Active Investment Management: Finding and Harnessing Investment Skill

Preface xv

Acknowledgements xix

PART I ASSET CLASSES AND PRODUCTS 1

1 Stocks and Shares 3

1.1 Three key preconditions 3

1.1.1 Property rights 3

1.1.2 Limited liability 4

1.1.3 Public financial markets 5

1.2 Market performance 5

1.2.1 Stock indices and performance measurement 6

1.2.2 Twentieth century performance 6

1.3 Active equity management 8

1.3.1 Dividend valuation models 9

1.3.2 Growth stocks 10

1.3.3 Small stocks 10

1.3.4 Sorting active approaches 10

1.4 Institutional investors 11

1.4.1 Life insurance 11

1.4.2 Pension funds 12

1.5 Conclusion 12

Endnotes 13

2 Investment Products 15

2.1 Traditional products 15

2.1.1 Closed-end products 15

2.1.2 Open-ended products 17

2.1.3 Index products 19

2.2 Alternative products 21

2.2.1 Illiquid assets 21

2.2.2 Liquid assets 22

2.2.3 Offshore products 23

2.3 Active overlays 24

2.4 Conclusion 26

Endnotes 26

3 Money 29

3.1 Three defining properties 29

3.1.1 Purchasing power 29

3.1.2 Return 29

3.1.3 Risk-free asset 30

3.2 Early forms of money 31

3.2.1 Gold 31

3.2.2 Deposits 32

3.3 Modern forms of money 33

3.3.1 Retail money funds 33

3.3.2 Institutional money funds 33

3.3.3 Eurodollars 34

3.4 Active cash management 35

3.4.1 Credit risk 35

3.4.2 Maturity risk 36

3.5 Conclusion 36

Endnotes 37

4 Fixed Interest 39

4.1 History 39

4.1.1 UK to 1945 39

4.1.2 USA to 1945 41

4.1.3 From 1945 41

4.1.4 Performance experience 43

4.2 Active maturity management 45

4.2.1 Duration 45

4.2.2 Benchmarks 46

4.2.3 Attribution 46

4.3 Active spread management 46

4.3.1 Mortgages 47

4.3.2 Index-linked bonds 48

4.3.3 Junk bonds and emerging debt 48

4.3.4 Swaps 49

4.4 Market efficiency 50

4.4.1 UK tax arbitrage 50

4.4.2 The US Treasury market 51

4.4.3 Salomon episode 53

4.5 Conclusion 54

Endnotes 54

5 Foreign Assets 57

5.1 History 57

5.1.1 To 1900 57

5.1.2 Foreign bonds from 1900 58

5.1.3 Foreign returns from 1900 59

5.2 Global investors 60

5.2.1 Modern portfolio theory 60

5.2.2 US overseas equity investors 60

5.2.3 US overseas bond investors 61

5.3 Government policy 61

5.3.1 Tax 61

5.3.2 UK exchange control 62

5.4 Active currency management 63

5.4.1 Theory and practice 63

5.4.2 Emerging high-yield strategies 64

5.4.3 European convergence strategies 65

5.4.4 Hedged overseas bonds 66

5.5 Conclusion 68

Endnotes 69

PART II BALANCING RISK AND RETURN 71

6 Measuring Risk 73

6.1 The chance of misfortune 73

6.1.1 Fixed odds 73

6.1.2 Uncertain odds 73

6.1.3 Historical prices 74

6.1.4 Measuring risk from historical prices 75

6.2 A simplifying proposition 75

6.2.1 The chance curve 76

6.2.2 Interval and variance 78

6.2.3 Random walk hypothesis 79

6.3 The case against active management 81

6.3.1 Testing the weak form 82

6.3.2 Testing the semi-strong form 82

6.3.3 Testing the strong form 82

6.4 Guarantees 83

6.5 Conclusion 84

Endnotes 84

7 Investor Objectives 85

7.1 Selected investor instructions 85

7.1.1 UK pensions funds 85

7.1.2 Individual investors 86

7.2 Three essentials 87

7.2.1 Risk-free asset 87

7.2.2 Liabilities 87

7.2.3 Attitude to risk 87

7.3 Trade-off between risk and return 88

7.3.1 Utility theory 88

7.3.2 Varying appetite for risk 89

7.3.3 Constant risk aversion 90

7.3.4 Modelling the risk-return trade-off 90

7.4 Active mandate design 91

7.5 Conclusion 92

Endnotes 92

8 Setting Policy 93

8.1 Policy uniqueness 93

8.1.1 Policy review 93

8.1.2 Policy variation 94

8.2 Liability matching 95

8.2.1 The liability matching condition 95

8.2.2 Historical evidence 96

8.3 Pension fund cash 96

8.4 Active asset allocation 98

8.5 Conclusion 99

Endnotes 99

PART III ACTIVE PRODUCT SELECTION 101

9 Finding Skill 103

9.1 Evidence of skill 104

9.1.1 People 104

9.1.2 Past performance 104

9.2 Measures of skill 105

9.2.1 Confidence 105

9.2.2 The information ratio 106

9.2.3 Active risk 107

9.3 Elusiveness of skill 107

9.3.1 Manager tenure 107

9.3.2 Benchmark ambiguity 108

