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The Actuary The magazine of the Institute & Faculty of Actuaries

Investment of the third kind

An important recommendation of the Sandler
Review of medium- and long-term retail
savings is that individuals wishing to
invest in equities through a collective investment vehicle should buy tracker funds in preference to actively managed funds. Sandler justifies this recommendation by referring to research showing that the majority of professionally managed funds underperform compared to their benchmarks. No less an authority than Warren Buffett has given qualified approval for tracker or index funds, accepting that, for the vast majority of people who have no understanding of the drivers of long-term investment performance, it is eminently sensible to follow a passive indexed approach. However, as actuaries who have adopted the mantra that we ‘make financial sense of the future’, should we give our support to this planned mediocrity approach?

Behavioural finance pointers
The exciting new area of behavioural finance is causing many academics and investment practitioners to realise the ‘rational behaviour’ and ‘no arbitrage’ cornerstones of traditional finance theory are inconsistent with the real world of stockmarket behaviour. To convert the observed irrationality and acute disequilibrium into hard cash, James O’Shaughnessy’s What works on Wall Street, first published in 1996, is by far the most useful book on the subject. O’Shaughnessy demonstrates that, over the 43 years to the end of 1994, major US stocks with low priceearnings ratios outperformed the S&P500 Index by an average of 2.9% per annum, while major stocks with high price-earnings ratios underperformed by an average of 1.3% per annum. Building on these results, I derived a commonsense formula for share selection based on consensus estimates of earnings per share growth and prospective priceearnings ratios to 12 months into the future. I describe this approach as being in generic terms ‘investment of the third kind’, ‘investment of the first kind’ being the traditional actively managed approach, and ‘investment of the second kind’ being the passive approach of tracking an index.
But does it work?
A convenient place to start assessing performance is with the results from my model portfolio over 2002 a horrendous year for equity investors worldwide. Ignoring dividends, if you had invested £1,000 in my model portfolio of 30 FTSE-100 stocks at the end of 2001, you would have had £824 at the end of 2002. This compares with £748 if your investment had performed in line with the FTSE All-Share Index, a very satisfactory outperformance of 10%. The portfolio you should have set up at the end of 2001 to have given you the maximum possible performance with the benefit of perfect hindsight would have returned £1,040, an outperformance of 39%. In other words, my model portfolio captured 26% of the theoretically possible outperformance over the following year.
My model portfolio also outperformed during 1997, 1998, 2000, and 2001 by over 10% in both 2000 and 2001. However, much of the good performance from 2000 onwards represents recovery from the serious underperformance of 20% in 1999, when Alan Greenspan’s ‘irrational exuberance’ took over the minds of equity investors worldwide and drove share prices of new economy companies to dizzy and unsustainable heights. My model portfolio has out-performed the All-Share Index over any rolling period of four years or longer. Therefore, I see this underperformance in 1999 as strong evidence for a key teaching of behavioural finance, namely that speculative bubbles sometimes develop taking the share prices of certain classes of company to insane levels, rather than indicating a flawed approach.

Similarities with Berkshire Hathaway
My belief that a short period of serious underperformance of an index while a speculative bubble is inflating is irrelevant to a long-term investor in equities, is corroborated by the performance of Warren Buffett’s company, Berkshire Hathaway. From 1965 to 2001, the increase in Berkshire Hathaway’s book value per share averaged 22.6% per year, against an average total return on the S&P500 index of 11.0% per year. Their 1999 result, an underperformance of 20.5% against the S&P 500, was the worst ever, but was followed by outperformances of 15.6% in 2000 and 5.7% in 2001. The similarities with my model portfolio performance over 1999, 2000, and 2001 are striking. The second worst year for Berkshire Hathaway was 1967, the underperformance of 19.9% mirroring the ‘nifty-fifty’ mania that temporarily overwhelmed Wall Street’s limited capacity for intelligent long-term thinking.
Not so prudential guidelines
As a shrewd observer of the business and investment communities, Warren Buffett respects the reasons why the vast majority of investment operations choose not to follow his successful but unconventional approach. He regards the failure of most professional managers to exceed the major indices as a symptom of the institutional decision-making process, rather than a reflection of inferior intelligence. He sees most institutional decisions as being made by groups or committees, who possess a strong desire to conform to their risk management guidelines that allow only small deviations from index weightings at either the individual stock level, the sector level, or both. Three years ago there was a clear demonstration that these guidelines are often counterproductive. When Vodafone acquired Mannesman in 2000, using expensive paper rather than cash, its weighting in the UK equity market increased to around 14%. Without regard for the likely long-term return in either absolute or relative terms, unthinking fund managers duly bought the necessary amounts of Vodafone shares (or other, already overvalued, telecommunications or technology stocks) at approximately 400p per share (the price at the time of writing is 110p), to take their weightings to the ‘correct’ levels in terms of their guidelines. This buying sent the FTSE techMark 100 Index to its all-time high on 6 March 2000. It was as if monkeys were pulling levers in a Pavlovian response to modern finance theory methodologies that, on sober reflection, seem virtually guaranteed to destroy long-term wealth in such circumstances.
Another generally accepted portfolio safeguard is that investment managers’ relative performance is monitored and commented on at regular intervals by trustees, investment advisers, and financial commentators, with the rolling three-year performance being the generally accepted measure of success or otherwise over the long term. On this criterion, my model portfolio would have been dead in the water at the end of 1999, although all that had happened was that I avoided the overvalued new economy stocks that were going to crash over the next two years. This short-term underperformance was more than recouped over 2000 and 2001, giving a return for the five-year period to the end of 2001 comfortably ahead of that on the All-Share Index.

Essence of the argument
I can now bring the two main strands of my argument together. First, a focused equity portfolio based on a highly disciplined approach to share selection, with a strong bias against highly rated shares, appears able to outperform equity market indices consistently over periods of five years or more. Second, the generally accepted ground rules of the traditional active approach effectively prohibit the provision of an investment product based on such a philosophy. The conventional diversification rules force managers to hold shares likely to show significant underperformance over the long term, and potential providers would, quite correctly, conclude that the commercial risks arising from possible short-term underperformance were totally unacceptable.

New ‘long term value’ category
I suggest providers of collective investment vehicles should be encouraged to set up a new category of equity funds, for which the classification ‘long-term value’ would be appropriate. The key characteristics of these ‘investment of the third kind’ equity schemes would be:
– The investment objective would be to outperform a chosen equity market index over rolling five-year periods.
– The investment strategy would be to hold a focused portfolio based on a highly disciplined approach to share selection, that in particular is strongly biased against highly rated shares.
– The managers would hold a diversified portfolio, but would pay little or no attention to index weightings.
– Prospective purchasers would be given a specific risk warning that the focus on long-term return could lead from time to time to unsatisfactory relative performance over the short term.