Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a former global head of asset allocation at a fund manager
Returns from equities have been so consistently and implausibly higher than government bonds over long time horizons that the phenomenon earned a name: the equity premium puzzle.
Despite this, few investors are willing to place all their chips on red. Typically, they or their regulator lack the stomach for stocks’ extreme valuation swings or do not have confidence in the persistence of historic market trends. Furthermore, belief that things will probably work out for markets in the long-run is little comfort to investors with short-run cash needs.
For this reason, investors build multi-asset strategic asset allocations, sometimes known as policy benchmarks. And this is the biggest investment decision an investor will make.
Before buying securities or appointing investment managers, every investor — whether they are choosing a retail investment fund or structuring a sovereign wealth fund — implicitly makes judgments as to their liquidity needs and their tolerance for return volatility as well as to the likely long-term returns that might be forthcoming. The stakes are high. On average, research shows around 100 per cent of their total returns can be ascribed to their choice of policy benchmark, along with around 90 per cent of their return volatility. The outcomes of those judgments are often complex.
Jan Loeys, JPMorgan’s veteran asset allocation guru, says in a recent client note that this complexity is both pointless and counterproductive. Pointless, because investors need only two assets: a global equity one and a local bond one, with the relative amounts driven by their ability to withstand short-term drawdowns and return needs.
Counterproductive, because the clarity and simplicity that is afforded by sticking just to two assets makes it easier to judge risk on them, and much cheaper in terms of manager and transaction fees, as well as governance time.
But academic journals are littered with empirical studies identifying assets with superior long-run risk-adjusted returns such as value stocks or companies with high share buybacks. Surely it makes sense to allocate to these superior assets? No, argues Loeys. Structurally better risk-adjusted returns are a historical artefact that have now faded. The same broad finance literature is so widely known that their specialness has been arbitraged away.
The implication is that complexity serves the financial services industry better than it serves investors. With a simpler set-up the sector would need fewer people and could pay them less.
If “everyone knows everything”, why does complexity persist? There are good and bad reasons.
Bad reasons include misaligned principal-agent incentives, poor advice, overconfidence as to one’s own skills and insights and the flattery and trappings that paying large fees to financial services firms afford the buyer. But perhaps the most expensive reason is the fear of missing out. While eminently relatable, the effects of herding investors into booms that might later be characterised as bubbles hurt both economic growth and investment performance.
But there are good reasons, too. First, outside the US and eurozone, practical market constraints abound. When even UK investors can find it hard to get diversified local bond exposure, the challenges for those based in currencies with under-developed fixed-income markets make advice to hold a broad local fixed-income exposure less than helpful. Second, some investors do have genuine skill, although it can be hard to discern from wild luck even after the fact. Ivy League university endowments have enjoyed tremendous success with their substantial allocations to private market assets so far.
Third, if structurally superior assets have seen their advantages arbitraged away, it is by virtue of the weight of money following policy benchmarks that now look overly complex. Investors making these moves enjoyed enhanced risk-adjusted returns while they lasted. But such anomalies could spring back if money moves back towards simplicity, making complexity again worthwhile.
The most important decision that investors make is built on fairly shaky long-term asset market return guesstimates. This feels incongruous in a world where hundreds of billions are wagered ironing out tiny pricing anomalies. But in the absence of better information, we must work with what we have. Loeys’ call for simplicity follows a fine tradition of successful long-term investors, from US public pension veteran Bob Maynard to the legendary Warren Buffett. For the vast majority of investors, the call for simplicity will be the best approach.
Read the full article here