large cap stocks (and 3.0% per year forinflation).

Asimilarpattern isevident fromresearch in theUKbyElroyDimsonand Paul Marsh, although as for the United States the margin ofoutperformancebysmallcompaniesdependson theperiodchosenand thedefinition of small cap that is used. Their work lies behind the NumisSmaller Companies Index (formerly the Hoare Govett smaller companiesindex), which has measured the performance of companies within thebottom10%oftheUKmarketcapitalisationsince1955.Overthe58yearstotheendof2012,thisindexgaveanannualisedreturn(beforefees,taxesandother costs)of15.5%,which is3.2%per annumabove thebroadUKmarket,measuredbytheFTSEAll-Shareindex.

FIG7.1CumulativetotalreturnofUSsmallcapandlargecapstocksBeforeexpenses,taxesandinflation,Dec1925–May2013

Source:CRSPUSdatabaseindices,CenterforResearchinSecurityPrices(CRSP),

UniversityofChicago,BoothSchoolofBusiness

Figure 7.2 shows a number of ten-year periods when small capunderperformed large cap in the United States. The most recent episode,includingalmosteveryoverlappingten-yearperiodinthe1990s,coincidedwithawidespreadview that theearlierobserved“smallcapanomaly”hadindeedbeencorrectedbyheavyinvestmentinsmallcapbyinvestorsbiddinguppricesastheytriedtoexploittheanomaly.Infact,since1925,USsmallcap stocks have underperformed large cap stocks (on the definitions usedhere) during around 30% of all rolling ten-year periods. Such relativelyfrequent periods of underperformance by small stocks are sufficient tocaution most long-term investors against holding much more than asignificantminorityoftheirequityinvestmentsasstrategicholdingsinsmallcapstocks.

FIG7.210-yearrollingaveragereturnsforUSsmallcapandlargecapstocksBeforefees,taxesandinflation,Dec1935–May2013

Source:CRSPUSdatabaseindices,CenterforResearchinSecurityPrices(CRSP),

UniversityofChicago,BoothSchoolofBusiness

Anunderstanding ofwhat ismeant by “small cap” is needed before adecision can be made on allocations. For example, different small capmanagersmay have different investable universes of stocks.ManymoneymanagerswouldregardstocksintheUnitedStatesorEuropeoflessthan$2billion market capitalisation as small cap, and a market cap range of $2billion–10 billion as mid cap and anything above that as large cap. Theindexprovidersdividethemarketintoproportionsofthemarket.Largecapmightbethetop70%or80%,midcapthenext15%or10%,andsmallcaptheremaining15%or10%.So10%oftotalequityinvestmentsrepresentsanallocation to small cap that could, if well diversified, constitute a neutralglobalallocation.Allocationsofmateriallymoreorlessthantheseamountsshouldreflectadecisiontodifferfromthemarket.

With any equity investment programme, exposure to small cap stocksshould be carefullymonitored. It is almost always amistake to approachsmallcapinvestinginanadhoc,piecemealfashion.This ismorelikelytobeanissuewithaprivateinvestorthananinstitutionalinvestor,buttheruleshould be that exposure to smaller companies should be obtained throughdedicated small-company portfolios or funds. In any event, there is atendency for active investment managers to drift into small-company

holdings(partlybecausetheymaybelesswellresearchedbycompetitors).For this reason, it is not sufficient to aggregate the benchmarks given todifferentmoneymanagers to arrive at a measure of exposure to differentsegments of the market. Active managers may vary significantly withinlooselydefinedinvestmentremits,andselectedpassivemanagersmayhavebeen appointed to manage money against index benchmarks that do notreflect themarket.Wherever possible,management information should beobtainedbyaggregatingunderlyingexposures to individualcompaniesandthencomparingthemwiththebroadestpossiblemeasureofthemarket(seeAppendix2).

Willitcostmetoinvestethicallyorsustainably?Many investors have a strong preference to avoid investing in companiesthat transgress their personal codes of ethics or religion, so-called “sin”stocks. “Ethical” investors differ in their categorisation of sin stocks, butcommon industry groupings include weapons, tobacco, alcohol, gamblingand pornography.A common supposition is that sin stockswill trade at adiscount since they are shunned by many investors, in which case suchstocks should be expected to outperform themarket and ethical investorswillpayapricefor theirethicalstandards.Theevidencefor this ismixed,butitseemsthat investmentmanagersoftenunderminethecaseforethicalinvestingbyloadinghighfeesontoethicalfunds,whichthenunderperformmarket indices and the most inexpensive index funds. But JacquelynHumphreyandDavidTan,researchersattheAustralianNationalUniversity,in a 2013 Journal of Business Ethics article, “Does it Really Hurt to beResponsible?”, have shown that responsible investing (for example, byscreening out categories of “sin” stocks) need not lower expected risk-adjustedreturnsfrominvestinginequities.

FIG7.3Ethicalinvesting,cumulativereturns$,Jan2001–Sep2013,Dec2001=1

Source:FTSE

Thetrackrecordforethicalinvesting,asillustratedbytheFTSE4Goodseries of equity indices, has underperformed the broad market since itslaunch in 2001 (see Figure 7.3). The FTSE4Good index provides abenchmarkforinvestorstoidentifyandinvestincompaniesthatmeetpresetcriteria. The index screens out companies that are tobacco producers,weaponsproducers,ornuclearpoweroperators.Tobeincluded,acompanymustadheretospecifiedstandardsforcombatingbribery,workingtowardsenvironmental sustainability, ensuringgood supply chain labour standards,promotingpositiverelationshipswithstakeholdersandsupportinguniversalhumanrights.

Analysis by the FTSE suggests that this past underperformance isexplained by the company size and industry differences between theFTSE4Good index and the broad market. Specifically, the FTSE4Goodindexunderrepresents theoil andgas,materialsandutilities sectors,whileoverweightingtechnologyandfinancials.Therewouldseemtobenoreasonto expect this underperformance to continue for the indefinite future,although significant differences frommarket performance should not be asurprise.

Investorswhofavour“sustainable investment”areoftennot seeking topromote a particular moral code but rather to address a potential market

failure,which is the likelihood thatmarketswill fail topriceappropriatelyexternalitieswhichimposemedium-orlong-termcostsontheeconomyandsociety.One examplewould be a company that relies on inexpensive andplentifulfreshwater,thesupplyofwhichislikelytobecomemoredifficultand so expensive over time, thereby undermining the company’s businessmodel. Other examples could involve waste management. Promoters ofsustainable investment look to the integrationofenvironmental, socialandgovernance issues in investment decision-making. Some institutionalinvestorsareembracingsuchapproachesasawayoffulfillingtheirdesiretoberesponsibleinvestors.Typically,theyalsoanticipatethatthiswilldeliversuperior risk-adjusted returns as themarket gradually takes account of thecosts of wasteful processes and corrects substandard governancearrangements.Suchapproacheshavebeen supportedbyacademic analysisof thecorporateandsocial responsibilityengagementswithUScompaniesbetween1999and2009bya leadinginstitutional investor.Thisfoundthatshareholder action by this large investor to improve the governancestandards of companies on average does subsequently lead to animprovementinsharepriceperformance.

Don’tgetcarriedawaybyyour“style”Equity investment managers have particular investment approaches andphilosophies, which lead to differences in style of investing. Thesecharacteristicsareoftenas ingrainedasanypersonalbelief. Investorsneedto know and understand these differences. Theywill often find that someapproachesaremoreappealingthanothersbecauseofthesortofpersontheyhappentobe.Investorsshouldbecarefulnottoletthesepreferencesresultinunwittingriskbiasesintheirinvestmentstrategy.

Philosophically, value and growthmanagers are quite different. Valuemanagers have in common that they believe that markets repeatedlyoverreact as investor enthusiasm or alarm becomes detached frominvestment reality. As a result, value managers are contrarian individualswhoare likely tomakeavirtueof implementingunfashionable investmentdecisions.Their analysis suggests thatmarket prices oscillate around theirfairvaluesandthattheturningpoint,whenvaluationsbecomeextended,is

unpredictable.Valuemanagerswilltrytopersuadetheirclientsthatwhatisrequired is patience, as eventually the strategy is sure to be rewarded. Inpractice, clients are particularly attracted when a value manager hasexperiencedrecentgoodperformance.Thisiswhenavaluemanagerwouldnaturally want to caution that such performance cannot be sustainedindefinitelyandthatleantimesmightlieahead.

Theparticularvulnerability forvaluemanagerswhobelieve that“whatgoes around, comes around” is changes in long-term macroeconomicrelationships. According to Sir John Templeton, a notably successfulinvestor,“Thefourmostdangerouswordsininvestingare‘it’sdifferentthistime’.” But sometimes, particularly in the prospects for individualcompanies,thingsaredifferent,foreithergoodorill.Agrowthmanagerislikely to criticise value managers for looking back and not identifyingpotential.For growthmanagers, analysesof technological and commercialchange, and how this can transform the earnings prospects of individualcompanies, provide the cornerstone of their pursuit of new investmentopportunitiesandunderstandingofbusinessprospects.Agrowthmanager’sportfoliowillconsistofavarietyofsuchinvestmentprospects.

A crucial discipline for any manager will be when to sell out of aprofitableinvestmentposition.Thiswilloftenbemuchmoreinstinctiveforavaluemanagerthanforagrowthmanager,withthelikelihoodthatavaluemanager may sell a profitable investment “too early” whereas a growthmanagermay bemore likely to err on the side of selling it too late. Thishelpstoshedlightonsomeofthedifferentrisksfacedbyvalueandgrowthmanagersandtheirclients.

Acloserelativeofthevaluestyleofinvestingisrepresentedbywealthor fundamental weighted equity indices. Stockmarket indices are almostalways constructed by giving different companies weights which reflecttheircomparativestockmarketvaluation.Thesearethemarketcapitalisationweighted indices such as theS&P500 index for theUS equitymarket.Acriticism of these traditional indices from those who believe that thestockmarketispronetooverreactioncausedbyfadsandfashionsisthattheyoverweight companies which are overpriced, but underweight companieswhich are underpriced.An alternativemethodology has been suggested to

reflect the contribution of each listed company to wealth creation, asindicated by their profit generation, cash flow and shareholders’ equity(bookvalue).Iftheunderlyingpremiseofthistypeofmarketoverreactioniscorrect,thesewealth-weightedindicesshouldbeexpectedtooutperformthemarketcapitalisationindicesovertime.

ValueandgrowthmanagersValuemanagerscommonlyhaveaninvestmentprocessthatstartswithstatisticalscreeningofstockmarketdatabasesforcompanieswhoseshareprice,earnings,dividendandbalance-sheetdatameetcertaincharacteristics.Avaluestockwillbeonethathassomecombinationof:

higherthanaveragedividendyield;

lowerthanaverageratioofthestockpricetoearningspershareorofthestockpricetothebookvalueofthecompany’sassetspershare;

lowerthanaverageratioofthecompany’svaluationtosalesorofvaluationtocashflow.

Thesearesomeoftheratiosthatareusedinconstructing“value”indicesofstockmarketperformance.Individualmanagerswillusedifferentcombinationsoftheseandotherindicatorstoscreenforvalueinthestockmarket.Apartfrompurelyquantitativemanagers,thisscreeningprocessisbestseenasasteptowardsreducingthepotentialuniverseofinvestablecompaniestoamanageablenumber,whichtheinvestmentmanagercanthenresearchqualitativelyindetail.Thisstage,involvingmanagement,productandindustryresearchandadhocanalysis,willoftenbethemostimportantpartoftheinvestmentprocess.Butthescreensarealsoimportantingredientsindescribingamanager’sinvestmentstyle,andtheywilldefinetheuniverseofstocksthatthemanagermaythenresearchfurther.Asstockpricesevolve,managersshouldbeabletorelatetheiractualportfoliosbacktothosescreenstodemonstratethattheportfoliosremaintruetothemanagers’descriptionsoftheirinvestmentstyle.

Valuemanagersdivideintotwocamps:

“Deep”valuemanagersinvestinstocksthatmeettheirqualitativeandquantitativecriteriairrespectiveofhowunrepresentativetheresultingportfoliomaybeofthemarketasawhole.Inparticular,theyarehappytohaveazeroweightinginpartsofthestockmarketwherethevaluescreenssuggestthatallstocksofferpoorvalue.

“Relative”valuemanagersmanagetherisksoftheirportfoliosrelativetothemarketasawhole,andsohavedisciplinesthatforcetheportfoliotoholdsomelessexpensivestocksinsectorsthatthescreenssuggestareabsolutelyexpensive.

Moneymanagerbusinessleaders(whodisliketheinstabilityofassetsunder

Moneymanagerbusinessleaders(whodisliketheinstabilityofassetsundermanagementthatcanbeassociatedwithdeepvaluestrategies)andinvestorswhoareparticularlyawareof“regretrisk”generallyfeelmorecomfortablewithrelativevaluethanwithdeepvaluemanagementstyles.

Growthmanagersareparticularlyconcernedtoexploitandprofitfromtherelationshipbetweenearningsgrowthandstockpriceperformance.Companiesgenerallydonotpostunusuallystrongearningsgrowthresultsyearafteryear.Butasthemarketdiscountsthestrongearningsofthosecompaniesthataregrowingrapidly,theirstockpricescanrisevery,verystrongly.Thisputsapremiumonprimaryresearchintocompaniesthatmaydemonstrateunexpectedlyrapidearningsgrowthinthefuture.

Manygrowthmanagersalsousestatisticalscreeningofdatabases,butthisisgenerallyalesspowerfultoolthansuccessfulqualitativeindustryorthematicresearch.Butsuchresearchisnotoriouslydifficulttoundertakesuccessfullyandconsistently.Thestatisticalscreensusedbytheindexcompilerstodefine“growth”stocksareearningspersharegrowth,salesgrowthandtheratioofretainedearningstoequitycapital(theinternalrateofgrowth).

Shouldcautiousinvestorsoverweightvaluestocks?Overthelongestperiodsoftime,bymostmeasures,valuestocksareshownto have outperformed growth stocks (see Figure 7.4).Despite this, by thetraditional measure of risk, the volatility of returns, value stocks (inaggregate) have often appeared to be “safer” or at least “less risky” thangrowth stocks (see Figure 7.5), although noticeably this was not the casefollowing2008.

Investorswhowish to tilt their investments toprofit fromthepotentialforvalueinvestments(orhighincomeproducingstocks)tooutperformneedto be able towithstand prolonged periods of underperforming themarket.During the late 1990s growth stocks outperformed value stocks by morethan 60% in just over two years, a process that was reversed in thesubsequent 18 months, but then repeated in 2007–09 when value stocks(influencedbybankstocks)underperformedgrowthstocksbyacumulative25%(seeFigure7.6).Fewinvestorshavetheconfidencetowithstandbeingentirely on the wrong side of such swings without making a mistakenreaction that would cost them dearly. As most equity investors nowappreciate,maintainingbalanceisaprerequisitetosleepingeasily.

FIG7.4CumulativetotalreturnperformanceofUSgrowthandvalueequityindicesDec1978–Sep2013

Source:©RussellInvestments2013.Allrightsreserved

FIG 7.5Volatility of US growth and value equity indices, 36-month rolling standarddeviationsofreturn%peryear,Dec1981–Sep2013

Source:©RussellInvestments2013.Allrightsreserved

FIG7.6USvalueandgrowthequityindices,5-yearrollingperformance%peryear,Dec1983–Sep2013

Source:©RussellInvestments2013.Allrightsreserved

Meanwhile, the possible risk explanations for the outperformance ofboth value as a style of equity investing and smaller company stocks castdoubtonthesuitabilityofbiasingcautiousinvestors’portfoliosinfavourofvalue (or small cap stocks). This reinforces the case for a broad marketapproach to investing. To overweight value stocks or smaller companystocksthenbecomesappropriateformoreaggressiveinvestors.

Fashionableinvestmentideas:lowvolatilityequitystrategiesInrecentyearstherehasbeenanenormousnumberofresearchpaperspublishedbyacademicsandinvestmentmanagersintostockmarket“anomalies”.Theholygrailforinvestmentmanagersisastrategythatofferstheprospectofhigherreturns(andsohighfees)atnohigheror,evenbetter,lowerrisk.Largelybasedonthefindingthatvaluestocks(whichareoftenlowvolatilitystocks)andalsosmallcapstockshavedeliveredhigherreturnsthanwouldbeexpectedbytheoriginalcapitalassetpricingmodel(CAPM),strategieshavebeendesignedtoexploittheseanomalies.Thishasledtoaproliferationofminimumvolatilityequitystrategieswhichselectportfoliosofstocksfortheirabilitytodeliverlowerportfoliovolatilitythantheequitymarketaswhole.

Itisacharacteristicoftheseapproachesthattheytendtooverweightlowbetastocks.ThesestrategiesareoftensoldonthepremisethatitisananomalythatlowbetastocksperformbetterthanwouldbeexpectedbythesimplifiedCAPM.However,asdiscussedabove,theremaybesystematicsourcesofriskthatarenotreflectedinthevolatilityorbetaofastock.Ifso,investorsoughttobe,andnormallyare,rewardedfortakingsuchrisk.“Badbeta”(seeStockmarketanomaliessectionabove)wouldbeoneexplanation.

Avariationonthis,proposedbyDandiBartolomeo,presidentofNorthfieldInformationServices,aninvestmentriskconsultancy,isthatthemarketmaybereflectingtheinteraction

ofacompany’ssharepricevolatility,itsfinancialleverage,andsobankruptcyrisk.Ifso,themarketmightrationallycompensateinvestorsforthisterminationrisk(andimplicitshortercorporatelifeexpectancy)withalowersharepriceandhigherreturn.Thisideathatthecomparativelylowvolatilityofasharepricemaybeamisleadingguide,whentakeninisolation,toacompany’sinvestmentriskhasechoesofthelessondrawnfromthecompletelydifferentcircumstancesoftheMadoffaffairinChapter1:thatinvestmentriskismostobviouswhenaninvestmentisvolatileandisleastobviouswhenariskyinvestmenthasnotyetshownmuchvolatility.

Equitydividendsandcautiousinvestors

Cautious investors should follow cautious strategies. In so far as theircautionallowsthemamarginofequityinvestments,equityriskshouldnotbemagnifiedbyfollowinganundiversifiedapproachtoequityinvesting.Afocus on dividend yield can easily result in amplified equity risk. Thedisadvantage of relying on a stock portfolio for essential income is that itwillnotprovidetheelementofinsurancethatisavailablefromgovernmentbondsasitprovidesalesscertainsourceofincome.Highdividend-yieldingequities are likely to be particularly vulnerable to company-specific andeconomy-widedisappointments inearningsgrowthand threats to the levelofdividends.

Inconclusion,treatscepticallyanysuggestionthatinvestingindividend-paying equities represents a sound investment strategy that is likely todeliver both dependable growing income and accumulating capital values.Anaggressiveinvestorwhohasaneedforincomemightemphasisehigher-yieldingequitiesandfixed-incomeinvestments.Foracautiousinvestor,anysuch tilt should be modest. Such a strategy is not a magic solution forconstrained finances, especially in an era of unusually low yields ongovernmentbonds.

Homebias:howmuchinternational?In recent years, investors around the world have allocated a growingproportionoftheirequityinvestmentstointernationalmarkets.Despitethis,equity investors in almost all countries still have a strong bias towardsdomestic investment.The reasons for this have been debatedwidely.Any

suggestion that domestic equities provide a better “match” for domesticcurrency obligations has little substance. The appropriate measure of“mismatch” is how well risk assets (such as domestic equities or foreignequities)correlatewiththerisk-freeasset,whichforalong-terminvestoristhedomesticinflation-linkedgovernmentbond.Althoughdomesticequitiesmay correlate better than international equities with domestic governmentbonds, they do not constitute any sort of “safe-haven” asset for long-terminvestment. But the reassurance of familiarity and habit, together withmisunderstandings about the contribution of currency risk, largely explainthecontinuinghome-countrybias.

In most countries, this home-country bias is a significant riskmanagement issue. However, the size and breadth of the US market,representing 48% of the world market in September 2013 according toMSCI, an index provider, means that well-diversified investors in USequitieswillhavealreadyachievedthebulkofthediversificationgainsthatareofferedbyaglobalapproachtoinvesting.Forinvestorsinmostcountriesinternational equity diversification matters a lot, but for US investors itmattersless.

A recurring theme of this book is that investment strategy should bebroadly appropriate for an investor’s objectives, risk tolerances andpreferences.Exceptforsomecashflowmatchingbondportfolios,precisioninidentifyingasuitablestrategyisapipedream.Internationalinvestingisanarea where strongly held differences of view on strategy are oftenindistinguishable within the range of broadly appropriate investmentstrategies. Despite this, when the performance numbers come in thedifferencescanbelarge.Thisleavesaconsiderablemarginofflexibilityforan investor’s gut preferences to influence policy legitimately. Ininternational investing there is a rangeof appropriatediversified strategiesanditwouldnormallybeinappropriatetosuggestthataparticularstrategyisexpected to be demonstrably superior to all others. For example, thediversification benefits of international investing are always subject todiminishingreturns.Doingalittlemaygetaninvestora longwaytowardswhateverisreckonedtobean“optimal”strategy.

Figure 7.7 shows (from aUS perspective) the scale of the differences

that can exist between US and international investing. After 1989, theUnitedStatessubstantiallyoutperformedforeignmarkets,asmuchbecauseoftheprolongedweaknessoftheJapanesemarketafter1989asthestrengthoftheUSmarket.Thispatternwasreversedafter2002.Figure7.8showstheUK has experienced fewer periods of marked outperformance orunderperformancebyinternationalequities.

FIG7.7USandinternationalequities,5-yearrollingequityperformance%peryear,$,Dec1974–Sep2013

Note:TheMSCIEAFE™IndexiswidelyusedintheUnitedStatestomeasureinternationalequitymarketperformance.ItcomprisestheMSCIcountryindicesthatrepresentdevelopedmarketsoutsideNorthAmerica:

Europe,AustralasiaandtheFarEast.Source:MSCI

FIG7.8UKandinternationalequities,5-yearrollingperformance%peryear,£,Dec1974–Sep2013

Source:MSCI

There are two reasons for investing internationally: opportunity anddiversification.Thenaturalstartingpoint,fromatextbookperspective,istheglobalmarket,withconsiderationbeinggivento thepossibilityofhedgingdirect foreign currency risk. A global approach to investing should beappropriateforallequityinvestors.Other,domesticallyorientedapproachescan also be appropriate; however, even for US investors there aredemonstrable diversification benefits and increased opportunities to begainedfrominternationalequityinvesting.

The easiest way to assess the benefits from international equitydiversification is to examine how it affects the measured risk of equityinvesting,usingtheconventionalmeasureofrisk:thevolatilityorstandarddeviation of returns.Thismetric is also used as the guide to the expectedgains from international investing, because the prudent (and consistent)assumption is that the same expected rate of return will apply tointernationalanddomesticequityinvestments.Theoutcomewillnot(exceptby chance) be the same, but in setting strategic allocations, it is safest toassumethatwedonotknowinadvancewhichequitymarketismorelikelytodobest.

This sidesteps the issue of whether there are any taxes or additionalmanagement costs that apply to international equity investing but not to

domesticinvestors.Ifthesearenoticeable,theyshouldbetakenintoaccountin determining international allocations. In what follows, this issue isignored,andthefocusisonvolatilityastheproxyforrisk.Figure7.9showsfor a number of countries the volatility of theMSCIWorld Index (shownunhedgedforforeignexchangerisk)andthevolatilityofthedomesticequitymarket,bothmeasuredineachcountry’sowncurrency.

FIG 7.9 Volatility of domestic and global equities from alternative nationalperspectivesAnnualised%standarddeviationofreturns,Jan1999–Sep2013

Source:AllmeasurementsinlocalcurrenciesusingMSCIAllCountiresWorldindex.“GreaterChina”representedbyMSCIGoldenDragonindex,

measuredinUSdollars,andincludesChina,HongKongandTaiwan

The pattern varies with the period that is chosen, but for this 14-yearperiodthepatternisclear.Forsmallerequitymarkets,morecanbegainedinreducingequityvolatilitybyfollowingawell-diversifiedglobalratherthanapurelynationalapproachtoequityinvesting.ThisisillustratedinFigure7.9by comparing “greater China” (represented by the MSCI Golden Dragonindex,whichincludesChina,HongKongandTaiwan),IndiaandSingaporewith theUnitedStates.Not surprisingly, Figure 7.9 suggests that efficientequitymanagementwouldrequiresubstantialinternationaldiversificationbyinvestorsfromthesecountries(amongothercountries),butthisismuchless

clearforUSinvestors.Repeatingthisexerciseoverdifferentperiods,theresultthatconsistently

emerges is that theUS stockmarket providesUS investorswith a level ofequitydiversificationclosetothatachievedbyglobaldiversification.Othersmaller national markets have not provided their domestic investors withcomparablediversification,exceptoverparticularperiods,whichshouldnotbeextrapolatedintothefuture.

Figure 7.10 shows the volatility trade-off between domestic andinternationalequitiesfortheUnitedStates,greaterChinaandIndiainmoredetail.Thedifferenceinthelinesshownforthethreecountriestellsastory.From a US dollar perspective, there is little apparent benefit in terms ofreduced volatility from international investing. For Indian investors inparticular, the historical data show a clear pattern, with equity volatilitypotentially being almost halved for investors who invest 80% of theirholdings in well-diversified holdings outside India. These exercises alsoillustratetheimpactofdiminishingreturnsontheprocessofdiversification:thebiggestcontribution todiversificationcomes fromthe initial foray into(diversified)internationalequities.

FIG 7.10 Who needs international equity diversification? Volatility of equityinvestmentsfromaUS,ChineseandIndianperspective

Source:Author’scalculationsusingMSCIindices,January1993–May

2013

The scale of the potential diversification gains from internationalinvestingdependsonthevolatilityoftheinternationalequitiesandonhowhighly international prices correlate with those of domestic equities. Thehigher the correlation, the less well international equities will diversifydomesticequities,andthelesswillbethescopeforreducingoverallequityvolatilitybyadding internationalequities. It shouldbenosurprise that thedegree of correlation is unstable, as is the level of volatility.Critically, attimesofcrisismeasuresofcorrelationandvolatilityoften“jump”upwards.Butjustbecausecorrelationsincrease,itdoesnotnecessarilyfollowthatthebenefits of international diversification are diminished if at the same timevolatility increases. This will, however, mean that systematic orundiversifiableriskfromequityinvestinghasincreased.

Figures7.11and7.12showmovementsincorrelationsofdomesticandinternationalequitiesfromtheperspectiveofUSandUKinvestors.Havingbeenunusuallylowinthemid-1990s,andhavingdippedagainaheadofthecredit crisis, correlations between US and international equities, whetherwith other developed markets or with emerging markets, have generallybeenhighinthepasttenyears.Figure7.12showsasimilarpatternfortheUK.Despite the increase incorrelations, internationalequitiesstillprovidevaluablediversificationbenefits.

FIG7.11CorrelationsbetweenUSequitymarket,internationalequitiesandemerging-marketequities36-monthrollingcorrelations,Dec1990–Sep2013

Source:DerivedfromMSCIindexdata

FIG7.12CorrelationsbetweenUKequitymarket,internationalequitiesandemerging-marketequities36-monthrollingcorrelations,Dec1990–Sep2013

Source:DerivedfromMSCIindexdata

Whoshouldhedgeinternationalequities?Thisdiscussionof international equity investinghas ignored the impactofcurrencyrisk(whichisdiscussedfurtherinChapter8).Thereliableruleof

thumbisthatcurrencyexposureininternationalequitiesgenerallyaddslittleto the risk of equity investing (this is in contrast to international bonds,wherecurrencyhedgingalmostalwaysachievesasignificantriskreduction– see Chapter 8). But recent research has shown that this generalisationneedsqualifyingtoallowforthetendencyforsafe-havencurrenciestomoveagainst equity markets, which is a particularly valuable characteristic attimesofequitymarketstress.ResearchbyJohnCampbell,KarineSerfaty-deMedeirosandLuisViceirapublishedintheJournalofFinance in2010hasshownthatbetween1975and2005holdingsoftheUSdollar,theSwissfranc and the euro (and before that the Deutschmark) diversified globalequity risk. This means that US, Swiss and German (and then euro)investorswouldhaveprofitedat timesofglobalequitymarketweaknessifthey had hedged their international equity exposure for currency risk.Hedging international equities for currencyexposuredoesnotmuchaffectthevolatilityofinternationalequityinvestingbutitdoesaffectthepatternofequityreturns.Forinvestorsfromsafe-havencurrenciestheresearchshowedthat it reduced losses (as compared with not hedging) at times of equitymarket weakness. An investorwith a currencywhich tends tomovewithequitymarkets (for example, strengthening inbullmarkets andweakeningwhenequitiesweaken)reducesriskbynothedging,andislikelytoreducelossesintimesofmarketstress.Historically,thishasappliedparticularlytotheCanadianandAustraliancurrencies,andtoalesserextentsterling.

However,acurrencycanrepresentasafehaveninoneperiodbutnotinanother. The changing views of sterling, and also the euro, suggest thatbefore drawing on this research to inform a decision to hedge or not tohedge internationalequities, a separateviewneeds tobe takenonwhetherthe investor’s base currency is likely to have “safe-haven” status in theperiodahead.Nevertheless,forinvestorswithsafe-havenbasecurrencies(orwhose currency is linked to a safe-haven currency), foreign currencyhedging can provide an element of valuable (and inexpensive) insurancewhichislikelytoprovideapay-offattimesofcrisis.Inexpensiveinsurancepoliciesthatarelikelytopayoutin“badtimes”areparticularlyattractivetoinvestors.

Thesedifferentnationalperspectivesoncurrencyhedgingare reflected

in Figure 7.13, which shows the volatility of hedged and unhedgedinternationalequities(asmeasuredbyMSCIindexdataforthevolatilityofhedged and unhedged world equities excluding that country). Consistentwiththefindingsofacademicresearch,unhedgedinternationalequitieswerelessvolatilethanhedgedinternationalequitiesforAustralianandCanadianinvestors. For Japan, Switzerland and theUnited States, currency hedgingnoticeably reduced internationalequityvolatility.For theUKand theeurozonethereductioninvolatilitywasscarcelynoticeable.ThisisalsoreflectedinFigures7.14and7.15which show thevolatilityover timeofunhedgedandhedgedinternationalequitiesfromaUSandthenaUKperspective.

FIG 7.13 International equity volatility from the perspective of different countries,annualisedstandarddeviationofreturns%,Jan1999–Sep2013

Source:MSCIWorldexorAllCountriesWorldexindexdatainlocalcurrencies.ForCanadaandSwitzerlandinternationalequitiesproxiedby

worldequities

FIG7.14USperspectiveonimpactofhedginginternationalequities,36-monthrollingstandarddeviationofreturns%peryear,Dec1990–Sep2012

Source:DerivedfromMSCIindexdata

FIG7.15UKperspectiveonimpactofhedginginternationalequities,36-monthrollingstandarddeviationofreturns%peryear,Dec1990–Sep2013

Source:DerivedfromMSCIindexdata

Howmuchinemergingmarkets?Over thepast25years“oldworld”developedmarketshave(inaggregate)declined in weight in global equity markets as the so-called emerging

markets,particularlyofAsia,havegrowninimportance.Emergingmarkets,asclassifiedbyMSCI,includesuchcomparativelydevelopedeconomiesastheCzechRepublic,Chile,SouthKorea,Taiwan,theUnitedArabEmiratesand,witheffectfromNovember2013,Greece.TheMSCIemergingmarketsindex represented less than1%of theworldmarket in 1988, a figure thathad grown to around 13% by the end of 2012, with over half the indexaccountedforbyChina,SouthKorea,BrazilandTaiwan.

Opinionsabouttheroleofemergingmarketsinglobalequityportfoliosdiffer. Some favour emerging markets because of their increasingimportance in the global economy, their impressive track record, theirdiversification benefits and the prospect of higher rates of return. FasterGDP growth in these markets is often cited as a reason for expectingsuperiorreturnsfromemergingmarkets,butthisiscontroversial,andhistoryshowsthatthelinkbetweenacountry’seconomicgrowthandthedomesticequitymarketcanbemoretenuousthanisoftensupposed.

There are several reasons for this. First, much economic growth canreflecttheactivityofthegovernmentsector,theunlistedprivatesector,orofcompanieswhicharelistedinothercountries.Inaddition,eveninemergingmarkets, domestic listed companies may earn much of their profits fromabroad.ElroyDimson,PaulMarshandMikeStauntonofLondonBusinessSchool have examined the relationship between economic growth andstockmarketperformanceacross19countriesovermorethan100yearsanda further 40 countrieswithmore than 25 years’ stockmarket performancerecord and “find no evidence of economic growth being a predictor ofstockmarketperformance”.However,theydothinkitisreasonabletoexpecthigher performance from investing in emerging markets rather thandevelopedmarkets, not because they are growing faster, but because theyareriskier.

The figures below illustrate this. Figure 7.16 shows that emergingmarkets are more volatile than developed markets. In part this reflectsinferior diversification in the emerging markets (which is not a risk thatshould systematically lead to higher returns) but also it reflects emergingmarkets behaving as if they provide a geared exposure to world markets(whichleadstohigherexpectedreturns).

FIG7.16Volatilityofworldandemerging-marketsequities,5-year rollingannualisedstandarddeviationsofreturns%peryear

Source:MSCIWorldandMSCIEmergingMarketsindexdatainUSdollars

Figures7.17and7.18showthatinthemonthswhendevelopedmarketshaveperformedbest,emergingmarketshavetendedtodoevenbetter,andthat when developedmarkets have recorded their worst results, emergingmarketstendtoperformevenworse.Thishighbetacharacteristic(seealsoFigure7.19)isareasontoexpectpremiumreturnsfromemergingmarkets,butitisarewardforrisk-takingandinvestorsneedtoconsiderwhethertheywill be sufficiently patient to weather the inevitable periods ofdisappointmenttoharvestthatlonger-termpremiumreturn.

FIG 7.17 Performance of emerging-market equities in best up months for worldequities%,Jan1990–Sep2013

Source:MSCI

FIG 7.18Performance of emerging-market equities inworst downmonths forworldequities%,Jan1990–Sep2013

Source:MSCI

Sincethelate1990s,theemergingmarketshaveconsistentlyhadahighbetawithrespecttoworldequities,averaging1.3betweenJanuary2000andMay 2013 (see Figure 7.19), suggesting it ought to be rewarded with anextrapremiumreturnofperhaps1%peryear,ifmarketsoperateefficientlyandarefairlypriced.Butatthesametime,thecorrelationofthesemarketswiththeworldindexhasincreasedfromaround0.4inthetenyearsbefore

themid-1990stoaround0.9inthefiveyearsto2013.Evenwiththeselevelsof correlation, an allocation to emerging markets provides usefuldiversificationbenefitsinamorevolatileenvironment.(Knowingthebetaofemerging markets with world markets and also their correlation tells usabout theirvolatilityrelative toworldmarkets,ascanbeseenfromFigure7.17.)

FIG7.195-yearrollingbetaabetweenemerging-marketandworldequitiesTotalreturn,%,Dec1992–Sep2013

aSeeAppendix1.Source:DerivedfromMSCIworldequityandMSCIemergingmarket

equityindices

FIG7.2010-yearrollingreturnsfromdevelopedandemerging-marketequities%peryear,Dec1997–Sep2013

Source:MSCIworldequityandemergingmarketequitygrossreturnindicesinUSdollars

Figure7.20showsthatprolongedperiodsofdisappointingperformanceareevidentevenintheshortperiodcoveredbytheMSCIEmergingMarketsindex.Inthe15yearssincetheMSCIindexstartedatthebeginningof1988,the rolling ten-year performance record has been equally divided betweenperiods with developed markets outperforming emerging markets andperiods when emerging markets outperformed. A predecessor index(covering yearswhen emergingmarketsweremuch smaller as a share ofglobal equity markets) shows emerging markets underperforming in theprevious decade. Emerging markets may offer the prospect of superiorperformancetocompensateforhigherrisk,butinvestorsneedtobeabletowithstandprolongedperiodsofunderperformance.

Forinvestorswhoaresurethattheyhavethecapacityandtheinclinationtoactasrisk-tolerant,long-terminvestors,CampbellHarvey,J.PaulStichtprofessor in international business at Duke University’s Fuqua School ofBusiness,argues that theundiversifiable riskcharacteristicsof investing inemergingmarkets goes wider than the observation that emergingmarketsprovideagearedexposuretoglobalmarkets.Thesewidersystematicfactorsinclude illiquidity, the scope to exploit inefficiencies in pricingwhich arestill reflected in segmentation of emerging equity markets, as well as anegativeskewofreturns,andtheexposureto“tailrisk”thatisexacerbated

by exposure of emerging markets to contagion and the risk of explosivevolatility due to “regime changes”. Harvey argues that these should beregarded as “known unknowns” of emerging-market investing. Emergingmarkets alsobenefit from the strong linkbetween liberalisationof financeand subsequently lower discount rates and faster growth. A patient long-terminvestorshouldhavetheabilityto“timediversify”theserisks,butalsoneeds to be aware that, often because of institutional failings, not allemergingmarketscantakeadvantageoftheirgrowthopportunities.

Foralong-terminvestorwiththeappetiteandcapacitytostomachtheserisks, Harvey says that the allocation within global equities to emergingmarketsshouldtakeasapointofreferencenotjusttheweightofemergingmarketsinglobalequitymarkets(around13%attheendof2012)butalsotheir weight in world GNP (around 37% in 2011, according to GoldmanSachs).

Fashionableinvestmentideas:frontiermarketsIninternationalinvesting,itiseasyforinvestorstobedrawnintothelatest“fashionable”theme.Whatisfashionableisoftenpotentiallyilliquid,withsurprisinglylowmeasuredvolatilityandattractivediversificationcharacteristics.Sometimesthesecharacteristicswillindicateinefficienciesandopportunitiesforactivemanagers.Theyalsoindicatepotentialliquidityissuesthatcouldariseinaflighttoquality.Atsuchtimes,asinvestorslearnedin2008,previouslyreassuringcorrelationsbetweenriskassetstypicallyincreaserapidlyandinvestmentvehicleswhosediversificationqualitiesweretoutedbyeagersalesmensuddenlydetractfromratherthanaddtoportfoliobalance.Frontieremergingmarketsarealikelycandidateforsuchpromotion.

FIG7.21World,emergingandfrontiermarkets,36-monthrollingcorrelationsDec2008–Sep2013

Source:DerivedfromMSCIfrontieremergingmarket,emergingmarketandworldequityindices

Figure7.21showsrollingthree-yearcorrelationsbetweenemergingmarkets,frontieremergingmarketsandtheMSCIWorldEquitymarketindex.TheFrontieremergingmarketindex(whoselargestcountryexposuresattheendofMay2013wereColombia,thePhilippines,Kuwait,NigeriaandQatar)showsamuchlowercorrelationwithworldequitymarketsthandoesthemainstreamemerging-marketsequityindex.Butamoredetailedexaminationofthereturnsseriesforfrontieremergingmarketsshowsagreaterdegreeofstickinessofprices(serialcorrelation),negativeskewandliabilitytoextremereturns(excesskurtosis)thanisthecasewiththebroademerging-marketsindex.Aswithemergingmarkets,aninvestmentinfrontiermarketsshouldbejustifiedbyalongtimehorizon,anappetitefortakingriskandanexpectationoflong-termrewardfortakingrisk.Anydiversificationstoryismostunlikelytobehelpfulwhenitismostneeded.

8 Credit

THECREDITCRUNCHOF2007–09showedmanybondportfoliostobelesswelldiversified than their managers believed them to be. It also reminded allinvestors that creditworthy government bonds are usually by far themostreliable diversifiers of risk assets. Before the credit crunch most bondportfolios became increasingly complicated as managers embraced newways of packaging, and they thought diversifying, credit risk. The bondmanagers who performed best in the “bad times” of 2008 included thosewhowerepreviouslydismissedas irredeemablyoldfashionedbysomefornot adoptingwhatwerewidely seen as new and betterways ofmanagingportfoliorisk.Table8.1showstheperformanceofgovernmentbondsintheUnitedStates,GermanyandtheUKin2008–09andthatofcorporatecreditand equities. It shows government bonds diversifying best whendiversificationismostneeded,thatisin“badtimes”.

TABLE8.1Governmentbondandequitymarkets%annualtotalreturn,2008and2009

2008 2009

BarclaysUSTreasuryindex 13.7 –3.6

BarclaysMunicipalbondindex –2.5 12.9

BarclaysUSCorporateinvestmentgrade –4.9 18.7

BarclaysUSCorporateHighYield –26.2 58.2

MSCIUSAAllequityindexgrossreturn –37.1 28.8

BarclaysGermanGovernmentbondindex

11.2 2.9

BarclaysEuroAggregateCorporate –3.8 15.7

BarclaysEuroAggregateCorporateinvestmentgrade

–3.8 15.7

BarclaysPanEuroHighYield –34.2 76.1

MSCIEMUgrossreturnequityindex –44.3 28.7

BarclaysSterlingGovernmentbondindex

12.9 –1.0

BarclaysSterlingAggregateCorporatebondindex –10.0 14.7

MSCIUKgrossreturnequityindex –28.5 27.7

Sources:Barclays;MSCI

A holding of government bonds should have been, and for manyinvestors was, sufficient to mitigate materially the damaging impact oninvestorwealthofthecollapseinriskassetpricesin2008.Mostbondfundshavealwaysexploited thepremiumyield (inexcessofgovernmentbonds)offeredbyexposuretocreditandthisunderminedthediversificationofferedbybondholdingsin2008.

Many lessonshavebeen learned, but themost important lesson is thatbondportfoliosdonotneedtobecomplicated, thoughtheyoftenare.Thischapterprovidesanoverviewofcreditandcreditratingsandwhyinvestorsmaynotreceivethepremiumreturnseeminglypromisedbysuperioryields.Italso introduces“securitisation”,which is theprocessof turningpoolsofbankloans(suchasmortgages)intomarketablesecurities,andgivesabriefintroductiontotheworldofcreditderivatives,whichare,andwillcontinuetobe,usedextensivelyinthemanagementofcreditportfolios.

However, a useful starting point for thinking about credit is anelementaryreviewwrittenbyJohnMaynardKeynes,aneconomist,in1925ofastudyoflong-termreturnsfromequitiesandbondsintheUnitedStatesbetween1866and1922.Thestudyshowedasubstantialoutperformanceofequitiesoverbondsinperiodsofbothdeflationandinflation.Keynesfoundthiscounter-intuitive,hisexpectationbeingthataperiodofdeflationwouldbebetterforbondsthanequities.Hesuggestedanumberofreasonsfortheinferiorperformanceofbonds:

Theasymmetricalthreatofchangesinthepricelevel.Whilebondscanbeerodedbyinflationwithoutlimit,thescopeforthepricelevel

tofall(whichwouldbenefitbondholders,solongasbondissuershavetheabilitytorepaythesehigherrealvalues)ismoreconstrained.

Althoughabondmaydefault,nobondeverpaysmorethanitscoupon.

Companymanagementsideswithequityinvestorsratherthanwithbondholdersand,“inparticular,managementcannormallybereliedontorepaybondsatdatesmostadvantageoustotheshareholdersandmostdisadvantageoustothebondholders”.

Retainedearningsprovideanelementofcompoundgrowthbeyondthedividendyield,andthiseventuallyaccruestoshareholdersinhigherprices(whilealsomakingexistingbondholdersmoresecureintheirentitlementtoafixedincome).

This underlies the message of many advisers and of a number ofacademics that the natural habitat for genuinely long-term investors is theequity market. Nevertheless, almost all investors do, and should, seekdiversification away from equity risk. In Part 1 this was argued from theperspective of investing in government bonds. This chapter provides thebackgroundtoothertypesofcreditinstrument,whichintroducenewaspectsofriskinreturnfortheprospectofnewsourcesofexcessperformance.Animportant element in this is the trade-off between credit quality andperformance.

