Dr Roelof Salomons, professor of investment theory and asset management at the University of Groningen and chief strategist, Kempen Capital Management, Amsterdam, offers ideas for investors and management based on major developments in financial theory and markets.
While the financial markets are in a continuous state of flux, the purpose of investing always stays the same. In its simplest form, investing is about postponed consumption. Economic models assume that rational investors only postpone consumption if they can consume more in the future. The link between the present and the future is the rate of return.
Alternatively stated, investments need to generate a return to finance a future liability, be it retirement, charity, wealth transfer or to cover an insurance claim.
Demands from investors have not changed very much in past decades. What has changed is how they get what they need. The economic and market environment is not constant, leading to changes in expected returns. Regulation is also not a given. But what changes most is the financial industry itself. It possesses an amazing ability to adapt its offerings to ensure that investors get what they desire. It can be argued that not all innovations reflect genuine change.
The first point of focus should be on trends that have emerged in recent years. Without aiming to be conclusive, five themes will be highlighted that have dominated the research agenda, and impacted economies and financial markets.
Power of long-term predictability
Academic research over the past decades has shown that absolute valuations are a prime determinant of future returns. Historical returns are a poor guide for the future. A wealth of papers produced since the early 1990s have shown that valuation ratios are mean reverting - they return to trend. Hence, when prices are high relative to fundamentals, one of two things (or a combination) must be true. Either fundamentals (say, earnings) must improve in order to justify the high valuation, or investors expect returns to be low in the future and discount using lower rates. The research is abundantly clear on this. If investors expect to be rewarded by improving fundamentals, the empirical results are disenchanting. Valuation ratios do a poor job in predicting future fundamentals. It predicts price variation.
This predictability of returns not only applies to equities, but can also be deducted from yields on government bonds, credit spreads on corporate bonds and rental yields on property. Expected returns always mean revert. Since valuation ratios slowly mean revert, this means predictability improves the longer the investment horizon becomes.
The collapse of two 'bubbles' in financial markets, the severe global recession and bailout of several financial institutions using taxpayer money has had a profound impact on markets. It has resulted in increased regulation, and stringent capital and liquidity buffers. While many new rules are for the good of society, there are drawbacks. One of the most pressing is that the new rules can be pro-cyclical. An example might be illustrative. Consider the case of a hypothetical pension fund that needs to mark-to-market assets and liabilities. Courtesy of lower interest rates, market value of liabilities has ballooned and asset growth has not kept pace. With the benefit of hindsight, the asset mix was not optimal. Looking forward, many funds find they are not solvent enough to take additional risk. Just when they need equity returns most, they cannot handle the short-term risk.
When buffers are not replenished or existing contracts are renegotiated, investors care about short-term volatility and loss aversion becomes unavoidable. Many pension boards will feel 'forced' to reduce risk when solvency drops. This is most likely to happen when expected on returns on bond drop, while risky assets become more attractive. So even while equity is likely to return more than bonds in the long run, the probability of a negative return might force long-term investors out of the equity markets for fear of short-term losses. This pro-cyclical behaviour is not beneficial for investors and runs counter to the predictability discussed earlier.
It has been a decade since I defended my thesis. In 2005, I wrote: "Low expected returns will cause a revolutionary change in the asset management industry. It will be pushed more towards absolute return strategies. In a low-return environment, the need for active management of portfolios increases. During the 1980s and 1990s, the need for an extra percentage point via active management was negligible on the total returns achieved. Nowadays, in a world of low expected returns, the extra active percentage point is really needed and could decide whether liabilities are met or not."
I still hold that view, but must admit that change has been slow in coming. The asset management industry is still clinging to benchmarks. Its almost sacrosanct status has not ended. There has, however, been one important change and one that is expected to continue. Historically, most of the debate surrounding active and passive management has focused on the deviation of fund returns compared with the returns of the respective index - the tracking error. This focus on tracking error has given way to a focus on the differences in holdings - the active share. It has been shown that managers with higher active shares are superior offerings and tend to be worth their 'active' fees. Many other fund managers are managing their funds close to the index. The active share measure clearly separates the index huggers from those that are genuinely active.
The focus on active share is not surprising given the larger focus on the costs of asset management that is a direct effect of lower returns. Why should an investor give up a large part of their returns for a fund that cannot be distinguished from an index tracker? In that case, the index tracker might as well be purchased at lower costs.
It was noted earlier that expected returns are to some extent predictable. This referred to the time series properties. A similar predictability exists in the cross section of return within asset classes. Value-oriented investors have always asserted that undervalued assets portend high subsequent returns. The literature picked up on this predictability when efficient market investing took hold. Based on research, we now know that value (cheap assets), size (smaller companies) and momentum (past winners) are important factors to employ. Similar factors have also been shown to impact bond, commodity and currency markets. And the quest for new factors continues to this day. It must be noted that this implied predictability is again at a longer-term investment horizon.
Given the advances in technology and lower trading costs, products that capture these risk factors separately are now on offer. Institutional investors are leading the charge here and are effectively blending 'active' and passive management. It is to be expected that similar products will also become available for the masses. Again, this will reinforce the 'pressure to perform' trend highlighted earlier.
If we can not only compare the return of a portfolio manager to the market return (for index trackers are available at low cost), but also correct for factor returns (which will become available), the active manager will only be worth their fees if they can deliver returns over and above the market corrected for factor returns.
Doing good and aligning interests
Institutional investors and high-net-worth private clients are increasingly taking their demands in two other directions. First, knowing that their liabilities are long term - and predictability is also a long-term phenomenon - they want their assets to be managed accordingly. Second, investors have increasingly focused not only on the returns from investing, but also on how those returns are being generated. This field of investing earned the moniker ESG (environmental, social and governance) investing. Recently the term 'responsible investing' has been widely used. Quantifying a return on responsible investing is challenging.
Incorporating these two views in investment beliefs is one thing. For it to be successful, two lessons from the literature should be learned. First, incentive structures need to be aligned. Asset managers who invest their own money alongside clients deliver superior returns. It reduces the typical principal-agent issues. Second, knowing if the returns are genuinely obtained 'responsibly' can only be done if portfolios are focused. Investors need to be on top of their holdings and understand what management does. Focused portfolios also tend to deliver better returns.
Challenges and changing models
Seeing that current valuations are far above their long-term averages does not bode well for financial markets. Mean reversion will bring valuation ratios back in line with the historical norm. Expected returns for bonds, credit, equity and real estate all point to the direction of lower returns.
This might force investors to seek higher returns in alternative asset classes. But these returns tend to be associated other embedded risks (illiquidity, for example) and higher costs. Given low expected returns, investors are well advised to go look for either low-cost solutions or for genuinely active offerings. High fees and low activity is surely becoming a dinosaur. Finally, just as investors expect their asset managers to invest in companies that are transparent, responsible and long-term, they should also do so themselves.
Given the pressure on fees and the need to perform, asset managers are also expected to change their business models. One would expect asset managers to reduce complexity and cut costs, and the active/passive debate to heat up. Instead of building a portfolio with multiple asset classes and several layers of 'active' managers within each asset class, they will need to change. First, they will build portfolios of low-cost passive-index funds to gain exposure to the asset class. Second, they will selectively offer active products that will be really active.