Archive for the Behavioral Finance Category

The Value of Virtue

Posted in Behavioral Finance, Emerging Markets, Financial Markets, Risk Management with tags , , , , , , , , , , , , on April 10, 2009 by evd101

By Erik L. van Dijk Introduction They are already working on it since 2002, but it is a fine academic paper on a topic that is getting an increasing amount of attention in recent years: corruption and fraud. Cornell scholars Charles Lee and David Ng studied corruption levels in 44 countries, using the Transparency International database. There have been numerous studies using this and other databases over the last decades, probably starting with work by Anne Krueger (later Chief Economist at the World Bank, together with the IMF and OECD also very active in this area)  in the 1970s. What makes the Lee-Ng study special is according to us at Lodewijk Meijer first of all the translation of country corruption scores into analyses of the impact of corruption at the firm level. By doing so, the authors are capable of answering the question if there is any ‘Value in Virtue’. This is a very important topic, because we see that the literature so far defended two positions. Up until 2003 we have seen various – mostly theoretical and deductive – studies that defended the view that corruption, defined as the misuse of public office for private gain, might actually be a kind of ‘bonus’ system in countries in which salary schemes and other remuneration for talented labour are inefficient. Empirical research presented over the years has indicated that this position is probably totally wrong. Theoretically fine, but the empirical evidence is overwhelming and contrarian. Various studies performed between 1995 (Mauro) and 2006 (Lee and Ng) led to the following conclusions: The Negative Impact of Corruption at the Macro Level, as presented in various academic studies

  1. A higher level of corruption translates into lower domestic investments and economic growth
  2. Higher levels of corruption hinder Foreign Direct Investments
  3. Higher corruption leads to lower tax revenues
  4. More corrupt environments stimulate negligence with respect to operations and maintenance in both firms and government institutions
  5. And point 4 even extends to health care: more corruption leads to higher infant mortality rates
  6. Higher corruption leads to higher student dropout levels in universities and high schools
  7. Higher corruption levels go hand in hand with a larger size of the grey economy, which is of course directly related to point 3

Jain (2007) analyzed what corruption actually is. When stating that corruption is about the misuse of public power for private gain, we basically translate it into an economic act. Why? Well, the cost-benefit analysis of corrupt persons involve three aspects:

  1. Someone must have the discretionary power to take decisions and consider a corrupt or fraudulent act
  2. There must be some kind of economic merit associated with that power
  3. The existing legal system provides a sufficiently low probability of detection and/or low penalty for the corrupt wrongdoing

Although it is clear that the legal part of the anti-corruption policy should play a leading role in fighting these crimes, it is also clear that social, cultural and economic aspects play an important role as well. Reason: in the end, corrupt acts are a cost-benefit decision case in which a probably talented individual or a group of talented individuals undertakes activities that are counterproductive from a macro- and microeconomic point of view. It would therefore be fantastic when it can be proven that economically, corruption destroys value at the micro- and firm level. If that can be shown, the likelihood that a well-defined remuneration system (positive stimulus) can help the negative stimulus derived from the improvements in the legal system will ensure a more effective anti-corruption policy. We are pleased to see that this philosophy of our firm, Lodewijk Meijer, has been translated into action by an Emerging Markets anti-corruption initiative: the CARICOM’s Caribbean Procurement Institute. Lodewijk Meijer managing director Erik van Dijk was appointed facutly member for ESG Finance and Investments. The abbreviation ESG was defined in the United Nations Principles for Responsible Investment, with E standing for Environmental, S for Socially-responsible and G for Governance. The idea is that a good ESG policy will help governments, firms and other economic actors in attracting capital and better conditions while at the same time ensuring better profitability and growth in the long-run at both the macro- and micro-level. In other words: we believe that there is Value in Virtue. With this being the case,  officials with the potential power to be corrupt might – when of course being confronted with a legal environment that makes fraudulous/corrupt freerider behavior too risky (i.e. the probability of getting caught and the negative incentive related to the penalty that follows make it more interesting to go for realization of a positive reward) – concentrate on realization of positive social and economic results. The Agency Theory work by Jensen and Meckling has of course indicated that this optimistic view is indeed only warranted when the legal and regulatory framework is sufficiently corruption-proof. This being said, initiatives like the Caribbean Procurement Institute are of the utmost importance in many countries. The latest ranking list of Transparency International indicates that the bulk of nations in the world still suffers from far too high – and therefore value-reducing – corruption levels. The list of countries which have a reasonable score is limited to about 22 with a score in excess of 7.0 on a scale from 10 (lowest or no corruption perceived by people surveyed) to 1 (highest level). This is approximately 15 percent of the number of nations in the world. So a lot needs to be done. The Transparency International 2008 Corruption Perception Index ranking The top (score in excess of 7.0) The top-22 consists of only two non-developed nations, namely Saint Lucia and Barbados. Both actually part of the CARICOM for which the Caribbean Procurement Institute defines its policy. The other 20 are mainly from Europe (13) with 3 Asian representatives (Singapore, Hong Kong and Japan), 2 from North-America (Canada and the USA) and 2 from Oceania (Australia and New Zealand).  Denmark, New Zealand and Sweden have the highest score (9.3) and my own country, The Netherlands, shows a good score (8.9) as well. The rest of the list The rest of the list is mainly filled with Emerging Markets nations, although there are certain developed nations were corruption levels have remained remarkably high. To some extent low places in the list are directly correlated with flaws in the legal system. But we do have the impression that ‘social’ and ‘cultural’ factors play a role as well, including religious factors. Treisman (2000) has done some interesting research in this area. He found that low corruption levels are positively correlated with the following factors:

  • Protestantism;
  • Former British Colonies;
  • Higher GDP;
  • Common Law versus Civil Law-based legal systems;
  • Higher ratios of imports to GDP (i.e. openness/integration of a country in the world economy);
  • Longer exposure to democracy;
  • Unitary forms of government.