Creditqualityandtheroleofcredit-ratingagenciesCredit-rating agencies originated early in the 20th century to assess thecreditworthinessandpublishratingsofsecurities.Inpractice,thetworelatedrisks that matter are default by a borrower and a deterioration in theassessmentofcreditworthinessofaborrowerwhoneverthelesscontinuestomeet contractual obligations. Investors routinely use the ratings of theleadingagenciestomeasurethecreditqualityoftheirportfoliosandalsoasthresholds to specify the minimum credit quality eligible for inclusion inparticularportfolios. Ineffect, thishasenabledprivate investorsandmanyinstitutional investors to outsource analysis of credit risk to these rating

agencies. Furthermore, capital adequacy guidelines for international bankshave incorporated a formal role for ratings assigned by the leading ratingagencies. This development in the regulation of banks encouraged theprocess of securitising bank loans, which enabled banks to shift creditexposures to other investors on a large scale. It also promoted thedevelopment of new credit instruments and markets as well as whatregulatorsquicklysawasanunhealthyrelianceontheassessmentsoftheserating agencies rather than research undertaken by banks and investmentinstitutionsthemselves.

Historically,a rating fromanagencyhasoftenbeenaprecondition formarketing a new security and the credit-rating agencies have had amajorroleinpromotingmarketliquidity.ThelatePeterBernsteinwrotein2007:

Theratingagenciescontribute(oratleasthavecontributed)tomarketliquiditybecausetheyspareinvestorsthetroubleofcarryingouttheirowncreditresearch.

Acuteproblemswiththeratingofsomestructuredproducts,particularlythosefocusedonsubprimemortgages,underminedconfidenceintheratingprocess. However, there has been no corresponding deterioration in thereliability of the ratings of corporate bonds. The long-term ratingclassifications used by the three main agencies – Fitch, Moody’s andStandard&Poor’s–areshowninTable8.2.

TABLE 8.2 Long-term rating bands of leading credit-rating agencies

Note:Precisedefinitions,whichvarybetweenratingagencies,aregivenonthewebsitesofparticularagencies.

An important break point in Table 8.2 is between investment gradesecurities and non-investment grade securities. The latter are commonlyreferred to as speculative or high yield. The ratings are intended to beobjectiveassessmentsofthecreditworthinessofborrowersorofinstrumentsand are reflected in the spreads that borrowers must pay to compensatecreditorsfortheriskofdefault(orofadeteriorationincreditrating).

Table8.3showsaveragedefaultratesforperiodsofuptotenyearsforcorporate bonds of differing credit rating based on experience from Fitchovertheperiod1990–2012.Thetabledemonstratesthattheratingagenciesperform at least reasonably well in assessing the likelihood of differentcorporatebondissuesdefaulting.Itsuggests,forexample,thatAAAbondshadnoexperienceofdefault,whilehigh-yieldbondsratedCCChada25%riskofdefaultover thenext12monthsanda37%riskofdefaultover thenextfiveyears.ThesedefaultratesareaveragesforFitch-rateddebt.

TABLE8.3Corporatebondaveragecumulativedefaultrates%,1990–2012

Source:FitchRatingsGlobalCorporateFinance,2012TransitionandDefaultStudy

FIG8.1DefaultrateofFitch-ratedissuersofcorporatebonds%ratedissuers

Source:FitchRatingsGlobalCorporateFinance,2012TransitionandDefaultStudy

Figure 8.1 shows that the incidence of bond defaults is cyclical. Itreflectsthedefaultexperienceofall issuersofFitch-ratedcorporatebonds,whether theyhavebeen rated investmentgradeor speculative. Indeed, theoverwhelming majority of defaults by rated companies were ascribed aspeculativeratingbeforetheydefaulted.Forexample,Fitchreportsthatall18of itsratedbondswhichdefaultedin2012werebondswhichFitchhadratedasspeculativegradeatthestartof2012.

ThepatternshowninFigure8.1isconsistentwiththepatternovermuchlonger time periods. A 2011 article by four financial economists, KayGiesecke, Francis A. Longstaff, Stephen Schaefer and Ilya Strebulaev,“Corporate bond default risk: A 150-year perspective”, found that defaultexperienceishighlyclusteredandthatonaverageintheUnitedStates,1.5%ofcorporatebondsdefaultedeachyearbetween1866and2008.However,the authors report, based on other research, that investors probablyrecovered on average around 40–50% of the amounts due, suggesting anannuallossratetoinvestorsinalltypesofcorporatebondsofaround0.75%per year. Over the long term, the authors found that “credit spreads areroughly twiceas largeasdefault losses, resulting inanaveragecredit riskpremiumofabout80basispoints”.

Table 8.4 shows how spreads over US Treasuries have varied with

differences in credit rating. These spreads follow the ordering of formalcredit-rating assessments, suggesting that the financial markets broadlysharetheassessmentsoftheratingagenciesasyieldspaidincreaseasratingsdeteriorate.Italsoshowsaverageperformanceof thecorporatebondswithdifferentratings.Notethatthepremiumreturnsearned(column4)tendtobenoticeablylessthantheaverageyieldspreadonwhichtheywillhavebeenpurchased(column2).Thisdiscrepancyisdiscussedbelow.

TABLE8.4USCorporatebondyields,spreadsandperformanceFeb1987–Sep2013

aAllmaturities.Source:Barclays

FIG8.2UScorporatebondspreads%peryear,Feb1987–Sep2013a

aIntermediatetermbondyieldsrelativetoUSTreasuries.Source:Barclays

Figure8.2 shows that credit spreads are, like thedefault rate, cyclical.However, thedetailed researchbyGiesecke andher colleagues found thatmovements in credit spreads were a poor predictor of future defaultexperience.Instead,theyfoundthatmovementsincreditspreadswerebestexplained by movements in financial variables such as the stockmarket(spreads narrow as the market goes up), and of its volatility (spreadsincrease as stockmarket volatility increases), and by changes in the short-term Treasury bond rate (spreads generally increase as the risk-free ratefalls).These resultsmatter for investors,as theysuggest thatageneralisedincrease in spreads is more likely to reflect adverse changes in marketliquidity, for example, which a long-term investor should be able towithstand,thantobeareliableforecastofthelikelihoodofdefault.Thisisconsistentwith the recoveryofcreditmarketsafter theseverewideningofspreadsin2008.

Although credit spreads have more than compensated for the defaultexperience of corporate bonds, it does not follow that investors havenecessarily been adequately rewarded for investing in corporate bonds.Figure8.3showstheperformancefortheBarclaysUSTreasurybondindexalongside that for single A-rated corporate bonds and also for high-yieldcorporatebonds.ThisshowsthesuperiorperformanceofsingleAbondsand

alsohighlightstherisksandvolatileperformanceassociatedwithhigh-yieldbonds.

FIG8.3CumulativeperformanceofUSunder10-yearTreasuryandcorporatebondsJan1987–Sep2013,Jan1987=100

aAllmaturitiesforhighyield.Source:Barclays

Table 8.5 shows how the performance of investment grade credit haspersistently delivered a smaller premium return over Treasury bonds thanwouldbesuggestedbythespreadsofferedbytheindex.Inthetablethisisshownbytheunexplained“performancegap”.

Some performance gap should be expected from the impact ofoccasionaldefaults.But their impacthasbeen toosmall toaccount for theperformancegap inTable8.5.Fitch,oneof the three leading internationalratingagencies,reportsthattheaveragefive-yearcumulativedefaultrateforFitch-ratedinvestmentgradebondissuersaveraged1.2%between1990and2012, or 0.25% per year. However, actual losses will have averaged lessthanthisasaresultofrecoveriesof,probably,around40%ofamountsdue.

TABLE8.5USinvestmentgradecreditspreadsandexcessreturns%peryear

Note:Noallowancemadeforfees.Source:DerivedfromBarclaysintermediateindicesforUSTreasurybondsandUSinvestmentgradecredit

Defaultsof investmentgradebondsthereforecannotexplainthefailureof the spreads at which investors buy such bonds to translate intocorrespondingpremiumperformance.Otherpossiblecausesofperformancedifferenceincludeamovementofcreditspreadsbetweenthestartandendofa period of comparison and the likelihood that the corporate bonds andgovernment bonds have different durations, and so respond differently tomoves in government bond yields over a particular period. These can beimportantovershortperiodsoftime,butoverthe40-yearperiodcoveredbyTable 8.5 this cannot be material (not least because the Barclaysintermediate indices shown in the table comprise bondswith less than tenyears’remainingmaturity).

Insteadthereasonisinstitutionalandrelatedtoindexcompositionrules.Investorscommonlyhavecredit-qualityguidelinesfortheirportfoliosorthefunds in which they invest, and the managers of investment grade bondportfolios are typically obliged to sell when bonds get downgraded to ahigh-yieldorspeculativerating,andperhapswhenthebondshavelessthanoneyeartomaturity(andsoareexcludedfromtheindex).

Antti Ilmanen, the author ofExpected Returns, An investor’s guide toharvestingmarketrewards,andKwok-YuenNgandBrucePhelps,authorsofa2011FinancialAnalysts’Journalarticle,“CapturingtheCreditSpreadPremium”, have highlighted the asymmetry between a bond’sunderperformance before it is downgraded from investment grade and abond’s(possiblythesamebond)outperformancebeforeitgetspromotedto

investment grade from high yield. An investor with a credit-qualityguidelinewhichrequiresthesaleofanyspeculativegradebondwillloseoutby suffering the underperformance before the downgrade and also bymissingtheoutperformanceofsoon-to-be-upgradedbonds.Theinvestorwillalso suffer from the much larger transaction costs that are paid whendowngraded bonds are sold. A low-fee index tracking fund which ismirroring an investment grade bond index will suffer these performancepenalties,while an activelymanaged bond fundwhich tries to exploit thephenomenonconfrontsasteepperformancepenaltyfromhighfees.Intheirdetailedanalysis,NgandPhelpsestimatedthatabuy-and-holdapproachtodowngraded bonds would have improved investment performance onaverage by 0.38% per year between 1990 and 2009. The risk of default,whichincreasesthelongerthematurityofabond,emphasisestheneedforany buy-and-hold approach to investing in corporate bonds to be welldiversified.

Portfoliodiversificationandcreditrisk

Thewords that rating agencies use to describe sub-investment grade debt,suchas“speculative”,“highlyspeculative”or“poorquality”,fairlydescribetheriskofindividualissueswhentreatedinisolation.

For a long time it has been evident to investors in well-diversifiedcorporatedebtthattheperformanceofthemarketismuchlessvolatilethanthe performance of an individual issue, and that when the market isperformingwell,goodperformancecanbeprovidedbyaportfolioofwell-diversifiedhigh-yieldbonds.So, it is inappropriate toregardaportfolioofhigh-yield bonds as if it had the risk characteristics of an individual sub-investmentgradebond.Equally,thestronglanguagethatratingagenciesusetodescribe theriskof individualhigh-yieldbondsshouldremind investorsthat the only sensibleway to invest in such credit risk is through awell-diversifiedportfolio.Diversificationamongaportfolioofhigh-yieldbondswill reduce the risk of an adverse event affecting a particular issue.However,whileafundwilldiversifytheidiosyncraticrisksassociatedwithindividualhigh-yieldbonds,itdoesnothingtoreducethesystemicriskthat

candriveallpricesinthemarket.

TABLE 8.6 Performance of selected debt markets in months of extreme US equityperformanceJan1994–Sep2013

Sources:Barclays;JPMorgan;MSCI

Table 8.6 compares the performance of the US government bond andinvestment grade credit indices with that of the high-yield and emerging-market debt markets in the months of most extreme US equity marketperformancesince1994.Debtissuedbysovereign(orcorporate)borrowersofemergingmarketsoffersanalternativesourceofdebt-based risk-taking.ThisdebtmaybedenominatedinUSdollarsorinthecurrencyoftheissuer(but see Local currency emerging-market debt box below). Such debtperformedwellintheyearsaftertheliquiditycrisisofAugust1998.Inthatmonth, the JPMorganemerging-marketdebt index fellby29%,more thantwice the amount it fell in October 2008 (see Table 8.6). The 1998experience revealed theundiversifiable riskof contagion in themarket foremerging-market debt. This risk may have lessened as more emergingmarketshaverepaiddebt,accumulatedforeignexchangereserves,acquiredinvestment grade credit ratings and evolved towards joining the group ofdeveloped financialmarkets. In the years leading to 2007, performanceof

themarketreliedheavilyonspreadcompression.Butthedangerofsystemicsetbacks leaves emerging-market debt exposed to the risk of occasionalextremenegativeperformance,whichhashistoricallybeena characteristicofthemarketplace.

TABLE8.7UScorporatehigh-yieldandemergingdebtmarketssummarystatisticsJan1994–Sep2013

Datasources:Barclays;JPMorgan;MSCI

Table8.7showsthatemerging-marketdebtandUShigh-yielddebthavea tendency towards extreme returns (as indicated by themeasure “excesskurtosis”). Emerging-market debt has had a similar volatility to the USequitymarket, but it ismore susceptible to sudden shocks.Thehigh-yieldmarketappearstohavebeenlessvolatile,thoughitisalsopronetoextrememonthly results (and the score for “serial correlation” reflects a greatertendencyforhighyieldpricestotrend).

Localcurrencyemerging-marketdebtEarlyinvestorsfromdevelopedmarketswhoinvestedinemerging-marketdebtalmostalwaysinvestedindebtdenominatedinUSdollars,orinothermajorcurrenciessuchastheyenortheeuro.Atthetimetherewaslittlelocalcurrencydebtavailableforinternationalinvestors(whichwasamajorstructuralweaknessfordebtorcountries).Thissuitedmanyinvestorsbecausetheydidnotwishtocompoundthecreditriskofinvestinginemerging-marketdebtwiththecurrencyriskassociatedwithemergingmarkets.

Inthepast15yearsagrowingnumberofemerging-marketgovernmentshaveissueddebtintheirownlocalcurrency,whichhasbeentargetedatinternationalinvestors.Thesestepsarerespondingtoamarketopportunitythatsuitsbothinvestorsandborrowers.

Awell-diversifiedportfolioapproachtoinvestinginlocalcurrencyemerging-marketdebtcanbeattractivetoarangeofinvestorsbecause:

yieldsmaybemoreattractivethancomparabledollardebt(thoughthisvariesbetweencountries);

itenablesinvestorstopositionstrategytotakeadvantageofaviewoftherelativeperformanceoftheUSdollarandemerging-marketcurrencies;

itmayprovideonesourceofefficientinvestmentdiversificationforanyinvestor(althoughthebasisforanysuchcalculationneedscarefulconsideration).

SuchinvestmentsmaybeparticularlyattractivetoinvestorsfromemergingeconomieswhohavetheirinvestmentaccountsmeasuredandreportedinUSdollars,andyettheirbasecurrencyistoadegreeambiguous(seeChapter1).Theattitudetocurrencyriskoftheseinvestorsislessclearlydefinedthanitis,forexample,foraUSresident.Forsomeoftheseinternationalinvestors,aportfolioofwell-diversifiedemerging-marketdebtmayofferanattractivewayofmitigatingsomeoftheirexposuretotheUSdollar.

Theavailablebenchmarksforemerging-marketdebtillustratethatthesemarketshavebeenhighlyvolatileinthepast.Althoughdiversificationbetweencountriesisamajorbenefit,theimpactofthe1997Asiancurrencycrisisshowshowextremetheperformanceofindividualmarketscanbe,andevenwithadiversifiedapproach,strongnegativereturnshavebeenrecordedattimesofcrisis.TheJPMorganlocalcurrencyemerging-marketliquidityindexdeclinedinUSdollartermsby15.7%betweenJuly1997andJanuary1998andby20%betweenJuly2008andFebruary2009.However,the2008–09declineowedmuchtomovementsintheUSdollarandwasjust2%whenmeasuredineurosand9.5%inSingaporedollars(Singapore’scurrencyfloatswithreferencetoabasketoftradingpartners).

Securitisation,modernwaystoinvestinbondmarketsandthecreditcrunchIn recent decades, innovations in securities markets have transformedinvestment markets and bank balance sheets. Securitisation was for anumberofyearswelcomedasenablingbanks tobettermanage theircredit

exposuresbyseparating their lendingdecisions from theirneed tomanagethe risks of their balance sheets. This was possible because standardisedarrangements evolved which enabled the banks to offload their riskexposurestootherbanks,tohedgefundsortolong-terminvestors.

Securitisation was a major innovation and it is a process that canfacilitateriskmanagementinthefinancialsector.Butitalsoliesattheheartof much that went wrong in the financial sector leading up to the creditcrunch.With hindsight, it seems as though banks used the invention of aseriesofuseful riskmanagementdevices as an excuse to takemuchmorerisk, rather than tomanage better the risks that theywere already taking.Behaviour and incentives lay at the root of this.Securitisation encouragedbankexecutiveswithsales targets toachieve to take less responsibility forthequalityoftheirlendingdecisions,whichtheyknewwouldnolongerstayon their banks’ balance sheets. Thus amechanism thatwas heralded as ameans of dispersing risk instead led to much greater and hiddenconcentrations of risk. Securitisation itself was a good idea, but it wasappliedinwaysthatencouraged,whileprovidingnomechanismtoreinin,muchlooserstandardsinbanking.

Mortgage-backedsecuritiesSecuritisation started and developed in the United States. The majorinnovation came in 1970 with the introduction of a mortgage-backedsecurityby theGovernmentNationalMortgageAssociation (GinnieMae),whosecashpaymentstoinvestorsrepresentedadirect“pass-through”ofthecash flows of the underlying householdmortgages. Previously,mortgage-backed bonds had represented claims on the issuing bank, with a furtherclaim on the underlyingmortgages should the bank default. The principalinvestmentfeatureofpass-throughbondsisthattheyexposetheinvestortoprepayment risk,becausehouseholdmortgageholders in theUnitedStatescangenerallyprepayfixed-ratemortgageswithoutpenalty.Prepaymentriskis the main differentiator of mortgage-backed securities as investments.Individualsprepayforanumberofdifferentreasons,buttheprincipaldriveris the opportunity to refinance at a lower interest rate and cut monthlymortgagepayments,afterallowingforthefeesinvolved.Soprepaymentrisk

isdirectlytiedtochangesinthelevelofinterestrates.AdefiningfeatureoftheUS residentialmortgagemarket is that interest and principal paymentobligations of mortgage-backed securities issued by the three federallysponsoredmortgageagenciesareguaranteedbythoseagencies.

Thisdifferentiatesmortgagesthatconformtotheloanqualityguidelinesof the federalmortgage institutions from those that do not – for example,becauseoftheirsize(“jumbo”mortgages),ahighloantohousevalueratioor the lowcredit score of the borrower, or because someother qualitativeguideline is breached (these are known collectively as “subprime”mortgages).Mortgage-backed securities basedonpools of conformingUSmortgages did not have the dramatic spike in yields experienced by othercreditsecuritiesduringthecreditcrunch,butdamagewasinflictedonbankand investor portfolios by securities based on pools of commercialmortgage-backed securities (see Figures 8.4 and 8.5) as well as non-conforminghomeequityloans.

FIG8.4YieldsonUSmortgagesecurities%peryear,Jul2000–Sep2013

Source:Barclays

FIG 8.5 Cumulative performance of agency mortgage-backed securities andcommercialmortgagesJun2000–Sep2013,Jun2000=100

Source:Barclays

By the mid-1980s the pass-through mortgage market led to thedevelopment of the collateralised mortgage obligation (CMO). The CMOarrangesforthepaymentsfromapoolofmortgagestobesplitintoaseriesof tranches, which are exposed to different elements of mortgageprepayment risk. These developments in the US mortgage markettransformedtheportfoliosof investors inUSdollar-denominatedbonds.Intheyearsbefore2008, the repackagingof conformingmortgagesprovidedthe model for related but increasingly convoluted and often ill-fatedinnovations in other areas, where the credit-quality guidelines that havealwaysappliedtomortgage-backedsecuritieswereabsent.

Theroleofmortgage-backedsecuritiesinmeetinginvestmentobjectivesMortgagesthataresubjecttoprepaymentriskrepresentapeculiarinvestmentwhichhasbecomemainstreamformanyinstitutionalinvestors.Aninvestor,consciousoftheneedtomeetparticularobjectivesatdatesinthefuture,isunlikelytohavethoughtofaninvestmentwiththepayoutprofileofamortgageasacandidateforacoreinvestmenttomeetthoseobjectives.However,investorsventureoutoftheirsafe-haven,minimumriskinvestmentstrategyinanticipationofapremiumyieldinreturnforacceptingprepaymentrisk.Thebenefitsofthemortgagemarketforissuersisclear.It

providesliquidityandhasincreasedaccesstoadditionalcapital,bothofwhichhaveprobablyloweredcoststoborrowers.TheoutstandingvolumeofUSmortgage-backedsecuritieswasaround$5.7trillionattheendof2012comparedwith$11.6trillionofoutstandingUSTreasurydebt.

Foraninvestor,replacinggovernmentbondswithmortgagebonds,whicharesubjecttoprepaymentrisk,introducesuncertaintytoapreviouslylow-riskinvestmentstrategy.Whenlong-terminterestratesfall,homeownerswillrefinancetheirmortgages.Thiswillbereflectedinprepaymentsonamortgagebond,whichwillreducethebond’sabilitytosupportagivenlevelofincomeinthefuturebecausetheprepaidincomehastobereinvestedatthelowerrateofinterest.Inthisenvironment,mortgagesshouldbeexpectedtounderperformgovernmentbonds.Bycontrast,whenlong-terminterestratesriseaboveexpectations,homeownerswillwanttoretaintheircurrentlowerlevelofmortgagepayment,andrepaymentsarelikelytobelowerthanexpected.Inotherwords,mortgagesecurities,whicharesubjecttoprepaymentrisk,prepaymorewheninvestorswantless,andmayprepaylesswheninvestorswantmore.Theyrepresentasourceofdynamicmismatchriskintryingtomeetlong-termobjectives.

Inreturnfortheseundesirablefeatures,investorsinmortgagesecuritiescollectaninsurancepremium,whichistheextrayieldthatmortgage-backedsecuritiesofferoverconventionalbonds(aftermakingappropriateadjustmentstoensurefaircomparison).Thisrepresentsthepremiumthatborrowersmustpayinvestorsfortheoptiontoprepaytheirmortgagesaheadofthematuritydateoftheloan.Thisinsurancepremiumrepresentsasourceofperformanceforinvestorsinmortgages.

Thephenomenonjustdescribedisknownasnegativeconvexityandisingeneralanunattractivecharacteristicforaninvestor.However,forlong-terminvestorswhosefutureobligationsaresubjecttouncertaintiming(forexample,anindividualwhoseretirementdateisunclearorafounda2ionwhoseexpenditureprofileisnotfixed),introducinganelementofnegativeconvexitythroughinvestinginmortgagesmightnotincreaseuncertaintyabouttheabilitytomeetfutureobjectives,andmight,thankstotheadditionalexpectedpremiumincome,modestlyreduceit.

Theperformanceofmortgagesincomparisonwithgovernmentbonds,asreflectedintheBarclaysAggregatebondindex,isshowninFigure8.6.Alinehasbeendrawnacrossthecharttoindicateequalperformanceofmortgagesandgovernmentbonds.Observationsabovethislineindicatemortgageoutperfomance;observationsbelowthelineindicatemonthswhengovernmentbondsoutperformedmortgages.

FIG 8.6 US government bond monthly returns compared with mortgage-backedsecuritiesJan1990–Sep2013

Source:Barclays

Figure8.6indicatesthatinmonthsofstronggovernmentbondperformance,mortgageperformancehaslaggedbehind.Italsoindicatesthatwhengovernmentbondpriceshavefallen,themortgageindexhasoftenoutperformed.

Table8.8comparesthereturnsonthemajorcomponentsoftheBarclaysAggregateBondIndexsince1990.Itshowsthatoverthis23-yearperiod,onaverage,conformingmortgagesdidnotrewardinvestorswithapremiumreturnoverotherpartsoftheUSbondmarket,thoughtheydidofferslightlylowervolatilityandlowerdrawdownwheninterestratesincreased.

TABLE8.8PerformanceandvolatilityofcomponentsofBarclaysUSAggregatebondindexJan1990–Sep2013

aComponentsshowndonottotalto100astheyexcludecommercialmortgage-backedsecuritiesandassetbackedsecurities.

Source:Barclays

Thepositionofmortgagesinaninvestor’sstrategyshoulddependonanalysisofthesuperiorrisk-adjustedreturnexpectedfrommortgages(ifany),itsuncertaintyandhowitcorrelateswithaninvestor’sothersourcesofsystematicreturn.Furthermore,sincemortgagesrepresentasourceofsystematicrisk-takingandgovernmentbonds(ofanappropriatematurity)provideasafe-haveninvestment,theappropriatebalancebetweengovernmentbondsandprepaymentmortgages(asoneofavarietyofriskyassets)shouldbeguidedbytheinvestor’stoleranceforrisk-takingratherthanthecompositionofmarketindices.

Internationalbondsandcurrencyhedging

Forallinvestors,foreigngovernmentbondsrepresentawayofdiversifyingyieldcurveriskandofseekingopportunitiestoaddvaluebeyondadomesticgovernmentbondbenchmark.InChapter1,theambiguityofthenotionofa“home” currency for many international executives or families wasdiscussed,andtheimportancewasemphasisedofcarefullythinkingthroughthe currency composition of “safe-harbour” investments, such as cash orgovernment bonds. Similar issues often apply to international investmentfunds, suchas sovereignwealth funds.For textbook investorswithaclearhome currency, investing in foreign currency government bonds involvesforeignexchangerisk,whichneednotbeaproblemso longas that risk isproperly managed. Otherwise the rationale for making a particularinvestmentmaybeoverwhelmedbytheimpactofcurrencyfluctuations.

Currencyriskisamanageablerisk.Itisalsoabigrisk,whichincorrectlyhandled can lead towindfall losses (or gains) of 20%ormore over a 12-month period. Currency hedging is the way to manage this risk ininternational investments. The intuitive way of understanding currencyhedgingistorememberthatitisequivalenttoplacingcashondepositintheinvestor’s home currency (for example, US dollars) and borrowing theequivalent amount in a foreign currency (for example, euros) to finance aforeigninvestment.Inthisway,fluctuationsintheexchangeratewillwashout,havinganequalandoppositeeffecton theforeign investmentand theforeigndebt.Theinvestor’sinvestmentreturnwillbetheperformanceoftheforeigninvestmentinforeigncurrency,plustheinterestrateonthedomestic

currencydeposit,lesstheinterestrateontheforeigncurrencydebt.The more conventional way to describe this is to say that foreign

currencyriskcanbeneutralisedthroughforeignexchange“hedging”,wherean investor contracts to sell foreign currency at a date in the future (or“forward”)atthecurrentexchangerate.Thecontractallowsfordifferencesin interest ratesbetween the twocountries.Typically, thecontractsare foroneorthreemonths.Theyarethenrolledforwardandadjustedasneededtoreflectanychangesinvalueoftheunderlyinginvestment,tomakesurethatitandanycapitalappreciation(ordecline)remainfullyhedged.

Whatdoesitachieve?Currencyhedgingisinterestingbecauseitenablesmanagementofcurrencyrisk and, for many investments, it provides a marked reduction in thevolatility of international investments. Figures 8.7, 8.8 and 8.9 show thisfromtheperspectiveofinvestorsinGermangovernmentbonds.Figure8.7shows the pattern of German government bond monthly performance ineuros.Figure8.8showsthesameinvestmentperformancetranslatedintoUSdollars, with no attempt to hedge the foreign exchange risk. It isdemonstrablymuchmorevolatilethanthepatternofreturnsineuros.Figure8.9showsthesamereturnseries,againinUSdollars,butthistimehedgedforforeigncurrencyrisk.TheprofileinFigure8.9isacloseapproximationtoFigure8.7.Thesamepatternofamarkedreductioninvolatilityisevidentforhedginghighestqualityinvestmentgradebondsfromwhichevermarketoverwhicheverperiodwherethereareliquidforwardcurrencymarkets.Forinvestmentsofmoderatevolatility,suchaswell-diversifiedhigh-yieldbondfunds ormany hedge fund strategies, the arguments in favour of hedgingcurrency risk remain strong. However, difficulties arise if the underlyinginvestments are illiquid (see below). For more volatile markets, such asequities,currencyhedgingalterstheprofileofinvestmentreturnsbuthasamuchmoremodesteffectonvolatility(seeChapter7).

FIG8.7Germangovernmentbondperformanceineuros%,Jan1999–Sep2013

Source:©2013CitigroupIndexLLC.Allrightsreserved

FIG 8.8German government bond performance inUS$, unhedged%, Jan 1999–Sep2013

Source:©2013CitigroupIndexLLC.Allrightsreserved

FIG8.9GermangovernmentbondperformancehedgedtoUS$%,Jan1999–Sep2013

Source:©2013CitigroupIndexLLC.Allrightsreserved

Whatdoesitcost?Threetypesofcostsmaybeincurredinforeigncurrencyhedging:

Transactioncosts.Foreignexchangemarketsareamongthemostliquidmarketsintheworld,andthetransactioncostsofputtinginplaceandparticularlyofrollingforwardhedgesintheprincipalcurrenciesaretiny–asmallnumberofbasispointseachyear.Butitisimportanttocheckwhetherthereareanysupplementarytransactioncoststhatovertimecouldmateriallyreducetheattractivenessofhedging.Forcurrenciesthataresubjecttooccasionalliquiditycrises,the“spread”leviedintheforeignexchangemarketbetweenforwardpurchasesandsales–whichwouldbeexpectedtoreflectthedifferenceinshort-terminterestrates–canwidensharplyattimesofmarketcrisis.Thiswilldramaticallyincreasethecostofhedginginthosecurrencies.Forthisreason,aninvestorshouldnotnormallyhedgeinvestmentsdenominatedincurrenciesthatmay,atatimeofcrisis,becomeilliquid.

Cashflowcosts.Thereareregularcashflowsassociatedwithcurrencyhedging.Theserepresentthecurrencygainsandlossesonthehedgethatshouldbeoffset,perfectlywithaperfecthedge,with

currencylossesandgainsonthehedgedinvestment.Inaninvestmentaccount,thegainsandlossesofthehedgewilloftenbepainfullyevident,whiletheforeignexchangegainsandlossesontheforeigninvestmentwillbelessobvious.Wheretheinvestmentisilliquid–forexample,ifaUSinvestorishedgingaEuropeanprivateequityinvestmentbacktodollarsandtheUSdollardepreciatesagainsttheeuro–thescaleofthedepreciationwillbefeltasacashoutflowassociatedwiththehedgeasthedollardepreciates.(SeeChapter11foradiscussionofforeigncurrencyriskandilliquidinvestments.)Foreigncurrencyhedgingisbestsuitedtohighlyliquidinvestments,suchasgovernmentbonds.Thecashflowsassociatedwithhedgingcanbebothembarrassingand,forilliquidinvestments,painful.

Opportunitycost.Thisiscloselytiedtoregretrisk,thatis,theriskthatthedecisiontohedgeaninternationalinvestmentwillberegrettedbecausesubsequentcurrencymovementswouldhavemadeitmoreprofitablenottohavehedged.Inthiscase,theinvestor’saccountsmayshowanegativecashflowimpactofthehedgeandencouragestatementssuchas“thishedgehascostme…”.Investorsneedtoreflectonthereasonsforthehedgedinvestmentwhenmakingthesestatements.

Sometimes,aswithinternationalequityinvesting,hedgingdecisionsarefinelybalanced(seeChapter7).Frequently,though,theappropriateruleofthumb is thatcertain typesof international investment shouldnotbemadeunless they are to be hedged. The obvious examples are investments inforeign bonds. Furthermore, many hedge fund strategies should be eithermanagedorhedgedtotheinvestor’sbasecurrency.Thisisbecauseexposingbond and hedge funds to unmanaged currency risk transforms theperformance pattern that should be expected from the investment and thiswilloftenunderminetherolethattheinvestmentissupposedtohaveinaninvestment strategy. If an investor likes the foreignbondmarket and likesthe currency, a critic might ask: why hedge? The answer is that sincecurrency volatilitywill contributemuchmore to the risk of losingmoneythan bond market volatility, the position should be seen as a foreign

currencyviewandnotabondmarketview.

Howeasyisforeignexchangeforecasting?Centralbanks,whichoughttobewell-informedaboutthenatureofcurrencymarkets,sometimesadmitthattheydonotknowhowtoforecastexchangerates. With hindsight it may appear that a particular exchange rate was“bound” to trend in a particular direction.With foresight it is never thateasy. One of the most dangerous things an investor can do is to takeunstructured foreign currency bets. These almost always degenerate into“bet the ranch” gambles, which make nonsense of any considered risk-taking thatmightuntil thenhavecharacterised investmentstrategy.This isbecause foreign exchange is a source of significant volatility with, onaverage, no expected pay-off. Nevertheless, carefully managed foreignexchangeriskcanhavearoleinanystrategywhereaninvestorusesateamthat has both insights and a track record, andwhere the riskmanagementprocess reassures the investor that the downside risk for when things gowrong–whichisinevitablefromtimetotime–isacceptable.

9 HedgefundsINTHEDECADEBEFOREtheglobalfinancialcrisistherewasanupsurgeinmoneymanagedbyhedgefunds.Intheearly1990s,theywerefringeinvestmentvehicles,managingmoneyforsomeenterprisingprivateinvestorsaswellasthehedgefundmanagersthemselves.Thentheybecameincreasinglypopularwithendowments,innovativepensionfundsandinsurancecompanies.Theyhavesincebecomemainstreamassetsformanyinstitutionalinvestors,whileprivateclientinvestment–thoughdifficulttogauge–seemstohavewanedincomparison.But2008wasawatershedyear.Totalassetsmanagedreachedapeakinlate2007of$2.3trillion(seeFigure9.1),accordingtoBarclayHedge,ahedgefundindustryresearchanddatabaseprovider,beforedecliningbyover30%byMarch2009throughacombinationofnegativereturnsandinvestorredemptions.Privateclientsseemtohaveaccountedforthebulkoftheseredemptions,leavingthehedgefundindustrymoreevenlybalancedbetween

institutionalandprivateclientinvestors.Intheyearsafterearly2009,hedgefundassetsincreasedsteadily,andalmostreacheditsearlierpeaklevelof$2.3trillionbyJune2013.

FIG9.1Hedgefundindustryassetsundermanagement$bn,1997–2013

aIncludingmanagedfuturesfunds(CTAs).Source:BarclayHedge,www.barclayhedge.com

The crisis year of 2008 was the hedge fund industry’s bleakest. Asleverage was withdrawn by banks, themselves under severe liquiditypressure,regulatorschangedrulesonshortselling,thesignaturehedgefundinvestment technique, and many hedge funds were confronted with amismatch between the liquidity they had offered their investors and theilliquidityofmanyoftheirunderlyinginvestments.Theresultwasaseveremark-downintheunitpricesofhedgefundsofalmostallstrategies,whichinturnledtosubstantialinvestorrequeststoliquidateholdings.Performancelosses were particularly acute in illiquid strategies. The year reached itsnadir inNovember,when thepreviously lowvolatilityCreditSuisse index

of equitymarket neutral hedge funds recorded a decline for themonth of40.5%.Otherindexprovidersshowedmoremodestdeclines,buttheCreditSuisse index included three hedge funds that were revealed to be feederfundsfortheenormousfraudassociatedwithMadoffInvestmentSecuritiesandwereimmediatelywrittendowntozero.

Since 2008 there have been important changes in the hedge fundindustry.One has been a continuation of the earlier trend towards greaterreliance by hedge funds on institutional clients. According to Preqin, ahedgefundconsultancy, in2008institutional investorsrepresented45%ofhedge fund assets. Following the crisis, institutions continued to increaseallocationstohedgefunds,whileprivateclientspulledback,sothatbytheendof2012institutionsaccountedfor63%ofhedgefundassets.Aparalleltrendhasbeenasustaineddeclineinfundsofhedgefunds,whichinvestinadiversified selection of hedge funds.During the three years from 2005 to2007, around 50% of the money invested in hedge funds (includingmanaged futures funds)was channelled through funds of hedge funds.Bymid-2013, this proportion had declined to around 25%. Initially, funds offundswere favouredasanefficientwayofgainingaccess tohedge funds,especially by investors who did not feel confident to select hedge fundsthemselves.Severalfactorsledtothedeclineoffundsofhedgefunds.Oneis that their rationale for undertaking due diligence on behalf of investorswas underminedwhen it emerged that a number of funds of hedge funds(especially servingprivate clients) had incorporated so-called feeder fundswhich gave exposure to the Madoff fraud. Another is a growingdetermination among institutional investors to manage their hedge fundexposure cost effectively by replacing holdings in funds of hedge funds,withtheirextraleveloffees,withlessexpensiveandbettertailoredadviceon individual hedge funds. Sometimes these portfolios of hedge funds areadvised by the same teams of hedge fund experts asmanage the funds ofhedge funds. According to BarclayHedge, the assets invested in funds ofhedgefundspeakedat$1.2trillionin2007andhaddeclinedto$480billionbyJune2013.

The hedge fund industry is dominated by US-based funds, whichaccordingtoPreqinwashometo69%ofglobalhedgefundassetsin2012,

withtheUK’s19%representingadistantsecondplace.Fiveothercountriesaccountedfor1–2%each.Switzerlandisoneofthese,anditsimportanceinhedgefundinvestingisincreasedbyitsbeingthehomeofanumberoflargefundsofhedgefunds.

Whatarehedgefunds?Hedge funds are best understood as private entrepreneurial investmentcompaniesthatoperatewithfewconstraints.Theirinvestmentstrategiescanbe sorted intogeneric types.Theyhavehistoricallybeen lightly regulated,thoughthispositionhaschangedinrecentyearswiththeintroductionoftheprovisionsof theDoddFrankAct in theUnitedStatesand theAlternativeInvestmentFundManagers’Directive in theEU.All hedge funds have incommon remuneration structures that are exceptionally favourable to thehedgefundmanagerswhentheirfundperformanceisgood.However,whenperformance is poor, management stability may be undermined by theimprobabilityofemployeesbeingableinthenearfuturetoearnsubstantialremuneration at that hedge fund. Three other characteristics are theinvestment of a substantial part of the managers’ net worth in their ownfund; their ability tohave shortpositions in investmentportfolios; and thesecrecy that has often surrounded their underlying investment positions.Theyare alsodistinguished inbeingdesigned togeneratepositive returns,ratherthantobeatormatchastockorbondmarketindex.Theilliquidityoftheunderlyinginvestmentsofanumberofhedgefundstrategieshasalwaysmeant that those strategies are not suitable for short-term investors –something that investors were reminded of in 2008 when many fundsdelayedwithdrawalstoprotecttheinterestsofotherinvestors.

AlternativesourcesofsystematicreturnandriskHedgefundsofferarangeofsourcesofriskandreturn.Someofthesehavedirect parallels with long-only stock and bond portfolios. Hedge fundstypically attempt to isolate manager skill by reducing the influence ofmarket returns on the portfolio, although funds still have a significantexposure to market risk. The origins of hedge fund investing in the late1940s were represented by such funds, which today would be known as

long-shortequityfunds.But other funds offer completely new opportunities, for example the

abilitytotreatmarketvolatilityasaninvestmenttobeboughtandsoldandtoexploittrendsinitspricing.Othersincludeanumberofmarketefficiencyraising arbitrage strategies, includingmerger arbitrage, statistical arbitrage(exploitingshort-termmomentuminmarkets),fixed-incomeandconvertiblearbitrage.Thereisnolong-onlyequivalenttothetechnicalskillandmarkettiminginvolvedinsuchstrategies,whicharesometimescalled“alternativebeta” strategies. Each of these represents a potential source of systematicreturn,althoughthehedgefundindustry’scasualuseoftheword“arbitrage”must not be taken tomean that these strategies are low risk (see below).Correspondingly, macro and commodity trading advisers (CTAs, alsoknownasmanagedfuturesfunds)areotherstrategiesthathavenolong-onlyparallel, and in the case of CTA strategies represent an indirect way ofprofitingfromthesystematicreturnthatappearstobeofferedtolong-terminvestorswhosupplyliquiditytothecommoditymarkets.

Intheseandotherareas,hedgefundsprovidearisktransferandliquidityservicewhich in previous times eitherwas not systematically provided orwasprovidedbycommercialbanks.Hedgefundsneedconsiderableskillinproviding these services, but the return that investors might expect fromtheseservicesderivesprimarilyfromthemarketreturntosuchrisk-taking.Itbecame clear in 2008 that many of these rely on ready access to liquidmarketsaswellasastableregulatoryregime.

“Dohedgefundshedge?”Figure9.2showsthattheindexofhedgefundindustryperformance(netoffees)hasoutperformedtheUSandglobalstockmarketindices(beforefees)since the early 1990s and with evidently less volatility. The prospect ofbeingabletoearnsuperiorrisk-adjustedreturnsfromdiversifiedinvestinginhedgefundshasalwaysbeenoneoftheprincipalattractionsofsuchfunds.

Thisargumentwascementedinthemindsofmanyinvestorsduringtheequity bear market of 2000–02, when hedge fund indices comfortablyoutperformedequitymarket indices.Thishelped to lay thefoundationsfortheenormousgrowthofthehedgefundindustryinthefollowingfiveyears.

In 2008 the modest margins by which hedge funds in aggregateoutperformed collapsing equity indices will have satisfied few investors.Although around one in five hedge funds did report positive returns for2008, the experience of that year will be etched on investors’ collectivememory:hedgefundsmayhelptodiversifyequitymarketrisk,buttheyareriskassetsandtheyprovidenosafehaven.Thisisnotanewrevelation.Bestpractice among private client and institutional advisers has for years beenthathedge funds representedan interestingwayofdiversifying,butnotofavoiding,equityrisk.Forinvestorswhoacceptedthathedgefundswereriskassets,theroleofhedgefundsindilutingequitymarketrisk,whileofferingtheprospectofadditionalsourcesofreturn,mayevenbeconfirmedbytheexperienceof2008.

FIG 9.2Cumulative performance of hedge fund index and equities $, Jan 1993–Sep2013,December1993=100

Sources:©2013CreditSuisse,allrightsreserved;MSCI

Manyequityhedgefundmanagersadjusttheirexposuretowhattheyseeas trends inmarkets, raising exposure aftermarket rises and cutting aftermarketfalls.The2000–02equitybearmarketwasunusualinbeinglonganddrawnout.Thatexperienceprobablymisledinvestorstoexpecthedgefundsto be able to hedge in the event of sharp equitymarket reversals.During2007–09, thecreditcrunchforceddeleveragingandassetsales,whetheror

nothedgefundmanagerswouldhavepreferredtoactdifferently.Table9.1shows the performanceof an aggregate hedge fund indexduring themostdisappointing equity market calendar quarters since the index started in1994.These figures emphasise that investing inhedge fundsmaymitigatemarketrisk,butitdoesnotavoidit.

TABLE9.1Hedgefundperformanceduringcalendarquartersofequitymarketcrisis1994Q1–2013Q3,%totalreturnin$

Sources:Barclays;CreditSuisse;MSCI

ThequalityofhedgefundperformancedataThe quality of hedge fund performance data is a subject that arousesconsiderabledebate.ThiswasbroughttotheforefrontagainbytheMadoffscandal. The Credit Suisse indices are asset weighted to show theperformanceof theaveragedollar invested in theCreditSuissesample forthat strategy.Other indexprovidersuse a simple averageof the returnsofeachfund(ofwhateversize)thatqualifiesfortheirindex.