9.3.3 Experience and age 109

9.4 Advisors and skill 110

9.4.1 Traditional products 110

9.4.2 Hedge funds 111

9.5 Conclusion 112

Endnotes 113

10 Using Style 115

10.1 Active product weights 115

10.1.1 The MPT solution 115

10.1.2 Accuracy 116

10.1.3 The industry solution 116

10.2 Style definition 116

10.2.1 Asset classes 117

10.2.2 Specialised categories 117

10.2.3 Universe medians 117

10.3 Portfolio construction 118

10.3.1 Specialist portfolios 118

10.3.2 Balanced portfolios 119

10.4 Freestanding overlays 119

10.5 Conclusion 121

Endnotes 122

PART IV THE NATURE OF SKILL 123

11 Firms and Professionals 125

11.1 Exceptional talents 125

11.1.1 Benjamin Graham 125

11.1.2 Phillip Fisher 126

11.1.3 Warren Buffett 126

11.2 Public and private information 127

11.2.1 Graham and Fisher 128

11.2.2 Market anomalies 128

11.2.3 Size and value effects 128

11.3 Intuitive and systematic approaches 129

11.3.1 Keynes’s metaphor 130

11.3.2 Information and strategy 131

11.3.3 Demonstrating skill 133

11.3.4 Portfolio manager autonomy 133

11.4 Fault lines 134

11.4.1 Institutional processes 134

11.4.2 LTCM 135

11.4.3 MAM fixed interest 136

11.5 Conclusion 137

Endnotes 137

12 Active Overlay Risk 139

12.1 LTCM 139

12.2 Active return distributions 140

12.2.1 Active strategies 140

12.2.2 Trading rules 141

12.3 Different processes 141

12.3.1 Systematic 142

12.3.2 Combined 142

12.3.3 Intuitive 143

12.4 Conclusion 143

Endnotes 144

PART V THE PRICE OF SKILL 145

13 Fees 147

13.1 Types of fee 147

13.1.1 Flat fees 147

13.1.2 Performance fees 148

13.1.3 Transaction charges 150

13.2 Demand and skill 151

13.2.1 The evidence 151

13.2.2 Skill-driven demand 152

13.3 Fee rates and skill 153

13.3.1 Revenue maximising 153

13.3.2 Paying for information 154

13.4 Fee-setting behaviour 155

13.4.1 Traditional products 155

13.4.2 Funds of hedge funds 155

13.4.3 Hedge funds 156

13.5 Conclusion 158

Endnotes 158

14 Pay 159

14.1 Pay and skill 159

14.1.1 Before hedge funds 160

14.1.2 After hedge funds 160

14.1.3 Hedge fund self-investing 162

14.2 Dividing the spoils 162

14.2.1 Prima donnas 163

14.2.2 Threshold skill 163

14.2.3 Position limits 165

14.3 Valuing investment management firms 165

14.3.1 Traditional firms 165

14.3.2 Hedge fund firms 167

14.3.3 Fund of hedge fund firms 167

14.4 Conclusion 168

Endnotes 168

Afterword 169

Technical Appendix 175

A.1 Basic modelling tools 175

A.1.1 Calculus 175

A.1.2 Natural logarithms 176

A.1.3 Normal distribution 177

A.1.4 Central Limit Theorem 177

A.1.5 Higher moments 177

A.2 Investment algebra 178

A.2.1 Time value of money 178

A.2.2 Time versus money-weighted performance measurement 178

A.2.3 Bond prices 179

A.2.4 On and off the run 179

A.2.5 Seventeenth century Dutch annuities 180

A.2.6 Duration 180

A.2.7 Bond attribution 181

A.2.8 Constant growth model 181

A.2.9 Purchasing Power Parity 182

A.2.10 Covered interest arbitrage 182

A.3 Time series analysis 182

A.3.1 Standard approach 182

A.3.2 Confidence interval 183

A.4 Utility theory 184

A.4.1 Certainty equivalent 184

A.4.2 Expected utility 184

A.4.3 Risk adjustment 184

A.4.4 Abnormal distribution 185

A.4.5 Constant relative risk aversion 185

A.5 Mean variance analysis 186

A.5.1 Correlation 186

A.5.2 Matrix algebra 186

A.5.3 Utility maximisation 186

A.5.4 Maximising the mean variance ratio 187

A.5.5 Optimal investment in risky assets 187

A.5.6 Two asset optimisation 187

A.5.7 Liability matching condition 188

A.5.8 Portfolio eligibility 188

A.5.9 Information ratio 189

A.6 Industry economics 190

A.6.1 Demand for freestanding overlays 190

A.6.2 Demand for products with style 191

A.6.3 Revenue maximising fee 192

A.6.4 Combining overlays 193

A.6.5 Information costs 194

A.6.6 Relaxing the independence assumption 194

A.6.7 Self investing 195

A.6.8 Running a hedge fund 195

A.6.9 Hedge fund style 196

A.6.10 Trading limits 196

A.6.11 Trader experience 197

A.6.12 Tenure and investor confidence 197

Endnotes 198

Index 199