The focus of much commentary on hedge fund performance is thatpublished indicesoverstate theactualexperienceof investors.Onehistoricexamplewasthe1998failureofLong-TermCapitalManagement(LTCM),the largest hedge fund thatwould then be described as following a fixed-incomearbitragestrategy.However,itsfailureisnotreflectedinthehedgefund industry performance numbers because from the outset LTCM, ahighlysecretiveorganisation,didnotwishtoshareitsperformancenumberswith anyone apart from its investors. Participation in databases of hedgefundperformanceisinpartvoluntaryandtheindicesarenotcomprehensive.

TheLTCMexampleisanillustrationofincompletereportingdistorting

theperformanceof hedge fund indices.However, consistent non-reportingby individual funds is not an obvious reason for the index numbers tooverstateperformance.Somehaveargued that theoppositemaybe trueasconsistentnon-reportersmaybeamongthegroupofsuccessful,historicallywell-performingfunds.Otherdataissuesmightbiasthenumbers.Oneisthatnew hedge funds are able to “backfill” their performance numbers indatabases of hedge fund performance after they decide to start reportingperformance (thedisappointing“incubator” resultsmaynotget reportedatall).However,reportingdatatoadatabasesaysnothingabouttherulesforeligibilityforinclusioninanindex;thesearegenerallydesignedtoexcludebackfill biasby ignoringdata formonthsbefore thedate thedata are firstreported.

Theconsensusisthathedgefundindicesdosufferfromsomeelementofsurvivor bias, which causes reported performance to be higher than theaverageexperienceofhedgefundinvestors.Furthermore, thetrackrecordsthat investors are shown ahead of new investment decisions are almostalwayssubjecttobias–investorsdonotinvitethepoorperformerstomakenewbusinesspresentations.However, investorsshouldnot takeinvestmentdecisionsbasedonpastperformancealone.Thekeyisalwaystheexpectedfuture performance (and its source), how a fund might perform in “badtimes”, how this relates to the pattern of performance expected from theinvestor’s other assets, andwhether the investor can access that source ofperformanceandriskfromanywhereelse.Anunderstandingoftheseissuesshould be much more important than historical reported performancenumbersininforminginvestors’decisions.

Whatmotivateshedgefundmanagers?The remuneration of hedge fund managers is important in understandingwhattoexpect,andwhattodemand,fromhedgefundarrangementsandforjudgingwhetherenoughvalueislikelytobeleftoverforexternalinvestors.

Theskillofanyfundmanager issubject touncertainty. It is investors’money that isused todiscover thedifferencebetweenskill and luck,eventhough insome instancesskillwillbeobscuredbybad luck,and inotherslackofskillwillcontinuetobeobscuredbyextendedgoodluck.

Thishighlightsadisconnectionbetweentheinterestsofinvestorsandtheinterests of hedge fundmanagers and is another aspect of the “principal–agent”problemwhichcomplicatesrelationshipsbetweeninvestorsandtheiradvisersinmanyinvestmentrelationships(seeAppendix3).Inhedgefundinvesting,theextenttowhichinvestorandhedgefundmanagerinterestsarealignedcanchange if andwhenaparticular fund starts toprosper and themanagerstartstoaccumulatewealth.Inthiscase,hedgefundmanagersarelikely tobemuchmoreconcerned topreserveandgrow rather thanputatrisktheirownwealth,whichisinvestedinthefund.Thiscanleadtoasubtleshift inhedge fundbusiness strategy from thepursuit ofperformance to agreaterfocusonassetgathering,onthebasisofthepastperformancerecord.Atthisstage,somehedgefundsdiversifytheirbusinessandwealthriskbyaddingnewstrategies;others,whichcontinue tomanagea single strategy,mayrespondbyreducingrisk-taking.

Arehedgefundfeestoohigh?Hedge fund fees need to be kept at the forefront of investors’minds.Theheadline feepayableonan individualhedge fundhasbeen“2and20”. Inotherwords,2%ayearofthevalueinvestedisleviedasabasefeeand20%of the returnearnedeachyear is retainedasaperformance fee, so longasthe return is positive and exceeds the previous “high watermark” ormaximumlevelofperformance.Inrecentyears,basefeeshavebeenundersomepressure,andin2012areestimatedbyPreqintohaveaveraged1.6%,butitseemsthattypicalperformancefeeshaveremainedcloseto20%.Itisnotable that there has normally been no hurdle rate of return beforeperformancefeesarepaid,otherthanthehighwatermark.Inotherwords,a“2and20”feecanbepayableonaperformancenohigherthanaTreasurybill return. Although it is bizarre to offer to pay a performance fee on areturnthatmightbelessthanthatguaranteedtobepaidbythegovernment,such an agreement is made in expectation that a premium return will beearned.Anecdotalevidencefromtheboomyearsbefore2008indicatesthatsomehedgefundsthatwerenormallyclosedtonewbusinessdidselectivelyacceptnewbusinessforaperformancefeeashighas50%offuturepositivereturns.

The fee structure places great pressure on hedge fund managers togeneratepositivereturns.Evenbefore2008, therewereexamplesofhedgefunds that incurred significant negative returns closing, not just becauseexistinginvestorslostconfidenceandwithdrewfunds,butalsobecausethemanagers had difficultymotivating staff (and themselves)when therewaslittle immediate prospect of a performance fee being earned. In thesecircumstances, they would rather start a new fund than have to wait torecoup past performance losses before earning a performance fee. Thisbecomesaself-fulfillingprophecyasinvestorscometoexpectmanagerstorespondtopoorperformanceinthisway.

Theexistingfeestructureisalreadysufficientlyrichtoweaken(butnotremove) the case for investing in hedge funds. As stated in Chapter 5, areasonablemagnitudefortheequityriskpremiumis4%ayearoverten-yearTreasurybonds, andanormal relationshipmightbe forTreasurybonds toofferayieldpremiumofaround0.5%ayearovercash.A“2and20” feeschedulemeans that if investors expect to receive an after-fee return fromhedgefundsthatiscomparabletotheafter-feereturnfromapassiveequitystrategy,theyneedtobewillingtopaytohedgefundmanagersaround50%of thepre-feeexcessreturnoverTreasurybills.Forafundofhedgefundsarrangement,whichinvolvesanextrafee,thecomparablefigureswouldbeevenhigher.Thesearegeneroustakesbyanyreckoning.

TheimportanceofskillinhedgefundreturnsByfarthelongestchapterinCharlesMackay’sbookExtraordinaryPopularDelusionsand theMadnessofCrowds isdevoted to“thealchymists”.ForcenturiestheygrippedthepopularimaginationofEuropeansintheirsearchfor and false claims to have discovered the secrets of the philosopher’sstone,whichwas tocreateanabundanceofwealthby turningbasemetalsinto gold. Hope springs eternal, and the alchemists’ claims would standcomparisonwithsomehedgefundmarketingmaterial.

Thereisanabundanceofresearchandpracticalexperiencethattestifiestothescarcityofunusualskillinmanagingtraditionalinvestmentportfolios.Thisisdemonstratedbythedifficultyofidentifyingmanagerswhoarelikelytooutperforminthefuture.

However,hedgefundsgiveskilledmanagersgreaterscopetoimplementtheirskills,althoughtheywillalsoneedtofindnewcompetencies.Theextralatitudeofferedbyhedgefundsarises fromthe fewerconstraints theyface(compared with long-only investing). The first is the ability to establishleveragedpositionsthroughborrowing.Thesecondistheabilitytoestablishshort positions, and tomakemoney from their negative investment views(long-only managers have to pass up such opportunities). Long-onlymanagers who become hedge fund managers are quickly struck by thecontrast between the way in which a large investment position in atraditional portfolio that underperforms because its price falls becomes asmaller, less risky position, and a short position in a hedge fund thatunderperforms because its price increases becomes a larger, more riskyposition. These extra flexibilities require additional investment riskmanagementandback-officeoperationalskills.However,theydonotmakeiteasiertoassesstheskillofahedgefundmanagerthanthatofalong-onlymanager.This isprobablymoredifficultbecausehedgefundstrategiesarelesstransparent.

Itisamistaketothinkthatunusualmanagerskillistheonlyelementofperformance that should attract investors to hedge funds. Hedge fundperformance is a reflection ofmanager skill, leverage andmarket returns.Sometimes the exposure to market returns generated by hedge fundsrepresentsexposuretoequityorcreditmarketreturnsthatcanbeobtainedatmuchlowercostbyinvestingpassivelyinequityorcreditmarkets.Thereisnoneed topayhedgefundfees toaccesssuchreturns.However, thereareother types of market returns that cannot be accessed efficiently throughtraditional investment manager mandates and which represent investmentperformancepaid for providingvaluable services.These liquidity and risktransfer services are offered by a number of hedge fund strategies,whichcamebadlyunstuckin2008.

TheshapeofthehedgefundmarketFigure9.3 showshowallocations tobroadcategoriesofhedge fundshaveevolved,particularly since2007.Equityandemerging-markethedge fundsaccountedforthebulkofthedeclineinassetsundermanagementafter2007,

with these types of hedge fundsmanaging in early 2013 around one-thirdless money than in 2007. By contrast, all other types of hedge funds,including fixed-income and arbitrage hedge funds, in aggregate hadexperiencedanincreaseinassetsoverthisperiodinexcessof25%.

FIG9.3Hedgefundassetsundermanagementbytypeofstrategy$bn

Source:BarclayHedge,www.barclayhedge.com

Table9.2 shows theweightofmoneydirectly invested in thedifferenttypesofhedge funds, according toBarclayHedge.One-quarterof the$1.9trillion estimated to have been invested in hedge funds in June 2013wasinvested through fund of hedge fund arrangements, where fund of fundmanagersareresponsibleforselectingindividualhedgefundmanagersandfortheriskmanagementofthehedgefundarrangement.AlsoinJune2013afurther $330 billion was invested in managed futures programmes withCTAs, which are not generally classified as hedge funds but are directlycomparable(seeCommoditytradingadviserssection).

Table9.2showsthat,accordingtodatafromBarclayHedge,ofthetotalamountallocateddirectlybyinvestorstodifferenthedgefundsinJune2013,22%wasplacedwithequityhedgefunds;13%withemerging-marketfunds;16%withfixed-incomeanddistressed-debtfunds;12%withmulti-strategyfunds;and10%withevent-drivenfunds.

TABLE9.2Hedgefundindustry:assetsundermanagementJune2013

$bn %oftotal

Hedgefundindustrya 1,946 –

Fundoffundsindustry 480 –

Sectors Convertiblearbitrage 38 2.0

Distressedsecurities 147 7.6

Emergingmarkets 261 13.4

Equitylongbias 168 8.6

Equitylong/short 170 8.7

Equitylong-only 74 3.8

Equitymarketneutral 21 1.1

Eventdriven 188 9.7

Fixedincome 308 15.8

Macro 176 9.0

Mergerarbitrage 24 1.2

Multi-strategy 230 11.8

Otherb 35 1.8

Sectorspecificc 107 5.5

Total 1,946

aExcludesfundoffundsassetsandmanagedfuturesfunds(CTAs).bIncludesfundscategorisedasregulationD,equityshortbias,mutualfundtiming,statisticalarbitrage,closedendfundsandwithoutacategory.

cIncludessectorfundscategorisedastechnology,finance,realestate,metalsandmining,andmiscellaneousoriented.

Source:BarclayHedge,www.barclayhedge.com

Hedgefundreplicationand“alternativebetas”Theenormousgrowthofthehedgefundindustryinthepastfewdecadesandthecombinationofhighfeesandtheapparentcompetitiveperformanceofhedgefundindiceshaveattractedmuchacademicanalysis.Twostrandsofthisresearchstandoutforinvestors.Oneistheanalysisofwhatcanbededucedabouttherisksofhedgefundinvestingfromthepatternsofmonthlyreturnsfordifferenttypesofhedgefund(seelaterinthischapter).Theotherrelatedareaofresearchhasbeentoestimatetheextenttowhichtheperformanceofhedgefundscanbeexplainedbydifferentmarketriskexposures(whichmaytakesignificantexpertisetoaccess)ratherthanpuremanagerskill.Iftheperformanceofhedgefundscan

bereplicated,sotheargumentgoes,bycombinationsofinexpensive,easy-to-accessmarketreturns,itshouldbepossibletoobtainthebenefitofhedgefundinvestinglessexpensively,withmoreliquidityandtransparency,thanbyinvestinginhedgefunds.HarryKatandHelderPalaro,workingatCassBusinessSchool,London,in2005,andthenJasminaHasanhodzicandAndrewLo,bothacademicsatMIT(KatandLoarealsoinvestmentmanagers),wereamongthefirsttosuggestsuchaliquidalternativetohedgefundinvesting.So-calledhedgefundreplicatorshavesincebeenmarketedbyanumberofbanksandassetmanagers.Theyhave,however,beensubjecttocriticism,notleastbecausethelacklustreperformanceofhedgefundindicesintheyearsupto2013(whenriskassetmarketsweregenerallystrong)meantthatthereplicatorsalsosuffereddullperformance.Furthermore,anumberofthereplicationstrategies,thoughofferingliquidityandtransparency,neverthelessleviedfeesinexcessofthechargesthatmightbeexpectedforsuchacommoditised(thoughtechnicallysophisticated)product.

Theanalysisofhedgefundperformancehighlightedthatinvestinginhedgefundsoftenincludesalargedegreeofexposuretoequity,creditandinterest-raterisk,aswellasothereasy-to-accessexposuressuchassmallercompaniesandforeignexchangerisk.Investorsdonotneedsophisticatedproductstoaccesstheserisks.However,hedgefundinvestinghastwoprincipalattractions.Oneistoaccesstheperformancebenefitsofunusualandexceptionalinvestmentmanagementskills,whicharerare,difficulttofindandcommandapremiumprice.Anotheristoaccessalternativesourcesofmarketreturns,soastobetterdiversifyinvestmentportfolioswhichareotherwisedominatedbyequity,creditandinterest-raterisk,eachofwhichcanbeaccessedinexpensivelyusingpassiveinvestments.Someofthesealternativesourcesofreturn,alsocalled“alternativebetas”,includecollectinginsurancepremiums(andsorisksufferingoccasionallargelosses),whicharerepresented,forexample,involatilityandevent-drivenhedgefundstrategies.(Volatilitystrategiesmaycollectpremiumsineffectforprovidinginsuranceagainststockmarketcrashes.)Otherstrategiesseektocapturesystematicreturnsofferedbymomentumstrategies.Thesesourcesofriskandreturnarerecognisedtobeunderrepresentedinmostinvestmentportfoliosandthetechniquesofhedgefundreplicationoffertheprospectofbeingabletoaccesstheminexpensively.Thisisdifferentfromanattempttoreplicatetheperformanceofbroadhedgefundindices(whichresearchhasshowntobedominatedbyequity,creditandinterest-raterisks).Suitablytailoredtooffsettheriskexposuresalreadypresentinaninvestmentportfolio,thisofferstheprospectofhelpinginvestorstodiversify,abit,therisksintheirstrategiestoachieveabetteroverallbalancebetweenriskandreturn.

DirectionalstrategiesGlobalmacroIntheearly1990smacrofundswerethedominanttypeofhedgefund.Theirimportance has diminished in the past two decades as the range of otherhedgefundstrategiesgrew.

A macro fund may use leverage to exploit a diverse range ofopportunities, investing in individual companies, equity or bond markets,

commoditiesorcurrencies.The instrumentsamacro funduses range fromlongandshortpositions inhighly liquid(andpotentiallyhighly leveraged)currencyorfuturesmarketsthroughquotedsecuritiestoilliquidinvestmentsinprivateequityordirectloanstocompanies.Historically,investmentbankswere able to replicate this range of opportunistic investing, but few otherinvestmentvehiclescancomeclosetoamacrohedgefundforthediversityof its entrepreneurial risk-taking. Performance comes from managerdecisions:thechangesintheirmarketexposuresmeanthattheremaybenopersistenceofsuchexposures,andthat littlecomfortshouldbe takenfromthe low average correlation between macro funds and the equity marketshown inTable 9.4.The flexibility of amacro fund’s strategymeans thatsometimesitwilldiversifyequitymarketriskandsometimesitwillamplifyit.Themacrofund’s investorsprobablywillnotknowuntilafter theeventhowthefundwaspositionedduringturbulentmarketconditions.

TABLE9.3Hedgefundperformanceduringcalendarquartersofequitymarketcrisis1994Q1–2013Q3,%totalreturnin$

Sources:Barclays;CreditSuisse;MSCI

Equityhedge,equitylong/shortandequitymarketneutralThehedgefundbusinessistraditionallyconsideredtohavestartedwiththepartnershipsetupbyAlfredJonesinthelate1940s(thoughthereareotherclaims forearlierantecedents). Itwouldbe recognised todayasan“equitylong/short” or “equity hedge” fund. It incorporated short selling ofovervaluedstocksalongsideholdingsofundervaluedstocks.Inthiswayitsexposure tomarketmovements was reduced and its exposure tomanagerskillswasemphasised.

Equitylong/shortfundsnormallyhavesomepositiveexposuretoequitymarkets and are considered to be directional funds. This is confirmed inTable9.4,whichshowsthatbetween1994and2013thecorrelationbetweentheindexofequitylong/shorthedgefundmanagerperformanceandthatofthe world stockmarket was 0.71. Furthermore, the pattern of returnsgeneratedbythesefundsoftenindicatesthatthestocksthatthey“short”,orsell,tendtobeeasy-to-borrowliquidlargecapstocksorevenindexfuturescontracts,whereasthestocksthattheypurchase(orgolong)tendtobelessliquid,smallercompanystocks.Thispatternintroducesadistinctiveelementof systematic risk into many of these hedge funds, which may have aleveragedexposuretotheperformanceofsmallcompaniesrelativetolargecompanies.

TABLE9.4Selectedhedgefundstrategies:correlationswithglobalequitymarketJan1994–Sep2013,%totalreturnin$

MSCIWorld

Equitylong/short 0.71

Globalmacro 0.23

Managedfutures –0.03

Shortbias –0.74

MSCIEmergingmarketequityindex

Emergingmarkets 0.80

Sources:CreditSuisse;MSCI

Equity long/short hedge funds typically have much less diversifiedportfolios than conventional long-only portfolios. Some of these equityhedge funds seek to neutralise market risk exposures and to offer aninvestment return that, as near as possible, reflects only the investmentmanager’sstock-pickingskills.These,calledequitymarketneutral, formaminorityoftheequityhedgefunds.

Short-sellingorshort-biasedmanagers

Short-sellingorshort-biasedmanagersShort-sellingmanagerssellstocksthattheyexpecttodeclineinvalueintheexpectationofbeingabletobuythembackatalaterdateatalowerprice.These directional funds should perform particularly well when thestockmarketdeclines.Howwellashort-sellingfundprovidesthisinsurancewill depend upon how well it is diversified. In practice, the averageperformance of the short-selling strategy in calendar quarters of equitysetbackhasbeenstronglypositive(seeTable9.5).

Table9.4indicatesthatthecorrelationbetweenshort-biasedhedgefundsand the US stockmarket has been around –0.74. Short-selling funds areparticularly used by fund of hedge fund managers to reduce the overallequitymarket exposure of their portfolios of hedge funds. In practice, themoneymanagedbyshort-sellingfundsisnormallymodest.

TABLE9.5Equityhedgefundperformanceduringcalendarquartersofequitymarketcrisis1994Q1–2013Q3,%totalreturnin$

aSeetextforcommentson2008Q4equitymarketneutralperformance.Sources:Barclays;CreditSuisse;MSCI

Long-onlyequityhedgefundsTheseexist.Theydonothedge,but theycall themselveshedge fundsandduringthebullmarketbefore2007,theyrepresentedawayforhedgefundstodiversifytheirbusiness.Theprincipalsownasignificantequitystakeandtypically they investopportunistically in smallerquotedandperhaps someunquotedprivatecompanies.Thefeearrangementsaremuchmoreattractivetothemanagersofthesefundsthanthosefortheircloserelative,thesmall

capmutualfund.Furthermore,theyaregivenagreaterdegreeofinvestmentflexibilitybybeinginastrongerposition(thanamutualfund)tomanagethetermsonwhichclientscanexitfromthefund.

Emerging-markethedgefundsAs the name suggests, these funds exploit opportunities in emergingmarkets.Theyaredirectionalfundswhichinvestinbothequitiesandbonds.Itcanbedifficulttoborrowstockinthesemarketsandonemeansofalteringmarketexposureisbyleveragingtheentireportfoliothroughborrowing,orby scaling back exposure through building up holdings of cash. Theirperformance is often highly correlatedwith emerging-market equities (seeTables9.4and9.6).

TABLE 9.6 Emerging-market hedge fund performance during calendar quarters ofequitymarketcrisis1994Q1–2013Q3,%totalreturnin$

Sources:Barclays;CreditSuisse;JPMorgan;MSCI

Fixed-incomehedgefunds:distresseddebt“Distresseddebt” conjuresup imagesof theobligationsof companies thatareclosetobankruptcy.Thisisthetraditionalfishingpondforhedgefundsspecialisingindistresseddebt.Thisgroupofhedgefundsalsoincludessomesignificanthedge fundswhichcan resemble“privatedebt funds”.The riskforinvestorsisafunctionoftheunderlyinginvestments,oftheleverageandof the illiquidity of the fund. The largest of these havemuch in commonwith large private equity funds (seeChapter 10). For an investor, there is

likelytobeanoverlapintermsoftheunderlyinginvestmentswiththemuchless expensive, well-diversified, high-yield corporate debt fund. Adistressed-debtfund,however,maybemoreleveraged.

Nevertheless, a distressed-debt fund is quite distinct from a high-yieldmutualfund.First, thehedgefundmanagersmaybethebankersextendingloanstotheirinvesteecompanies.Theywillhaveamuchmoredirectsenseof ownership for their holdings, and greater scope to influence corporatemanagement,thanthebest-informedhigh-yieldmanager.Second,thehedgefundcanimposelock-upperiodsoninvestorsandsocangaintheadvantageoftimeandbeinbettercontrolofflowsofliquidityintoandoutofthefund.This canprovide an investment advantage to a distressed-debt hedge fundcomparedwithahigh-yieldbondmutualfund.

TABLE9.7Fixed-incomehedgefundperformanceduringcalendarquartersofequitymarketcrisis1994Q1–2013Q3,%totalreturnin$

Note:SeetextcommentsfordiscussionofAugust1998fixed-incomearbitragereportedperformance.Sources:Barclays;CreditSuisse;MSCI

ArbitragestrategiesBefore the credit crisis, arbitrage hedge fund strategies commonly usedsignificant leverage and often had illiquid holdings. The crisis put suchfunds under severe pressure. A number of them closed, but those thatsurvived adjusted to operatingwith the lower levels of leverage andoftenhigherlevelsofmarginpaymentsrequestedfromthebanks.

Fixed-incomearbitrageFixed-incomearbitragestrategiesexploitpricinganomaliesinfixed-incomeinstruments while managing exposure to interest-rate risk. Fixed-incomearbitrage funds establish long and short positions in closely related fixed-income markets or securities. Where the offsetting positions are closesubstitutes, leverage may be used, though the degree of leverage wascurtailedbythecreditcrisis.Shortpositionsaregenerallyhighlyliquidandlongpositionsmaybe less liquid.These strategieswilloftenbepositivelyaffectedbyanarrowingofcreditspreadsandviceversa,althoughthehedgefundscanequallyeasilybetoncreditspreadswideningasnarrowing.

MergerarbitrageMerger arbitrage (sometimes simply called “risk arbitrage”) funds provideaninsurancewhichpreviouslywasleftasunsoughtriskbylong-onlyequitymanagers.When an intended merger or takeover is announced, the sharepriceof the targetcompanymovesclose to theannounced takeover terms.Itsnewsharepriceisnormally(unlessahigherbidisanticipated)lessthanacashbidprice.Theamountof thediscountwill reflect theprobability thatthe bid will succeed, as well as the intervening rate of interest. Mergerarbitragefundsprovideinsuranceagainsttheriskthattheannouncedmergermightfailbyacquiring the targetcompanyandhedging thatbyselling theacquiring company. As well as potential restrictions on fund leverage orshort selling, this strategy is vulnerable to two risks that can underminepositions: company-specific issues could cause the merger to fail; or asevereequitymarketdeclinecouldcausearenegotiationofthetermsofthedeal. In common with other difficult-to-diversify insurance arrangements,merger arbitrage provides a steady flow of income with the risk ofoccasionallargelosses.

TABLE 9.8 Arbitrage hedge fund performance during calendar quarters of globalequitymarketweakness1994Q1–2013Q3,%totalreturnin$

Sources:CreditSuisse;MSCI

ConvertiblearbitrageHedge funds were said in early 2005 to hold around three-quarters ofoutstanding convertible bonds, such was the popularity at that time ofconvertiblearbitragestrategies.Convertiblebondspayalowcoupon(orlowyield)becausetheyhavetheaddedbenefitthattheycan,atthediscretionoftheinvestor,beconvertedintoequity.Theyprovidetheupsidepotentialofequities and the downside protection of a bond. They offer a naturalopportunity for hedge funds seeking to exploit any technical anomalies inthe pricing of the debt, convertible bonds, warrants (that is, options onequity)andequityofaparticularissuer.

In principle, these strategies should be able to deliver steady profits.However, illiquidity can cause anomalies to become more exaggeratedbefore the date at which the arbitrage profit should be crystallised. If thefundissubject tosevereredemptionsasinvestorsrespondtodisappointingperformance,forcedsalescaneasilyhaveacumulativelynegativeimpactonperformance.In2008,theimpactofthiswascompoundedbytheneedtocutpositionsasmarginrequirementswereraised,andbytheimpactofbansonshortselling.Thesecontributedtoanunprecedentednegativereturnforthisstrategy. Nevertheless, in principle there can be clear arbitrage profits forpatientlong-terminvestors,andhedgefundsprovidetheobviousvehicletoexploitsuchanomalies.

StatisticalarbitrageThereareanumberofarbitragestrategiesthatmaybeusedbyrelativevalue

hedge fundmanagers and that may be found within multi-strategy funds.These include liquidity arbitrage trades to exploit (and correct) the short-term impact on market prices of securities of large market trades.Historically, another type of trade was the observed positive or negativeimpact on stock prices of companies joining or leaving an index that iswidely used as an investment benchmark.This declined in profitability asnewmoneychased theunusualprofits thathadpreviouslybeenearnedbyexploiting thesephenomena.Both these typesofstatisticalarbitrage tradesshowhowhedgefundscanimprovetheefficientfunctioningofmarketsbyreducing the scale of these short-term anomalies. But they also illustratehow anomalies can be eroded by a weight of money, leaving few if anyprofitsforlatecomers.

Multi-strategyfundsFrom the beginning of the hedge fund industry, larger funds have oftenmanagedtheirownrisksandtheirinvestors’risksbyhavingmorethanoneteam of portfolio managers, each dedicated to a different investmentstrategy.This enables the hedge fund’smanagement to take responsibilityfor allocating resources as opportunities in the different strategies change.Multi-strategyfundsprovideincreasingcompetitionwithfundofhedgefundarrangements because of the central ownership of risk management anddecision-making,and,critically,lowerfees,asperformancefeesarepayableonthecombinationofstrategies,ratherthanoneachstrategyindividually.

Multi-strategy funds include some of the largest hedge funds. Somemulti-strategy funds have developed expertise in corporate finance, tofacilitateinvolvementincorporatetakeoversandmanagementbuy-outs.

TABLE9.9Multi-strategyhedgefundperformanceduringcalendarquartersofequitymarketcrisis1994Q1–2013Q3,%totalreturnin$

Sources:Barclays;CreditSuisse;MSCI

Commoditytradingadvisers(ormanagedfuturesfunds)Commoditytradingadvisers(CTAs)provideoneofthemostinterestingabsolutereturnstrategies.Theirinvestableuniverseisprovidedbytheworld’sfutures,optionsandforeignexchangemarkets.ThedominantgroupofCTAsissystematictraderswhoarehighlyquantitativefollowersoftrendsrangingfromafewdaystoseveralmonthsinthefuturesmarketscoveringagriculturalcommodities,industrialandpreciousmetals,currencies,governmentbondsandequityindices.Thesearegenerallyhighlyliquidandeasytovalue.Someinvestorsarenervousoftheopaque,model-driven(black-box)approachtoinvestinginsystematicCTAs.OneconcernisthatthehighlyqualifiedquantitativeanalystsbuildingthemodelsinthedifferentfirmsmayunwittinglyidentifythesametrendsandleadtohiddenconcentrationsofpositionsheldbyCTAfundsinindividualfuturescontracts.DiscretionaryCTAs,whichrelyonmanagerjudgmentsofwhentotrade,accountedforjust7%ofCTAassetsinmid-2013.

CTAstrategieshavebeensubjecttoextensivestatisticalanalysis,whichshows that, on average, they have demonstrated strong diversifyingcharacteristics and a tendency to perform well at times of equity marketcrisiswhenotherhedgefundstrategiesoftenunderperform.Thepatternofreturns shown by indices of CTA manager performance during calendarquartersofequitymarketweakness(seeTable9.10)isimmediatelydifferentfrom the corresponding figures for hedge fund performance. With theexceptionofdedicatedshortstrategies, theoverridingmessagefromhedgefund data is that hedge funds do not provide short-term insurance against

poor equity market performance. On average, CTAs have provided somesuch hedge. This continued in 2008 when the Credit Suisse ManagedFuturesindexreturned18.3%,comparedwithanegativereturnof19.1%forthebroadindex.Thereisnoassurancethatthispatternwillcontinue,andtheperformanceofindividualCTAscanbeverydifferent.

The role of CTA funds in providing readily marketable portfoliodiversificationcanbecomparedwiththeroleofcommodityindexexposure,which became popular for institutional investors in the years before thecreditcrunch,whencommodityindicesrosestrongly.Table9.10showsthaton average CTAs have performed better during months of equity marketweakness than the Dow Jones-UBS Commodity index. However, whileinvestors in commodity indices should receive the index performance, thedispersionofmanagerperformancemeansthatitismuchmorelikelythatanindividualCTAmanagerwilldifferstronglyfromtheresultsfortheindexofCTAmanagers.

TABLE 9.10Managed futures fund (CTA) and commodity index performance duringcalendarquartersofequitymarketcrisis1994Q1–2013Q3,%totalreturnin$

Sources:Barclays;CreditSuisse;MSCI;S&PDowJonesIndices

There are various possible explanations for the apparent insuranceagainstequitymarketsetbacksthatCTAstrategieshaveprovided.Itmaybedowntoluckthatintherelativelysmallnumberofquarters(ormonths)withlarge negative equity returns the average CTA manager has delivered asomewhat surprisingly strong performance. Or, more likely, CTAs haveprovided insuranceagainstequitymarketsetbackswhen theirmodelshavebeenabletoidentifyachangeinmarketdirection,whichhassubsequently

proved to represent a change of trend that the CTAs have successfullyexploited. Sometimes this will work and sometimes, when markets areaffected by a sudden setback, itwill not.Nevertheless, an investment thatoffers the prospect of good performance during bad times is rare andvaluabletoinvestors.

HedgefundriskMadoff,hedgefundduediligenceandregulationHedgefundriskshouldfeatureprominentlyinanyassessmentofhedgefundinvesting. There have beenwell-publicised examples of hedge fund fraudandapparentfraud,anditislikelythattheentrepreneurial,cottage-industrynature of some parts of the hedge fund industry make it more prone toelementaryprocessweaknesses.Thescaleofthemultibillion-dollarfraudatBernardL.MadoffInvestmentSecurities,whichwasrevealedinlate2008,wasparticularlyshockingasitwasfarremovedfromanyideaofacottageindustry.Itexposedtheshallownessofwaysinwhichmanyprivateclientsappeared to have chosen hedge funds – often being led by personalrecommendationsandareviewofhistoricperformancedata,togetherwithaconfirmationoftheevidentesteemandreputationoftheprincipals.

Rigorous due diligence is different. Many investment firms avoideddealing withMadoff, and since the event there have been several reportshighlighting concerns that a thorough due diligence process should havepickedup.Thesearesummarisedin“Madoff:ariotofredflags”,areportbyGregGregoriou,professoroffinanceatPlattsburghStateUniversityofNewYork, and François-Serge Lhabitant, professor of finance at EDHECBusiness School in France, published in January 2009. These reportsprovideusefultrainingmaterialforhedgefundresearchers.

OperationalrisksThe hedge fund industry is rapidly evolving and the flurry of industryreportsinrecentyearsonhedgefundrisksandbestpracticeareindicationsof both shortcomings and the emergence of an understanding of bestpractice. Nevertheless, investors cannot take for granted that their hedgefundsaremanagedtoahighstandard.Operationalriskshouldbeaparticular

focusofahedgefundduediligenceprocesssinceithasbeenhighlightedasaprime reason for suddencatastrophicclosuresofhedge funds.One issuethat investorsneedtoconsiderarisesfromthedifficulties thathedgefundshave in developing an enduring franchise, partly because of the incentiveeffects of hedge fundperformance fees,which lead to a high rate of fundclosures.Forexample,accordingtoHFR,ahedgefundconsultancy,15%ofhedgefundsclosedduring2008,andalmost9%closedineachofthethreeyears to 2012. This rate of closure, as well as the potential incentive forhedge funds to close after a period of poor performance, suggests thatinvestors in hedge funds or their advisers should always be searching forreplacementhedgefundmanagers–whichaddstothecost,atleastintimeandeffort,ofhedgefundinvesting.

IlliquidhedgefundinvestmentsandlongnoticeperiodsMany hedge funds find promising opportunities in unquoted and illiquidinvestments.Typicalexamplesincludeprivateloanstocorporations,whichmaybeinvestmentgradeordistresseddebt,andunquotedorilliquidequityopportunities. These are precisely the sort of opportunities that anentrepreneurialinvestmentcompanywouldbeexpectedtoexploit.

However, 2008 exposed the long-established weakness of the hedgefund industry, which is a mismatch between the illiquidity of underlyinginvestmentsandthefrequentopportunitiestoredeem.Thishasalwaysbeenaconcernbecauseerrors invaluing illiquid investmentswhenhedgefundsare bought and sold give rise to windfall transfers of wealth among fundparticipants. In 2008 these issues led to the widespread imposition ofrestrictions on redemptions of hedge fund holdings by funds that wereunable, or unwilling, to meet their regular schedules of dealing dates. InMarch 2009,Credit Suisse estimated that 17%of hedge funds (by assets)were“impaired”byhavingputrestrictionson,orsuspended,redemptionsorhad frozen investors’ share of hard-to-value investments in a separateportfolio. This illustrates that investors in illiquid hedge fund strategiesshouldnotobject,indeedshoulddemand,thatfellowinvestorsaresubjecttoearly redemptionpenalties (to accrue to the fund) that properly reflect theunderlying illiquidity of the hedge fund. Long lock-up periods, seemingly

inflexible redemption arrangements or wide bid-offer spreads for hedgefundswithilliquidunderlyinginvestmentscanbeinthebestinterestsofallinvestorsinthosefunds.

Lies,damnliesandsomehedgefundriskstatisticsThere are other problems that arise with illiquid hedge fund investments.Anypriceforanunquotedinvestmentwillbeanappraisalprice.Appraisalprices unavoidably smooth and lag changes in underlying market prices.Thismeansthatifinvestorshavetheopportunitytotransactatanappraisalpriceforafund,trendsmaybeevidentthatenablethemtobuyorsellwhentheyreasonablyassessthattheappraisalpriceishigherorlowerthanwherethemarketactuallyappearstobe.

Furthermore, appraisal prices are less volatile thanmarket prices.Thismeansthatthevolatilityofmonthlyappraisalpricesshouldnotbeusedasaguidetotheriskofastrategythatinvolvesasignificantelementofappraisalpricesinitsvaluations.Wherethepricedataaresmoothed,calculationsforvolatilityandforrisk-adjustedreturns(suchasSharperatios,seeAppendix1) will be distorted, with risk looking lower than it is and risk-adjustedperformance better. Appraisal prices can provide useful managementinformation,buttheymustbeusedwithcare.

There has been extensive research into the issue of illiquidity and theunavoidable smoothingof hedge fund returns, and the implicationsof thisfor measures of hedge fund risk. The results tend to be uniform inestablishing the importance of the issue and theway that it is focused onilliquid hedge fund strategies. The affected categories include distresseddebt, convertible arbitrage, event-driven and emerging-market strategies.The strategies that are not normally affected by this valuation-smoothingphenomenon are the generally liquid strategies: equity long/short, macro,short-biasedandespeciallyCTAormanagedfuturesfunds.

Compilingpricesforfundsthatincludelargeproportionsofilliquidandprivate investments runs the risk of accurately following a procedure tocompute valuations, but then using the data to construct performance andespeciallyriskstatisticsthataremorelikelytomisinformthantoinform.Inprivate equity, where the same issues arise, appraisal valuations of

underlyinginvestmentsprovidemanagement information,butnotnormallydealingprices,anditisunderstoodthattheonlyperformancethatmattersisthe internal rate of return calculated from the amount of cash originallyinvested, the cash subsequently paid back to investors and the passage oftimeinbetween(seeChapter10).

Subscriptions to private equity funds are designed to be held untilrealisation, and in so far as there is a secondary market for holdings inprivateequity funds, thesedonot set the terms forwholesaleexits fromafund.Forexample, investorsinaprivateequityfundwouldbesurprisedifthey were shown a pattern of monthly statistics of returns for a venturecapital or private equity portfolio from which “risk” statistics, such asstandarddeviationsorSharperatios,werecalculated.Butinthehedgefundworldthissortofthinghappensroutinely,evenforportfoliosthatincludealargeelementofilliquidinvestments.Moreusefulasperformanceindicatorsthatmayshed lightonriskcanbemeasuressuchasmaximumdrawdown,whichmeasuretheexperienceofnegativereturnsinthefundandgenerallymitigatetheproblemofsmoothedvaluations.

Another danger that investors should look for is where there is acombination of price smoothing and the pursuit of an investment strategyinvolvingthecollectionofoptionorinsurancepremiumswhichhappennottohavebeenreflectedinperiodicpoorperformance,sofar.CliffordAsness,co-founderofAQRCapitalManagement,wrotein2004:

CombiningsomelagsinmarkingtomarketwithinvisibleoptionwritingcanproduceoneheckofahistoricalSharperatio,butwithapotentiallytoxiccombinationgoingforward.

Theseweaknessesofwidelyusedhedgefundrisk indicatorshavebeenknownforaconsiderabletime,buttheyhavemadelessimpressiononhedgefundpracticethanwouldbehoped.Asurveyofhedgefundperformanceandrisk reporting standards by EDHEC, a French business school, in 2008found that only 5% of hedge funds adjust their results for the smoothedpatternofmanyhedgefundreturns,andthatmosthedgefundsdidnotknowhow to allow for a “non-normal” pattern of hedge fund performance incalculating risk statistics. Instead hedge funds have found it convenient to

relyontheflatteringandeasy-to-calculateSharperatio,whoseuseisvalidonlyunderconditionswhichoftendonotapplytohedgefunds.

“Perfectstorms”andhedgefundriskMoney managers often attribute unusual poor performance to a highlyimprobableconfluenceofevents.Nowhere is thismore true than inhedgefundinvesting.Eventsthataredescribedbyhedgefundmanagersas“beingexpected”tooccuronly“onceinamillionyears”seemtobesocommonastobeunremarkable. In2008 thecombinationof theevaporationofmarketliquidityandrestrictionsonshortsellingmadeitseemasifnomatterhowinsightful was a fund’s investment process, events were conspiring toundermineitsendeavours.Butanapparentlyunusualfrequencyofextremeeventsalwayshasaccompaniedhedgefundinvesting.

Thiscanbeillustratedwiththehistoricalanecdotefromthecarindustrydescribed in Chapter 6. On that occasion groups of hedge funds foundthemselveson thewrong sideofoffsettingpositions inGMsecurities thatthey thoughtweregoodhedges foreachother.Asimilarexamplearose in2008,whenVolkswagensharesweresqueezedwhenitbecameknownthatPorscheownedmuchmoreofVWthanhadpreviouslybeenbelieved.TheGMepisodewasdescribedbyonehedgefund(whichwascaughtshort)asan “eight standard deviation event”,which should almost never happen ifmarketsbehavedassimplemodelswouldsuggesttheyshould.However,theapparent frequent occurrence of “bad news” in hedge fund performancereflects a particular characteristic of many hedge fund strategies thatinvestorsmust understand. Since they are often comparable to investmentinsurance-typearrangements, theyprovidesteadyreturnsmostof the time,astheinsurancepremiumsarecollected,whilebeingexposedtotheriskofoccasionallargelosses,whentheinsurancepolicymustpayup.

This is illustrated in Figure 9.4, which combines the monthlyperformanceforthemulti-strategyandarbitragestrategyindicesasreportedby Credit Suisse. It vividly reflects this combination of modest positivereturnsmostofthetime,withoccasionallargenegativereturns.

As Bill Sharpe, the Nobel Prize-winning originator of the standardmeasureof risk-adjusted returns, said inanarticle inAugust2005 inWall

Street Journal: “Past average performance may be a terrible predictor offutureperformance.”Thispatternofreturnsisparticularlycommoninsomehedgefundstrategiesthatofferinvestorstheprospectofsystematicmarketreturnsforbearingthisinsurancerisk.

FIG9.4Monthlyperformanceofarbitrageandmulti-strategyhedgefundindices1994–2013

Note:ShowsequallyweightedperformanceofCreditSuisseconvertiblearbitrage,event-driven,fixed-incomearbitrageandmulti-strategyhedge

fundindices.Source:CreditSuisse

Managinginvestorrisk:theroleoffundsofhedgefundsInvestors should accept the risk of an occasional extreme negative returnonly if it is judged to be more than outweighed by the prospect ofcompensating performance over time. Even then the risk will need to beoffsetasfaraspossiblewithinanoverallassetallocation.Mostcommonlythismeanscombiningdifferenthedgefundstrategiesinawaywhichtriestomanagetheserisks,andthenmakingsurethattheallocationtohedgefundsfitsinwiththeoverallriskappetite,oratleastcomfortlevel,oftheinvestor.

Theportfolioconstructionrolemaybeundertakenbyfundofhedgefundmanagers, who manage portfolios of hedge funds. Fund of hedge fundmanagers perform two critical roles: one is portfolio construction and

overall investment riskmanagement; theother is hedge fundmanagerduediligence.Attheendofthischapterthereisalistofsomeoftheissuesthatneed tobe covered in ahedge fundduediligenceprocess.Given thehighlevelofoperationalandreputationalriskinvolvedinhedgefundinvesting,afund of hedge funds arrangement is often the most appropriate way fornovicehedgefundinvestorstoproceed.Followingtheworkofthefundofhedge funds manager is also an effective way for investors to seeprofessionalhedgefundriskmanagementinaction.

Investorsneedtotrytosatisfythemselvesthattheduediligenceprocessthey areusing is thorough.But therewill alwaysbe a riskof a surprisinginvestment performance or operational mishap and of investors saying totheirduediligence team:“I thoughtyouwere supposed tocheckon that.”These risks should be mitigated by a fund of hedge funds approach.However,itdoescomeataprice.Inparticular,ithastoovercomethehurdleof imposing an additional level of fees on top of an already expensivestructure.

Howmuchshouldyouallocatetohedgefunds?Youdo not need to allocate anything to hedge funds, and you should notunless you think that you can access a hedge fund arrangement whichcomplements your other investments. Paying higher fees for a dilutedversionofyourequityinvestmentsiswasteful.Thereshouldbeanelementofextraskilloraccesstorewardsthatarenotavailableelsewheretojustifyadecisiontoinvestinhedgefunds.

A common weakness with a fund of funds approach to hedge fundinvestingisthatitistypicallystructuredinignoranceoftheinvestmentrisksthat are present elsewhere in an investor’s strategy.With some aspects ofhedgefundperformanceandriskbeingclosesubstitutesforthoseavailableelsewhere andothers beingunique, askinghowmuch to allocate to hedgefundsceasestobeasensiblequestion.Instead,theinvestmentissueishowmuchshouldinvestorswishtoallocatetodifferenttypesofsystematicrisk?Thusthereisastrongargumentinfavouroftheapproachofsomefundsofhedge fundsmanagers,which is tooffercombinationsof fundssegregatedinto different categories or “buckets” of risk-taking. For example, some

hedge fund strategies (such as equity hedge funds) offer combinations ofequity market risk and manager skill exposures which are obviousalternativesto,orcompetitorswith,therisksandopportunitiesthatinvestorsexpose themselves towhen they select conventional equitymanagers.Thesame principles apply to hedge funds that specialise in, for example,emergingmarkets or some creditmarket strategies: the allocation to suchmanagers should be considered at the same time as decisions aremade toallocatetoemerging-marketdebtorequityor,forexample,sub-investmentgradecorporatedebt (allowing for thedifferent elementsofdiversificationprovidedbyeach).

This much is clear, and it is a process that is followed by increasingnumbersofinstitutionalinvestors.Moreinterestingishowtodecidewhattoallocatetohedgefundswhichoffersourcesofinvestmentperformanceandriskthataredifferentfromthosefoundinequityandbondmarkets.Thisisthe reward offered to hedge fund investors for providing a variety ofinsurance services,most commonly through the provision of liquidity andintermediation services in different markets. These include the range of“alternativemarketbeta”strategies,looselydescribedasarbitragestrategies,eachofwhichalsohasastrongcomponentofmanagerskill.Theprocessofdetermininghowmuchtoallocatetothesestrategiesshouldbedrivenbyaviewoftheriskassociatedwiththemandhowwellitisdiversifiedbyotherinvestments,andbyaninformedopiniononhowmuchrewardisexpectedtobeearnedfromallocatingcapitaltothem.

From an investor’s perspective this iswhere difficulties arise, becausethis is still relatively uncharted territory, particularly in respect of returnexpectations.Nevertheless,severalconclusionswouldbebroadlyagreed:

Thediversificationbenefitsofanumberofthesestrategiesappearwellestablished(althoughtheyarenotrobustinallperiods).

Itisreasonabletoassumethatthemarketshouldrewardtheseservicessinceothermarketparticipantsaredemonstrablywillingtopayforthem.

Thediversificationbenefitsaresuchthattherequiredpremiumreturn(abovethereturnonsafe-haveninvestments)neededtojustifyan

allocationtothesealternativehedgefundstrategiesismodest.

Thisleadstothetwofinalconclusions:

Theuncertaintiesinvolvedmeanthatanallocationtothesealternativebetasshoulderronthesideofcautionbynotdominatinganinvestor’sstrategy.

Formostinvestors,somesuchallocationcannormallybejustified.

Questionstoask

Yourhedgefundmanager

AgoodstartingpointisGregoriouandLhabitant’sreport“Madoff:ariotofredflags”.Investorsshouldbeabletoconfirmthepresenceofgreenratherthanredflagsinwhicheverarrangementstheyareconsidering.

SomegeneralguidanceforinvestorscanbefoundontheSecuritiesandExchangeCommission(SEC)website.Thebackgroundofsomeindividualhedge fund managers licensed by the SEC or National Association ofSecuritiesDealers(NASD)canbecheckedontheirrespectivewebsites.Thequestions that followare toodetailed formosthedge fundclients to askarepresentative of a hedge fund or even a financial adviser who isrecommending hedge fund investments to answer. However, they are thesorts of questions that an investor shouldwant to know someone at somestagehasaskedahedgefundmanageronbehalfofinvestors,andreceivedsatisfactoryresponses.

Performanceandinvestment

Pleaseprovideamonthlytrackrecordoftheperformanceofthefund.

Pleasesummarisethestrategyofthefundandthemajordeterminantsoffundperformance.Pleaserelatethistothepatternofmonthlyreturns.

Whatwasthesizeofassetsofthefundatthestartofthistrackrecord,

andwhatisthemostrecentsizeofthefund?

Howhasthestrategyofthefundchangedsincethestartofthetrackrecord?

Doyoumanageorhaveyoumanagedafundwithcomparableobjectives?Ifso,whatwasitsperformancetrackrecord?

Howdoyoujudgetheinvestmentsuccessofthefund?

Pleasedescribehowthemanagementofyourfundrespondedtothemarketandregulatorychallengesof2008.

Pleasedescribetheinvestmentdecisionsthatledtoyourmostdisappointingmonthlyperformanceresultsand,separately,thebestmonthlyperformanceresults.

Whatconclusionsdidyoudrawforthefuturemanagementofthefund?

Howdoyouexpectperformancetocorrelatewithequityandfixed-incomemarkets?

Isthereanyinvestmentstrategyreasontoexpectperformancetobeparticularlycorrelatedwithextremeequitymarketperformance?

Howdoyoumanagethepossibilityofextremenegativeperformanceresults?

Howlargecouldthefundgrowandstillhavethesameprospectforsuccess?

Hasyour(andyourfund’s)pastsuccessledyoutoscalebacktherisk-takinginthefund?

Howdoyouconductresearch?

Howdoesresearchaffectportfolioconstruction?

Business,operationsandvaluation

Who,ifanyone,isthefundmanager’sregulator?IfitistheSEC,requestacopyofthemostrecentformADV.

Whatproportionofthefundisvaluedatmonthendusingthird-party

pricingsources?

Whatproportionofthefundisrepresentedbyquotedsecurities?

Areanyinvestmentsvaluedatbookcost?

Hasthisproportionchangedovertime?

Pleasedescribetheunquotedinvestmentsandexplainhowtheyarevalued.

Dotheseinvestmentssmooththereportedperformanceofthefund?

Doyoumonitornetassetvalueeachday?Howdoyoupriceunquotedinvestmentsforthis?

Howfrequentarethefunddealingdates,andarethereanylock-upperiodsfornewinvestments?

Whatprovisionsexistfordelayingredemptions?

Didyourfundimposerestrictionsonredemptionsduring2008–09?

HowquicklycanIwithdrawmyfunds?

Whatexitpenaltiesapply?

Whatdiscretiondoesthemanagerhavetoaltertheseterms,andwithwhatnoticetoinvestors?

Whatwerecapitaloutflowsandinflowsinthelast12months?

Towhomdoestheback-officereport?

Howoftenarereportsproducedforinvestors?

Howdoyoumanageinflowsandredemptions?

Howdoyoumonitorthefund’scounterpartyexposure?

Whoisyourfundadministrator?Pleasedescribetheirroleforyou.

Doyouhaveone,ormorethanone,primebroker?Pleaseexplainwhy.

Whoisyourprimebroker?Pleasedescribetheirroleforyou.

Whatcreditrisksdoyourclientsfacevis-à-visyourprimebroker?

Doyouallowyourprimebrokertomakeanyuseofthefund’sassetsfortheirownpurposes(ie,“rehypothecation”)?

Isthecustodyofthehedgefund’sassetsindependentfromtheprimebroker?

Pleaseexplaintheextentofuseofover-the-counterderivativesandthecollateralrequirementswhichaccompanythesepositions.

Whatproblemsdoyouencounterinshortselling?

Howwasyourfundaffectedbytherestrictionsonshortsellingin2008?

Doshort-sellingdifficultieslimityourabilitytoimplementinvestmentpolicy?

Howmanyfailedtradesdoyouhaveoutstandingatpresent?

Isthisnumberoffailedtradesusualorunusual?

Howdoyoumonitorfailedtrades?

Ispricingdonein-houseorbyathirdparty?

Whoareyourexternalauditors?Whendidyoulastchangeauditors?

Pleaseprovideatimelineforpaymentsonredemptionofunitsinthefund.

Howdoyouensurefairnessinpricingilliquidorunquotedinvestmentswhenmakingredemptionpayments?

Howisyourpersonalfinancialinterestalignedwiththatofyourclients?

Whoarethefoundersorprincipalsofthefund?Whenaretheyexpectedtoretire?Whatsuccessionplanisthere?

Pleaseprovidereferences.

Risk

Howdoyoumonitorinvestmentrisk?

Whodoesthisworkandtowhomdotheyreport?

Howreliablearetheriskmeasurementtools?Pleaseillustrate.

Howdoyouallowfortheweaknessesthatareinherentinriskmodels?

Howdoyoumanagethecreditriskofyourinvestments?Howdoyoumanagethecreditriskofyourcounterparties?

Haveyoustresstestedyourstrategyagainstthemarketdevelopmentsofextrememarketconditions,suchasOctober1987,August–September1998,orthelastfourmonthsof2008?Hasthisaffectedinvestmentpolicy?

Whatistheworsthistoricaldrawdownthefundhasexperienced?

Hasinvestmentpolicybeenalteredtoreducetheriskofthishappeningagain?

Arethereanyelementsofinvestmentstrategythatexposethefundtothelowriskofanextremenegativereturn?

Howdoesthisrelatetoyourinvestmentpolicy,redemptiontermsandassessmentofextremeeventsinmarkets?

Doyouhaveformalparametersthatlimityourrisk-taking?Pleasedescribe.

Whatisyourleveragepolicy?Hasthischangedsince2007–08?

Howdoyoudefineleverage?Pleasecontrastthiswithotherdefinitionsusedinthehedgefundindustry.

Isitintendedthattheriskprofileofthefundshouldbepredictableoropportunistic?Ifpredictable,pleaseprovideaproofstatementofpractice.

Doyouhaveaformalsetofpermissibleinvestments?

WhatisthebestorworstmonthlyperformancethatIshouldexpecttoexperience?

Howdoyouallocateriskinconstructingtheportfolio?

Howdoyoureportinvestmentrisktoinvestors?

Liquidity

Liquidity

Howdoyoumanageliquidityriskinyourinvestments?

Howdoyoumanagetheliquidityofyourfundingorclientredemptions?

Howdoyoumonitortheadequacyofyourfund’saccesstoliquidity?Howdoyoumonitortheliquidityoftheinvestmentsofthefund?

Howdoyouensurethatyoualwayshaveenoughliquiditytomeetcollateralrequirements?

Howdoliquidityconsiderationsalteryourapproachtoportfolioconstruction?

Doyoumonitoranyliquidityriskmeasures?

Doesilliquidityofyourinvestmentscausethemeasuresofriskthatyoushowtoinvestorstobeunderstated?

Yourhedgefundadviser

Whoregulatesyou?

Doyouresearchandrecommendproductsfromthewholemarket,oronlyselectedproviders?

Howdoyougetcompensated?

DoyougetanintroductionfeeoranyotherformofremunerationfromthehedgefundifIinvest?

Ifyes,howmuchandhowdoesitinfluenceyourrecommendations?

Istheproposaltoinvestinthehedgefund,orinavehiclethatinvestsinthehedgefund?

Yourfundofhedgefundsmanager

Howdoyoumanagetheinvestmentriskforyourrecommendedorchosencombinationsoffunds?

Doyoureceiveafeefromfundsthatyouselectforyourfundof

funds?

Doyouincludeanyfundswhichdonotpayyoufees?

Doyouuseleverage?Ifso,why?

Howmanyoftheunderlyingfundsinwhichyouinvesthaveimposedrestrictionsonredemptionsbyinvestors?

Whatisyourbiggestadministrativeheadache?

Howdoyoumanagecashinflowsandoutflows?

Canclientcashflowsaltertheinvestmentallocationforallyourclients?

10 Privateequity:information-basedinvestmentreturns

THE PAST AND PROSPECTIVE investment performance of the private equitymarket has been analysed in numerous studies. But even if the estimatesproducedbythosestudiesarereliable,investorscannottakeforgrantedthattheywillbeabletoearnthem.

Investorsshouldavoidprivateequity investingunless theybelieve thatthey have access to skilled investment managers. The key to unlockingreturns in private equity is information, and investors have to believe thattheir managers have an edge that enables them to deliver at least marketreturns. Investing inanarrangement that lacks this edgewill condemn thestrategytoinferiorperformance.

The appropriate place for private equity in investment strategy isstraightforward.Privateequityiswhatitsays.Itisequity,andsoifincludedinstrategyitshouldformpartofaninvestor’sallocationtoequity.Itisalsoprivate, and so unquoted and illiquid and not suitable for short-terminvestors,anditsilliquiditywilladdinflexibilitiesandopportunitycostsintoanyinvestmentportfolio.Investorsneedtosatisfythemselvesthattheycanexpect a premium return to compensate for these costs.All the commentsabout diversification by style, by size and by geography for investing inquotedequities (seeChapter7)canbeapplied toprivateequity.However,sinceprivateequityisonlypartofaninvestor’sallocationtoequity,thereisnorequirementtoincludeinaprivateequityportfolioallthediversificationthat can be obtained from the private equitymarket, when it can also beobtainedinexpensivelyandwithconfidencefromthequotedequitymarket.Thekeyforinvestorsistobedrivenbyadispassionateassessmentoftheirability to gain access to skilledmanagers. The investor has to attempt to

separate the impact of skill from that of leverage on themanager’s trackrecord. Having done this and become comfortable with the manager’sapproachtogearingtheinvestments,theinvestorcanthendecidewhethertomakeanallocation.Thenextstepistoensurethatthetotalequityallocation(publicaswellasprivate)has thedegreeofdiversificationwithwhich theinvestoriscomfortable.

Whatisprivateequity?It isuseful to thinkof themarket in twodistinctparts.Thefirst isstart-upventurecapital.Thesecondisthemarketforleveragedbuyoutsofexistingbusinesses. Themarket is commonly divided further, with venture capitaldifferentiatedbetweenseedcapitalandearly-stageventurecapital,whilethelaterstagesofinvestingdifferentiatebetweenbuyoutsandexpansioncapital.

Expansioncapitalmaytaketheformof“mezzanine”financing,whichisthe riskiest form of debt obligations. Itwill often have options to convertintoequityifthefirmfailstomeetthetermsofitsdebt,whichwillbepricedto deliver a high rate of return. Mezzanine finance is expensive forcompanies.Managementbuyoutsoccurwhenanexistingmanagementteamis supported with external private equity, for example when a familybusiness is sold, or a larger firm decides that an existing division is nolongeracorebusinessfortheparentcompany.

The word “leverage” in a leveraged buy-out (LBO) refers to thefinancing of the deal, when the new private equity owners will haveleveragedtheirequityownership.Thismayoccur,forexample,throughtheissueofasset-backedloansorthesaleofhigh-yieldbonds,or,wherebondor loan covenants areweak, by restructuring the company’s balance sheetsuchthatexistingdebtbecomesdevalued,andsohigheryielding.Thisfocuson the use of leverage is the principal reason private equity should, ingeneral,beregardedasmoreriskythanquotedequity.

Private equity firms transform the businesses they acquire throughfinancial engineering, through changing the incentives facing managers,through more direct management of the governance of firms (than, forexample, is possible with a shareholding in a listed company) and bydeployingindustryexpertisetotransformtheoperationalmanagementofthe

business. Buyouts are also often associated with restructuring, whichincludes the divestment of non-core activities and also the acquisition ofrelatedbusinesses.

Privateequitymarketrisk

Inallcountriesthereisawidevarietyofprivatecompanies,ofwhichmostare small but some are large enterprises. In the years before the creditcrunch,thedevelopmentofprivateequitygroupscontrollinglargeamountsofinvestormoneyledtotheemergenceofsubstantialprivateindustrialandcommercial conglomerates controlling private companies across differentsectorsoftheeconomythroughouttheworld.Thesehavebranchedoutintonewareasof investing,whichhavecaused theboundariesbetweenprivateequity,hedgefundsandrealestatefundstobecomeblurred.

Private companies often look similar to the quoted companies withwhich they compete. However, this does not mean that the risks forinvestorsarecomparablewiththoseofthestockmarket.Alongsideleverage,a principal risk is illiquidity, and the great difficulty of selling a partownership in a private company and the impossibility, other than atinfrequentintervals,ofrebalancingtheallocationtoprivateequity.Anotherrisk is that there are systematic biases in the characteristics of privatecompanies compared with quoted companies (for example, privatecompanies will have a bias towards small andmedium-sized companies).Nevertheless,itmightbethoughtthattheinherentriskorvolatilityoftheiraggregatevalueshouldbebroadlycomparabletothatofquotedcompanies.Leveragenormallymeansthatthisisnottrue.Furthermore,evenifthiswasthecase,illiquiditywouldmeanthatitwasnotanadequatemeasureofrisk.

Oneperspectiveontheintrinsicvolatilityoftheprivateequitymarketisgivenbythevolatilityofdiversifiedlistedprivateequityfirms.Anexampleisprovidedbythe3iGroup,whichhasbeenlistedontheUKstockmarketsince 1994, and was for a number of years the world’s largest quotedcompany whose core business is themanagement of a diversified privateequityportfolio.Theevolutionofthevolatilityofthe3isharepriceandthatof theUK stockmarket is shown in Figures 10.1 and 10.2. Since the late

1990s,3ihasalwayshadavolatilitysignificantlyhigherthanthatoftheUKstockmarket;betweenJune1995andAugust2013thiswasonaverage80%higher (see Figure 10.2). This would not be the case for a diversifiedportfoliooflistedUKstocks.

FIG10.1Volatilityofpublicandprivateequity,proxiedby3isharepriceandFTSE100index%peryear,Oct1994–Oct2013

Source:Bloomberg

FIG10.2Volatilityofprivateandpublicequity,proxiedby60-dayvolatilityof3irelativetoUKstockmarket%,Oct1994–Oct2013,UKstockmarketvolatility=100

Source:Bloomberg

Somesystematicdifferencesapartfromsmallersizeshouldbeexpectedbetweenthetypesoffirmsthatareincludedinbuy-outandventurecapitalfundsandthosethatdominatethestockmarket.Thesebiaseswillvaryovertime.Forexample,afocusontechnologycompanieswasafeatureofmanyprivateequityfunds,especiallyventurecapitalfunds,inthelate1990s.Thatthisoccurredisunsurprising,asabiastowardswhateveristhelatest“new,new thing” will always be a characteristic feature and risk of early-stageventurecapital investing.Butif itwasinevitablethatventurefundsshouldfindthemselvesheavilyexposedtotechnologycompaniesinthelate1990s,it was also unsurprising that private equity funds should become moreheavilyleveragedduringtherun-uptothecreditcrunch,whenliquidityandtheabilitytoleverageportfolioswerereadilyavailable.

Researchershaveusedavarietyofothermoreorlesssatisfactorywaysof getting a handle on private equity market volatility. These includeexamining the volatility of returns earned from private equity funds andusingindicesofsmallercompanystocksasaproxyforprivateequity.

Individual venture investments will always be subject to considerablestock-specificriskand,todiversifythisrisk,ventureportfoliostendtoholdmorepositions(thoughtheymayfocusonaparticularsectorortheme)thanbuy-out portfolios. The financing structure is critical to the risk of LBOinvestments. For this reason, the intrinsic volatility of the private equity

market,howeverwelldiversified, isprobablysignificantlyhigher thanthatof the quoted equity market. Investors should not be satisfied with anexpectedreturnthatdoesnotcompensatethemforthisleverage.Moreover,itmakesnosensetopayperformancefeessimplytoleverageaninvestmentportfolio.Any investor can achieve this atminimal cost by buying equityindexfuturesoraleveredequitytrackerfund.Fewseemtochoosetodoso.

The process of allocating investment capital requires some rules ofthumbfortheriskofprivateequity.Herearesomesuggestedguidelines:

Amajorriskforbothinvestorsandmanagersofprivateequityportfoliosistoactoninferiorinformation.Donothinginprivateequityunlessyoucanaccessacredibleinformationadvantage.

Abroad-brushfundoffundsapproachthatcombinesexposuretobuyoutsandventurecapitalcanbeseverelyunderminedinadversemarketsbyacombinationofleverageandrisingriskpremiums,evenifgreatskillhasbeenappliedinselectingtheunderlyingcompaniesinwhichthefundsareinvested.

Investorsneedtoaskwhatinformationadvantageawell-diversifiedfundoffundsarrangementislikelytohave.

Anassumptionthatawell-diversifiedfundoffundshasavolatilityapproximatelytwicethatofthequotedmarketisprobablyreasonable.Foramoreconcentratedapproach,anassumptionofavolatilitythreetimesthatofthemarketmightbeused,butthismightexaggeratetheintrinsicvolatilityunlessleveragewasparticularlyhigh.

Insofarasprivateequityrepresentsaleveragedversionofquotedequity,investorsshouldrequireapremiumreturnforincurringtheadditionalriskintroducedbythatleverage,andshouldbenchmarktheirprivateequityagainstaleveragedquotedequityindex.However,investorsshouldbeawarethatthelevelofleverage,andsothelevelofrisk-taking,inbuyoutsiscyclical.

Thesemagnitudesmatterbecauseinvestorsneedtohaveafeelforhowanallocationtoprivateequityischangingtheriskthatisalreadypresentin

theirallocationtoquotedequity.Figure10.3givesanindicationofhowanallocation towell-diversified private equity, alongside an allocation to thequoted equity market, may affect the volatility of the combined equityportfolio.The importantmessage is that a diversified allocation to privateequity of, say, 10% of an investor’s equity allocation will, with theassumptionsusedhere,haveanoticeablebutnottransformingeffectonthevolatilityoftheoverallequityportfolio.

FIG10.3Volatilityoftotalequityasprivateequityincreases

Source:Author’sillustration

Listedprivateequity

The traditional way for institutions to invest in private equity or venturecapitalisthroughbuy-outorventurecapitalfunds,orthroughfundsoffundsthat invest in these funds. Typically, they have a high minimumsubscription.Wealthyindividualsoftenobtainexposuretoventuresthroughless formal business angel (see Appendix 1) arrangements, as only thewealthiest have been able to subscribe to partnerships or to funds. Theemergence of the listed private equity sector within mainstream equitymarketsoffersanadditional route toobtainprivateequityexposure. In theyearsbeforethecreditcrunch,thissectorofthemarketexpandedrapidlyas

privateequityfirmsincludingBlackstone,KKRandBrookfield,aCanadianfirm, obtained stockmarket listings for parts of their private equityinvestment businesses. In the UK, the globally diversified private equitybusiness3ihasbeenincludedintheFTSEAll-Shareindexsince1994,andin Japan, Jafco has been listed in the first section of the Tokyo StockExchangesince2001.

TABLE10.1GeographicalspreadofStandard&Poor’sListedPrivateEquityindexOct2013

%

US 58.7

UK 12.0

Canada 11.6

France 6.8

Switzerland 3.5

Japan 3.0

Sweden 2.2

Germany 0.9

Other 1.2

Note:Indexcoverslargestlistedprivatecompaniesthatmeetliquidity,freefloatandothereligibilitycriteria.Source:S&PDowJonesindices

Therearenowestimatedtobeover100listedprivateequitycompaniesspreadaroundtheworld.Thegeographicalbreakdownof theStandardandPoor’s index isgiven inTable10.1andFigure10.4 shows thecumulativeperformance of this global index of listed private equity companies since2003.Thecorrelationbetweenthebroadequitymarketandthelistedprivateequity sector is apparent, as is a leveraged relationship between privateequityandglobalequities.

FIG10.4CumulativeperformanceofgloballistedprivateequitycompaniesandglobalequitiesNov2003–Sep2013

Source:S&PDowJonesindices

The listed private equity sector enables private investors with modestresourcestoestablishexposuretoprivateequitythroughthequotedmarket.Italsoprovidesamarketpricethatshowseitherapremiumoradiscounttotheappraisalvaluesatwhichprivateequityfundsareotherwisevalued.Thispremiumordiscount toappraisalnetassetvalues“marks-to-market” thosevaluationsandsogivesabenchmarkthatcouldbeusedasacheckagainstappraisalvalues.

However, the premium or discount of listed private equity combinesseveral factors. One is the valuation of business prospects of underlyingcompanies. A second is the assessment of themanagement of the privateequityfirm(forexample,whetheritwillsuccessfullymanagethecashflowneeds of its underlying firms during a recession). The share prices of thelistedprivateequitycompanieswillincorporatemoreup-to-dateinformationaboutthesefactorsthanarereflectedinappraisalvalues.

A third, most important, influence on the premium or discount isliquidity.Itreflectsthepricethatbuyersandsellersofalistedprivateequityfirm pay for the ability to trade immediately (at least for small amounts)while investors in funds (whichmay have the same or similar underlyinginvestments)normallyare committed to their investments foryears.Whenliquidityishighlyprized(suchasduringacreditcrisis),listedprivateequityvehicles will trade at a discount to net asset value, as sellers pay for the

abilitytoexittheirinvestment.Thismayrepresentabuyingopportunityforlong-term investors who have convinced themselves of the quality andsustainabilityoftheunderlyingportfolio.

PrivateequityportfoliosAn old adage in private banking says that you should concentrateinvestmentstogetwealthy(attheriskoflosingyourshirt),butthathavingbecomewealthy,youshoulddiversifytomaintainthewealththatyouhavealreadyaccumulated.Thishasparallelswiththesafety-firstandaspirationalportfoliosdescribedbybehaviouralfinance(seeChapter2).Privateequityisaboutexploitinginformationadvantagesbyidentifyingentrepreneurialskill.Itisnotaboutbeingfinanciallyconservative.Itmayformacomponentofanefficient diversified approach to investing, butwithin that it clearly formspartofanaspirationalstrategytoaccumulatewealth.

Thisleadstoseveralconclusions:

Well-diversifiedfundoffundsarrangementsarelikelytodiversifyawaypreciouselementsofinformationadvantage,whichwillbefurthererodedbytheburdenofhighfees.

Ifhighleveragepersistsacrossthefunds,intrinsicvolatilitymaystillbesurprisinglyhighevenwithawell-diversifiedfundoffunds.

Itcanbeentirelyappropriatetohaveamodestallocationtoasmallnumberoffunds(evenfromjustoneteam),solongasthecombinedallocationtoprivateandquotedequityisreasonablybalanced.

Acommondangerinprivateequityinvestingistofailtodiversifyprivateequityovertime.Onceapreferredarrangementhasbeenselected,itmakessensetomaintainacommitmenttothemarketovertime,mostprobablystayingwiththesameteam(orteams).Otherwise,risksthatwereparticularlyprevalentinthemarketataparticularpointintime(forexample,highleverageorexposuretoparticularthemesinventurecapitalinvesting)willundulycharacterisetheinvestor’sexperienceofinvestinginprivateequity.

Privateequityreturns

Before making an investment in private equity, investors need to beconfident that it is likely to beworthwhile. It is not sufficient that privateequity firms should improve the financial performance of the companiestheyholdintheirfunds(researchsuggeststhatonaveragetheydo).Privateequity funds need to raise performance to a degree that rewards investorsadequately for the additional risks they encounter including illiquidity andleverage. A major self-imposed hurdle private equity funds have toovercomeisthehighlevelofdirectandindirectfeeschargedbytheprivateequityfirmsthatmanagebuy-outandventurecapitalfunds.Another,whichisrelated,istheasymmetryofinformationthatalwaysconfrontsinvestorsintheirdealingswithinvestmentmanagersinprivateequity.

Private equity performance data suffer (as do those for private equityrisk) from the absence of market indications of the value of privatebusinesses. They need to rely on appraisal estimates which smooth thereported performance included in published calendar-year performanceresults. Appraisal valuations are still useful as they provide importantmanagement information for investors on what is “work in progress”.However,theonlyprivateequityperformancedatathatreallymattersistheinternal rate of return (IRR) earned on investments. This combines theamount invested, the amount received back and the interval of time inbetween. In substance, these are the only financial magnitudes that theinvestor eventually knows for certainwhen investing in private equity (oranyprivateinvestment).TheIRRisthestandardrateofreturnreportedforfundsandindividualinvestments,butitisimportanttonotethatunrealisedinvestmentswillbeincludedatanappraisalvalueinreportsoffundIRRs.

IndustrydataoftenreportIRRsforfundsstartedinaparticular“vintage”year. This information does not reveal the volatility of those returns orenable like-for-like comparison with stockmarket performance. Suchinformation is often broken down in marketing material to show theattractiveperformanceofbetter-performingmanagers(forexample,thetop25%),withthemessagethatitisimportanttoselectamanagerwhowillbeinthetopquartileinthefuture.Itisalwaysdesirabletoselectwinners,but

the issue is whether the historical performance data of private equitymanagersprovidesanyguidetofutureperformance.

In mutual fund investing it is agreed that past performance in leaguetablesisapoorpredictoroffutureleaguetableperformance.Butinprivateequitytherehavelongbeensuggestionsthatsuccessisrepeatable,andthereis now increasing evidence from academic research that this may be thecase.

One of the challenges in assessing private equity managers is thedifficulty of comparing the performance of amanager, or a private equityfund,withthatofthestockmarket.OnewaytodothisistocomparetheIRRthat a fundachievedon itsprivate equity investmentswith the IRR that itwould have achieved if the cash had instead been invested, on the samedates, in the stockmarket index, and if the correspondingly equivalentdistributionshad thenbeenmade to investors (this issometimescalled thepublicmarketequivalentorPME).Academicresearchpublishedin2005hasdone this for funds on the Thomson Venture Economics database of USventure capital and buy-out funds. Examining data from 1980 to 2000,researchers found that the average performance of such funds, after fees,was approximately in line with the S&P 500 index (though suchcomparisons make no allowance for comparisons of illiquidity and otherinvestment risks).Othermore recent researchconfirms the impression thattheaverage investor inprivateequity fundsdoesnotoutperformthebroadstockmarket.There is awidedispersionof results among fundsaswell asevidencethatgoodandpoorperformancepersistedinsuccessivelaunchesoffunds by particular private equity teams. However, the usefulness of thisfindingislessclearthanitseems,asmoneyistypicallycommittedtoanewfundbefore the results of its predecessor fund areknown. Inotherwords,suchmarketingclaimsmayrelyonout-of-dateinformation.

This research highlights the importance of a number of themesemphasised earlier in this chapter. First, the hurdle of fees is high,particularly when a investor can gain exposure to global stockmarketsthrough low-costpassivefunds.LudovicPhalippouofOxfordUniversity’sSaïd Business School, in a 2011 report for the Norwegian Ministry ofFinance,said:

Abuy-outfundwithareturnafterfeesequaltothehistoricalaveragereturnoftheUSstockmarket(overthelast30years,ie,11%perannum)wouldcharge6%feeperyear.

This is after taking into account headline fees (typically 2%per year plus2%oftotalreturninexcessofthehurdlerate,often8%)andanyconsultingandadvisoryfeesthatmaybechargedbythebuy-outfundtothecompaniesinitsportfolio.Itprobablyshouldnotbeasurprisethatinvestorsinprivateequity have not, after fees, on average earned a premium reward tocompensate them for the extra financial gearing or illiquidity involved inprivateequity.

Asecondthemeisthatinvestorsneedtoconvincethemselvesthattheycan identify better-than-average managers. Skill is essential. Investorscannot profit from market returns in private equity through a passive,market-matching strategy, so they should not expect to do even averagelywellunless theycangainaccess to skilledmanagers,which requiresmorethan reliance on a possibly out-of-date track record. Without skilledmanagers,investorswillbecondemnedtounderperformunless,foraperiod,theyhappentogetlucky.Theproblemisthatitismostlikelythataprivateequity manager who presents to an investor will be able to claim upperquartile performance. In the same report,Phalippou included an appendix,“Isthereanyfundthatisnottopquartile?”Hestartsbysayingthat“theoft-repeated private equity quip that ‘75% of funds claim to be in the topquartile’mayindeedbetrue”.Thegoodnews,hegoesontosay,isthatnoevidencehasbeen foundofmanagers systematicallymis-stating their ownperformance.Instead,theflexibilitywasfoundintheirchoiceofbenchmark,andtheambiguitythatexistsaboutwhenafundproperlyopensforbusiness.

Privateinvestments,successfultransactionsandbiasesinappraisalvaluationsEveryonelikestogetagoodpriceinanytransaction.Onewaytoincreasethelikelihoodofasuccessfultransactionistoensurethatthecriterionbywhichsuccessisjudgediscrediblebutundemanding.Inprivateinvestments,theimmediatebenchmarkagainstwhichatransactionisjudgedisthemostrecentappraisalvaluationforthatinvestment.

Howeversuccessfulordisappointinganinvestmentmighthavebeen,privateequityand

realestatemanagersalwaysliketobeabletodemonstratethesuccessfultermsonwhichtheyachievedasale(suchreadybenchmarksdonotexistwhenamanagermakesapurchase).Evidencetosupporttheseassertionsreliesmostlyonanecdotalcommentsovertheyearsfromprivateequityandrealestatemanagers,aswellasanindicationthatrealestateturnoverdeclinesindownmarketswhenitbecomesmuchhardertoachievea“successful”price(becausethelevelofthemarketismorelikelytobebelowthemostrecentappraisalvaluation).

Theartmarket,whosepre-auctionbrochuresgiveappraisalvaluations,providesanopportunitytostudytheexistenceofsuchabias.Auctionhousesclaimaproventrackrecordin“meetingorexceeding”pre-saleestimatesofvalue.Someyearsagotheauthorandacolleaguefoundthatof1,700worksofartsoldatauction,largelyoverthedecadebefore1991,28%failedtoreachtheauctioneer’slowestimateofvalue,25%fellbetweenthelowandhighestimates,and47%exceededthehighestimates.Successfulresultsweresomuchmorecommonthandisappointments(asindicatedbythefrequencywithwhichthehighandlowestimateswereovershotorundershot)thatthereislittlelikelihoodoftherebeingnodownwardbiasinthesepre-auctionestimates.Morerecentevidenceforsuchabiasinpre-auctionappraisalvaluationscomesfromthemarketforrarestamps.ApexPhilatelicAuctions,aBritishstampauctioneer,reportedinitsNovember2005cataloguethatitspreceding£8mofstampsales“fetched104.21%ofestimateonaverage”,confirmingthepatternofrealisedpricestendingtoexceedpre-auctionestimates.

11 Realestate

THEEXPERIENCEOF INVESTORS inrealestate isdeterminedbythree things:theperformanceofthemarket;theskilloftheiradvisers;andthedegreeofleverageinvolvedinthevehicletheyusetoaccessthemarket.This,inturn,isinfluencedbythelevelofinterestratesandwhethertherentgeneratedbythepropertiescancoverthedebtinterestpayments.Itisaroutineweaknessinappraisingrealestatemanagerstofailtoaccountproperlyfortheimpactofleverageonperformanceandrisk.

Developments in theUSpublicmarket for realestate investment trusts(REITs), a US innovation dating from the early 1970s, and paralleldevelopmentselsewhereintheworld,havemadethepublicmarketforrealestate comparable to the rest of the quoted equity market. Investors canobtain,atlowcost,exposuretotherealestatemarket.TheREITmarketisaleveragedmarket and in the years before 2007many new investors wereintroducedtothepowerofleverage.Thiswaswhendebtinterestcostswerelowerthantheincomereceivedfromrealestaterents,theunderlyingmarketconditions appeared benign and performance was strong. During the realestatecrisisof2007–09andthecreditcrunchinvestorswereremindedthatan income yield higher than the debt service cost is a necessary but notsufficientconditionforfinancialsuccesswithaleveredpropertyportfolio.

Propertyinvestmentscanbeeitherprivateorpublic.Privateinvestmentinvolves the direct ownership of properties. The public market involvesownership through a public commingled fund, or through stock exchangelisted vehicles, most commonly REITs. REITs grew substantially in theyears before the global financial crisis and in the United States theiraggregate market capitalisation reached $438 billion at the end of 2006,declining to$192billionat theendof2008, and then rebounding to$603

billionbytheendof2012.Similarentitieshavebeenintroducedinarangeof jurisdictions including Australia, Brazil, Canada, France, Hong Kong,Japan, the Netherlands, Singapore and the UK. In the United States,individual REITs specialise by sector of the market, with a minorityinvestingprimarilyinmortgages.

TheprincipaldifferencebetweenaREITandaconventionalcompany,whose business is investing in and managing properties, lies in their taxtreatment.Generally,REITsareexemptfromprofitorcorporationtaxand,intheUnitedStates,haveaguidelinethatatleast90%oftheirincomemustbe distributed to investors as a taxable dividend.Guidelines vary betweencountries. The equivalent in Australia is the large, long-established listedpropertytrustmarket.

Themaindifferencesbetweenlistedrealestatevehicles,suchasREITs,anddirect investments inpropertyare that theformeraresecuritised,havedailypricesandaretypicallyleveragedtosomedegreethroughborrowing.They are ideally suited to giving diversified exposure to real estate formodest levels of investment. Since they have daily prices, appraisalvaluationsofunderlyingpropertieshelpanalystsconstructestimatesforthenetassetvalueofREITs,but theydonotset the termsonwhich investorstransact.

Whatisrealestateinvesting?It is common to divide the real estatemarket into segments such as thoseshown inFigure11.1. Inanumberof internationalmarkets,privateequityfundshavebecomeimportantparticipants in therealestatemarket.Privateequityrealestatefundsbroughtamoreaggressiveattitudetoleverage,withthe introductionofhigh-risk,potentiallyhigh-return“mezzanine”debt intorealestate transactions.Thesedevelopmentsmean that investorsnowhavemorewaysofgainingaccess to realestate returns thanwaspreviously thecase.

FIG11.1Thefourquadrantsofrealestateinvesting

Source:Author

The underlying real estate market is divided into the main types ofproperty: retail, office, industrial and residential. (Other categories includehotels and resorts and mixed category properties.) The REIT marketprovidesaccesstoeachsegmentofthemarket.TwoprincipaldatabasesforinstitutionalrealestatearetheNationalCouncilforRealEstateInvestmentFiduciaries(NCREIF)intheUnitedStatesandIPD(formerlyknownastheInvestmentPropertyDatabank),whichisbasedintheUK.TheUSNationalAssociation of Real Estate Investment Trusts (NAREIT) is the source forinformationaboutUSREITs.Table11.1givesabreakdownofthetypesofpropertiesownedbyinvestorsintheUnitedStatesandEurope.

TABLE11.1Directrealestateinvestmentbytypeofproperty

%

aEquityREITsonly.

aEquityREITsonly.bIncludingmixeduseandself-storage.cIncludingmanufacturedhomes.dIncludingdiversified,lodging/resorts,healthcare,speciality.Sources:IPD;NationalAssociationofRealEstateInvestmentTrusts;NationalCouncilofRealEstateInvestmentFiduciaries

Whataretheattractionsofinvestinginrealestate?Thetraditionalreasonsformakinginvestmentsinrealestateequityincludeportfolio diversification; accessing premium and relatively secure incomeyields; and the potential for attractive total returns that should offer someprotectionfrominflation.

DiversificationAppraisalvaluationsofpropertiesunavoidablysmoothchangesinthelevelof property prices. This complicates an assessment of the diversificationqualities of real estate. Smoothing performance often gives short-termcomforttoprivateinvestorsandpensionfundtrusteeswhodonotneedtobeconfrontedwiththerealityofmarketpricesexceptwhentheytransact.Thispaucityof reliableprice informationdoesnotprovidea substantive reasonfor favouring realestate investment.Themarket forREITsgivesamarketvaluation and a time series of transaction prices,which permits amarket-based assessment of the contribution of real estate in an investmentportfolio,althoughallowancehastobemadeforthevalueofthedebtheldinaREIT.

ModernrealestateindicesandassessingthediversifyingroleofrealestateInrecentyearstheilliquidrealestatemarkethasseenthebenefitsofmorereliablemarketindices,whichmakeuseoftransactionpricesaswellasappraisalvaluations.(SeeChapter12foradiscussionofcorrespondingdevelopmentsintheartmarket.)Oneofthefeaturesoftransaction-basedindicesisthattheyenablemoreaccuratemeasurementofthevolatilityofpricesinilliquidmarkets,whichisnormallysmoothedbyappraisalvalues.Therepeatsalesregression(RSR)methodology,whichwasoriginallyproposedin1963,buildsonthepurchaseandsaleinformationofindividualpropertiestogenerateamarketindexthatisbasedontransactionpricesratherthanestimatesofvalue.TheCase-ShillerUShousepriceindexseries,whichgrewoutofresearchundertakeninthe1980s,providesthequalitybenchmarkforthesetransaction-basedindicesinilliquidmarkets.TheUK’sLandRegistry

indexfollowsthesameprinciplesformeasuringhousepricedevelopmentsinEnglandandWales.

Forinstitutionalinvestorsinrealestate,arelateddevelopmentinrecentyearswasthedevelopmentofatransaction-basedindexbytheMassachusettsInstituteofTechnologyCenterforRealEstate(CRE).ThishasbeentakenforwardbytheNCREIF’sNationalTransactionBasedIndex(NTBI),whichusesthetransactiondataunderlyingitsNationalPropertyIndex(NPI).ItisasimplifiedversionoftheCRE’sindex.TheNTBIisnotarepeat-salesindex.Itusestransactionsdatatoassesstheextenttowhichtransactionprices,acrosstheNCREIFuniverseofUStax-exemptinstitutions’directinvestmentsinrealestate,deviatefromtheappraisalpricesforthosepropertieswhichappliedbeforethestartofsalesnegotiations.ItthenappliestheaverageofsuchdifferencestotheNPIindextocalculatetheNCREIFtransaction-basedindex,NTBI.ToavoidtheNTBIbeingundulyinfluencedbyasmallnumberoflargetransactionsitisequallyweighted;theNPIisavalueweightedindex.

Figure11.2comparesthecumulativetotalreturnperformanceofthesetwoseries.ItshowsthattheNPIisobviouslysmootherthantheNTBI(thecumulativedifferencebetweenthetwoseriesmaylargelyreflectthedifferentindexweightingmethodologies).InEurope,acorrespondingdevelopmenthasbeenthepublicationoftransaction-linkedindices(TLI)byIPD,apropertyperformancemeasurementconsultancy(seeFigures11.3and11.4).LiketheNTBI,itmakesuseoftherelationshipbetweentransactionvaluesandtherecentappraisalvaluationsofthosetransactedpropertiestoadjustappraisal-basedvaluationindices.IPD’svaluation-basedandtransaction-linkedindicesarevalueweightedpriceindices,thatisexcludingtheaccumulationofincomereceipts.

IntheUnitedStatesandtheUKtherewereindicationsthatappraisalvaluesofinstitutionalrealestaterespondedmorerapidlytothedeclineintransactionpricesin2008–09thanwasthecaseinearlieryears.

Thegreateruseoftransaction-basedortransaction-linkedindicesfortherealestatemarkethashighlightedanumberofcharacteristicsofthesemeasures,whichalsoapplytotheartmarket.Thefirstisthatthenewindicesrequiretransactionsdata,andwhenmarketliquiditydriesupbecauseofashortageofwillingbuyersorsellers,interpretationofthedatabecomestroublesome.Forexample,inthefirstthreemonthsof2009,just19transactionswererecordedintheNCREIFdatabaseofUSinstitutionalrealestate,one-tenthofthepreviousaveragevolume.Thisinevitablyincreasesuncertaintyabouttheinterpretationofmarketindiceswhenfewtransactionsoccur.

FIG 11.2Valuation-based and transaction-based measures of total return from realestateinvestmentsintheUSCumulativetotalreturnindex,$,Dec1993=1.00

Source:NationalCouncilofRealEstateInvestmentFiduciaries

FIG11.3Valuation-basedand transaction-linkedmeasuresofcommercial realestatepricesintheUKCumulativepriceindex,£,2001Q4=100

Source:IPD

FIG11.4Valuation-basedand transaction-linkedmeasuresofcommercial realestatepricesintheeurozoneCumulativepriceindex,€,2001Q4=100

Source:IPD

Overtime,theappraisalandtransaction-basedorlinkedindicesforUSandalsoforEuropeaninstitutionaldirectrealestateinvestmentappeartogivesimilarresults,anditistheshort-termpatternofreturnsthatcandiffer.Forlong-terminvestors,itmaybethoughtthatthedifferenceisoflittleimportance.Thisisnotcorrect.Transaction-basedindicesallowmoreaccuratemeasuresofthevolatilityofthedirectrealestatemarketandofhowrealestatecorrelateswiththestockandbondmarkets.Theseshouldenablemorereliableassessmentofthediversificationroleofrealestateinaninvestmentstrategy.Researchpublishedin2006byMarthaS.PeytonandFabianaLotitoofTIAA-CREF,aUSretirementfundforuniversitystaff,“Realestate:theclassicdiversifyingasset”,andseparatelya2007articleinJournalofPortfolioManagementbyShaunBond,SoosungHwang,PaulMitchellandStephenSatchell,“Willprivateequityandhedgefundsreplacerealestateinmixedassetportfolios?”,pointthewaytohowilliquidinvestmentsareincreasinglybeingmodelledinassetallocationexercises.Thekeyistocorrectforthesmoothingimpactofappraisalvaluesinilliquidinvestments,suchasrealestate,hedgefundsandprivateequity(andtoallowforthecostsofilliquidity).Bothstudiesarestronglysupportiveofthediversifyingroleofrealestate,andthesecondarticleanswersitstitle’squestionwithitspithysubtitle:“Notlikely”.

Privateinvestorsaccessrealestatethroughdirectownershipofindividualproperties(whichisdifficulttodiversify)andthroughthepublicmarketforREITs.ThepotentialdiversificationroleofREITsinoverallinvestmentstrategywasdemonstratedduringtheequitybearmarketofMarch2000–March2003.

Figures11.5and11.6comparetheperformanceandvolatilityoftheUSequitymarketandUSequityREITs.TheperformancechartshowsthatREITscanbehaveverydifferentlyfromtherestofthestockmarket,andsoprovidevaluablediversification.Thishappenedinthelate1990sandearly2000s,whenREITsfirstmissedoutonthetechnologyboomandthenavoidedthesubsequentmarketdownturn.However,REITscanatothertimesactasiftheyarealeveredplayonthestockmarket.Intheyearsleadingupto2007,REITsexperiencedastrongbullmarket,fuelledbycreditandthehousingboom,andamplifiedthesubsequentdownturnandthenrecoveryafter2008.Thesedifferencesarealsoshownin

Figure11.6:formanyyearsREITs,despitetheirsectorfocusanddegreeofleverage,hadavolatilitynomorethantheequitymarket,andoftenless.After2007theirvolatilitywasconsiderablymorethanthemarketasawhole.Thisemphasisesanimportantlesson:becautiousaboutrelyingoncounter-intuitivestatisticsthatmaywellnotpersistinthefuture.

FIG11.5CumulativeperformanceofUSequitiesandREITs1984–2013,Dec1984=1.0

Sources:FTSENAREIT;MSCI

FIG11.6VolatilityofUSequityREITsandUSstockmarket,rolling36-monthstandarddeviationsofreturn%peryear,1987–2013

Sources:FTSENAREIT;MSCI

EquityREITsaretypicallyleveraged,around40–60%,whereastheNPIandTBIseriesexcludetheimpactofanyborrowing.(About10%ofUSREITsaremortgageREITs,whichhaveamuchhigherlevelofleveragethanequityREITs.ThebusinessofequityREITsistoinvestinproperties;thebusinessofmortgageREITsistoinvestinmortgages.MortgageREITsarenormallymorevolatilethanequityREITs.)

Table11.2givesstatisticsforthreerealestatemarketmeasuresfortheUnitedStates,UKandtheeurozone.Itshowstheannualisedvolatility(standarddeviation)oftheindicesfortheperiod2002to2012,theextenttowhichperformanceinoneperiodiscorrelatedwiththepreviousperiod(serialcorrelation,whichcanbeanindicatorofpricesmoothing)andthecorrelationofeachserieswiththestockmarket.Notsurprisingly,ineachregiontheperformanceofREITsismorevolatilethanthemeasuresofinstitutionalpropertyvaluesandismorehighlycorrelatedwiththestockmarketthanistheperformanceofdirectinstitutionalinvestmentsinrealestate.Ineachcasethevaluation-basedmeasuresofinstitutionalpropertyperformanceshowhighlevelsofserialcorrelation,demonstratingsmoothingprices.ThisisabsentfromtheNCREIFtransaction-basedindex,butapparentlynot,forexample,fromIPD’stransaction-linkedindex.

TABLE 11.2 US, UK and euro zone real estate market indices: volatility, andcorrelationswithstocksandbondsMarch2002–December2012

Source:Author’scalculationsbasedonBarclays,FTSENAREIT,IPD,MSCIandNCREIFindexdataforcalendarquarters.

TherelativelyhighserialcorrelationintheUKtransaction-linkedseries(andthecomparativelyhighvolatilityofIPD’sUKvaluation-basedindex)duringthisperiodechoesthefindingof2012researchintothebehaviourofUKpropertypricesbyColinLizieri,SteveSatchellandWarapongWongwachara.Thisfoundthatappraisalvaluationsandtransactionpricesseemtorespondvigorouslytostockmarketmoveswhenthosemovesarestronglynegative,aprocesswhichseemstoreinforceserialcorrelationinpropertyprices.Inturn,thisisoneaspectoftheriseincorrelationsbetweenriskassetsattimesofgreatriskaversion.

Incomeyield

Arecurringargumentinfavourofrealestateinvestingistheprovisionofadependable income that can be expected to increase in linewith inflation.Theabilitytogainaccesstoseeminglyreliableincomebecomesparticularlyattractivetoinvestorsattimesoflownominalinterestrates.

Table11.3compares the incomereturnofferedbydifferent investmentmarkets.Overtheperiod,theincomereturnforREITshasbeencomparabletothatoninvestmentgradebonds,whichhave,inaggregate,beensubjecttomuchlesspricerisk.TheincomestreamfromREITsmayappearstable,onaverage,butthepricevolatilityhasbeencomparabletoequities.ThismeansthatREITs cannot be regarded as “low-risk” substitutes for a high-qualitybondportfolio.

TABLE11.3IncomeyieldfromREITs,quotedequitiesandbondsJan1990–Dec2012,%annualaverageincomeyield

aRedemptionyields.Sources:Barclays;FTSENAREITGlobalRealEstateIndex;MSCI

InflationhedgeRealestate investmentsalwayshaveoneclearadvantageover investmentsinconventionalbonds:whilebondsareerodedbyanyunexpectedinflation,rentsfromrealestateshouldbeexpectedtorespondovertimetoinflation.Thisdoesnotmeanthatrentswillalwayskeepupwithinflation.Amarketwith excess or obsolete capacity should expect to see rents fall.Nevertheless, it is reasonable to assume that rents will increase faster thehigheristherateofinflation.Thisinturnwillbereflectedinthevalueputonbuildings,whichshouldalsorespondtoinflation.Inthiswaylong-term

investments in real estate provide an element of insurance against thebiggestdangerfacinglong-terminvestorsinconventionalbonds:erosionofwealthbyinflation.(Butseethediscussionofrentalincomebelow.)

StylesofrealestateinvestingandopportunitiesforactivemanagementEntrepreneurial real estate managers have always liked real estate for thesame reason thatmoneymanagers of any asset class do: they see it as anopportunity to use their skills to make money for themselves and theirclients. Since the real estate market is such a heterogeneous, lumpy andimmobile market, it provides a natural habitat for well-informed, skilledmanagerstoaddvalue(andforothermarketparticipantstounderperform).This,togetherwithitsotheradvantagessuchaslong-terminflationhedging,helpsexplainwhysomeinvestorshavefocusedondevelopinganexpertiseandportfolioconcentrationinrealestateinvesting.

Equitymanagersareoftencharacterisedbytheirstyleofinvesting,andthisalsohappenswithrealestatemanagers.Ithastheadvantageofhelpinginvestors understand better what to expect from a particular manager.Broadly,therearetwoapproachestorealestateinvesting:acoreapproach,with an emphasis on the generation of steadily growing income from abalanced portfolio of well-let prime properties; and an opportunisticapproach,whichismoreconcernedwiththeprospectsforpriceappreciationthrough redevelopment and exploiting changes in market trends andfashions.The first shoulddeliver a lessvolatile, less excitingperformancethanthesecond.Realestatemanagerspointtoathirdcategory,adistinctive“core-plus” approach for the more entrepreneurial commingled orinstitutional portfolios. The more aggressive, opportunistic approach islikely to be reflected in the real estate activities of, for example, privateequityorhedgefunds.Thesehavebecome,andarelikelytoremain,majorplayersinpartsoftheinternationalrealestatemarket.

Whatisapropertyworthandhowmuchreturnshouldyouexpect?One of the attractions of real estate investing is that it is often easy to

analyse individual investments in direct property quantitatively. Althoughthis is no guarantee of investment success, it helps to identify anyopportunitiesthatrelyonunusuallystrongassumptions.

Thefinancialappraisalofrealestaterequiresassessmentofanumberofvariables:

today’sgovernmentbondyield;

marketsupplyanddemandforecastsasinfluencesonprospectsforrentalincomes;

tenantcreditworthiness;

propertydepreciationorobsolescence.

Norealestate investmentshouldbeundertakenunless it isexpected toperform better than the guaranteed return from high-quality governmentbonds. And any real estate investment should be sold if it is expected tounderperformgovernmentbondsoversomerelevanttimehorizon.

RentalincomeThe return to be expected from a property is the discounted value of theexpectedrentalincome,netofexpenses,plustheproceedsfromsellingthepropertyatsomedateinthefuture.Thekeyvariablesinthisevaluationarethe future rate of change in rents and the appropriate rate at which todiscount that rental stream back to a present value or fair price for theproperty.

Just as forecasts of corporate earnings growth drive an analyst’svaluation of a company, so in real estate investing the principal driver ofvaluation is the forecast change in a property’s rental income. Detailedprojections for local or regional real estate markets can provide the rawmaterial for thesecalculations.Whenappraising these forecasts, it isoftenhelpfultogaugehowtherentforecastrelatestoaforecastforeconomy-wideinflation. This is because rents need to be forecast, either implicitly orexplicitly,forlongperiods,ifonlytoprovideabasisforestimatingthepriceat which the building might be sold in the future (which will itself be a

functionofexpectedrents).Thisfocusonrentalincomeisimportanttoavoidtwocommonmistakes.

First,thevalueofapropertyoftenhaslittletodowiththecostofrebuildingit.Itisthevalueoffuturerentthatdeterminesitsvalue.Giventhevalueoftheproperty,thiscanbebrokendownintothecostofrebuilding,proxiedbytheinsurancevalueputontheproperty,andaresidual,whichisthevalueofthe land underneath the building. Second, a property is never expensivebecause the land underneath it is expensive. It is always the other wayround.Landisexpensivebecauserentsarehigh,andbecauserentsarehighproperty is expensive. A third important feature for real estate investingfollowsfromthis:thepriceofland,theresidualinpropertyvaluation,canbeextremelyvolatile.AsimpleillustrationisgiveninTable11.4.

TABLE11.4Directrealestateinvestmentbytypeofproperty$m

Initialvalue Subsequentvalue

Propertyvalue 10 11

Costofrebuild 9 9

Landvalue 1 2

Source:Author

In this example, if the value of the property increases by 10%, and ifrebuildingcostsstaythesame,thevalueofthelandwilldoubleto$2m.Thisis important both as an explanation for the speculative nature ofdevelopment land and as a useful cross-check on valuations. Equally, theimportanceofthepriceoflandwilldependuponthescarcityofland.Wherelandisabundantandplanningrestrictionsdonotimpedenewconstruction,rentswilltendtowardsreimbursingwitha“normal”profitthemarginalcostofnewbuilding,whichmayormaynotkeeppacewiththegenerallevelofinflation.

So long as this situation persists, land will always be cheap. Withtechnological progress in building, commercial properties risk becoming acommoditythatindividualsorcorporationswhoneedtouserealestate(for

homes,offices,industrialorretailspace)mustdecidewhethertoown,rentor lease on the same basis as other financial decisions. So although rents,and thecostof land,willmovewithchanges insupplyofanddemandforproperties, there isno inexorable tendencyfor themto increase faster thaninflation.Rentscanlagbehindinflationforalongtime.Forexample,attheheightofaboominCityofLondonpropertyin1973,rentswerereportedtohavebeenintheregionof£20persquarefoot.Allowingforinflationsincethen, rents should nowbe in excess of £200 per square foot.But in early2013 prime rents in theCity ofLondonwere only around £55 per squarefoot(partlybecauseofcompetitionfromthenewfinancialdistrictofCanaryWharf).There isnoassurance that rentswillkeeppacewith inflation,andlittlereasontoexpectthemtoincreaseinlinewiththerateofgrowthoftheeconomy.

However, it may be reasonable to assume that the growth of equitydividendsisultimatelyrelatedtothegrowthoftheeconomy.Itfollowsthatrealestate investors relyonrental income, rather thancapitalappreciation,as theprincipal sourceof investmentperformance.Thisalsoexplainswhytheincomeyieldfromrealestateinvestingisnormallymuchhigherthantheincomeyieldfrommainstreamequityinvesting.

Itisnotclearhowmuchpremiumreturnovergovernmentbondsshouldbe expected by financial investors in real estate in the long term. Thisrequiredpremium is reducedby thediversificationbenefits that realestatebringstoabalancedinvestmentstrategy.Itcanbeinfluencedbythedegreeof confidence that investors have in the quality of the investment processthat they are able to deploy in investing in real estate markets. Mostimportantly,aswithprivateequity,directinvestorsinrealestateshouldnotassume that theywill earn themarket return.The prerequisite is to put inplace a demonstrably skilful investment process. However, themore skillthatisassumed,theeasieritwillbetojustifyalargeallocationtorealestate.Inthiscase,greatcautionneedstobeexercisedinassessingthebasisforabeliefthattheinvestorcanaccessunusualskill.Particularcareisneededininterpreting past performance, in isolating the effects on performance ofleverageduringarisingmarketandindifferentiatingbetweenskillandluck.AswasemphasisedinChapter4,inthepresenceofuncertainty,theprudent

approachistoerronthesideofcaution.

GovernmentbondyieldsasthebenchmarkforrealestateinvestingUsing government bond yields as the benchmark for assessing real estateinvestments ishelpful inseveral respects. It focuseson theonly legitimatereasontomoveawayfromsafe-haveninvesting:toachieveasuperiorreturnthat more than compensates for the risk of a disappointing result. In realestate, theprospects for superior returnswill be influencedby the stateofthemarketandalsobythequalityofthecontractualrentalincome.Forthis,thecreditworthinessofthetenants,aswellasotherfactorssuchasbuildingdepreciation,willbecritical.

TenantcreditriskApropertywithagovernmentagencyasalong-termtenantwillbedirectlycomparablewithgovernmentbonds,althoughallowanceshouldbemadefortheilliquidityoftherealestateinvestment,aswellasthelikelyexistenceofoptionstobreakthecontract.Organisationalissuesmayinhibittheabilityofinstitutional investors to exploit fully the comparison between long-termholdings of government bonds and a long-term rental income from agovernment agency. Other investors such as hedge funds have no suchinhibition, so long as they can access the liquidity needed to exploit theopportunity.Nevertheless,allrealestateinvestorsshouldmaketheefforttoanalyseopportunitiesinthisway.

Thespreadovergovernmentbondyieldspaidbyprivate-sector tenantsneedstoallowforthecreditriskassociatedwiththosetenants,aswellastheilliquidityofthecontract.Thecreditriskistheriskthatthetenantwillfailtomeet the terms of the lease; that there will be an interruption to rentalpayments;thattherewillbecostsassociatedwithattractingnewtenants;andthat a new tenant might be attracted at less favourable terms than theexisting one. These potential costs will be influenced by the state of themarket – in a buoyant market replacement tenants can be found morequickly and at less expense than in a depressed market. Corporate creditratings can provide a guide to the credit risk spread that investors shoulddemand from tenants.Whena tenant fails, a replacement cannormallybe

found in due course and so it is unclearwhether the credit spread shouldapplytotheentirerentalstreamexpectedfromtheclient.

PropertyobsolescenceTherequiredyieldalsoneedstoallowfor theexpecteddepreciationof theproperty, which may be a very different cost from the actual outlay onpropertymaintenance.Thisrateofobsolescencewillbeamajordeterminantoftherentsthatwillbeearnedonthepropertyinthefuture.Obsolescenceispartlyamatterofphysicaldeterioration,butitisalsoacceleratedbychangesin the pattern of demand for particular types of building or location.Standard depreciation schedules rarely reflect actual experience, which iswhatmattersformarketinvestmentvalues.Obsolescenceisalwayssubjecttouncertainty,butitisuncertaintyofakindthatcanaffectwholepartsofadiversified real estate portfolio. As Green Street Advisors, a real estateconsultancy,hassaid:“Oneoftherealestateindustry’sdirtiestlittlesecretsisthedegreetowhichdepreciationisaveryrealexpense.”Thisiswhyitisappropriatetoallowamaterialriskpremiumforobsolescence.

PrivateandpublicmarketsforrealestateTheparallelprivateandpublicmarketsforrealestateinvitecomparisonsofwhere it is cheaper tobuyexposure to real estate:bybuyingREITsorbydirectly buying properties. This is the old stockmarket valuation question:are corporate assets valued below or above their replacement value? Theratio of themarket value of a company to the replacement cost of its netassetsiscalledTobin’sQ.Intheorythisratio,iftheunderlyingdataarefreefrom measurement biases, should tend towards 1 (see Chapter 4). ThegreaterliquidityofREITsmightnormallycausethemtotradeatapremiumtonetassetvalues,andonaveragetheyhavedone.InFigure11.7evidencefromtheUnitedStatesisshownforthemovementinthisratiofortherealestatemarket in recent years and its average value. Substantial real estateinvestors in countries with a thriving REIT market have a clear choicebetween investing in direct property or throughREITs, although formostprivateinvestorsitisnotrealistictoseektoachieveadiversifiedportfolioindirectrealestate.

FIG11.7IsitcheapertobuyrealestateonWallStreetorMainStreet?USREITs’sharepricecomparedwithGreenStreetestimatesofpropertynetassetvalue%premiumordiscounttoGreenStreetestimateofNAV,Jan1990–Jul2013

Source:GreenStreetAdvisors

TherelationshipbetweenthetworealestatemarketsintheUnitedStatesshowninFigure11.7illustratesthatoveralmost25yearsto2013thepricesofREITs have (when taken together) ranged froma premium to net assetvalueoftheunderlyingpropertiesof32.6%in1997toadiscountof43.6%in November 2008. Green Street Advisors, whose research is shown inFigure 11.7 (and whose UK and continental European research on REITvaluations shows a similar pattern though for a shorter time period), saysthataftertheearly1990sbondandequitymarketshadamuchmoredirectinfluenceonpropertymarketdevelopmentsthanpreviously.

InternationaldiversificationofrealestateinvestmentWith the spread of REIT markets around the world, internationaldiversification of real estate investing has never been easier. The worddiversification implies risk reduction.Butdoes internationaldiversificationof real estate reduce risk? It turns out that currency risk is a particularlyknottyissueforinternationalrealestateinvesting.

CurrencyriskandinternationalrealestateinvestingTheguidelinesonforeigncurrencyexposureandthedesirabilityofforeign

currencyhedgingsuggestedinthisbookcanbesummarisedasfollows:

Lowervolatilityinternationalinvestmentsneedtobehedgedforforeignexchangeriskotherwisecurrencyfluctuationswilltransformtheriskandreturnoftheunderlyinginvestmentsbymarkedlyincreasingtheirvolatility.

Highervolatilityinternationalinvestments(suchasequities)donotneedtobehedgedforcurrencyriskbecausecurrencyhedgingwillsimplyalterthepatternofreturns,notmateriallyincreaseordecreasethemagnitudeofvolatility(butseeChapter7foradiscussionofexceptionstothisruleofthumb).

Itiseasytoputinplaceforeigncurrencyhedgesbetweenthemajorliquidcurrenciesandtohedgeliquidinvestments.Itcanbeexpensiveorimpracticaltohedgetheforeignexchangeriskswhichinvolveoneormorelessliquidcurrencies.

Foreigncurrencyhedginginvolvesfrequentaccountingforcashgainsorlossesonthehedgedinvestment.Thesegainsandlossesaremucheasiertoaccommodateinaninvestmentarrangementifthehedgedinvestmentisitselfhighlyliquid.Inthesecircumstances,forexample,currencygainsonaninvestmentcanbeoffsetbyinvestmentsalestofundoffsettingcurrencylossesonthecurrencyhedge.Withanilliquidinvestmentthisismuchmoredifficulttoachieve.Accumulatedcashflowlossesfromapersistenthomecurrencydepreciationcanrequireadditionalinjectionsofcash,whichmaybesubstantial.Investorsshouldthereforenothedgeilliquidandlumpyinternationalinvestments,suchaswholeproperties,unlesstheyaresurethattheycanfundthepotentialliquiditydrainfromthehedge.(Notethatanalternativeistoraiseamortgageabroadtofundtheforeigninvestment,andifneedbetooffsetthiswithacashdepositathomesoastoreducethescaleofleverage.Thiswouldreducethescopeforliquiditypressuresinmanagingtheinvestment,andwouldhedgethegreaterpartoftheforeignexchangerisk.)

Theimplicationsofthisforinternationalrealestatediversificationareas

follows:

Privatemarketinternationalrealestateinvestmentsshouldnotbehedgedbecausetheinvestmentsareilliquidandtheholdingsaregenerallyindivisible.

Thismeansthattheunhedgedinvestmentswillbevolatileandsoshouldonlybemadefortheiropportunisticperformancepotentialandnot,forexample,forthepotentialincomeyield.Anexceptiontothisarisesifinvestorsgenuinelyhaveanexceptionallylongtimehorizon(anddonotsimplywishthattheyhad).Inthiscase,aninvestormaybejustifiedinputtingfaithinanexpectationthateventuallycurrencymovementswillkeeptrackwiththerelativepurchasingpowerofdifferentcountries.

Investmentsinpublicmarketrealestatesecurities(suchasREITs)ininternationalmarketscaneasilybehedged.ThiswillbenecessaryifinvestorsintendtorelyontheincomefromtheoverseasREIT.However,theyshouldcheckwhetherthelevelofleverageintheREITcausesittohaveavolatilitythatwillswampanycushioningeffectfromhedging.Nevertheless,hedgedorunhedged,investorsshouldexpectthepriceofaREITthatinvestsindirectrealestateequitytobevolatile.

12 Artandinvestmentsofpassion

“IWOULDRATHERMYFAMILY’SWEALTHwastiedupinaTitianthaninabankshare,”oneartconsultant told theauthor.Manypeoplehavecollectionsofpaintings,otherworksofartoritemssuchasstamps,rarebooks,classiccarsorfinewinesonwhichtheyhaveexpendedsignificantamountsofmoney.Suchcollectionsaresometimescalled investmentsofpassion,but theyareprimarily treasured collections. Consistent anecdotes from a range ofmarkets indicate that few acquire fine art or collectibles solely to earn afinancial return. The prospect of earning an emotional, not financial,dividend from owning a beautiful work or a prized possession is almostalwaysthecatalystforadecisiontobuy.

Intheyearsfollowingthedarkestdaysofthefinancialcrisisattheendof2008andtheextraordinaryeasingofmonetaryconditionsthatfollowed,interestrateswereclosetozeroandthepricesofawiderangeofriskassetsrecovered strongly. Investments of passion fromclassic cars to finewinesandalsofineartsharedinthisandinmanycaseshadneverbeensostrong.Althoughitisdifficulttoverify,marketparticipantsandanalystsagreethatthemonetary environment encouragedmore spendingandhigherprices inthesenicheareas.Withnointerestbeingpaidoncash,theopportunitycostofindulginginapassionforcollectinghasnotbeenlowerinlivingmemory.As an article in the New York Times put it in April 2013, “Whether heintendeditornot,orevenrealisesit,BenS.Bernankehasbecomeapatronofthearts.”

HowmonetaryeasingprobablyinflatedthepricesoffineartandcollectiblesAnypurchaseinvolveschoices.Bypurchasingapaintingacollectordecidestoforgothe

interestthatcouldbeearnedonabankdepositorfromagovernmentbondofroughlythematurityinyearsthatthecollectormightownthepainting.Collectorsbuypaintingsbecausetheyprefertheprospectofenjoyingtheartatleastasmuchastheywouldbenefitfromtheincomethatcouldbeearnedfromcashorgovernmentbonds.Chapter4reportedevidencefromtheCapgeminiandRBCWealthManagement“WorldWealthReport”2013thattheworld’shighnetworthfamiliesmayholdoverone-quarteroftheirfinancialwealthascashordeposits.Theincomeofthesefamilieswillhavebeenreducedbyaround$100billionperyearforeach1%cutininterestrates.Wheninterestratesfalltoalmostzero,itismucheasiertojustifyspendingmoneyonart(oronalmostanything)ratherthanleavingthemoneyinthebank.Easymoneyalmostcertainlyincreasedthedemandforandpricesoffineartandcollectibles.

This increase in demand for collectibles has occurred against thebackground of the internet having facilitated price discovery and, almostcertainly,theliquidityofauctionmarketsforcollectibles.WebsitessuchaseBayaremuchmoreaccessiblethantraditional“bricksandmortar”auctionhouses, though investorsmay fear that counterparty risk is a bigger issuewithonlineauctionhouses.Eventhehumblestauctionhousecannowputitscatalogues for forthcoming auctions online, and there are well-developedinternet services which enable almost any local auction house to acceptonline bids. It is easy to forget how difficult itwas before the internet toaccessinformationthatisroutinelyofinterestandimportancetoacollector.Furthermore, online auction websites (which traditionalists argue are notsuitable formany treasuredpossessions) are apowerful force for reducingtransaction costs. This, together with easier price discovery and theenormously reduced “shoe-leather” costs of attending auctions shouldprovideanenduringlifttodemandforcollectibles,wellaftertheimpactofultra-lowinterestrateshaspassed.

PsychicreturnsfromartandcollectiblesCollectorscollectandartloversbuyartbecausetheyexpecttoenjoytheircollections.Thisaestheticor“psychic”rewardisadividendtobevaluedoverandaboveanymonetaryreturnthattheymighthopetogetwhen(orif)theyeventuallyselltheircollection.

Anumberofeconomistshaveattemptedtoestimatethepsychicreturnfromart.Somehaveuseddataonthecostofrentingart(forexample,bycorporations)andproducedhighimpliedpsychicreturns,intheorderof10–30%peryear.Thesehighfigureshavebeencriticisedforcombiningthecostofavaluableconsultancyservice,whichisadvisingindividualsonwhicharttheyoughttorent,withtheenjoymentthatflowsfromatreasuredpossession.Ina2013researchpaper,RachelPownall,associateprofessoroffinanceat

possession.Ina2013researchpaper,RachelPownall,associateprofessoroffinanceatMaastrichtUniversity,togetherwithSteveSatchellandNandiniSrivastava,bothmembersoftheeconomicsfacultyatCambridgeUniversity,haveevaluatedalternativeapproachesformeasuringpsychicreturnstoculturalassets.Aftertakingintoaccountthesubstantialtransactioncosts,apparentlongholdingperiodsforworksofartandlikelyproportionsofinvestablewealthinvestedinart,theyestimatethatpsychicreturnsfromfineartareprobablyintheregionofabitlessthan1%to2%peryearofthecostofapainting.AmongtheirotherfindingsisthatinFranceandtheUKfineartmayaccountforaround4–5%ofinvestablewealth(dataissuespreventedtheauthorsfromconsideringaglobalapproach).Theyfindthatthelongperiodsforwhichworksofartaregenerallyheldmeanthattheimpactofhightransactioncostsintheartmarket(forexample,commissionratesatauction–seebelow)islessofaburdenincomparisonwithstockmarketinvesting(whereholdingperiodsaremuchshorter)thantheheadlinenumberssuggest.Theirconclusionisthatanannualexpenseadvantagetoinvestinginequitiesoverbuyingapaintingofbetween0.5%and1%peryearseemsplausible,ifboththepaintingandtheinvestmentinthestockmarketareheldfor20–30years.

Recent trends in prices for fine art and collectibles can be seenmoreclearlythankstothepublicationbyacademicsofannualpriceindiceswhichtracetheevolutionofthepricesoffineart,stampsandviolinsoverthepast100years.Forshortertimeperiodsthereexistsamultiplicityofindicesfordifferentsegmentsoftheartmarket(andevenforindividualartists)aswellasforasurprisinglywiderangeofcollectibles.

Twoof the academics,ElroyDimson, emeritusprofessorof finance atLondonBusinessSchool, andChristopheSpaenjers, associateprofessoroffinanceatHEC,abusinessschoolinParis,havecalculatedthattheaveragepriceincreaseofart,stampsandviolinsovertheperiodfrom1900to2012beat the investment return on cash and government bonds but noticeablyunderperformed the stockmarket. The three types of “emotional” assets,whenmeasured in sterling (most of the data were originally expressed insterling),producedaveragereturnsofbetween2.4%and2.9%peryear,afterinflation,comparedwith1.5%peryearfrombonds,and0.9%peryearfromcash comparedwith 5.2% per year from equities.Other studies have alsoplacedthepriceperformanceoffineartoverdifferinglongtimeperiodsasbeingsomewherebelowthatofequitiesbutbetterthancash.

Inpractice,theaveragecollectoroffineartwillnothavedonesowell,because the data take no account of the costs of buying and selling itemsfrom their collections. Transaction costs are generally higher in illiquidmarketssuchasthoseforcollectibles,andcaneasilybe25%ofthepriceof

anobjectoffered for sale (seebelow).Average index returns from illiquidmarketsareearnedbynooneandtheyalsohidefluctuationsovertimeandoffashionswithinit.

An important sourceofdetailedhistorical informationon thepricesoffineartisGeraldReitlinger’s1960study,TheEconomicsofTaste,which,inhis words, traced “the rise and fall of picture prices” after 1760. Oneillustration he gavewas of a pair of paintings byClaudeLorrain, a 17th-centurylandscapeartist,whichweresoldin1808for£12,600,makingthem,according to Reitlinger, then the most expensive paintings ever sold, theprice being equivalent to roughly £900,000 in 2013 prices. The samepaintings were sold together 140 years later for £5,355, equivalent to£170,000 in today’s prices. Great paintings, which are bought at a highprice,can representanappalling returnonmoney,even ifheld foragreatlengthoftime.Ifproperlymaintained,andifattributionisnotindoubt,theyare, however, not going to decline in value to zero,which is the fate of ashareholdinginacompanywhichbecomesbankrupt.

FIG12.1Returnsfromfineart,stamps,violins,goldandfinancialassets1900–2013,1900=1

Note:Figure12.1showsthedeflatedindexvaluesfordifferentemotionalandfinancialassetclassesover1900–2012.Dataexcludetransactionandothercosts,includinginsurance.Eachindexissetequalto1atthe

beginningof1900.Thedataforequities,bondsandbillscomefromDimson,Marsh,andStaunton(2013).Thedataforartweresourcedfrom

Goetzmann,RenneboogandSpaenjers(2011)andArtprice.com;forstampsfromDimsonandSpaenjers(2011);forviolinsfromDimsonand

Spaenjers(2014);forgoldfromtheWorldGoldCouncil.Source:Dimson,E.andSpaenjers,C.,2014

ResearchbyMichaelMoses,formerlyaprofessoratNewYork’sSternSchoolofBusiness,andJiangpingMei,anassociateprofessoroffinanceatStern School of Business, indicates that underperformance of the broadermarket by a masterpiece is not unusual. They found that indicatorssuggestinghighqualityforaworkoffineart(suchasthepurchasepriceofthe painting or the number of scholarly citations or the number ofexhibitions featuring the work) provide no assurance that it is going tooutperform the rest of the art market in the future, and it may performconsiderablyworse.

Most art is not amasterpiece.WilliamGrampp, emeritus professor ofeconomics at the University of Chicago, in his 1989 book Pricing thepriceless:art,artistsandeconomicssoughttoreconciletheaestheticandthemonetary value of art.He argues that there is a correlation between priceand assessments of aesthetic value in fine art (presumably, he argues, thepricespaidbyleadingartgalleriesreflecttheirjudgmentsofartisticquality).Healsoaskswhatbecameofthe20,000paintingsproducedeachyearinlate19th-centuryFrance.He points out thatmost art declines in value to zerowhen it isno longerenjoyed,and thengetsdiscarded.Art thatsuffers thisfate might be described as “local” art. Some fine art maintains criticalappreciation from generation to generation (see below) and so keeps asignificant monetary as well as aesthetic value. This is not the fate ofpicturesthatmostpicturebuyersbuy.

Reitlinger’sbookhasprovedtobeatreasuretroveforresearchers.Itwasaprimesource for theartpriceseries inFigure12.1,and threeof the fivestudies of the evolution of art prices over time that were reviewed byGrampp in 1989 used Reitlinger’s data. Grampp concludes: “All except[one]givethesameanswertothequestion:Isbuyingartsimplytoresellatahigherpricelikelytobeprofitable?Theanswerisno.”

Oneofthefivestudieswasa1986article,“Unnaturalvalueorartasafloatingcrapgame”,byWilliamBaumol,emeritusprofessorofeconomicsatPrincetonUniversity.Hewasoneofthescepticsandarguedthatartprices

“floatmoreor lessaimlesslyand theirunpredictableoscillationsareapt tobe exacerbated by the activities of those who treat such art objects as‘investments’”. Baumol’s calculations showed an average return, afterinflation, of close to zero, though the other studies have given somewhathigherestimates.

Thisdoesnotmeanthatthepaintingswerenotworthowning,ratherthata collector of paintings (or of stamps, classic cars or vintage wine) willjudge a good investment differently from an institution which is onlyconcernedwithfinancialreturn.Forcollectors,thecombinationofthepricechange and the dividend of being able to enjoy the treasured possessionprovidesthecriteriatoassesssuccess.

Wealth,inequalityandthepriceofartRecent research has explored the relationship between art prices and theeconomy.WilliamGoetzmann, Edwin J. Beinecke professor of finance atYale School of Management, Luc Renneboog, professor of corporatefinanceatTilburgUniversity,andChristopheSpaenjershaveshown,usingUKdata, that the artmarket has followed the fortunes of the stockmarketand is also influenced by changes in income inequality. When high-endincomes increase much faster than average incomes, art prices tend torespondstrongly.Thishasbeenseeninthepatternsofartmarketboomsandstagnationsoverthepastcentury.Artpricesdidnotreachtheir1914levels,after inflation, until a strong recovery in the 1960s. The intervening longperiod of stagnation occurred despite personal income rising almostfourfold. It was, however, a period when income inequality declinedsharply,erodingtherelativebuyingpowerofthewealthiest.

The past 100 years show that a disappointing environment for the artmarketcanpersistfordecades.Afterthe1970s,inequality(measuredbytheauthorsastheshareofthetop0.1%ofUKincomeearnersintotalincome)increasedstrongly,havingdeclinedduringthepreceding70years.Sincethe1960s, fine art prices have easily outpaced inflation, supported by muchhighertopincomes,andhaveclimbedtolevelsnotseenbefore,eventhoughthere have been significant setbacks in the overall market and markedchanges of fashion within it. Figure 12.1 shows a similar pattern in the

indicators for prices of stamps and violins over the past century, althoughtheir periods of weakness do not always coincide with those in the artmarket.

Thispatterninpricesforartandcollectiblesover100yearsisreflectedin prices for luxury goods.Althoughmillions of people reportedly collectassortedtreasureditems,thetopendofeachcategoryofluxurygoods,beitfine wine, fine art, rare stamps, classic cars or even violins, will beinfluencedbytheincomes,wealthandperceptionsofcompetinginvestmentopportunities of the most affluent. The spending power of hedge fundmanagers, Russian oligarchs and Chinese billionaires helped to propel artpricesintheyearsupto2008,andthecontinuingdemandfromthewealthyinChinahelpedthemarkettorecoverafter2009muchfasterthanafterthebearmarketintheearly1990s.Investmentmanagersascollectorsofstamps,moguls from the entertainment and fashion world as collectors of classiccars, and Chinese multimillionaires as buyers of fine wine each point tosimilar influences on the top end ofmarkets for collectibles as have beenfoundintheartmarket.

The rise of China as a major player in the fine art market has beenremarkable.LondonandespeciallyNewYorkhaddominatedtheartauctionmarket,at leastfromtheearly1960sto2008.However, ineachyearfrom2009to2012fineartauctionsales inChinafor thefirst timeexceededbyrevenue those in the United States. In earlier years, Hong Kong was theprincipalmarketplace forart inChina,butaccording toArtsEconomics,aconsultancy,HongKong’sshareofChineseartauctionrevenuesin2009–12wasless than20%,withBeijing takingthe lion’sshare.Thechangein theartauctionmarkethasalsoledtoChineseworksoffineartoverwhelmingly,byvalue,beingsold inChina.Nevertheless,according toArtsEconomics,Chinese buyers have also represented a growing share of purchases inWesternartmarkets.

FIG12.2Worldwidefineartauctionhousesales$bn

Source:www.artprice.com

Economicsmay help explain overallmarket trends, but it is less clearwhichcriteria explain the financial valueof theworkof individual artists.Thevaluationofanypaintingought tobeanassessmentofwhat someoneelse would be willing to pay for it, which will be strongly influenced byassessments of its quality.Maintenance of value is likely to be supportedwherecriticalacclaimforanartistsurvivesfromonegenerationtoanother.Severalstudieshavelookedforthis.VictorGinsburghandSheilaWeyersofthe University of Louvain examined the critical recognition of ItalianRenaissanceartistsover thepast450years.Theyusedas theirbenchmarkthe prominence given to artists in authoritative art history textbooks atdifferent dates over this period. The measures used were the number ofcitationsandthelengthofwrittenreviewsofeachartist.

GinsburghandWeyers’sanalysisstartswiththeassessmentpublishedin1550byGiorgioVasari,anotableartistandalsoapioneeringarthistorian.Theycompare thiswithsixothersourcesspreadover theyearssince then,ending with The Grove Dictionary of Art, which was published as 34volumesin1996andhasnowbeensupersededbyanonlineedition.Thisiswidely available through public library subscriptions (particularly in theUK) and includes around 21,000 biographies, written by art experts fromaround the world. Ginsburgh and Weyers highlight an impressivepersistence in theartestablishment’sapparent ratingof the leading figures

of ItalianRenaissancepainting.Theyshow thateachof thesevenselectedart authorities from the past 450 years appear to have chosen Giotto,MichelangeloandRaphaelasamongthetoptenItalianRenaissanceartists,withsixalsoincludingTitianandfiveLeonardodaVinci.

Thispatternofpersistentrecognitionofqualityoverfivecenturiesofthetop-rankingItalianoldmasterpaintersdemonstrates thatsomeassessmentsofartqualitycanbereliedontoendure.Thishelpstounderpinthefinancialvalueofacclaimedartistsfromonegenerationtothenext.Itseemstobeasafebet that in200yearsapaintingbyRaphaelwillbeprizedandhighlyvalued.Anartgalleryisunlikelytobeembarrassedbyowningit,butitdoesnotmean,ifitevercametomarket,thatitwouldperformwellasafinancialinvestment.

Inthemarketforcontemporaryartthereisnohistoryofcriticalacclaim,and whether a contemporary artist’s work is judged by art experts to be“strong”or“weak”islargelyamatterofsubjectiveopinion.Thesupportofinfluential opinion formers and patrons has always been important insecuring recognition and commercial success for artists, and this can taketimeevenforthoselateracknowledgedasmasters.Thecelebratedexample,whichgives hope to countless yet-to-be-discovered artists, isVincentVanGogh,whodiedpennilessandapparentlysoldonlyonepaintingduringhisbrieflifetimedespitehisbrother’sbeinganartdealer.

Don Thompson, the author of The $12 million Stuffed Shark: theCuriousEconomicsofContemporaryArtandAuctionHouses,commentsontheimportanceofbrandinthemarketforcontemporaryart.Brandingor,asart market people call it, “validation” can be provided by an artist beingsupportedbyaleadingartdealer,orbyworkbeingofferedforsalebyeitherSotheby’sorChristie’s,stilltheworld’stwodominantartauctionhouses,orby being exhibited at or bought by a leading modern art gallery, or byhavingworks bought by a celebrated collector.These are the gatekeepers,the most important arbiters of perceived quality in the market forcontemporaryart.Whenacontemporaryartisthasbeenvalidatedbyseveralof these, he or she becomes a branded artist whose work will henceforthcommand a higher price. If a collector had the ability to anticipate thisprocess by buying pre-branded, yet-to-be-discovered artists, the road to

financial success in collecting contemporary art would be secured. Inpractice, there may be many good contemporary artists, but only a fewsecurefinancialsuccessbybecomingbranded.

Overtheagestherehavebeencountlesswealthypatrons,collectorsandsponsorsofart.Amongthesearesomewhosecollectionshavesubsequentlybecome extremely valuable. There is little indication that a desire toaccumulatewealthratherthanaloveofartmotivatedtheircollections,eventhough history might judge them to have been canny collectors. Anoutstandingexampleof this is thecollectionof20thcenturyart, includingsome by Pablo Picasso and Jasper Johns, amassed over the lifetimes ofVictorandSallyGanzofNewYork.TheGanzestatesold114paintingsatauctionin1997,raisingatotalof$207mcomparedwithanoriginaloutlayof $764,000.WilliamLandes, theCliftonR.Musser professor of law andeconomicsat theUniversityofChicago,foundthat theperformanceof theGanzcollectioneasilybeat investing in theUSstockmarketover thesameperiod;andalthoughdatacomparisonsaredifficult, it seemsclear that theGanz collection outperformed thewider artmarket.Landes found that thefinancialperformanceoftheGanzcollectionwasnotsimplyattributabletotheextraordinaryresultsfromoneortwopaintings,butshowedadegreeofpersistencefromoneartist toanotherandacross timeperiodsof investing.HealsofoundthatpaintingsandprintsfromtheGanzcollectionappearedtoattractapremiumpricebecausetheycamefromtheGanzcollection.

ArtmarketindicesArtcollectorswish(ifonlyforinsurancepurposes)tohaveanestimateofthevalueoftheirmosttreasuredworks.ThesectionattheendofChapter10discussesbiasesthatseemtoaffectappraisalvaluationsofprivateinvestment,includingfineartandcollectibles.Inrecentyearstherehasbeenthedevelopmentofanumberofcompetingprovidersofartmarketindicesandonlineartvaluationservices.Theroleoftheauctionhouseshasfacilitatedthedevelopmentoftheseservicesbyprovidingadegreeoftransparencytopricingthatwouldnotbeavailableifalltransactionsoccurredthroughdealers’galleriesoratartfairs.However,eachoftheartindicessuffersfromweaknesses.Somearecommontothemeasurementofperformanceinanyilliquidmarket;somearemorespecifictotheartmarket;andothersreflectdifferencesinmethodologicalapproachandcoverage.

Eachoftheleadingartindicesreflectstransactionsthatoccuratpublicauctionbutnotthose,bytheirnatureconfidential,thatoccurthroughdealers’galleriesoratartfairs.ItisestimatedbyClareMcAndrew,founderofArtsEconomics,thatpublicauctionsaccountforaround50%ofthevalueoftheturnoverofthefineartmarket.However,thereadyavailability

around50%ofthevalueoftheturnoverofthefineartmarket.However,thereadyavailabilityofpriceinformationmakesauctionsagoldmineforstatisticiansandanalysts.Unlikesomeilliquidmarketswherealltransactionsareprivateandwhereindicesofmarketperformanceneedtorelyonexpertvaluations,intheartmarkettheindexprovidersareabletouseauctionprices.Asinothermarkets,theindicesexcludetheimpactonfinancialperformanceofcommissioncosts,andtypicallytheindexprovidersalsoexcludeitemsthatfailtoreachtheirreservepriceandsoremainunsold(or“bought-in”).Initsannualreviewoftheglobalfineartmarket,Artprice,anartmarketinformationprovider,saysthat37%ofitemssubmittedforauctionin2012outsideChinawerebought-in,afigurebroadlyinlinewithpreviousexperience,whereasinChina,thelargestmarketplaceforfineartinrecentyears,thecomparablefigurewas54%,muchhigherthanindicatedbyrecentexperience.

Therearethreemainapproachestomeasuringartmarketperformance:

Thefirstissimplytomeasurethechangeintheaveragepricepaidforpaintingsatauction.Refinementisaddedbybreakingtheindicesdownintotheaveragepricepaidfordifferentcategories(forexample,impressionistpaintings)orforindividualartistsandbyremovingoutliers.Thisissometimescalleda“naive”index,butithassomesignificantstrengths.Theweaknessesofthisapproachareclear–onework,evenbythesameartist,isqualitativelydifferentfromanotherandmaybeexpectedtocommandaverydifferentprice.However,theattractionsofthisapproachincludetransparency,easeofunderstandingandofcomputation,anexpectationthaterrorsinmeasurementwillreduceaslargenumbersofworksareincluded,andimportantly,thatitincludesalltheavailablepriceinformationfromtheauctionhouses.Otherapproaches,seebelow,maycoveraminorityofthetransactionsatartauctions,andwillbeparticularlyweakintheircoverageofpaintingswhichhavenotpreviouslysoldatauction–contemporaryartinparticular.Inpractice,thisapproachmakesuseofmovingaveragesandsowillreactwithalagtoanymarketchangesandcanexcludethehighestandlowest10%byvalueofauctionpricestoreducethepossibledistortingeffectofoutlyingtransactions.

Thesecondapproachattemptstotakeaccountofphysicalcharacteristicsofaworkofartthatexperiencesuggestsinfluenceitsprice.Theseincludethenameoftheartist,thecategoryoftheart,thesizeofthepaintingandthenameoftheauctionhouse.Thisisthe“hedonic”approachandaimstoremovenon-standardinfluencesfromthemovementintheartmarketindex.Theadvantageofthehedonicapproachoverthesimpleaveragepricemethodisthatitmakesuseofsupplementaryinformationthatappearstohavebeenimportantinpastauctions.Itcanalsomakeuseofallthepricedatafromtheauctionhouses.

Thethird,muchlovedbypurists,isthe“repeatsalesregression”approach.Thismakesuseofpairsofdataforindividualworksofart,comparingapurchasepricewiththesubsequentsalespriceforthesameworkatalaterdate.Thestrengthofthismethodisthatitusesrealisedreturnsfromindividualworksofartandcombinesthemintoarepresentativeseriesforthemarketasawhole.ThemethodologyiscomparabletothatoftheauthoritativeCase-ShillerseriesfortheUShousingmarket,wheretransactioninformationismadepubliclyavailable.Therearesomedifficultieswithapplyingthemethodologytotheartmarketthatdonotapplyinthehousingmarkettothesamedegree:

Thefirstisthattheneedtorelyonrepeatsalessubstantiallyrestrictstheamountofauctionpricedatathatisbeingusedintheindex.

Thesecondisthattheauctionmarketdoesnotcoverthewholemarketasitfailstocapturetransactionsbydealers.Thiswouldnotmatterifpricetrendsinthetwomarketsegmentswerebelievedtobecomparable.However,theremaybeasurvivorbiaswhichinflatestherepeat-salesindicesifworksbyartistswhowereformerlyfashionablearenolongeracceptedforsaleattheleadingauctionhouses,andinsteadaresoldbydealersatreducedpriceswhicharenotreflectedintheindices.

Thethirdisthattheneedforapairofauctiontransactions(apurchaseandalatersale)foranindividualworkbeforeitjoinsthedatabasemeansthatitwillalwayslaginitscoverageofcontemporaryart.

Thefourth,theimportanceofwhichwilldiminishasthenumberoftransactionsmeasuredbyanindexincreases,isthatthepurityofrepeat-salesanalysisassumesthatapaintingisthesamepaintingwhenitisresold.However,changesinexpertopinionaboutapainting’sauthenticityorattributionwillinfluencethepricesubsequentlyachievedatauction.Thisdoesnotaffectthevalueofotherworksbythatartistorofthemarketasawhole,butitmaydistorttheindexbetweenthosetransactiondates.Correspondingissuesarisewithrealestateandthepossibilityofphysicalimprovementsordeteriorationinapropertybetweenpurchaseandsale.Theinfluenceofsuchdistortionswillbedilutedasthenumberofrepeattransactionsrecordedbyanindexincreases.

Priceindicesforotherinvestmentsofpassionor“collectibles”In any market, attempts to construct price indices are constrained by theavailable data. A major source of price indices for a large range ofcollectiblesisArtMarketResearch,aconsultancybasedinLondon,whichcomputes prices for different categories of collectibles and then removesoutlyingobservations.ItsimpressiverangeofitemsincludesColtrevolvers,wristwatches,Chinese ceramics andGerman toy trains.Other approacheswhichonlycomparedirectlythepricesofidenticalitems(suchasthesamepaintingwhenboughtandthenwhensold)useonlyasubsetoftheavailabledataandwillmissoutonnewmarkettrends(untilarecordisestablishedofpurchasesandlatersalesofparticularitemswithinthenewtrend).

Insomemarkets (forexample,classiccars)auctionsplayan importantrole in providing one ready source for index compilers. In othermarkets,auctionsmay have a smaller role and index compilers prefer to rely on a

consistentsourcethatisavailableforlongperiodsoftime.InthemarketforBritishstamps,forexample,althoughthereisanactiveauctionmarket,theavailablelong-runpriceinformationiscontainedinthecataloguespublishedby Stanley Gibbons, a stamp dealer, which has been the main source ofreference for collectors ofBritish stamps. This is the source of price datausedbyDimsonandSpaenjersintheir2011study“ExPost:theinvestmentperformanceofcollectiblestamps”.Thesehavebeenavailablearoundmostyear-ends since the late 19th century and they represent estimated sellingpricesofStanleyGibbonsatthetimeofpublicationforneworusedstampsin“finecondition”.

Theattractionof thisdata series is that it is available,ona reasonablyconsistent basis, for almost all years and that the dealer provides anassurance of attribution. The weakness of the data is primarily that theyreflectadealer’svaluationestimatesratherthantransactionpricesandsoarelikely to lag behindmarket developments and be less volatile than actualprices, and that the catalogue prices are likely to be difficult to reconcilewithadvertisedonlineorpublicauctionprices.TheremayalsobechangesovertimeinthespreadbetweenthepriceatwhichStanleyGibbonsofferstosell and the price at which it is willing to buy. Furthermore, a catalogueencourages theunwaryto interpret thedealer’sofferpricesforaparticularitem as an indication of value for a broad category of collectibles.Philatelists know that thousands, perhaps hundreds of thousands, ofexamplesofthePennyBlack,thefirstprepaidadhesivepostagestampintheworld,havesurvivedinsomeformoutofthe55million(somesourcessay68million)thatwereprintedintheUKbetween1840and1841.Theyalsoknow that one unused Penny Black in fine condition can have a verydifferentvaluefromanotherunusedPennyBlackinfinecondition.

Stamps, coins and probably most collectibles are extremelyheterogeneous, and gaining and growing an understanding of theirdistinctivedifferencesiscentraltoacollector’sexpertise.However,makinguse of a wide cross-section (50 in the case of the Dimson and Spaenjersstudy)ofcataloguepricesforrepresentativeitemsforalmosteveryyearforover a century will greatly reduce the uncertainty that derives from thecomparability of items fromone period to another.Amarket index is not

attempting to reflect the idiosyncrasies of individual items, but rather toreflectbroadmovementsintheoveralllevelofthemarket.

Assessing changes in the level of prices in themarket for classic carsintroducesnewchallenges. In thismarket,aparticularcarwhich isboughtandsubsequentlyresoldisonlythesamecarintermsofitschassisnumber:collectors will always beworking on their cars, andwithoutmaintenancethey alwaysdeteriorate.Maintenancemight cost 2.5–5%of thevalueof acar each year, which can be seen as a negative dividend attached to thisinvestmentofpassion.Sowhereasanartindexorahousepriceindexmayseekdata on repeat sales of the samepaintingor house, in themarket forclassiccarssuchinformation,evenwhereitisavailable,isnotseenasusefulforconstructinganindexofmarketprices.Thepricelevelforclassiccarsismeasured by the Historic Automobile Group International (HAGI) index,whichhasbeenconstructed since2008byagroupof finance industry carenthusiasts, with expertise in compiling stockmarket indices. The index,whichincludes50valuablecarmodels,wasestimatedinmid-2013tohaveacapitalisationofaround$15billion,whichrepresentstheestimatednumberofsurvivingcarsmultipliedbythepriceforthetypeandassumedconditionofthecar.TheHAGIindicesarebasedonlyontransactionsforcarsin“verygood”or“highlyoriginal”conditionandexcludepricesstronglyinfluencedby extraneous factors, such as celebrity former owners.TheUnitedStatesdominates the classic car auction market, with the UK and continentalEuropeinsubsidiaryroles.Unlikeintheartmarket,mainlandChinahasnotemergedasamajorcentreforclassiccars.

The prices for theHAGI indices are sourced from auctioneers (whichaccount for around one-third of the market) and from the confidentialtransaction records of dealers and collectors. If there are no trades for acategoryofclassiccarduringamonth,theindexforthatcategorywillshowno change that month (which, in common with a number of othermethodologies for constructing indices of collectibles, could slow theindex’s response to a market downturn). Although they will not collectevery transaction, the index compilers are confident that they are able tocapture the majority of relevant transactions globally. The HAGI hassupplemented the monthly series since 2008 with back-filled annual data

backto1980(seeFigures12.3and12.4).

FIG12.3Calendaryearperformanceofglobalequitiesandclassiccars1980–2008,Dec1980=100

Sources:HistoricAutomobileGroupInternational;MSCI

FIG12.4MonthlyperformanceofworldequitiesandclassiccarsDec2008–Sep2013,Dec2008=100

Sources:HistoricAutomobileGroupInternational;MSCI

Investinginartandcollectibles

Therehasbeenagreatdealoftalkaboutinvestinginart,butapparentlylittlepurelyfinancial investment.Artconsultantsareaskedfromtimetotimetogivepresentationson thepotential roleofaportfolioofworksofart inaninvestment strategy. But as often as not it seems that investing in art islooked upon as an interesting and imaginative idea for investors to haveconsidered rather than an idea that they wish to implement. The oneexception to this is themarket for art funds, though even these aremoretalkedaboutthanpurchased.Therehavebeennumerousattemptstolaunchartfunds.MichaelFindlay,anartdealerandtheauthorofTheValueofArt,says that “there is an adage among old hands in the art world that theemergenceofartinvestmentfundssignalsthataboomisover”.Hecitesanearlyexamplefrom1904whenaFrenchfinancierand12friendsformedafund called, “with intentional irony”, La Peau de l’Ours (“the skin of thebear”)aftera fable inwhichhunterssell theskinofabearwhich theyarethenunabletocatch.Thisfundwasagreatsuccess,havingacquiredworksby emerging artists including Gauguin and Monet and two then“unknowns”,MatisseandPicasso.Anditwasafinancialsuccess,thankstoshrewdselectionofworksofartandextraordinarygoodluckinwindingupaftertenyears,justbeforethestartofthefirstworldwar.Thenewlong-runprice indexfor theartmarketshows that thiswasalsoapeak level forartmarketprices,whichwasnotreachedagain,afterallowingforinflation,forover50years.

Immediately before the 2008 financial crisis, there was a flurry ofambitiousplans to launch funds, especially inChina, to invest indifferingpartsof the artmarket. In theWest, proposals includedproposed funds toinvest in art from emerging economies, to invest in emerging artists(irrespectiveofhomecountry),tosupportpromotionssoasto“brand”newartists, and to focuson relatively high turnover and alsoon relatively lowturnover.

In 2013, there were relatively few funds operating, although thecombined assets under management have been estimated at around $1billion(whichisdifficulttoverify).Artfundsoffertheprospectofmakingafinancialinvestmentinadiversifiedportfolioofworksofart.Inpractice,thetransactioncharges leviedbydealersandauctionhouses imposeadifficult

hurdle on relatively short-life funds to buy, hold, then sell art and give acompetitivereturntoinvestors.Artfundsneedtogetroundthishurdle,andoneavenueistodealdirectlywithbuyersandsellers(whoforcontemporaryworks might be the artists). The management of funds has sought toovercome the hurdle of transaction costs by providing liquidity to artcollectorswhowish to sell art quickly or anonymously (or both). To thisextent, investors in an art fund have been investing in and providingvaluableliquiditytoabusinessthatcanbecomparedwithanartdealership.However,anattractivefeatureofanartfundforinvestorsis that theymaybeabletoborrowworksofartfromthefundfordisplayintheirownhomesoroffices.

Overall, though, the development of art funds has been disappointing,with a few successes. A few private banks have flirted with the idea oflaunching them, but the banks’ more common role is advising theirwealthiest clients on the management of their art collections and, inparticular, the arrangement of credit facilities secured against their art.Worksofartmayrepresentasignificantpartofthewealthofsuchinvestors,but they are normally better described as collections, rather than asinvestmentportfolios.

ArareexamplefromthepastofaninstitutionalforayintotheartmarketwastheinvestmentportfoliocreatedbytheBritishRailPensionFundintheyears following 1974. The decision to make this unusual alternativeinvestmentwasa response to the financialcrisesof the time(especially intheUK)andledtothepurchaseofaportfoliocomprising2,505individualworksofart.(Thistotalwasinflatedbytheacquisitionofseveralportfolioscomprisingmodestvalueitems.)Thepurchasesoccurredbetween1974and1980 and the final item was sold in 2003. The fund had spent £41.1macquiring theworks and the proceeds from the sales (net of commissions,feesandtaxes,butnotallowingforinterveningstorageandinsurancecosts)was£170.4m.Thisrepresentedaninternalrateofreturnof11.3%,or3.7%per year after allowing for the impact of UK inflation. Set against thebenchmarks thatwouldhavebeenestablishedat theoutset, theexperiencewasasuccess.Nevertheless,itdidnotpersuadethepensionfundtocontinuewith its experiment. This example ismore relevant for potential investors

thanthatoftheGanzcollectionbecauseitdoesnotsufferfromthehindsightbias that affects that highly successful private collection. The Ganzcollectionisinterestingbecauseithappenedtobefinanciallysuccessful;theBritishRailportfolioisinterestingbecauseitisasingleexampleofawell-diversifiedfinancialinvestmentinart.

FIG12.5BritishRailPensionFundrealisedratesofreturnfor2,505individualworksofartacquiredbetween1974and1980Internalratesofreturn,%peryear,afterinflation

Source:RailwaysPensionTrusteeCompanyLimited

TheBritishRailexamplesheds lighton the financial riskofcollectingart. Figure 12.5 plots the distribution of rates of return, after allowing forUKinflation,foreachoftheindividualitems,whichwereoriginallychosenfortheircontributiontoadiversifiedportfolioofworksofart.ThesimilaritybetweenthisfigureandthecorrespondingonedrawnbyBaumolinhis1986article (based on 640 purchases and then sales of paintings) is striking.Figure 12.5 shows that the performance of individual works was widelydispersedaroundthatofthemedian,ormiddleranking,holding,whichwasjust –0.39% per year. Despite this, the performance of the portfolio as awhole was 3.7% per year, helped by the exceptional performance of thepensionfund’sholdingsofimpressionistpaintings.

The British Rail experiment was perhaps too short term. Greatcollections hold works of art from generation to generation; the averageholdingperiodintheBritishRailworksofartcollectionwasjust12.9years.

SharedcharacteristicsoffineartandotherinvestmentsofpassionInvestmentsofpassion,orhobbycollections,shareanumberofcharacteristics:

Theimportanceof“provenance”,thatisauthenticationandownershiphistoryofanyitem.Eventhegrandestartcollectionsandgalleriesruntheriskofhavingmajorworksreassessedbyexperts.Theimplicationsonvaluationofhavinganimportantworkreassessedas“fromtheschoolof”ratherthanbyaparticularoldmasterpainterwouldbesevere;tohaveatreasuredworkofartexposedasaforgerywouldbemuchworse.Correspondingthreatsconfrontacollectionofstampsorcoins:differencesinqualitativeassessmentcanseemarcanetoanoutsiderbutcanmakeanimportantdifferencetojudgmentsofthequalityofacollection.Theexpertiseandpassionofthecollector,whetheroffineartorcollectibles,aredirectedatminimisingsuchrisk.

Theasymmetryofinformationthatexistsbetweenmarketinsidersandmostinvestorsisafeaturethatissharedwithallilliquidmarkets.Thosewishingtobuildacollectionneedtoappreciatethataninformationaladvantagealmostalwayslieswiththemarketprofessional.

Theprevalenceofhightransactioncosts,whicharenormallymuchhigherthaninmoreliquidsecuritiesmarkets.Atartauctions,transactioncostsaredominatedbythebuyerandseller“premia”,orcommissions.Forexample,atoneofthemajorauctionhouses,wherethebuyer’scommissioniscalculatedonaslidingscale,thecommissionpayableforapurchasewithahammerpriceof$1.5mcouldbe17.5%,with25%payableonthefirst$50,000.Commissionspayablebytheseller(orconsignor)ofaworkarealsosignificant,butsinceaprice-fixingscandalin2002,theymaynowbemoresusceptibletoeconomicpressures.Nevertheless,itissafetoassumethattheauctionhousesmayextract25%ofthepriceofahigh-valuepaintingandmoreforsmallervalueitems.Suchtransactioncostsarelikelytocripplemostapproachestoinvestmentsofpassionthatdonotinvolveapatientbuy-and-holdstrategy.

The financial resources that could in principle be allocated toacquisitionsofartareenormousrelativetothesizeoftheglobalartmarket.Deeppockets in theMiddleEast are fundingnewnationalgalleries.Moreimportantly,thereisatraditionalimbalancebetweenthetinysizeoftheart

market compared with total private financial wealth. Art auctions had arecordturnoverin2012accordingtoArtpriceof$12.3billionin2012,butinvestablefinancialwealthwasestimatedbytheCapgeminiandRBC2013“WorldWealthReport”tohavebeen$46.2trillion(thatis,$46.2thousandbillion),withperhaps$12trillionavailableascashordeposits.

Theinsignificantsizeoftheartmarket,inrelationtodisposablewealth,means that a move by any substantial investor or group of investors toestablish or extend amajor art collection is likely to provide considerablesupporttoprices.Theeasiestwaytojustifyapurelyfinancialinvestmentinsought-afterpartsofthefineartmarketwouldbeabeliefthatpriceswouldincreasinglybesupportedbyatleastsomesuchinvestorsfordecadesahead.AsBaumolimplied,economicsisunabletosuggestanyupperlimitforthepricesofhighlyprizedart.

Appendix1

Glossary

THIS GLOSSARY DOES NOT REPEAT definitions and explanations of concepts that areprovided in the main text, for example in Chapter 2 (terms relating to behavioural finance) andchaptersinPart2(fortermsrelatingtoequitymarkets,creditmarkets,hedgefunds,privateequityandrealestate).Forreferencestothese,pleaseconsulttheindex.

Activemanagement Investmentstrategiesofactiveinvestmentmanagerswhoareappointedintheexpectationorhopethattheywillperformbetterthanthemarketasawhole,afterallowingfortheextrafeespaidforactivemanagement.Thesestrategiesalwaysinvolveavoidableturnover(comparedwithapassiveormarketmatchingstrategy)andtheavoidableriskofunderperformingthemarket.Seealsopassivestrategies.

Annualisedreturns Seegeometricaveragereturns.Arithmeticaveragereturns Thesimpleaverageovertimeofinvestmentreturns.Thisishigher

thanthecompoundedorgeometricaverageofreturns.Thedifferenceiseasytoillustrate.Supposeaportfolioperformanceinoneperiodis–50%andinthenextis+100%.Thearithmeticaverageperformanceis+25%[(–50+100)÷2].Thegeometricaverageorcompoundreturn,however,is100×(0.5×2.0)–100or0%.Standardriskmeasuressuchasthestandarddeviationshouldbeusedinconjunctionwiththearithmeticaverage.However,thegeometricorcompoundreturndescribestheevolutionofwealthovertime.

Assetallocation Allocationofinvestmentsamongdifferentmarkets.Contrastwithstockselection,whichistheallocationofinvestmentswithinaparticularmarket.

Basecurrency Investors’homecurrencyinwhichtheirinvestmentobjectivesareexpressed.Theirbasecurrencyisnormally,butnotalways,unambiguous.SeeChapter1.

Basispoint(BP) Onehundredthofonepercent,or0.01%.Beta Ameasureoftheextenttowhichastockmightprovidediluted

exposure(ifthemeasureofbetaislessthan1.0)orleveragedexposure(ifthemeasureofbetaisgreaterthan1.0)toequitymarketrisk.SeeChapter7fordiscussionofthefundamentalinsights,strengthsandweaknessesofthecapitalassetpricingmodel,inwhichtheconceptof“beta”playsacentralrole.

Bondladder

Bondladder Aportfolioofhigh-qualitybondsofsuccessivematuritiesdesignedtoprovideasteadystreamofinvestmentincome.SeeChapter5.

Break-evenrateofinflation Thisis(approximately)thedifferencebetweentheredemptionyieldonconventionalgovernmentbondsandthatoninflation-linkedgovernmentbondsofthesamematurity.Ifinflationhappenstoequalthebreak-evenrate,thetotalreturnoninflation-linkedandconventionalgovernmentbondswillbeapproximatelyidentical.SeeChapter3.

Businessangel Anentrepreneurwhocontributesfinanceandoftenbusinessexpertisetosupportaventurecapitalinvestmentinreturnforasignificantshareholding.

Calloption Acontractthatgivestherighttobuyaspecifiedinvestmentatagiventimeinthefutureforapredeterminedprice.Seealsooptionandputoption.

CapitalAssetPricingModel(CAPM)

SeebetaandChapter7.

Coefficientoflossaversion Aconceptfrombehaviouralfinance.Theratioofthesensitivitytolossescomparedwiththesensitivitytogains.Acommonlycitedresultisthatthecoefficientisaround2,inotherwords,thatinvestorsweighlossestwiceashighlyastheyweighgains.

Contrarian Aninvestor,orastrategy,thatdeliberatelyseekstobeunfashionableandtogoagainstrecentmarkettrends.Typically,thisisanadjectivethatisusedtodescribevalueinvestors;seeChapter7.

Conventionalbond Afixed-incomebond(whichhasapredeterminedscheduleoffixed-interestcouponsandafixedredemptionvalue).Theword“conventional”isusedtodistinguishthebondfrominflation-linkedorfloating-ratebonds.Inflation-linkedbondshavecouponsand/orredemptionvaluesthatareadjustedinlinewithinflation.Floating-ratebondshavecouponsthatareresetinlinewithaspecifiedshort-termreferencerateofinterest,suchastheLondonInterbankOfferedRate(LIBOR).

Convertiblebond Usuallyacorporatebondthatgivesinvestorstheoptiontoconvertitatsomestageinthefutureintoagivennumberofordinarysharesoftheissuingcompany.Convertiblebondsgenerallypaylowercouponsthanbondsissuedbythesamecompanywhichdonotoffertheoptiontoconvertintoequity.

Convexity Ameasureofthechangeinabond’sdurationthatisaresultofachangeininterestrates.Allowanceforabond’sconvexityenablesamoreaccurateassessmentofhowitspricewillrespondtointerestratechangesthancanbeprovidedbyconsideringonlyitsduration.Thisisbecausetherelationshipbetweenachangeininterestratesandtheconsequentchangeinbondpricesisgenerallynotlinear.Positiveconvexityisadesirablecharacteristicandisanattributeof

conventionalbondswhosedurationincreasesasinterestratesfallanddecreasesasinterestratesrise.Thisisbecausethepresentvalueoffuturepaymentsincreaseswithlowerinterestratesandviceversa.Thusthesebondsperformbetterthancalculationsbasedonlyonthebond’sdurationwouldsuggestwheninterestrateschange.Negativeconvexityistheopposite,andbondswhichdisplaythischaracteristictendtounderperformwheninterestratesfalland/orrise.Bondswhichareexposedtocertaintypesofembeddedoptions,suchasmortgagebonds,candisplaynegativeconvexity.SeeChapter8.

Correlation Thedegreeoflinearassociationbetweentwovariables.Inotherwords,itisameasureoftheextenttowhichthepricesoftwoinvestmentsmovetogether(butnotnecessarilybythesameamount).Thecorrelationcoefficient,R,canvarybetween–1and+1.Acorrelationcoefficientof0suggestsnorelationshipbetweenthemovementsinthepricesofthetwoinvestments.Apositivecorrelationsuggeststhatthepricesofthetwoinvestmentstendtoriseorfallatthesametime.Anegativecorrelationsuggeststhatthepricesofthetwoinvestmentstendtomoveinoppositedirectionsatanyparticulartime.Negativecorrelationsarehighlydesirableinconstructingportfoliosofriskyassets,becausetheyreducerisk.However,negativelycorrelatedattractiveinvestmentsarerare.

Creditspread TheextrayieldofferedbyariskybondoverthatofferedbytheTreasuryforabondofthesamematuritytocompensateaninvestorfortheriskthattheissuemightdefault.Extrayieldmayalsobepaidtocompensatefortheilliquidityofanissue.

Derivatives Derivedinvestmentcontracts,whicharedesignedtoreplicatecertainaspectsofriskthatcanbeobtainedfromdirectinvestmentinmarketssuchasequityorfixedincome.

Directionalfunds Acommoncategorisationofhedgefundstrategiesistodividethembetweendirectionalandnon-directionalstrategies.Directionalstrategiesarethosewhoseperformanceisexpectedtobehighlycorrelatedwithequityorothermarketrisk.

Disinflation Theprocessofreducingtherateofinflation–thatis,therateatwhichpricesareincreasing.Disinflationshouldnotbeconfusedwithdeflation,whichreferstoactualdeclinesinprices.

Duration Theaveragelifeofabondandalsoameasureofabond’ssensitivitytomovementsininterestrates.(Slightdifferencesincalculationarereflectedinthesedefinitions.)Durationistheweightedaveragetimetothetotalofscheduledpayments,wheretheweightsaredeterminedbythepresentvalueofeachpayment.Durationisshorterthanthematurityofabond,becauseittakesaccountoftheearlierdatesonwhichinterestcouponsarepaid.Theexceptionisazerocouponbond,thedurationofwhichisthesameasitsmaturity.Therearetwocommonbutsimilartechnicaldefinitionsofduration:Macaulayduration,whichismostusefulin

definitionsofduration:Macaulayduration,whichismostusefulinpreciselymatchingafuturestreamofpayments;andmodifiedduration,whichprovidesameasureofthesensitivityofabondportfoliotosmallchangesininterestrates.

Efficientfrontier Onagraphwhichplotsfordifferentinvestments(andforportfoliosofdifferentinvestments)theexpectedreturn(y-axis)andexpectedvolatility(x-axis)ofthoseinvestments,theefficientfrontiershowsthemostefficientcombinationsofriskandreturn.Atanypointonthefrontiercurveforagivenlevelofvolatility,expectedreturnismaximised,andforagivenlevelofexpectedreturn,expectedvolatilityisminimised.SeefuzzyfrontierandChapter5.

ETF Shortforexchangetradedfund,aninvestmentproductthatgivesexposuretoaparticularmarket.TheETFitselfislistedonthestockmarket,andsoishighlyliquidandgenerallyaccessibleatmodesttransactionprices.

Familyoffice Theprivateofficeofawealthyfamilywhichisentrustedwiththemanagementofthefamily’sfinancialaffairs.

Fattails Seekurtosis.

Forwardcontract Similartoafuturescontract,exceptthatitmaynotbestandardised(thoughmostprobablyitwillbe)anddoesnotbenefitfromthetransparentpricingandsupportofaformalexchange.Asaresultforwardsmaynotbemarkedtomarketeachday.Thisgivesrisetolargerissuesofcounterpartyriskthanexistwithfuturescontracts,whicharetransactedonaformalexchange.

Futurescontract Astandardisedcontractenteredintoonafuturesexchangetobuyorsellaparticularinvestmentorbasketofinvestmentsatagivendateinthefuture.Theexchangeguaranteespaymentsbetweenmembersoftheexchange(butnottheirclients).Inpractice,profitandlossonafuturescontractiscalculatedonadailybasisandreflectedinpaymentsofvariationmargintoandfromtheexchange’sclearinghousebybothpartiestoacontract.

Fuzzyfrontier Anadaptationoftheconceptoftheefficientfrontierwhichacknowledgesthat,becauseinvestmentrelationshipsandinvestmentclassificationsaretoadegreeuncertain,thereisrarelyonemostefficientstrategythataparticularinvestorshouldfollow.Insteadthereisalwaysarangeofbroadlyefficientappropriatestrategies.SeeChapter2.

Geometricaveragereturns Anothertermforcompoundorannualisedinvestmentreturns.Forthedifferencebetweengeometricorcompoundandarithmeticinvestmentreturns,seearithmeticaveragereturns.

Hedged Anindicationthatmarketrisk,forexamplefromthestockmarketoraforeignexchangemarket,hasbeenneutralisedusingderivativesorotherinstruments.ButseeChapter9foradiscussionofthelooseuseoftheterm“hedging”byhedgefunds.

Heuristic Asimpleprocedurethathelpsfindadequatethoughoftenimperfect

answerstodifficultquestions.Ashortcut.Highwatermark Thisconceptisimportantforthecalculationofhedgefund

performancefees.Itreferstotheprecedinghighestcumulativetotalreturn.Hedgefundperformancefeesarenormallypayableonlyifcumulativeperformanceexceedsthepreceding“highwatermark”.SeeChapter9.

High-yieldbond Adebtissuewhichisjudgedbycredit-ratingagenciestobeatbestspeculativeornotwellsecured.Seealsosub-investmentgrade,investmentgradeandChapter8.

Inflationriskpremium Anamountbywhichthebreak-evenrateofinflationmayexceedtheexpectedrateofinflationtoallowfortheriskthatinflationmaybehigherthanexpected.SeeChapter3.

In-the-money Acalloptionissaidtobe“in-the-money”whenthemarketpriceoftheunderlyinginvestmentisabovethe“strike”priceatwhichtheoptiontobuythatinvestmentcanbeexercised.Aputoptionisin-the-moneywhenthemarketpriceisbelowthestrikepriceatwhichtheoptioncanbeexercised.Anoptioncanbeexercisedprofitablyonlyifitisin-the-money.

Investmentgrade Thegroupofcreditratingsgivenbytheprincipalratingagenciestodebtsecuritieswhosecreditratingisassessedasbeingatleastmoderatetogoodquality.Thisdifferentiatesinvestmentgradedebtfromissueswhicharejudgedtobeatbestspeculativeornotwellsecured.Seesub-investmentgradeandChapter8.

Kurtosis Alsocalledexcesskurtosis.Ameasureofwhetheraseriesofinvestmentreturnshasmoreextremeresultsthanwouldbesuggestedbythenormaldistribution.Adistributionwithmorethanexpectedextremeresultsiscalledleptokurtic.Thisphenomenonismorecommonlyreferredtoas“fattails”.Anumberofhedgefundstrategies,andsomestockmarketreturns,demonstratepronouncedfattailsorexcesskurtosis.SeeChapter9.

Largecap Oneofthelargestcompaniesbystockmarketcapitalisation.IntheUnitedStatesacommondefinitionisthataquotedcompanyislargecapifitsmarketcapitalisationexceeds$10billion.SeeChapter7.

Leverage Anindicationoftheextenttowhichaninvestment,andthusitsperformance,isgearedthroughthelevelofdebtembeddedinit.

Liquidity Anindicationoftheeasewithwhichinvestmentscanbeboughtorsoldatclosetotheiradvertisedprice.Inilliquidmarketsitcanbedifficulttobuyandsellinvestments.

Listedinvestment Aninvestment,typicallyastockorbond,whichislistedonarecognisedexchangeandprovidesregularquotationsforitsprice.Contrastwithanunlistedorprivateinvestment(suchasaventurecapitalinvestmentorapropertyinvestment),thepriceofwhich,exceptwhenitisboughtandsold,representsappraisalvaluations.

Lognormaldistribution

Lognormaldistribution Seenormaldistribution.

Long-onlystrategy Atraditionalinvestmentstrategyorportfolioconsistingonlyofinvestmentswhichareowned,notinvestmentswhichareborrowedorsoldshort.Seealsoshortposition.

Longposition Aninvestmentwhichisowned,asdistinctfromaninvestmentwhichisborrowed.Seealsoshortposition.

Mark-to-market Theprocessofaccountingforthevalueofinvestments,andsoprofitsandlosses,attheirmarketprices,ratherthantheirbookorhistoricalcost.

Marketriskpremium Thepremiumreturnexpectedforinvestingoutsidethesecuresafehavenandincurringtherisksassociatedwithinvestinginvolatilemarketsthatoffersystematicinvestmentreturnstoinvestors.

Meanreversion Thebelief,fundamentaltotheoutlookofvalueinvestors,thatpricesinfinancialmarketstendtooverreact,oscillatingbetweenovervaluationandundervaluation.Meanreversionreferstoanexpectationthatexpensivemarketscanbereliedupontobecomecheaperandinexpensivemarketscanbereliedupontobecomepricedcloserto“fairvalue”.SeeChapters3,5and7.

Mentalaccounting Aconceptfrombehaviouralfinance.Thesetofcognitiveoperationsusedbyindividualsandhouseholdstoorganise,evaluateandkeeptrackoffinancialactivities.

Mezzaninedebt Oftenthemostjunior–thatis,themostrisky–categoryofdebtinaborrower’sbalancesheet.Typicallyitwillbeaccompaniedbyoptionstoconvertintoequity.Itisbestconsideredassharingtheriskcharacteristicsofequityratherthandebt.

Naturalhabitat Thenaturalinvestmenthomeforaparticularinvestor,suchaslong-datedTreasurybondsforapensionfund.

Negativeconvexity Seeconvexity.Noise Meaninglessapparentmarketsignalswhichmakeitmoredifficult

tointerpretmarketdevelopments.Noiseisbothacauseandareflectionofuncertainty.Onecauseofnoiseistheimpactonmarketsofthetransactionsofinvestorswholackinsightorwhotransactforreasonsotherthaninresponsetomarketsignals(forexample,investorswhohaveanimpactonmarketsbecause,forwhateverreason,theyneedtosell).SeeChapter6.

Normaldistribution Thenormalandlognormaldistributionsarethetwomostcommonlyusedstatisticalmodelsinfinance.Anormaldistributionissymmetrical,withabell-shapedcurveandonepeak;alognormaldistributionisskewedtotheright.Returnseriesthatarelognormallydistributedleadtogeometric,orlogarithmic,returnsthatarethemselvesnormallydistributed.Thepopularityofthenormalandlognormaldistributionsreflectstheircomparativeeaseofuseinanalysisandtheevidencethattheyprovideaplausibleapproximationtomanymarketperformancedataseries.Much

efforthasbeeninvestedinexaminingwhenthenormal,orlognormal,distributionfailstodescribehowmarketsbehave.See,forexample,Chapters3,5and7.

Option Acontractthatgivesthepurchasertheright,butnottheobligation,tobuy(calloption)orsell(putoption)aparticularinvestmentatagivenpriceon(ifaEuropeanoption)orbefore(ifanAmericanoption)thegivenexpirydateforthecontract.

Passivestrategies Market-matchinginvestmentstrategieswhichinvolveminimalturnoverandexpense.Turnovertypicallyoccursonlytoaccommodateinflowsoroutflowsofinvestorfundsandtoimprovethemarket-matchingfeaturesoftheinvestmentportfolio.

Ponzischeme AtypeofscamnamedafterthefraudsterCharlesPonziwhointhe1920sdefraudedthousandsofNewEnglandresidentswiththepromiseofsuperlativereturnsontheirsavingsbyexploitinganomaliesintheratesofexchangeofferedoninternationalmailcoupons.APonzischemeisaninvestmentfraudthatoffersthepromiseofenticingperformancebydivertingcashfromnewinvestorstoprovidethepromisedreturnstoexitingoldinvestors.Suchaschemeisdoomedtofailandworksonlyaslongasnewinflowsatleastmatchthedemandforcashfromleavers.

Prepaymentrisk Theriskthatabond,particularlyamortgagebond,willexperiencefasterthanscheduledrepaymentsofprincipalbecauseresidentialmortgageholders,particularlyintheUnitedStates,canexercisetherighttorepaymortgagesearlierthanspecifiedinarepaymentschedule.Thisreducesthetermofamortgagebondandismostlikelytohappenwheninterestratesfall(orwhenmortgageproviderscompeteaggressivelyfornewbusiness),givingprofitableopportunitiesforborrowerstoremortgagepropertyatmoreattractiveinterestrates.SeeChapter8.

Price/earningsratio Theratioofthesharepriceofacompanytoitsearningsdividedbythenumberofsharesithasissued.Ahighprice/earnings(P/E)ratioindicatesthatthestockmarketexpectsthecompany’searningstogrowfast,andviceversa.

Priceperformance Theperformanceofaninvestmentthatmakesnoallowanceforitsincomeordividendyield.Contrastwithtotalreturn,whichincludesthepriceperformanceandtheincomereturn.

Primebroker Adepartmentofaninvestmentbankwhichprovidesbankingservicestohedgefunds.

Privateinvestment Anunlistedorunquotedinvestmentforwhichpricequotationsaregenerallynotreadilyavailable.

Prospecttheory Akeypartofbehaviouralfinance.Itisbasedonexperimentsthatindicatethatpeoplearemoremotivatedbylossesthanbygains(seecoefficientoflossaversion)andsowilltryhardtoavoidrealisinglosses.SeeChapter2.

Publicinvestment Alistedorquotedinvestmentforwhichpricesareregularlyquotedonaformalexchangeatwhich,orclosetowhich,transactionscanbeeffected.

Purediscountbond Seezerocouponbond.Putoption Acontractthatgivestherighttosellaspecifiedinvestmentata

giventimeinthefutureforapredeterminedprice.Seealsooptionandcalloption.

Quotedinvestment Apublicinvestment.R2 Thesquareofthecorrelationcoefficient.Thismeasuresthe

percentageofvariation(thatis,variance)inthepriceofoneinvestmentthatis“explained”byachangeinthepriceofanother.

Realinterestrate Therateofinterestafterallowingforinflation.Redemptionyield Seeyieldtomaturity.

Relativerisk Typically,theriskofanactivelymanagedportfoliorelativetothatofthemarketortheinvestor’sbenchmarkorneutralinvestmentpolicy.

Riskpremium SeeChapter3.

Safehaven Aninvestor’sminimumriskstrategy.SeeChapter3.Sharperatio Ameasureofrisk-adjustedperformance.Foraninvestment

portfolioorstrategy,theSharperatioistheratioofperformanceinexcessoftherisk-freeinvestment(generallyTreasurybills)tothevolatilityofperformancerelativetotherisk-freerate.Performanceandvolatilityaregenerallycalculatedasannualisedrates.InvestorsshouldbeawarethatilliquidinvestmentstrategiesdistortmeasurementofSharperatiossincetheapparentvolatilityofthosestrategieswillbeartificiallyreducedbymarketsthatrelyonappraisalvaluationsofunderlyinginvestments.Furthermore,Sharperatiosareonlymeaningfulifthedistributionofperformanceoftheunderlyinginvestmentsapproximatelyresemblesanormaldistribution.ItfollowsthatSharperatiosshouldnotbeusedforinvestmentstrategieswhichresembleinsuranceprogrammesandwhichincorporateamarkeddegreeofoptionality.Forboththesereasons,Sharperatiosshownformanyhedgefundstrategiesaremorelikelytomisinforminvestorsthantoinformthem.SeeChapter9.

Shortposition Ariseswheninvestorssellaninvestmentthattheydonotown.Unlesstheshortpositionisestablishedonafuturesexchange,investorswillneedtoborrowtheinvestmenttodeliverittothecounterpartywhoboughtitfromthem.Theshortsellerwillneedtoprovidecollateraltothestocklenderwhenborrowingthestock(orotherinvestment).

Skewness Ameasureofthesymmetrybetweeninvestmentreturnsfromamarket.Ifthereturnsaretiltedtowardstheleft(morenegative)sideofthedistribution,adistributionissaidtoexhibitnegative

ofthedistribution,adistributionissaidtoexhibitnegativeskewness.Ifreturnsaretiltedtowardstheright(morepositive)sideofthedistribution,theresultsaresaidtoexhibitpositiveskewness.

Smallcap Asmallercompanybystockmarketcapitalisation.IntheUnitedStatesacommondefinitionisthataquotedcompanyissmallcapifitsmarketcapitalisationislessthan$2billion.SeeChapter7.

SMID Shortforsmallormidcapcompanies,agroupofcompaniesthatisreckonedtobeeithersmallormidcapbyvalueofmarketcapitalisation.IntheUnitedStatesacommondefinitionisthataquotedcompanyisSMIDifitsmarketcapitalisationislessthan$6billion.SeeChapter7.

Sovereignwealthfund(SWF) Agovernment-ownedinvestmentfund,typicallyarisingfrompersistentbalance-of-paymentssurpluses.Seebox,Whatisasovereignwealthfund?,inChapter4.

Speculativegrade Adebtissuejudgedbycredit-ratingagenciestobeatbestspeculativeornotwellsecured.Seealsohigh-yieldbond,investmentgradeandChapter8.

Standarddeviation Thestandardmeasureofthevolatilityofthepriceorperformanceofaninvestment.Commoninterpretationsofthestandarddeviationderivefromthenormaldistribution.Forexample,ifanequityportfoliohasanexpectedreturnof7%ayearandanexpectedvolatilityof15%ayear,itwouldbeexpected,approximately,tohavereturnsofbetween–8%and22%intwoyearsoutofthree.

Stockselection Theallocationofinvestmentsinaportfoliowithinaparticularmarket.Contrastwiththeallocationofinvestmentsamongdifferentmarkets,whichisknownasassetallocation.

Strategicassetallocation Decisions,typicallyintendedtobequitelongterminnature,tomanagerisksandopportunitiesrelativetoaninvestor’sultimatepaymentobligationsorobjectives.Strategicassetallocationinvolvestheallocationofinvestmentsbetweenaninvestor’ssafe-haveninvestmentandanefficientdiversityofothermarketrisks.SeeChapter4.

Structuredproduct Aninvestmentorinvestmentstrategythatistypicallysoldwithsomeelementofprincipalprotectionand/orofleveragetogiveacceleratedexposuretotheunderlyingmarket.Structuredproductsaresoldbyinvestmentbanksandtypicallyinvolveeithersomecombinationofzerocouponbonds,whichmaturewiththestructuredproduct,togetherwithcalloptionsontherelevantunderlyingmarket;oradynamicstrategythatadjustsexposuretotheunderlyinginvestmentandgovernmentbondstoensurethattheissuingbankwillbeableprofitablytohonourthepromisedcapitalrepaymentatmaturity.

Sub-investmentgrade Adebtissuejudgedbycredit-ratingagenciestobeatbestspeculativeornotwellsecured.Seealsohigh-yieldbond,investmentgradeandChapter8.

Systematicreturn Themarketreturnthatisexpectedtobeprovidedforbearingwell-diversifiedsystematicrisk.Oftenthoughtofintermsofequitymarketreturn,systematicreturnalsoreferstothereturnthatshouldbeexpectedforbearinganytypeofmarketriskforwhichmarketparticipantsarewillingtopay.Thisincludes,inadditiontoequitymarketrisk,creditmarketrisk,aswellasvarioustypesofinsuranceandotherrisktransferservices.Suchalternativesourcesofsystematicreturnarenowunderstoodtobeanimportantpotentialsourceofhedgefundreturns.

Systematicrisk Themarketriskthatremainsafterdiversification.Mostcommonlythisreferstoequitymarketrisk,butitcanalsorefertotheriskassociatedwitharangeofdifferentsourcesofsystematicreturn.

Tacticalassetallocation Decisions,typicallyshortormediumterm,toallocatemoreorlessofaninvestmentstrategytodifferentmarketsinthehopeofprofitingfromexpecteddifferentialperformancebetweenmarkets.

Tobin’sQ NamedafterJamesTobin,aNobelPrize-winningeconomistfromYaleUniversity,thisistheratioofthestockmarketvalueofafirmtoitsreplacementcost.IfQislessthan1itwouldbecheapertobuythefirm’ssharesthantoexpandtoreplicatethatfirm.SeeChapter4foritsapplicationtotheUSequitymarketandChapter11foritsapplicationtotheUSrealestatemarket.

Totalreturn Thetotalperformanceofaninvestment,combiningincomeyieldaswellaspriceperformance.

Trackingerror Seerelativerisk.Tranche Aslice,specificallyofacollateraliseddebtobligation(CDO),that

hasdifferentriskcharacteristicsfromothertranchesofthesameCDO.SeeChapter8.

Treasurybill Governmentdebtwithlessthanoneyear’soriginalmaturity(typically1–6months).

Treasurybond Governmentdebtwithmorethanoneyear’soriginalmaturity.Indesigningbroadinvestmentstrategies,itisconventionaltotreatagovernmentbondwitharemainingmaturityoflessthan12monthsasifitwereaTreasurybill.IntheUnitedStates,Treasurydebtswithbetweenoneandtenyears’originalmaturityarecalled“notes”.Inthisbook,theexpression“Treasurybond”referstoanyTreasurysecurityofmorethanoneyear’smaturity.

Unhedged Anindicationthatmarketrisk,forexamplefromthestockmarketoraforeignexchangemarket,hasnotbeenneutralisedusingderivativesorotherinstruments.

Utility Anindicationofsatisfaction,oftenproxiedbymoney.

Volatility Fluctuationsinthepriceorperformanceofaninvestment,typicallymeasuredbytheannualisedstandarddeviationofreturns.

Warrant Anoptiontoabuyasecurityataparticularpriceandsubjecttoparticulartimeconstraints.

particulartimeconstraints.

Yieldcurve SeeChapter3.Yieldtomaturity Thestandardmeasureofthereturnaninvestorwillreceivefroma

Treasurybondifthebondisheldtomaturity.Yieldtomaturity(YTM)takesaccountoftheinterestincomeandanycapitalgainorlossonthebondoverthattime.

Zerocouponbond Zerocouponbonds,alsoknownaszeros,ZCBS,orpurediscountbonds,paynointerest,onlytherepaymentofprincipalatmaturity.Theirmaturityisequaltotheirduration,andforlongmaturitiestheyrepresentthemostvolatileofhigh-qualitybonds.Priortomaturity,zerocouponbondstradeatadiscounttofacevalue.

Appendix2

Essentialmanagementinformationforinvestors

SIMPLEMANAGEMENTINFORMATIONisaprerequisitefortakingcontrolofinvestments,anditshould be easy to obtain. Investment management firms routinely provide easy-to-comprehendportfoliosummaries,althoughtheformatwilldifferfromonefirmtoanotherandsomewillbemoreuseful than others. However, investors who employmore than onemanager need to have reliableoverallsnapshotsthattheycandrilldownintotoseeindividualpositionsiftheywish.

SomeillustrativeportfoliosummariesareshowninTables1–4below.Theyneedtobeadaptedtoparticular situations, but they provide a general impression. Investors need to decide whether theinformation is best presented in an aggregated form, adding together all their investments fromdifferent accounts.Thiswilloftenbe thebestway toproceed.However, if investments areheld indifferentaccountstiedtodifferentinvestmentobjectiveswithdifferentrisktolerances,aggregatingtheholdingsmayencourageinappropriateconclusions,whichtakeinsufficientaccountoftheobjectivesof the various accounts, to be drawn. Conversely, a failure to aggregate holdings could causeconcentrated,inappropriateorinefficientriskexposurestobeoverlooked.ThisisdiscussedinChapter2andneedscarefulconsideration,preferablywiththeassistanceofaprofessionaladviser.

PerformancemeasurementandcomparingwiththeperformanceofthelowestriskstrategyAswellastransparentholdingsinformation,investorsshouldpayattentiontohowperformanceinformationispresentedtothem.Itwillnormallybeappropriatetoaggregatealltheirlisted,oratleastfrequentlyvalued,investmentstoreviewtheperformanceoftheoverallstrategy.Forunquotedinvestments,reviewofmanagementinformationontheinvestmentsneedstotaketheplaceofreviewofaccurateperformanceinformation.Wheredifferentaccountshavebeenestablishedtomeetdifferentobjectiveswithdifferentrisktolerances,performanceagainstthoseobjectivesshouldbemonitored.Evenwhenithasnotbeenanoptiontofullyhedgeaparticularobjective(becauseitistooexpensive),itisstillusefultoshowperformancerelativetothenotionalperformanceofthefullyhedgedstrategy.

A similarway of achieving the same objective is tomeasure how the purchasing power of aninvestmentportfolio evolves in termsof its ability to support continuing flowsof expenditure.Theeasywaytodothisfora(very)long-terminvestoristotaketheinflation-linkedyieldonthelongest

datedTIPS in the domesticmarket – assuming it is positive – to generate a hypothetical recurringincome from the investments. For example, for each $1,000 of investments, if the yield on TIPSmovedfrom1%to2%ayear,thesupportableincomewouldincreasefrom$10to$20ayear.Doingthe same exercisewith nominal government (ormunicipal) bond yieldswill provide an apparentlymorereassuringlevelofincome,butthisissubjecttoerosionbyinflationovertime.Howthislevelofsupportable income changes as markets move will reflect the degree of investment risk in theinvestmentstrategy.Thisisasimplemeasurethatcouldbeuseful,particularlyforcautiouslong-terminvestors.

Performance measurement is a substantial subject. One of the principal features is that theperformancethatmattersisaninvestmentfund’stotalreturn,whichcomprisespricechangesandnetinterestanddividendreceipts.Thisshouldpreferablybeafterpaymentof feesand taxes.When theperformance of a fund is being compared with a market index, it is important that a like-for-likecomparison ismade. For example, if the purpose is to evaluate the skill of amoneymanager, thecomparisonshouldbewiththetotalreturnindexthatbestrepresentsthemarketandstrategyofthatmanager.Comparinganequitymanager’sperformancewith thatofabondindex is inappropriate iftheintentionistoshedlightonmanagerskill.However,comparingtheperformanceofanequityfundwithagovernmentbondindexmaybeusefulinmonitoringtheabilityofthatfundtomeetparticularobjectivesinthefuture.

Therearetwoprincipalmeasuresoftotalreturn:

moneyweightedrateofreturn(MWR),whichisalsoknownastheinternalrateofreturn(IRR);

timeweightedrateofreturn(TWR).

The difference between them concerns the treatment of cash flows. The TWR enables a faircomparisonbetweenafundthatreceivescashflowsandtheperformanceofamarketindexthatdoesnot.Thisisbyfarthemostcommonbasisfortheformalmeasurementofinvestmentperformanceofstocksandbondsandfrequentlyvaluedfunds.However,theMWRorIRRtakesaccountofthetimingofcashflowsandistheusualwaytomeasuretheperformanceoffunds(suchasprivateequityfunds)forwhichmarketvaluationsarenotusuallyavailable,andwherethekeymeasureisacomparisonofthe amount invested, the amount returned to investors and the time taken. An IRR should not becomparedwiththetimeweightedreturnonamarketindex(thoughfrequentlyitis).

SummaryriskinformationAllinvestorsshouldtrytogetsimplifiedriskinformationontheirportfolios.Since2008someeasilyaccessedonline quantitative services have beenwithdrawn.The easiestway for investors to obtaininformative risk information is to track the volatility of themonthly performance of an investmentfund.Thiscanthenbeusedtogaugecomfortlevels.Forexample,ifafundhasbeenperformingwell,howwouldtheinvestorrespond,andwouldobjectivesbethreatened,if thepatternofvolatilitywastranslatedintoacorresponding,unsurprisingpatternofdisappointingperformance?Butthepatternofrecentmonthlyperformanceshouldnotberelieduponasasufficientmeasureofrisk-taking.

TABLE 1 Summary asset allocation

aIncludingstructuredproducts.Note:Referencestoforeigncurrencyareintendedtohighlightunhedgedforeignexposureswhichwouldbesafehavenorlowtomodestvolatilityinvestmentsintheirbasecurrency,butwhoseriskismagnifiedbyforeigncurrencyrisk.

TABLE 2 Equity investment allocation

aGlobalIndustryClassificationStandard.

TABLE 3 Alternative investment allocation

aSeeChapter9.

TABLE 4 Fixed income and cash allocation

aThatis,liquidinvestmentswhicharerealisableatfacevaluewithinashortperiodoftime.bIncludingforeignbondshedgedintolocalcurrency.cConventionsonmaturitybandsdifferbetweenmarkets.dAggregatingallholdingsofanndividualissuer.

dAggregatingallholdingsofanndividualissuer.

Appendix3Trustingandaligningwithyouradviser

CHOOSINGANADVISER is themost important investment decision that investorsmake.Goodinvestment advice is extremely valuable, so investors must be willing to pay for it. Giving goodadvicewill involve teasingoutfrominvestors theirobjectivesandtheirmotivationsaswellas theiraversiontoincurringlossesorfailingtomeetobjectives.Suchdiscussionscanbeintenselypersonal,andfortherelationshiptobesuccessful,theinvestorneedstobefrankwithanadviser.Forthis,thereneedstoberespectbetweentheinvestorandtheadviser.Asuccessfuladvisoryrelationshipisrarelyrestricted to investment advice. If self-advised investors or investors who are advised by pureinvestment advisers fail to account for the full range of financial planning issues (including, forexample,taxandgenerationalplanning),theymaynotknowiftheyaremeetingtheirobjectives,oriftheyaredoingsoefficiently.

Twofeaturesofinvestmentadviceareparticularlyimportantfortherelationshipbetweenadvisersandtheirclients.Oneconcernsthescopeforpotentialconflictsofinterests.Theother,whichislessobviousbutalsoimportant,istheinvestmentstyleoftheadviser;inotherwords,howdoestheadviserthink that investments should best bemanaged, orwhat are the adviser’s “investment beliefs” (seebelow)?Overperiodsof time,both theseaspectsof investmentadviceare important for success inmanagingwealth,and the investmentbeliefsof theadviserneed tobewell-alignedandsuitable formeetingtheobjectivesoftheinvestor.

Investmentbeliefs

Differentadvisersembracedifferentapproachestoinvestmentwhichoftenreflectdeeplyheldbeliefsabout how best to invest. For example, some adviserswill look at the roller-coaster path taken byequitymarketsinthetenyearsafter2000andconcludethatinvestorshavetotrytotimemarkets,toavoidthe“badtimes”andtopayquitehighfeestoinvestinfundswhichtrytodothis.Otherswillbemoresceptical,andsuggestthatnetoffees,thisisunlikelytoberewarding,andwillmorenaturallysticktoapre-agreedstrategy,perhapsanchoredonthesecurityofgovernmentbonds.Athirdgroupwillfromtimetotimesuggestrevisionstostrategyiftheyareconvincedthatoneorothermarketismarkedlyoverpricedorunderpriced.Thesethreeoptionsrepresentimportantdifferencesofapproach,whichwill be reflected in different levels of activity in a portfolio, and potentially quite differentinvestmentoutcomes.AsdiscussedinChapters4and5,theseareareasofdebateonwhichadvisersmayhavestrongviews,whichwouldbereflectedintheir investmentadvice.Anothermajorareaofdifferenceiswhetheranadviserexpectstoidentifyskilledmanagerswhocan,netoffees,withsomeconsistencyoutperforminparticularmarkets.Relatedtobothoftheseistheissueofwhethertoinvestinhigh-costinvestmentvehicles,suchasprivateequityorhedgefunds.

These differences of opinion are reflected in debates about how the largest and also the mostmodestinvestorsshouldinvest,andinstitutionalinvestorsoftendescribetheirviewsonthesedebatesastheir“investmentbeliefs”.Manyinstitutionalinvestorstaketimetorecordtheirbeliefs,andpublishthem,asaformofpublicaccountability.Thesearetailoredtotheirunderstandingoftheopportunitiespresentedbymarketsandtheirownparticularcircumstances,andtheyreflect(orshouldreflect)thewaytheyinvest.

Investment beliefs are implicit in how an investor invests. The same applies to the differentrecommendationsthatdifferentadvisersmaketoinvestors.Thesewillreflectdifferencesofopinion–forexample,onthecostsandbenefitsofpayinghighorlowfees,oracceptingilliquidity,andontheabilitytotimemarkets–and,moregenerally,differencesinstyleofinvesting.Animportantpartofbuilding trust in a relationship with an adviser is for investors to have an understanding of theiradviser’s investment beliefs, and to find them both credible and appropriate for their particularcircumstances.

One risk for self-advised investors is that they may not have properly thought through theirattitudestoinvestmentmarkets.Thiscanbeparticularlydangerousiftheyfailtoaccountsufficientlyforthelikelihoodof“badtimes”inhowtheydesigntheirstrategy.Furthermore,inbadtimes,havingatrustedadvisertoconsult,andtoremindthemwhythestrategyisdesignedasitis,canbeofgreatvalue. A poorly self-designed strategy that, for example, generates income in good times only byincurring risks of loss of capital and income in bad times can easily prove to be an irreversiblemistake. The recent history of tumultuousmarkets gives scope to ask advisers for references fromclientswhoshouldbeabletotestifytotheskillsshownbythoseadvisersinhelpinginvestorsthroughbadtimes.

ConflictsofinterestRegulationinanumberofcountriesispushingadvicetowardsexplicitadvisoryfeesandawayfromtransactioncommissions.This ishelpfulforencouraginganadvice-drivenrather thanasales-drivenculture in themanagement of wealth. However, both good and poor advice can come from eitherapproachtoremuneratingadvisers.

Thepotential forconflictsof interestbetweeninvestorsandtheiradvisers isoftenknownas theprincipal–agentproblem,ormore looselyas“agency issues”.Thesearisebecause theprincipal (theinvestor) has inferior access to information than the agent (the investment adviser) does. This canencourageadviserstousesuperiorinformationinawaythatservestheirowninterestratherthanthebestinterestoftheinvestor.Althoughinstitutionalinvestorstypicallyhavestructuresthatcanmitigatethis,suchconflictsarecommon.Onewayinvestorscanreducetheirexposuretotheseconflictsistodistancethemselvesfrommuchofthedetailedinvestmentdecision-making,andemploydiscretionaryinvestment managers whose remuneration is transparent and who are (depending upon thejurisdiction)underanobligation toprovidebestexecution to their clients.However, thiscaneasilyleadtoadvicewhichislesswelltailoredtothecircumstancesofaninvestor,andsomeinvestments,whichbestsuitparticularinvestors,maybeavailableonlyonanadvisorybasis.

Many private clients prefer an advisory relationship where they retain control over eachinvestmentdecision.Thedangeristhatthiscanalsoleadtotheaccumulationofaportfolioofadhocinvestments,eachofwhich“seemedagoodideaatthetime”.However,withgoodadvicethiscanbeavoided,andeffectivemanagementofoverallriskandbalanceinastrategymaintained.

The danger, though, is that investors will be sold what an adviser wishes to sell rather thandeciding tobuywhat theyneed for their investment strategy.Thebest safeguard is for investors tosatisfy themselves that their interests and thoseof their advisers are appropriately aligned, and that

conflictsofinterestareintheopen.Inpractice,reassuranceonthiswilldependmoreonthecharactersoftheindividualsconcernedthantheinstitutionalarrangementswithinwhichtheywork.

Ultimately,noadvisorybusinessmodelwillbesuccessfulif itfailstoputtheestablishmentandnurturingof trustbetweenclientsandtheiradvisersfirst.However, investorsmustalwaysbeawarethat conflicts of interest are endemic in the financial services industry. The key to unlocking theproblemoftheseconflictsistohavetransparencyoffeearrangementsandthentodecideonacase-by-case basis how to proceed. The general message is “buyer, beware”. For some categories ofinvestor (or investor account) in some jurisdictions, regulators insistondisclosureof all sourcesofinvestmentmanagementorprivatebank remuneration fromaclient account.Clients should requestinformationontheadviser’s(orthebank’s)financialinterestinaproposedtransaction.

Lastly, remember that good advice is valuable, and when the going gets tough, simplehandholdingbyanadviserwhichpreventsshort-termmistakesmaybethemostvaluableservicethattheadviserprovides.Superficiallyitwillcomeforfree–butthereisarelationshipthatprovidesfeeincomefortheadviserandaccesstoadvicefortheinvestor.Theself-advisedinvestormissesoutonthis.Knowwhatyouarepaying,andreviewbutdon’tquibbleovereachitem.Makesurethatyouarecomfortablewiththeoverallleveloffees,anddo,fromtimetotime,askyouradviserswhethertheywouldmake a recommended investment on their own account. Low fees do not ensure that goodadviceisbeingoffered,orthataninvestmentstrategyissensibleorthatrisk-takingisappropriate,butover periods of years, differences in fee levels can make a significant difference to wealthaccumulation.

Appendix4

Sourcesandrecommendedreading

Part1:Theessentials

1SettingthesceneThereareanumberofinvestmentclassicswhichprovideageneralbackgroundtothefirstpartofthischapter(andotherpartsofthebook).Manias,PanicsandCrashes(6thedition,Wiley,2011)bythelateCharlesKindlebergerandRobertZ.Aiberisalwaysworthre-reading,nevermoresothaninthelight of the 2007–09 credit crunch and the scandalswhich it helped to uncover. The discussion inChapter 1 on the Madoff scandal draws on extensive discussions with wealth managementprofessionals.

Otherclassicsthatshouldadornanyinvestor’sbookshelfinclude:Bernstein,P.L.,AgainsttheGods:TheRemarkableStoryofRisk,JohnWiley&Sons,1998Carswell,J.,TheSouthSeaBubble,3rdedition,SuttonPublishing,2001Galbraith,J.K.,TheGreatCrash,PenguinBooks,1992Mackay,C.,ExtraordinaryPopularDelusionsandtheMadnessofCrowds,WordsworthEditions,

1995Theintroductiontoriskdrawson:

Kritzman,M.P.,ThePortableFinancialAnalyst:WhatPractitionersNeedtoKnow,2ndedition,JohnWiley&Sons,2003

Kritzman,M.andRich,D.,“TheMismeasurementofRisk”,FinancialAnalystsJournal,May/June2002Thediscussionofrisktoleranceanditsrelationtoriskaversionandloss

aversion draws on a number of different sources, including conversationswithfinancialplannersandacademics.Someparticularlyusefulsourcesare:Guillemette,M.A.,Finke,M.andGilliam,J.,“RiskToleranceQuestionstoBest Determine Client Portfolio Allocation Preferences”, Journal ofFinancialPlanning,July2012Kahneman,D.,“TheMythofRiskAttitudes”,JournalofPortfolioManagement,Fall2009Roszkowski,M.J.andDavey,G.,“RiskPerceptionandRiskTolerance:ChangesAttributabletothe

2008EconomicCrisis”,JournalofFinancialServiceProfessionals,July2010

2Understandyourbehaviour

ThischapterdrawsheavilyonDanielKahneman’smagisterialThinkingFastandSlow(Farrar,StrausandGiroux,2011),whichprovidesaretrospectiveassessmentoftheprogressmadeinrecentdecades(oftenledbyKahnemanandhiscolleague,thelateAmosTversky)inunderstandingthestrengthsandweaknessesofhowwetakedecisions.

Otherusefulsourcesinclude:Barberis,N.andThaler,R.,“ASurveyofBehavioralFinance”,inConstantinides,G.M.etal.(eds),

HandbookoftheEconomicsofFinance:FinancialMarketsandAssetPricing,Elsevier/North-Holland,2003

Lo,A.,“TheAdaptiveMarketsHypothesis”,JournalofPortfolioManagement,30thanniversaryissue,2004

Statman,M.,WhatInvestorsReallyWant:KnowWhatDrivesInvestorBehaviorandMakeSmarterFinancialDecisions,McGraw-Hill,2010

Thaler,R.H.andSunstein,C.R.,Nudge:ImprovingDecisionsAboutHealth,WealthandHappiness,PenguinBooks,2009

3MarketinvestmentreturnsThe section titled “Are government bonds risk free?” draws on Carmen Reinhart and KennethRogoff’s This Time is Different: Eight Centuries of Financial Folly (Princeton University Press,2009).Someofthehistoricalexamplesofdefaulttheyciteappeartohavebeenmisclassified.IntheUK, instances of the government exercising its option to refinancemarketable debts (gilts) to takeadvantageof lowmarket interest rates in1932andalso in the19thcenturyare listedas“de jure”defaults.Theprospectusforthe1932debtconversionindicatesthatthiswasvoluntary,withanoptionto redeem at par. The prospectus can be found at:www.dmo.gov.uk/docs/gilts/public/prospectus/announcement300632.pdf. The steps that the UKgovernmenttookinthelate19thcenturytorefinancedebtweredescribedbyA.C.Millerinhis1890article“TheConversionofEnglishDebt”,whichisavailablefrom:http://qje.oxfordjournals.org.

Thetitleforthebox“AcountrycalledEurope”comesfromaseriesofbroadcastsandspeechesontheprospectsforEuropeanmonetaryunionwhichweregiveninthelate1990sbyPeterJay,thentheBBC’seconomicseditor.

Otherimportantsourcesincludethefollowing:

ThetermstructureofrealandnominalinterestratesBuraschi,A.andJiltsov,A.,“InflationRiskPremiaandtheExpectationsHypothesis”,Journalof

FinancialEconomics,Vol.75,Issue2,February2005Campbell,J.Y.,Shiller,R.J.andViceira,L.M.,“Understandinginflation-indexedbondmarkets”,

BrookingsPapersonEconomicActivity,Spring2009Ilmanen,A.,ExpectedReturns:AnInvestor’sGuidetoHarvestingMarketRewards,JohnWiley&

Sons,2011Ilmanen,A.,ExpectedReturnsonMajorAssetClasses,CFAInstitute2012Pflueger,C.E.andViceira,L.M.,“Inflation-IndexedBondsandtheExpectationsHypothesis”,

HarvardBusinessSchoolWorkingPaperH-11-095,2011

TheequityriskpremiumBrett,H.P.,Leibowitz,M.L.andSiegel,L.B.(eds),RethinkingtheEquityRiskPremium,CFA

Institute,2011“CreditSuisseGlobalInvestmentReturnsSourcebook”,2013“CreditSuisseGlobalInvestmentReturnsYearbook”,2013Dimson,E.,Marsh,P.andStaunton,M.,TriumphoftheOptimists:101YearsofGlobalInvestment

Returns,PrincetonUniversityPress,2002Dimson,E.,Marsh,P.andStaunton,M.,“IrrationalOptimism”,FinancialAnalystsJournal,

January/February2004Siegel,J.,StocksfortheLongRun,5thedition,McGraw-Hill,2014

4Howshouldandhowdoinvestorstrategiesevolve?TheprovocativearticleunderlyingthischapteristhelatePeterL.Bernstein’s2003article“ArePolicyPortfoliosObsolete?” in theEconomics andPortfolio Strategy newsletter. In recent years,whethermarketreturnspredictablyvaryfromoneperiodtoanotherhasbeenthesubjectofextensivepublishedresearch.AgoodsummaryisprovidedbyAnttiIlmanen’sExpectedReturns(2011).

Thesecondpartofthischapterlooksathowinvestorshavealteredportfoliossince2007.Thisisanareathatisfraughtwithstatisticaldifficulties,fromwhichitiseasytodrawspuriousconclusions.ThechapterdrawsontheIMF’s2011report,Long-TermInvestorsandTheirAssetAllocation:WhereAreTheyNow?aswellasthedatasourceslistedinTable4.1,theMoneyManagementInstituteandindustrysources.

5Thetimehorizonandtheshapeofstrategy:keepitsimpleThechapteropenswith thesuggestion,whicharisesfromJamesTobin’s“separation theorem”, thatinvestment strategy for any investor can be reduced to an appropriate balance between just twoinvestments:anallocationtorisk-freeassetsandanallocationto themarketportfolioofriskassets.(Themarketportfolioisoften,asinthefirstpartofthisbook,proxiedbytheglobalequitymarket.)Tobinsetouthistheoremina1958article,“Liquiditypreferenceasbehaviourtowardsrisk”,intheReviewofEconomicStudieswhichexplainedhowinvestors,withdifferentattitudestorisk,choosetoallocate monetary assets between cash and volatile assets. The separation theorem, which is alsoknownasthe“twofundmoneyseparationtheorem”orthe“mutualfundseparationtheorem”,reliesonstrongassumptions.Thusiftheglobalmarketforriskyinvestmentsisfullyrepresentedbylistedequities(whichitisnot)andifthepricesofriskyinvestmentsaredeterminedefficiently(whichtheyarenot)andifexpectedreturnsinexcessoftherisk-freerateareconstant(whichtheyarenot),thenusinganinvestor’sdegreeofriskaversiontoselectappropriateproportionsofrisk-freeandriskassetswillprovideasuitablestrategyforanyinvestor.

In practice, to address the shortcomings of the highly simplified approach requires high-feeactivelymanagedinvestmentstrategies,whereasTobin’stwo-investmentapproachcanbeproxiedbylow-costglobalequitiesandcash(orgovernmentbonds).Thecostsofthemorecomplicatedversions,which seek to address the criticisms of Tobin’s simplified model, place them at a significantdisadvantage to the simplicity of the low-cost two-portfolio approach. The simplified allocationbetween diversified equities and cash or government bonds remains a useful reference strategy forinvestors, and, ineffect, reflectspractice formany financialadvisers.Thediscussion in thechapter(and here) reflects discussions with Stephen Satchell and Mark Ralphs of the Financial PlanningCorporation.

JohnCampbellandTuomoVuolteenaho’s“BadBeta,GoodBeta”(AmericanEconomicReview,Vol.94,No.5,December2004)isoneofthoseoccasionalarticlesthatdevelopsasimpleinvestmentideathatthenhaspowerfulpolicy(aswellasinvestoreducation)implications.Itistheinspirationfor

thischapter’sdiscussionofgoodandbadpricedeclinesaswellasChapter7’sdiscussionofapparentstockmarket anomalies. In a similar vein is Zvi Bodie’s “Thoughts for the Future: Life-CycleInvesting in Theory and Practice” (Financial Analysts Journal, January/February 2003),where thedifferent strands of traditional and behavioural finance are synthesised into designing suitablestrategiesforlossaverseinvestors.

Otherimportantsourcesforthischapterinclude:Campbell,J.Y.andViceira,L.M.,StrategicAssetAllocation:PortfolioChoiceforLong-Term

Investors,OxfordUniversityPress,2002Swensen,D.,PioneeringPortfolioManagement:AnUnconventionalApproachtoInstitutional

Investment,2ndedition,FreePress,2009Theanalysisofbondladders inmanagingretirement incomeformsacorepartof thisbookand

buildsondiscussionsaboutbond laddersand theUSmunicipalbondmarketwith JeffreyBryanofMerrill Lynch’s Private Banking and Investment Group and Norman Deitrich of High TowerAdvisors. Hildy Richelson and Stan Richelson’sBonds: The Unbeaten Path to Secure InvestmentGrowth(2ndedition,BloombergPress,2007)givesaguidetothepracticalaspectsofmanagingandestablishingbondladders.

Thetitleofthebox“Modelsbehavingbadly”istakenfromEmanuelDerman’s2011bookofthesametitle.

Part2Implementingmorecomplicatedstrategies

6SettingthesceneThe discussion of the costs of liquidity draws heavily on the work of AndrewAng, for example,“IlliquidAssets”(CFAInstituteConferenceProceedingsQuarterly,Vol.28,No.4,2011).Duringthecreditcrisis, itwas immediatelyevident that illiquiditywas imposingheavycostson investors;see,for example, Laurence B. Siegel’s article “Alternatives and Liquidity: Will Spending and CapitalCallsEatYour‘Modern’Portfolio?”(JournalofPortfolioManagement,Fall2008).Thereisnothingnewaboutthedangersofilliquidity,whichwereamplyhighlightedin,forexample,DanBorge’sTheBookofRisk,publishedin2001(JohnWiley&Sons).

Themajorchanges in thecostsof liquidity frombefore2007 to theperiodof thecrisisand themaintenance of historically high transaction costs after 2008 have been highlighted by investmentmanagers – see, for example, Blackrock Investment Institute’s 2012 report Got liquidity? andcommentsinChapter5onchangesininvestmentpatternsintheUSmunicipalbondmarket.

AnalysisofarbitrageopportunitiesinthischapterreliesheavilyonNicholasBarberisandRichardThaler’ssurveyofbehaviouralfinance(seeChapter2sourcesabove).

Thediscussionoftaxationmakesuseof:Evensky,H.andKatz,D.(eds),TheInvestmentThinkTank:Theory,Strategy,andPracticefor

Advisers,BloombergPress,2004Poterba,J.M.andSamwick,A.A.,“TaxationandHouseholdPortfolioComposition:USEvidence

fromthe1980sand1990s”,JournalofPublicEconomics,Vol.87,No.1,January2003

7Equities

The treatment of the capital asset pricingmodel (CAPM) and the stockmarket anomalies drawsonEugene Fama and Kenneth R. French’s article “The Capital Asset Pricing Model: Theory andEvidence”(JournalofEconomicPerspectives,2004),helpfulsuggestionsfromStephenSatchell,andJohnCampbellandTuomoVuolteenaho’sarticle“BadBeta,GoodBeta”(seeChapter5sources).

ThediscussionofequityinvestingdrawsonpaperspresentedanddebatedatseminarssponsoredbyNorway’sMinistryofFinanceandNorgesBankInvestmentManagement,inparticularpapersbyCampbell Harvey (2011), Andrew Ang (2011), Elroy Dimson (2011 and 2013), and JacquelynHumphreyandDavidTan(2013).

The discussion of whether to hedge international equity investments for investors whose basecurrencies might have “safe-haven” status during times of crisis draws on John Campbell, KarineSerfaty-de Medeiros and Luis Viceira’s article “Global Currency Hedging” (Journal of Finance,February2010).

8CreditKayGiesecke,FrancisA.Longstaff,StephenSchaeferandIlyaStrebulaev’sarticle“CorporateBondDefaultRisk:A150-yearPerspective”(JournalofFinancialEconomics,2011)providesthehistoricalcontextforthediscussionofcorporatecreditriskandrewardinthischapter.Bycontrast,Kwok-YuenNgandBrucePhelps,“CapturingtheCreditSpreadPremium”(FinancialAnalystsJournal,May/June2011),andAntiiIlmanen(ExpectedReturns,2011,especiallyChapter10,Thecreditriskpremium)explainwhymanyinvestorsdonotmanagetoturntheyieldpremiumovergovernmentbondsonofferwhentheybuyinvestmentgradecorporatebondsintocorrespondingsuperiorperformance.

ThediscussionofdebtmarketsandinstrumentsdrawsonmarketcontactsandonFrankFabozziandStevenMann(eds),TheHandbookofFixedIncomeSecurities(8thedition,McGraw-Hill,2011).

9HedgefundsThischapterdrawsonmarketcontactsaswellasindustryreviewsandacademicanalyses.Anumberofarticlesoverthepastdecadehavehighlightedweaknessesinthereportingofhedgefundriskandreturn,andtheseseemasrelevantin2014aswhenthearticleswerefirstwritten.

Usefulsourcesinclude:Asness,C.,“AnAlternativeFuture”,JournalofPortfolioManagement,30thAnniversaryIssue,2004Asness,C.,“AnAlternativeFutureII”,JournalofPortfolioManagement,Vol.31,No.1,Fall2004Getmansky,M.,Lo,A.W.andMakarov,I.,“AnEconometricModelofSerialCorrelationand

IlliquidityinHedgeFundReturns”,JournalofFinancialEconomics,Vol.74,No.3,2004Goltz,F.andSchroeder,D.,“Hedgefundreportingsurvey”,EDHECRiskandAssetManagement

ResearchCentre,November2008Gregoriou,G.andLhabitant,F-S.,“Madoff:ARiotofRedFlags”,EDHECRiskandAsset

ManagementResearchCentre,January2009Hasanhodzica,J.andLo,A.W.,“Canhedgefundreturnsbereplicated?:Thelinearcase”,Journalof

InvestmentManagement,Vol.5,No.2,2007Kat,H.andPalaro,H.,“HedgeFundReturns:YouCanMakeThemYourself!”,JournalofWealth

Management,No.8,2005Prequin,GlobalHedgeFundReport2013,providedaninvaluableresourceonindustrytrends

10Privateequity:information-basedinvestmentreturns

Anumberofarticlesinrecentyearshavesoughttoassessthecostsofilliquidity,leverage,feesandagency issues that need to be addressed beforemaking investments in private equity funds. TheseincludeAndrewAngandMortenSorensen,“Risks,Returns,andOptimalHoldingsofPrivateEquity”(QuarterlyJournalofFinance,Vol.2,No.3,2012)andLudovicPhalippouandOliverGottschalg,“ThePerformanceofPrivateEquityFunds”(ReviewofFinancialStudies,No.22,2009).Phalippou’s2011 report for the Norwegian Government Pension Fund (Global) provides an update to earlierevidenceofpersistenceofoutperformancebysomeprivateequitymanagers.

StevenKaplanandPerStromberg’sarticle“LeveragedBuyoutsandPrivateEquity”(JournalofEconomicPerspectives,AmericanEconomicAssociation,Vol. 23,No. 1,Winter 2009) provides areview of how private equity firms seek to improve the performance of their investee companies.IssuesinmeasuringriskofprivateequityfundsarediscussedinSusanWoodward,“MeasuringRiskforVentureCapital andBuyoutPortfolios”,JournalofPerformanceMeasurement,Vol.17,No.1,2012.

11RealestateThis chapter draws onmarket contacts and published resources including the Journal of PortfolioManagement’sspecialrealestateissuesof2011and2007.ParticularlyrelevantisanarticlebyShaunBond,SoosungHwang,PaulMitchellandStephenSatchell,“WillPrivateEquityandHedgeFundsReplaceRealEstateinMixedAssetPortfolios?”(JournalofPortfolioManagement,specialrealestateissue, 2007) and Jim Clayton and others, “The Changing Face of Real Estate InvestmentManagement” (Journal of Portfolio Management, special real estate issue, 2011). Ralph Block’sInvesting in REITs: Real Estate Investment Trusts (4th edition, Bloomberg Press, 2011) is aninvaluablesourceoninvestinginREITs.

12ArtandcollectiblesThis chapter draws on discussions with a range of market and academic contacts. Recommendedpublishedsourcesinclude:Baumol,W.J.,“Unnaturalvalueorartasafloatingcrapgame”,AmericanEconomicReview,Vol.76,1986Dimson,E.andSpaenjers,C.,“ExPost:TheInvestmentPerformanceofCollectibleStamps”,Journal

ofFinancialEconomics,Vol.100,No.2,2011Dimson,E.andSpaenjers,C.,“Theinvestmentperformanceofemotionalassets”,inDempster,A.

(ed.),RiskandUncertaintyintheArtWorld,BloomsburyPress,2014Findlay,M.,TheValueofArt,Prestel,2012Goetzman,W.,Renneboog,L.andSpaenjers,C.,“ArtandMoney”,AmericanEconomicReview,Vol.

101,No.3,2011,pp.222–6Grampp,W.D.,PricingthePriceless:Art,Artists,andEconomics,BasicBooks,1989Plattner,S.,“AMostIngeniousParadox:TheMarketforContemporaryFineArt”,American

Anthropologist,Vol.100,No.2,1998Pownall,R.,Satchell,S.andSrivastava,N.,“TheEstimationofPsychicReturnsfromCultural

Assets”,mimeo,2013Reitlinger,G.,TheEconomicsofTaste:TheRiseandFallofPicturePrices,1760–1960,Barrieand

Rockliff,1961

Renneboog,L.andSpaenjers,C.,“BuyingBeauty:OnPricesandReturnsintheArtMarket”,ManagementScience,October2012

Satchell,S.(ed.),CollectibleInvestmentsfortheHighNetWorthInvestor,Elsevier,2009Thompson,D.,The$12MillionStuffedShark:TheCuriousEconomicsofContemporaryArt,Aurum

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OtherusefulsourcesAcharya,S.andDimson,E.,EndowmentAssetManagement,OxfordUniversityPress,2007Ang,A.,AssetManagement:ASystematicApproachtoFactorInvesting,OxfordUniversityPress,

forthcomingArnott,R.D.,Berkin,A.L.andYe,J.,“LossHarvesting:WhatisitWorthtoaTaxableInvestor?”,JournalofWealthManagement,Spring2001

Asness,C.,Krail,R.andLiew,J.,“DoHedgeFundsHedge?”,JournalofPortfolioManagement,Fall2001.

Athayde,G.andFlores,R.,“ACAPMwithHigherMoments:TheoryandEconometrics”,EnsaiosEconomicos,No.317,RiodeJaneiro,1997

Athayde,G.andFlores,R.,“Incorporatingskewnessandkurtosisinportfoliooptimisation:amulti-dimensionalefficientset”,inSatchell,S.andScowcroft,A.(eds),AdvancesinPortfolioConstructionandImplementation,Butterworth-Heinemann,2003

Athayde,G.andFlores,R.,“DoHigherMomentsReallyMatterinPortfolioOptimisation?”,FundaçãoGetúlioVargas,No.574,2004

Baltussen,G.,“BehavioralFinance:anintroduction”,2009,availableat:SSRN,http://ssrn.com/abstract=1488110orhttp://dx.doi.org/10.2139/ssrn.1488110

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Benartzi,S.,“Excessiveextrapolationandtheallocationof401(k)accountstocompanystock”,JournalofFinance,October2001

Benartzi,S.andThaler,R.,“Naivediversificationstrategiesindefinedcontributionsavingsplans”,AmericanEconomicReview,March2001

Bilo,S.,Christophers,H.,Degosciu,M.andZimmermann,H.,“Risk,returns,andbiasesoflistedprivateequityportfolios”,WWZWorkingPaperNo.1/05,2005

Black,F.,“Noise”,JournalofFinance,July1986Bloomfield,R.,“TraditionalvsBehavioralFinance”,CornellUniversity,JohnsonSchoolResearch

PaperSeries#22,2010Bodie,Z.,Kane,A.andMarcus,A.J.,Investments,6thinternationaledition,McGraw-Hill,2005Bodie,Z.,Merton,R.andSamuelson,W.,“LaborSupplyFlexibilityandPortfolioChoiceinaLife

CycleModel”,NBERWorkingPaper3954,1992Bodie,Z.andTaqqu,R.,RiskLessandProsper:YourGuidetoSaferInvesting,JohnWiley&Sons,

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Boyle,P.S.,Loewy,D.,Riess,J.A.andWeiss,R.A.,“TheEnviableDilemma:Hold,Sell,orHedge

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Hill,2013Brown,J.R.,Mitchell,O.S.,Poterba,J.M.andWarshawsky,M.J.,TheRoleofAnnuityMarketsin

FinancingRetirement,MITPress,2001Brunel,J.L.P.,IntegratedWealthManagement:TheNewDirectionforPortfolioManagers,

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Index

Pagenumbersinitalicrefertofiguresandtables.

3iGroup236–8,237$12millionStuffedShark,The(Thompson,2008)277401(k)pensionplans135–6

A“absolutereturn”investors92–3activemanagement20,143,167,259–60advisers8,20,82,122,233,248

cautiousxxvi,81changing133–4fees313,313–14investmentstyle311relationshipswith10,13–14,202–3,311–14risktoleranceof9,11,12,66andtaxation133–4,134

“agencyissues”122,313aggressiveinvestors83,92,98,110,152

short-term91,111,123Aguirreamalloa,Javier58Allen,Franklin58alpha34,35“alternativebetas”198,208,227,228AlternativeInvestmentFundManagers’Directive2011197alternativeinvestments75,76,77,78,79anchoring22,67,82–3,84,312Ang,Andrewxxv,122annuities99–100ApexPhilatelicAuctions247appraisalvaluations

artmarket247,278privateequity222–3,244,246–7property251,252,258,281

appraisal-basedindices253–4,254arbitrage40,125

barriersto126–31strategies198,201,214–17,215,227

arbitragehedgefunds205,206,207,225Arnott,Rob57artxxvii,268,269,284–8

aestheticandmonetaryvalue272–3attribution271,280BritishRailPensionFund285–7,286contemporaryart276,279,280,285equitiescomparedwith270,271,272holdingperiods270,271,287performance272–3,277,285–7,286prices247,269,270–1,272,273–80,288psychicreturnsfrom268,270risk286–7transactioncosts270,271,285,287–8valuationofpaintings275–7seealsoauctionhouses;collectibles;investmentsofpassion

artcollections277artdealers278,279,280,285artfunds284–5artmarket252,270–1,273–4,278–80,284,288

China’srolein274–5,275,278ArtMarketResearch280Artprice288ArtsEconomics275,278Asia16,17,162Asiancurrencycrisis(1997)183Asness,Clifford223assetallocation,patterns73,76–7,77–8assetallocationmodels82,85,122“endowmentmodel”78,79,79–80

long-term64–5,95–7,96–7short-term95,112,113

asymmetryofinformation122,244,287,313auctionhouses247,269,277,278,279,280

commissionrates270,285,287–8sales274–5,275

auctionmarkets269,280–1Australia43,155,160,161,249Australiandollar159

B

BAB(“BuildAmericaBond”)103“badbeta”139,151baddecisions23badluck21badoutcomes3,4,23,108,110–14“badtimes”xxvi,5,66,78,80,161,169,311–12

diversificationand80,110,115,169,170failingtoaccountfor312performanceinxxv,3,110,116,117rebalancingin122

BankofEnglandxxvi,71–2,73,80bankfailures84BankofJapan71bankloans169–70,172bankruptcy105,151banks16,25,84,172,183,285Banz,Rolf140BarclayHedge195,197,206BarclaysAggregatebondindex188,188basecurrency16–17,35,159–61,182,189,193Baumol,William273,286,288bearmarkets70,85–6,199,255behaviouralbiases14–15behaviouralfinance4–5,10,18–20,31,60,98,243

andinvestmentstrategy28–9parameteruncertainty30–1andtraditionalfinance19,31–2seealsolossaversion;losstolerance;riskaversion;risktolerance

behaviouralportfoliotheory27–8beliefperseverance22benchmarkallocations13,82benchmarks25,49,90,91,92,143Bernanke,BenS.xxvii,268BernardL.MadoffInvestmentSecuritiesLLCxxv–xxvi,5–8,7,9–10,115,151,196,197,201,220Bernstein,Peter64,72,73,82,172beta34,137,138,139

“bad”139,151emergingmarkets164,165,166

betrayalaversion10biases14–15,18

inappraisalvaluations247,278confirmationbias20–1hindsightbias21homebias80,152–3ininflationmeasures47,49ofintuition20,20–4investorbiases20–4systematic236,238

Blackstone240Bodie,Zvi131Bohnet,Iris10bondfunds169,179bondladders83,91,93,99–101,105–6,106–7bondmanagers169,178bondmarkets85–6,266bondportfolios169Bond,Shaun254–5bonds

comparedwithequities85–8,86–7,170–1creditworthiness35–6,93,101,102–3,103,105,179defaultsseedefaultsdurations91,92,178income25,33,75,171,305andinflation42,170–1insuranceforshort-terminvestors85–8,86–7returns95,170–1,258,258,271,272yields56,75,87,179–80seealsocorporatebonds;governmentbonds;municipalbonds

boomsandbusts70–1,97branding,inartmarket277Brazil43,162,249“break-even”inflationrate43–7,44–5,99Brealey,Richard58BritishRailPensionFund285–7,286Brookfield240bubbles70–1,97,128“BuildAmericaBond”(BAB)103Buiter,Willem81businessangels240bustsseeboomsandbustsbuy-and-holdapproach71,72,107,179buy-outfunds238,240,245buy-outs217,235,236,239

CCampbell,Johnxxvi,48,71,139,159Canada43,155,160,161,241,249Canadiandollar159CAPE(cyclicallyadjustedprice/earningsratio)seeShillerPEcapitaladequacyguidelines172capitalassetpricingmodelseeCAPMcapitalgains134capitalgainstax,taxation132

capitalpreservation91CAPM(capitalassetpricingmodel)137–9,151CarnegieInstitution89carsseeclassiccarsCase-Shillerseries251–2,279cashxxvi,83,84,98,111,269

currenciesfor17equities’outperformanceof55,56,114,114returns271,272assafehaven65,83,84,86,92–3seealsoTreasurybills

cashflowcosts193cautiousadvicexxvi,9,81cautiousinvestmentstrategies78,92,97–8,115cautiousinvestorsxxvi,12,33,72,148–50,151–2

andbonds83,91,92,98,108long-term33,49,83,91,92,108,139short-term3,91,98,108,110

CenterforRealEstateseeCREcentralbanks27–8,71–2,72,73,80,194changingstrategy4,108–9Chen,Peng58Chile155,162China50,52,156,162,282

artmarket274–5,275,278,284greaterChina155,156,157

Christie’s277classiccarsxxvii,268,273,280–1,282–4,283closed-endfunds102CMO(collateralisedmortgageobligation)186coefficientoflossaversion25collectibles268,271,284–8,286

comparedwithequities271,272monetaryeasingand268,269priceindices270–1,280–4prices269,270–1,274psychicreturnsfrom268,270transactioncosts269,270,271,287–8seealsoart;classiccars;stamps;violins;wine

commercialproperties262commingledfunds,realestate248,250,260commissionrates

advisers313auctionhouses270,287–8

commodityindices218–19,219commoditytradingadvisersseeCTAsconcentratedstockpositions134,135–6

concentration,toaccumulatewealth15,243confirmationbias20–1conflictsofinterest311,313–14conservatism21–2consumerpricesindex(CPI)47contagion,riskof180–1contemporaryart276,279,280,285convertiblearbitrage22,198,216convertiblebonds216corporatebondmarkets116,117corporatebonds34,69–70,70,87,115,173–9,174–8

bondladders100–1defaults93,116,173–5,173–4,176,177–8,179

corporatedebtfunds213corporatesocialresponsibility145Corre,Luis58correlationsbetweeninvestments28–9,31,80,152,157,158,167–8,167CPI(consumerpricesindex)47CRE(MITCenterforRealEstate)252creditcrunch(2007–09)xxv,33,67,84,157,169,201,214

hedgefundsand248andliquidity122–3,248andMadofffraud8securitisationand183–4seealsofinancialcrisis

creditdefaultswaps36creditderivatives170creditmarkets70creditquality171–9,172–8,184,186

downgrades93,100,101,127creditriskxxvi–xxvii,34,37,100–1,106,172,175

diversificationand101,179–83emerging-marketdebt182governmentbonds35–7

CreditSuisseindices196,201,218,219,224,225credit-ratingagencies35–6,171–4,172–4,179

seealsoFitch;Moody’s;Standard&Poor’screditworthiness93,171,173

governmentbonds35–6,93municipalbonds101,102–3,103,105tenants260,263–4seealsocredit-ratingagencies

CTAs(commoditytradingadvisers)79,196–7,198,206,206,210,218–19,219,222currency28,37,266

volatility193–4,194,267currencyrisk152,159–61,182,183,189,193–4,194

hedging153,155,159–61,160–1,189–94,266–7

internationalrealestate266–7cyclicallyadjustedprice/earningsratio(CAPE)seeShillerPE

DDamodaran,Aswath125debt,denomination180,182–3debtcrises,government33decision-making18,31“deep”valuemanagers148defaults93,171

bonds171,176,177corporatebonds93,116,173–5,173–4,176,177–8,179governments35–7,37municipalbonds105

deflation46,170–1depositguaranteeschemes84deposits84,269Detroit,Cityof105devaluation37developedmarkets162,163–4,164,167diBartolomeo,Dan151Dimson,Elroy57–8,112,140–1,162,271,272,281

historicalreturnsresearch48,49,50–2,51–5,53directpropertyinvestment248,249,250,255,263,264–5,265,267disappointments4,4–5,21,32,59–60,152discretionaryinvestmentmanagers313distresseddebthedgefunds206,206,207,213–14,214,221,222diversification9,14,15,19,31,87–8,95

in“badtimes”80,110,115,169,170bonds86–7,87,101,105–6creditas171ofcreditrisk101,179–83emergingmarkets166,168“endowmentmodel”78equitiesxxvi,171,234–5governmentbonds42,80,169,170,171hedgefunds199,208,209,227–8internationalinvestments152–3,155–6,166,168,183,266–7lackofxxvi,136privateequity234,243realestate249,251–8,262,266–7andsystematicrisk79–80tomaintainwealth15,243

diversifiedgrowthfunds78dividends151–2,262

DoddFrankAct2010197downgrades,creditquality100,101,127duediligence8,9,106,197,220,225–6

Eearly-stageventurecapital235,238easymoney125economicgrowth162,169,262EconomicsofTaste,The(Reitlinger,1961)271,273economy,andartprices273–4“efficientfrontier”analysis19efficientportfolios111emergingmarkets36,43,135,162–8,163–5,167emerging-marketdebt180–1,180–1,183emerging-marketequities139,157,158,212,227emerging-markethedgefunds206,206,207,210,212,213,222,227EmployeeRetirementIncomeSecurityAct1974(ERISA)129“endowmentmodel”78,79,79–80endowments82,88,89,90,93,94,109

assetallocations77,77,78entrepreneurs14,15–16,243equities

1990sboom71advantagesoverart270,271,272bearmarkets70,85–6,199,255comparedwithbonds59,85–8,86–7,170–1comparedwithgovernmentbonds50–5,51–4,59,60–3,61–2,86–8,86–7comparedwithhedgefunds199–201,200correlationsbetween157,158,167–8,167diversificationxxvi,171,234–5emerging-market139,157,158,212,227fees59holdingperiods97–8,270homebias80,152–3long-terminvestorsand59,97–8,171performance60,61,97–8,255,255,283

futureprospects55–9historic49–55,51–6,63

returns11,33,57–9,89,97,170–1,271,272asriskassets83transactioncosts124–5volatility71,149,151,236–8,237,239,240,255–6,256seealsointernationalequities;largecap;privateequity;smallcap;valuestocks

equityhedgefunds79,206,206,207,209–11,210,226–7equityindexfutures238

equitylong/shortfunds79,209–11,210,222equitymarket135,162,171,248

andbondmarket85–6andrealestatemarket248,266

equitymarketcrises159,170,210hedgefundperformance211,212,213–14,213,214,215,217

equitymarketneutralfunds211equityREITs250,256equityrisk34,59–63,61–2,71equityriskpremium34,49–59,54–5,57,59,204ERISA(EmployeeRetirementIncomeSecurityAct1974)129ETFs(exchangetradedfunds)35,56,79,102,106ethicalinvesting143–5,144euro17,159,183eurozone37,38–40,39,42,71,155,160,254Europe,sovereignrisk37EuropeanCentralBank71Europeanmonetaryunion37event-drivenhedgefunds206,206,207,222excesskurtosis116,117,168,181–2,181exchangerates73,189–90exchangetradedfundsseeETFs“execution”costs124expansioncapital235expectations4,13,25ExpectedReturns:anInvestor’sGuidetoHarvestingMarketRewards(Ilmanen,2011)3,178–9externalities145ExtraordinaryPopularDelusionsandtheMadnessofCrowds(Mackay,1995)204extremeevents224–5,225

FFairfieldSentry7,7fashions138,146–7,151,167–8FederalReservexxvi,xxvii,71,71–2,73,80fees59,80,305

advisers311–12,313,313–14ethicalfunds143fundsoffunds197,204,243fundsofhedgefunds197,204,217hedgefunds203–4,205,207,212,217,220–1,226,311inilliquidmarkets121,122managers’137,151,203–4privateequity238,244,245–6

Fernandez,Pablo58FidelityInvestmentsAssetAllocationPlanner29

fiduciaries129–30,131Finametrica11–12financialcrisis(2007–09)xxvii,19,77,81,124,195,224,268

andattitudestorisk13seealsocreditcrunch

“financialinnovationspiral”131financialplanning91,311Findlay,Michael284Fitch172,173,173–5,173–4,177fixedassetallocationmodelsxxviifixed-incomearbitrage198,201,214–15fixed-incomehedgefunds205,206,206,207,213–14,214Ford127foreigncurrency36–7,137,266–7

hedging153,155,159–61,160–1,189–94,190–1,266–7seealsocurrencyrisk

foreignexchangeforecasting194reserves27–8,75volatility193–4,194seealsocurrencyrisk

France36,43,241,249,270,273fraud5–6,8

seealsoMadofffraudfrontiermarkets167–8,167FTSEAll-Shareindex140–1,240FTSE4Goodindices144fundmanagersseemanagersfundamentalrisk126–7funds35,123,127fundsoffunds

fees197,204,243privateequity239,243

fundsofhedgefunds80,196–7,196,204,206,217,225–6fees197,204,217managers206,225–6,233

“fuzzyfrontier”30–1

Ggains25,26,134gambling19,26Ganz,VictorandSally,artcollection277,286GeneralMotorsseeGMgeneralobligationbonds102Germany43,54,58

governmentbondperformance69,70,190–1,190–1Giesecke,Kay174–5,176GinnieMaeseeGovernment

NationalMortgageAssociationGinsburgh,Victor275–6globalGNP167globalinvestableassets73,74globalmarket135,153,167GM(GeneralMotors)126–7,224GNP,global167Goetzmann,William273–4“goodbeta”139goodtimes5,16governance94,145governmentbonds32,35,48–9,55

anchoringwith82–3,312benchmarkingrole49,90,92bondladders99–101,106comparedwithequities50–5,51–4,60–3,61–2,86–8,86–7comparedwithmortgage-backedsecurities186–8,187,188asdiversifiers42,80,169,170,171incomefrom25,33,38–40,38–9,152andinflation34,38,43,47,98inflation-linkedseeinflation-linkedgovernmentbondsinterestrates33,34,47,81liquidity42,46,49,103forlong-terminvestors42–3,49,152performance40–7,50,62,63,98,180–1,180purchasedbycentralbanks71–2,73,80rebalancingand66–7,72return33,41,48risk35–7safehavensxxvi,47,48–9,64,65,80,83,92,94,98,189,263securityxxvi,33,72–3,80volatility25,42,48,85–6yield40–3,41–2,56,71,72,72,73,152,178,260,263seealsobonds;Treasurybonds

governmentdebt,acquiredbycentralbanks71–2,73,80governmentdebtcrises33governmentdefaults35–7,37governmentdepositinsurance84GovernmentNationalMortgageAssociation(GinnieMae)184Grampp,William272–3greaterChina155,156,157“greaterfool”theory128Greece43,162GreenStreetAdvisors264,265–6,265Greenspan,Alan70–1

Gregoriou,Greg9,220,228GroveDictionaryofArt,The(1996)276growthmanagers146,148growthstocks148,149–50

HHAGI(HistoricAutomobileGroupInternational)index282–4,283HarvardUniversity78,79,89Harvey,Campbell166–7Hasanhodzic,Jasmina208hedgefundindices207,209hedgefundmanagers206,213,216,221,274

questionstoask228–33remuneration197–8,202–3,203–4skill198,204–5,208,211,226–7

hedgefundreplicators79,208hedgefunds78,79,115,126,127,195–8,236

allocationsto110,226–8arbitragehedgefunds205,206,206,207,222,225arbitragestrategies130,198,214–17,215assets195,196,197,205–6,206,207,208basecurrency193comparedwithequities199–201,200andcreditcrunch201distresseddebt206,206,207,213–14,214,222anddiversification199,208,209,227–8duediligence8,9,197,220,225–6emerging-market79,206,206,207,210,212,213,222,227equityhedgefunds79,206,206,207,209–11,210,226–7equitylong/shortfunds79,209–11,210,222event-driven206,206,207,222fees203–4,205,207,212,217,220–1,226,312fixed-income205,206,206,207,213–14,214fundsofseefundsofhedgefundsgrowthof207illiquidity198,213,216,221,222,254institutionalinvestorsand227leverage214liquidity198–9,208,213,232–3long-onlyequity211–12macrohedgefunds198,206,209,210,222andMadofffraud196,197managersseehedgefundmanagersandmarketanomalies126–7,128multi-strategy206,206,207,216,217,217,225

performance199–202,200,207–8,210–12,213–14,213–15,217,218,224–5,225realestateactivities260,263regulation197,229riskxxvi,198,199,207–8,213,220–6,225,231–2shortbias210,211,222intimesofcrisis130–1types205–14,206,209–14,210volatility198,199–200,200seealsoCTAs;LTCM

“hedgedmutualfunds”79hedging80,95,96,110,126–7,267

currency153,155,159,189–94,190–1,266–7internationalequities159–61,160–1,193

herdbehaviour84,127–30heuristics22–3highbeta137,164,165highreturn,lowrisk7,8,115high-levelbenchmarksseepolicyportfolioshigh-yieldbondmutualfunds213–14high-yieldbonds179–81,180–1,182high-yieldsecurities172,173,179hindsight21,22,71HistoricAutomobileGroupInternationalseeHAGIhistoricmarketperformance50–5,51,52,53,54HoareGovettsmallercompaniesindexseeNumisSmallerCompaniesIndexholdingperiods97–8,134,270,271,287holdingsize,andliquidity123–4holdings,aggregating304Holton,Glynn5homebias80,152–3HongKong156,249,275Humphrey,Jacquelyn143Hwang,Soosung254–5hybridfunds78

IIbbotson,Roger50idiosyncraticrisk137,138illiquidinvestmentsxxv,67,121,122,123,124,254–5illiquidmarkets121–3,123,123–4,129,130,278,287illiquidity49,79,121,122,125,245,312

in“badtimes”78collectiblesmarkets271andcurrencyhedging192,193emergingmarkets166

fashionableinvestments167hedgefunds198,213,216,221,222,254inliquidmarkets123–5municipalbonds102,105privateequity234,236,244,246realestate79,263,264,267

Ilmanen,Antiixxv,3,178–9implementationcosts130–1incomexxvii,25,96,108,312

frombonds25,33,38–40,38–9,75,99–101,106,152,171,305fromequities152future3,92,99,110fromgovernmentbonds25,33,38–40,38–9,152fromrealestate250,251,258–9,260,260–3rentalincome250,260,260–3retirementincome91,99–101,107

incomeinequality273–4incometax102,103,132indexfuturescontracts211indextrackingfunds56,179India43,135,155,156,157inequality,artmarketand273–4inflation36,42–3,75,94,95,98

annuitiesand100biasesinmeasures47,49bondladdersand99–101bondsand42,170–1“break-even”rate43–7,44–5,99andgovernmentbonds34,38,43,47,98andrealestate251,259,261,262andrents261,262

inflationrisk37,42,46,49,93,98–9,100inflation-linkedgovernmentbonds33,34,42,43–7,44–5,48,49,95,98,99

comparedwithbondladders100forhedging61forpensionplans40,107–8seealsoTIPS

informationasymmetryof122,244,287,313managementinformation143,304–10privateequity234–5,239,243

institutionalinvestorsxxvi,75,89,94,103,108,143,313andalternatives79–80andcredit-ratingagencies172andhedgefunds227herdbehaviour129–30“investmentbeliefs”23,312

andMadofffraud8,9andmortgage-backedsecurities186realestate252,256,260,263sustainableinvestment145timehorizons88–9,89–90seealso“endowmentmodel”;endowments;sovereignwealthfunds

institutionalwealth79,131,132insurance19,26,35insurancecompanies40,42,47,73,75,88,89–90,102insurancerisk34interestrates92,93–4,94,95,137,184,248

governmentbonds33,34,47,81andincome9,38,91,100andshort-terminvesting84–5,85UK49ultra-lowxxvi,xxvii,32,81,268

interest-rateriskxxvi–xxvii,100internalrateofreturnseeIRRinternationalbonds159,189–94,190–1internationalequities77,152–7,154–5,157,158

hedging159–61,160–1,193internationalfamilies17,189internationalinvestment152–6,189

hedging159–61,160–1,193seealsointernationalbonds;internationalequities

internationalrealestate266–7internet269intuition,biasesof20,20–4investmentbanks25,126,209“investmentbeliefs”23,316,311–12investmentfunds123,127investmentgradesecurities172,173,177–9,178,179,180–1,180investmentmanagersseemanagersInvestmentPropertyDatabankseeIPDinvestmentstrategyappropriateness153

andbehaviouralfinance28–9changingstrategy4,108–9long-term88–9,90,92,107–8short-term83–8andtaxation132–4seealsomodelinvestmentstrategies

investmentstyles134,145–8,259–60,311–12investmentsofpassionxxvii,268–73,271,272,287–8

seealsoart;classiccars;stamps;violins;wineinvestors

“absolutereturn”92–3andadvisers10,13–14,202–3

aggressive123,152biases20–4cautiousseecautiousinvestorseducation12,20,25expectations4,13,25expertise13,14fashions138,146–7,151,167–8informationaldisadvantages122,244,287,313“irrational”138long-termseelong-terminvestorsandmanagers202preferences20,24,30,31,153“rational”18,19,24,30,138short-termseeshort-terminvestorsstyleofinvolvement13–16

IPD249–50,250,252indices256–7,257,258

Ireland,creditrating36IRR(internalrateofreturn)244,245,305–6IrrationalExuberance(Shiller,2000)67–8Italy36,43,58

JJafco240Japan36,43,54,240,241,249

1980sequitybubbleandbust135,153equityvolatility155,160,161

Johns,Jasper277Jones,Alfred209–10

KKahneman,Daniel5,20,24,26Kat,Harry208“keep-it-simple”strategies92–3,95–7,96–7,110,121,133Kerkorian,Kirk126–7Keynes,JohnMaynard64–5,170–1KKR240kurtosis117,117,168,181–2,181

L

LaPeaudel’Ours284LandRegistryindex252landvalue261–2,261Landes,William277largecap140–3,141,142,142,211largecompanies,performance140largeinvestors123–4LatinAmerica16,17,36LBOs(leveragedbuy-outs)235,238LehmanBrothers84leverage

hedgefunds214privateequity238,239,243,244realestate248,249,256,267

leveragedbuy-outsseeLBOsleveredequitytrackerfunds238Lhabitant,François-Serge9,220,228liquidinvestments79,122–3,123liquidmarkets122–5,130liquidityxxvii,16,66–7,82,121,123–4

artandcollectiblesmarket269,285credit-ratingagenciesand172currencies266governmentbonds42,46,49,103hedgefunds198–9,208,213,232–3listedprivateequity242long-terminvestorsand46,122,123,124,125mortgagemarket186REITs265

“liquiditybudgets”122–3liquiditypremium80,122listedprivateequity79,240–2,241,242listedpropertytrustmarket249Lizieri,Colin258Lo,Andrew32,208localcurrencyemerging-marketdebt180,182–3localgovernments37

seealsomunicipalbondsLondon,Cityof,rents262longrun64–5longrunhistoricalreturns58long-datedbonds52–3,53–5,53,56,92long-onlyequityhedgefunds211–12long-onlymanagers205long-termassetallocationmodels64–5,95–7,96–7Long-TermCapitalManagement(LTCM)130–1,201long-terminvestmentfunds127

long-terminvestmentstrategies88–90,107–8long-terminvestors88,90,91,93,95,98,138

cautious33,49,83,91,92,98,108,139,148–50,305andemergingmarkets166–7andequities59,97–8,171andgovernmentbonds42–3,46,47,49,152andliquidity46,122,123,124,125andnegativeconvexity187–8performancemeasuresfor305andpricedeclines94andprivateequity242andrealestate259rebalancing66–7strategicassetallocations71seealsolong-terminvestmentstrategies

long-termmanagers125Longstaff,FrancisA.174–5,176Lorrain,Claude271lossaversion4,10,13,24,24–6,60,65,98losstolerance12,110–11,112,113,114losses12,25,26,94,312Lotito,Fabiana254–5lotterytickets19,26,31–2lowbetastocks138,151lowrisk,highreturn7,8,115lowvolatilityxxvi,7,9,151

strategies115–16LTCM(Long-TermCapitalManagement)130–1,201

MMcAndrew,Clare278Mackay,Charles204macrohedgefunds198,206,209,210,222macroeconomicchange146“Madoff:ariotofredflags”(GregoriouandLhabitant,2009)9,220,228Madoff,BernardL.xxvi,6,22Madofffraudxxv–xxvi,5–8,7,9–10,115,151,196,197,201,220managedfuturesfundsseeCTAsmanagementinformationforinvestors304–10managers9,125,133–4,138,169

active20,143,167bondmanagers169,178CTAs218,219,219discretionaryinvestmentmanagers313fees137,151,203–4

offundsofhedgefunds206,225–6,233growthmanagers146,148hedgefundsseehedgefundmanagersidentifying22,110,312information234–5,244long-only205“momentum”managers125,127–8passive143performance21,244–5privateequity234–5,244,244–5,246,246–7questionstoask228–33realestate246–7,259–60remuneration197–8,202–3short-bias210,211skillseeskill,managersstyles134,145–8,259valuemanagers124–5,145–6,147–8,216

MAR(minimumacceptablereturn)110–14marketanomaliesxxv,109,125–31,137–9,151

“smallcap”anomaly140–2marketcapitalisation137,138

seealsolargecap;smallcapmarketcapitalisationindices146–7marketcrises86

2008199,200,200,201marketcycles97marketefficiency125–31marketriskpremium34,35markets19,19–20,30,34,35

historicperformance50–5,51–4predicting33,65,70–1timingxxvii,70,71,97,108,108–9,312volatility57,61,65–6,66,82seealsobearmarkets;emergingmarkets

Marsh,Paul48,49,50–2,51–5,57–8,112,140–1,162meanreversion60–1,64,66,67–70,68,70,71,98“meanvariance”optimisermodels122Mei,Jianping272mentalaccounting24,27–8,28–9mentalshortcuts22–3mergerarbitrage198,215–16Merton,Robert131“mezzanine”debt249,250“mezzanine”finance235MiddleEast17,288minimumacceptablereturnseeMARMitchell,Paul254–5

modelassetallocations64–73,85modelinvestmentstrategies64–73

short-term95,112,113,114models,poorperformance115–17“momentum”managers125,127–8“momentum”stocks138monetaryeasing33,71–2,268,269moneyweightedrateofreturn(MWR)305–6money-marketfunds83Moody’s105,172,173mortgageagencies184mortgagemarket184–6,185,186mortgageREITs249,250,256mortgage-backedsecurities80,184–9,185,187,188mortgages169–70,184–6,188

high-qualityxxvipurchasedbyFederalReserve71,80raisedabroad267subprime173,184

Moses,Michael272MSCIindices155–6,160,161,162,166multi-assetfunds78multi-strategyhedgefunds206,206,207,216,217,217,225municipalbonds37,100–1,101–7,104mutualfunds79,244–5MWR(moneyweightedrateofreturn)305–6Myers,Stewart58

NNAREIT(NationalAssociationof

RealEstateInvestmentTrusts)250–1,257NASD(NationalAssociationofSecuritiesDealers)228NASDAQstockexchange8,31NationalPropertyIndexseeNPINationalTransactionBasedIndexseeNTBINCREIF(NationalCouncilforRealEstateInvestmentFiduciaries)249–50,250,252,256–7,257negativeconvexity187–8negativereturnrisk3,84–5,85theNetherlands249Ng,Kwok-Yuen178–9niche,knowingyour13–16“noise”34–5,128–9,137“noisetraders”127–9non-investmentgradesecurities172,173,179NorthernRock84

NPI(NationalPropertyIndex)252,256,257NTBI(NationalTransactionBasedIndex)252,256,257NumisSmallerCompaniesIndex141

Oobjectives3,4–5,12,28–9,92,131,153

differentaccountsforeach12,29,134,304–5institutionalinvestors131mortgage-backedsecuritiesand186–9,187,188timehorizons4,31,94,98

operationalrisk220–1optimism20optionpricing65OrangeCounty,California105overconfidence20–1

PPalaro,Helder208parameteruncertainty30–1pass-throughmortgagemarket184–6passiveinvestmentmanagers143pensionfunds47,75,88,89–90,90,129–30,251

assetallocation76,77,82BritishRail285–7,286

pensionplans76,107–8,135–6pensionsavings12,132–3pensioners3,40,42,92,93,99,107perceivedrisks4,5“perfectstorms”224–5,225performancexxv–xxvi,4–5,25,34–5,64

art272–3,277,278–80,285–7,286in“badtimes”3,110,117BernardL.MadoffInvestmentSecuritiesLLC6–7,7classiccars282–4,283corporatebonds115,175,175,176–7,177CTAs218–19,219developedmarkets163–4,164emergingmarkets163–5,164–6emerging-marketdebt180–1,180,181equities60,61,97–8,255,255,283

futureprospects55–9historic49–55,51–6,63

ethicalinvesting143–4,144governmentbonds40–7,50,62,63,98,180–1,180hedgefunds199–201,200,207–8,210–12,213–14,213–14,217,218,224–5,225high-yieldbonds180–1,180,181historicmarketperformance50–5,51,52,53,54illiquidmarkets278internationalequities153,154investmentgradesecurities180–1,180largecompanies140ofmanagers21,244–5measurement304–6pastaspredictorofthefuturexxv–xxvi,224–5privateequity241–2,242,243–7realestatemarket248REITs255,255smallcompanies140–3,141–2,211sourcesof34–5stockmarket67–9,68–9,146–7,162surprisinglypoor115–17,116Treasurybills50Treasurybonds50,51,54,56,177,177,178,178

performanceindicators67–9,68,69Perold,AndréxxviPeyton,MarthaS.254–5Phalippou,Ludovic245,246Phelps,Bruce178–9Picard,IrvingS.6Picasso,Pablo277,284PioneeringPortfolioManagement(Swensen,2000)78PME(publicmarketequivalent)245policyportfoliosseestrategicassetallocationsPonzischemes7–8pooledfunds56Porsche224portfoliorisk29,134,137–9,226portfolioseparationtheoremxxvi,81portfoliosummaries304,306–10portfolios29,305efficientportfolios111Pownall,Rachel270predictingmarkets33,65,70–1preferences20,24,30,31,153prepaymentrisk184,186,187,189Preqin196,197,203prices93

art269,270–1,272,274,288collectibles269,270–1,272,274,280–4,283

declinesin93–4,95,100,108,139Treasurybonds72,73

PricingthePriceless:Art,ArtistsandEconomics(Grampp,1989)272–3“principal-agent”problem202–3,313privateequity35,78,79,235–6,312

allocationguidelines239appraisalvaluations241,244,246–7,254–5diversification234,243fees238,244,245–6illiquidity79,234,236,244,246importanceofinformation234–5,239,243leverage239,244liquidity242managers234–5,244,244–5,246,246–7performance241–2,242,243–7return243–7riskxxvi,236–9,237,239,243,244volatility15,236–9,237,239,239,240,243

privateequityfunds213,222–3,238,239,242,243,305–6realestate249,250,260

privateequityportfolios243privateinvestment80,311

concentratedstockpositions134,135–6realestate248,249,250,255,264–5,265,267

privateinvestors76,77,79,88,92,94,143,255seealsoprivateinvestment

privatewealth88,98,130,131–3inart269,285,288assetallocation76,77,78taxation131–4,133timehorizons79,89–90,91seealsowealthyfamilies

propertyappraisalvaluations251,252,258depreciation260,263,264,280directinvestmentin248,249,250,255,263,264–5,265,267informationonprices251obsolescence260,264types249,250value260,261–2,261seealsorealestate

prospecttheory24–6,26provenance287“prudentperson”rule129–30psychometricprofiling11–12,13publicmarketequivalent(PME)245publicrealestateinvestment248,249,250,264–5,265,267

Q

quantitativeeasing33,71–2,268,269

R

rationality,assumptionsof18–19realestate78

appraisalvaluations251,252,258,281commingledfunds248,250,260comparedwithgovernmentbonds260,262–3,264directinvestment248,249,250,255,263,264–5,265,267anddiversification249,251–8,262,266–7illiquidity79,263,264,267indices251–8,253–7andinflation251,259,261,262leverage248,249,256,267managers246–7,259–60prices251,253,254privateequityfunds249,250,260privateinvestment248,249,250,265publicinvestment248,249,250return253,260–3value260,261–2,261yield248,251,258–9seealsoproperty;REITs

realestatecommingledfunds248,250,260realestatecrisis(2007–09)248realestatefunds236,248,250,260realestateinvestmenttrustsseeREITsrealestatemarket248,249–51,250,254,264–6,265,267rebalancing13,66–7,72,122,134,236regretrisk23,109,148regulation9,47,129–30

adviserremuneration313banks172hedgefunds197,229

Reich,Robert31Reitlinger,Gerald271,273REITs(realestateinvestmenttrusts)79,248,248–9,249,250–1,251,264–6,265

comparedwithequities255–6,256–7,256–7,257diversifyingrole255equityREITs250hedging267incomeyield258,258

mortgageREITs249,250,256performance255,255volatility255–6,256–7,256,257,258–9,267

“relative”valuemanagers148,216remuneration

advisers313,313–14managers197–8,202–3

Renneboog,Luc273–4rentalincome250,260,260–3rents,andinflation261,262“repeatsalesregression”approach251,279–80ReservePrimaryFund84retailpricesindex(RPI)47retirementincome91,99–101,107retirementsaving12,76,77,91returns3,4,58,113,305–6

artinvestment285–6,286bonds95,170–1,271,272cash271,272equities33,57–9,89,170–1,271,272ethicalinvestments143–4,144governmentbonds33,41,48largecap140,141,142–3,142privateequity243–7realestate252,253,260–3andriskxxv–xxvi,7,8,9,24,29,35,78,111,115smallcap140,141,142–3,142sustainableinvestment145Treasurybills41,48,271,272Treasurybonds41,48volatility9,148

revenuebonds102,102–3,106riskxxvi,3–5,8–9,15,66–7,226

artandcollectibles286–7attitudesto10–12,13,19,29,64,66ofbusinesses15creditriskseecreditriskcurrencyriskseecurrencyriskdiversification15,136,137,138dynamicmismatchrisk187emergingmarkets166equityrisk34,59–63,61–2,71fundamentalrisk126–7governmentbonds35–7hedgefundsxxvi,198,199,207–8,213,220–6,225,231–2idiosyncratic137,138inflationrisk37,42,46,49,93,98–9,100

insurancerisk34interest-rateriskxxvi–xxvii,100measuring3–4,5,139,148,155operationalrisk220–1andperformance7,8,24,111,115portfoliorisk29,134,137–9,226prepaymentrisk184,186,187,189privateequityxxvi,236–9,237,239,243,244privatewealthand132regretrisk23,148andreturnxxv–xxvi,4,9,24,29,35,78,111securitisationand183–4sourcesof137–8systematic79–80,137,138,151,189,226“tailrisk”166andvolatility3,9,151,155seealsoriskaversion;risktolerance;risk-taking

riskarbitrageseemergerarbitrageriskassets66,80,82riskaversionxxvi,10,13,24,26,81,116riskinformation,summary306riskprofiles109,134risktolerance10–13,11,82–3,87,91,109,153,189

ofadvisers9,11,12,66mentalaccounting24,29,304,305

risk-takingxxvi,12,32,109,111,125attitudesto10–12,13,19,29,64,66rewardsforxxv,xxvi,3,5,50segmentationof27–8,29seealsorisk;riskaversion;risktolerance

RoyalDutch126RPI(retailpricesindex)47Russia36,50,52,135

SS&PseeStandard&Poor’ssafehavensxxvi,29,38–40,63,82,83,152

cash65,83,84,86,92–3currencies17,159–61,189governmentbondsxxvi,47,48–9,64,65,83,92,94,98,189,263

safe-havenstrategies92,186safetynets14safety-firstportfolios27–8,37,61,91,99–101,243Satchell,Stephen5,254–5,258,270savers84

Schaefer,Stephen174–5,176SEC(SecuritiesandExchangeCommission)6,102,228,229securitisation169–70,172,183–9,185,187,188seedcapital235self-advisedinvestors312,314self-attribution21Serfaty-deMedeiros,Karine159Sharpe,Bill224–5Sharperatios115,222,223,224ShellTransport&Trading126ShillerPE67–9,68Shiller,Robert48,50,67–9,68,69,125,129shortbiashedgefunds210,211,222short-sellingmanagers211short-termassetallocationmodels95,112,113short-terminvestmentstrategies83–8,111–14,112–13short-terminvestors38,83,87–8,90,91,93,94,95

aggressive91,111,123benchmarksfor49bondsasinsurancefor85–8,86–7cautious3,91,98,108,110andliquidity123,124,198seealsoshort-terminvestmentstrategies

short-termrisk60shortcutsxxvi,5,22–3shortfalls32,59–60,91,96Siegel,Jeremy97–8“sin”stocks143Singapore17,155,156,241,249Singaporedollar183Sinquefield,Rex50skillxxv,243

managers80,305,312hedgefunds198,202,204–5,208,211,226–7investmentmanagers21,34,34–5,109privateequity234–5,246realestate259

smallcap138,139,140–3,141,142,150,151mutualfunds212

“smallcapanomaly”140–2smallcompanies34,139,140,236

stocks139,150,211,238seealsosmallcap

Smith,Vernon20Smithers,Andrew67,68Sortino,Frank5Sotheby’s277

SouthSeabubble(1720)128sovereigndebt36–7sovereignwealthfunds(SWFs)28,75,82,88,93–4,109,189

assetallocations75,77,77Spaenjers,Christophe271,272,273–4,281Spain36,58speculativegradesecurities172,173,179Srivastava,Nandini270stampsxxvii,247,272,273,287

prices270,271,274,281standardofliving42–3,88,92,100StandardandPoor’s35–6,127,172,173,241,241

indices67,146,245StanleyGibbons281start-upventurecapital235statisticalarbitrage198,216–17Statman,Meir29,32Staunton,Mike48,49,50–2,51–5,53,57–8,112,162stereotyping21sterling17,159stockmarket

andartmarket273–4indices146–7overreaction67,68,146–7patternofreturns57–9performance67–9,68–9,146–7,162volatility65–6,66,113

stockmarketrisk97strategicassetallocations64,66,71,81,122,155

seealsorebalancingstrategychange4,108–9Strebulaev,Ilya174–5,176structuredproducts25,26,35,173sub-investmentgradedebt172,173,179,227subprimemortgages173,184surplusrisk97,97“sustainableinvestment”144,145Sweden43,241Swensen,David78,89SWFsseesovereignwealthfundsSwissfranc159Switzerland54,155,160,161,241

hedgefundinvesting197systematicbiases236,238systematicreturns198,199,208systematicrisk79–80,137,138,151,189,226systemicsetbacks181

T

Taiwan156,162Tan,David143tax-deferredaccounts132–3tax-exemptaccounts132,132–3tax-exemptbonds102,103–5,104taxableaccounts132,134taxation29,132–4,305

capitalgains132,134governmentbonds46,103–5,104incometax132,134institutionalwealth131internationalequities155municipalbonds102,103–5,104,106privatewealth131–4,133REITs249

Templeton,SirJohn146tenants,creditworthiness260,263–4“thinkingfastandslow”5–6,20Thompson,Don277ThomsonVentureEconomicsdatabase245timehorizons31,88,91,94,98

arbitrage127institutionalinvestors79,88–9,89–90long71,168,267privatewealth79,88,89–90sovereignwealthfunds75warchests16seealsolong-terminvestors;short-terminvestors

timeweightedrateofreturn(TWR)305–6timesofcrisis115,122,124,130

bondsin86,86–7timingxxv,3,146

marketsxxvii,70,71,97,108,108–9,312TIPS(TreasuryInflationProtectedSecurities)43,46,95,107–8,305

yields44–5seealsoinflation-linkedgovernmentbonds

Tobin,Jamesxxvi,67,81Tobin’sQ67,68,68,265“toogoodtobetrue”9“topslicing”134totalreturn305–6traditionalfinance19,24,28–9,31–2transactioncosts49,108

artandcollectibles269,270,271,285,287–8

bonds49,103,179currencyhedging192equities124–5

transactionpricesart247,281realestate251,252,258

transactionstyles124–5transaction-based/linkedindices251–5,253–4,256–8,257Treasurybills27–8,33,38,49,50,54,57–8,84

anchoringwith82–3returns41,48,271,272short-terminvestors38,82,83yield34,38–40,38–9,41seealsocash

Treasurybonds27–8,73,80,87,111,175,175,176equitypremiumover58,204andinflation34,38andinterestrates34,38liquidity103performance50,51,54,56,177,177,178,178quantitativeeasingand71–2,72return41,48security33,38yield34,38–40,38–9,41,41,43,44,72,72,73

TreasuryInflationProtectedSecuritiesseeTIPStrendfollowing127–30TriumphoftheOptimists,The(Dimson,MarshandStaunton,2002)49,50trustxxvi,10,312,313–14Tversky,Amos20,26TWR(timeweightedrateofreturn)305–6

UUK(UnitedKingdom)249,282

artinvestments270creditrating36equities52–3,52,56,153,154–5,155,157,158,160–1gilts38–40,39,41,43,45,46,51–2,54–6hedgefunds197inflationmeasurebiases47,49interestrates49nationaldebtpurchasedbyBankofEnglandxxvi,71privateequity241realestate252,253,256–8,257smallandlargecapreturns140–1,141,142–3,142taxation46

seealsoBankofEnglandumbrellas16,83uncertainty4,30–1,61,111,133,186,189

erronthesideofcaution263aboutinflation93,99marketanomalies127inrealestate263,264reducedbybondladders99

“Unnaturalvalueorartasafloatingcrapgame”(Baumol,1986)273,286,288

USdollar16,17,159,180,183USinvestors152–3,153,156,157,158US(UnitedStates)

bondladders91classiccarmarket282creditrating36equities50–5,51–4,56,58,60,61,153,154–5,156,157,157–8,160,161housingmarket251–2,279market50–5,51–5,152–3,156mortgagemarket184–6,185,186nationaldebtpurchasedbyFederalReservexxvi,71–2,73,80privateequity241realestate252,253,256–8,257,265–6,265smallcapandlargecapreturns140,141,142,142–3seealsoFederalReserve;municipalbonds;REITs;TIPS;Treasurybills;Treasurybonds

utility24

Vvaluation,paintings275–7valuation-basedindices257“value”indices147valuemanagers124–5,145–6,147–8valuestocks138,139,148–50,149–50,151VanGogh,Vincent276Vasari,Giorgio276venturecapital14,235,239,243venturecapitalfunds238,240,245Viceira,Luis48,159violins270,271,272,274VIX13,65,66volatilityxxv,5,9,35,85,91,148,306

appraisalprices222–3cash98

concentratedstockpositions135–6currency193–4,194,267emergingmarkets162–4,163,166,183equities71,149,151,236–8,237,239,240,255–6,256fluctuations116–17,116foreignexchange193–4,194foreigngovernmentbonds190–2,190–1governmentbonds25,42,48,85–6hedgefunds198,199–200,200andhedging266high-yieldbonds181,182internationalinvestments159,160,161,190–2,190–1,266lowxxvi,7,9,115–16,151market57,61,65–6,66,82privateequity15,236–9,237,239,239,243realestatemarket251,254REITs255–6,256–7,256,257,258–9,267returns9,148andrisk3,9,151,155stockmarket65–6,66,113VIXindex13,65,66

Volkswagen224Vuolteenaho,Tuomoxxvi,139

Wwarchests16,83wealth15,88,108,243

accumulation15,59,133,136,243,314artasproportionof285,288evolution73–5,74,132,133investmentof73,74,76–7,77–8seealsoinstitutionalwealth;privatewealth

wealthmanagement94,311wealthplanning61wealth-weightedindices146–7wealthyfamiliesxxvii,17,76,77,131,269Weyers,Sheila275–6winexxvii,268,273wishfulthinking20,108Wongwachara,Warapong258Wood,Vincent29Wright,Stephen67

Y

YaleUniversity78,79,89yield

bonds56,75,87,179–80governmentbonds40–3,41–2,56,71,72,72,73,152,178,260,263mortgage-backedsecurities187realestate248,251,258–9,260–2Treasurybills34,38–9,41Treasurybonds34,38–40,38–9,41,41,43,44,72,72,73

ZZeckhauser,Richard10

“Successfully translates sophisticated academic thinking into simple,intuitive principles that can be used by both individual and institutionalinvestors. These principles are all the more valuable as Stanyer appliesthem to the full range of asset classes and investment strategies availabletoday.”JohnCampbell,MortonL. andCarole S.OlshanProfessor ofEconomics,HarvardUniversity

“OvertheyearsI’vehadtheprivilegeofreviewingmanyinvestmentbooks,butthisisunquestionablyoneofthebest.Icouldgoonatlengthexplainingwhy I am so impressed but suffice it to say, it will be a well read andprominent book in my personal library. Every financial planner, wealthmanager,broker,investmentadviserandseriousindividualinvestorowesittothemselvestocarefullyreadthisextraordinarybook.”HaroldEvensky,President,Evensky&KatzLLC

“PeterStanyerhasararegiftformakingadvancedandseeminglyesotericideas such as betrayal aversion or psychic returns not just accessible buthighly relevant. In addition to the help this guide will provide individualinvestorsonwhattomakeofallthearcanafloodingfrombusinessschoolsandfundmanagers,itisabookthatprovideswelcomelightandinsightinaworldinwhichtheglobalfinancialcrisishashighlightedtheimportanceoffinancialeducationandliteracy.”StephenSatchell,Fellow,TrinityCollege,Cambridge

“If you want to understand the key factors in constructing a successfulinvestmentstrategythatsuitsyou,thisbookwillenableyoutomakebetterinformedchoices.”MarkRalphs,Partner,FinancialPlanningCorporationLLC

“Broad in its overview, filled with recent data and research, and clearlywritten, this useful guide should appeal to both experienced and new

investors.Theauthordeliversrelevant,practicaladvicebydeftlydiscussingboth the big picture at the overall portfolio level and the nuances andinstitutionaldetailsattheassetclasslevel.”Andrew Ang, Ann F. Kaplan Professor of Business, Columbia BusinessSchool,NewYork

“PeterStanyerstandsoutasanextraordinarilyclearthinkerandhecarriesthatclaritythroughtohiswritinginthisbookon,forexample,hedgefunds.In addition he is tremendously good at explaining what works best inestablishingandadaptinganinvestmentstrategy.Thisisabookeverychiefinvestmentofficershouldread.”RogerUrwin,GlobalHeadofInvestmentContent,TowersWatson

PublicAffairsisapublishinghousefoundedin1997.Itisatributetothestandards,values,andflairofthreepersonswhohaveservedasmentorstocountlessreporters,writers,editors,andbookpeopleofallkinds,includingme.I.F.STONE,proprietorofI.F.Stone’sWeekly,combinedacommitmenttotheFirstAmendmentwithentrepreneurialzealandreportingskillandbecameoneofthegreatindependentjournalistsinAmericanhistory.Attheageofeighty,IzzypublishedTheTrialofSocrates,whichwasanationalbestseller.HewrotethebookafterhetaughthimselfancientGreek.BENJAMINC.BRADLEEwasfornearlythirtyyearsthecharismaticeditorialleaderofTheWashingtonPost.ItwasBenwhogavethePosttherangeandcouragetopursuesuchhistoricissuesasWatergate.Hesupportedhisreporterswithatenacitythatmadethemfearlessanditisnoaccidentthatsomanybecameauthorsofinfluential,bestsellingbooks.ROBERTL.BERNSTEIN,thechiefexecutiveofRandomHouseformorethanaquartercentury,guidedoneofthenation’spremierpublishinghouses.Bobwaspersonallyresponsibleformanybooksofpoliticaldissentandargumentthatchallengedtyrannyaroundtheglobe.HeisalsothefounderandlongtimechairofHumanRightsWatch,oneofthemostrespectedhumanrightsorganizationsintheworld.

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