Remarkably, Treisman’s study showed that the following factors are not significant.

  • Relative salaries in the public sector;
  • Degree of political stability in a country;
  • Endowment with natural resources;
  • Degree of state intervention in the economy;
  • Level of ethnical diversity.

The need for a multi-factor approach at the micro level As you can see, the bulk of these analyses is focused on the macro level. However, acts of corruption are undertaken by individuals or groups of individuals at various levels of society with the bulk of course being at the lower levels (simply because of the law of large numbers). Sure, at the lower levels the relative amounts at stake are often smaller or marginal, but added up they have just as much of a disruptive impact on society as the few occasions of big fraud and corruption that catch the attention of the media. We do believe however that it is important that procurement lawyers keep a good balance between the bulk of smaller cases with in the end the largest aggregated impact and the few media cases that catch the public eye. The latter play an important role in showing people that the high level hot shots are not getting away with their fraud. This has an extremely important effect on the cost-benefit analysis at the lower levels. At the lower levels, it is not just corruption that is at stake. Corrupt acts can easily be examples for employees working in firms. The recently published report on fraud by PriceWaterhouseCoopers under some 5400 firms in 40 countries shows the following results:

  • Men are responsible for 85 percent of fraudulous acts. To some extent this is related to their dominance in the labour force, especially in emerging markets, but it is also directly related to what we already indicated in our blog entry on investment styles. Basically, the cost-benefit analysis that is at stake when commiting fraud or corruption is an investment decision. The risk to get caught is probably seen as less of a barrier for men – who normally opt for higher risk strategies – than for women. Machoism in cultures is also important. A men who gets away a few times with fraud and then gets caught might be considered a ‘tough, cool guy’, contrary to the sissy whimp that just listens to his superior. Women are not so sensitive to this kind of reasoning.
  • About 70 percent of fraud cases is commited by men in the age class 35-55. In other words, the age class in which men get a bit more confident concerning their societal status, with their built-up experience giving them the feeling that even after being caught they might find employment elsewhere. Younger men suffer more from machoism, but probably tend to translate that into other acts (harrassment; or fighting in bars in the weekend etc.) than their older gender colleagues.
  • Social control – also in the work place – is important. The PwC study indicates that 68 percent of frauds worked as a loner.
  • Contrary to standard beliefs the main frauds were not temporary workers that switch from one employer to the other quickly. One third of frauds worked 2-5 years for the firm, with the bulk of the others working longer for a specific firm!
  • And just like what we see in the government corruption case, it is definitely not true that it is about peanut crimes at the lower levels only: about 25 percent of fraud cases was directly related to top management, with industries known for their complex valuation and risk management structures like real estate, construction and banking/insurance/investments being well-known for large fraud cases in recent years.

It is impossible to create a corruption- and fraud-free world. Everybody makes his or her own cost-benefit analysis. Moral decay is a reality and so is the deterioration of social control structures. This implies that there is a growing need for strong procurement initiatives and improvements in law, just as much as there is a need for attractive, smart salary and wage structures that reward acts of good-doing. In both areas a lot needs to be done. Recent discussions in the financial industry about excessive greed and horrible bonuses for top managers were just as much indicative of the moral decay and mentality of the people accepting these bonuses as they were of incapable human resource professionals and corporate lawyers helping top management and their controlling bodies (governments, labour unions, board of directors) to create smart bonus structures that award tremendous performance and penalize bad performance. When analyzing the Value of Virtue, it is important to check things at the micro level as well. Firms are still the economic drivers of most developed and developing societies. It would be fantastic if we can prove that firms acting in a more corrupt environment (and therefore probably being direcly or indirectly part of this system) are actually valued lower than their less corrupt counterparts. That is exactly what Lee and Ng tried to achieve in their study. There are a few problems when translating the macro results into micro-level conclusions. First, the available ratings are often at the country level. It is only recently that specialist ESG asset managers have started to use analysts or special bureaus to rank and rate individual firms. And unfortunately – due to a lack of data and maybe even interest (after all Emerging Markets investments are still just 5-10 percent of the institutional equity portfolios of institutional investors in developed nations) – they have started this trend in the developed nations. I.e. in the group of nations where the need for firm-level analysis is probably a bit smaller due to good control and legal systems. This is another reason why Lodewijk Meijer supported the Caribbean Procurement Institute initiative. It is a) from a mainly Emerging Markets region (CARICOM) and b) a region that has shown the willingness to act; with c) the presence of 2 CARICOM nations (Saint Lucia and Barbados) in the world top-22 indicating that it is not just willingness, but also actual success that can be shown. When analyzing the valuation effect of corruption at the firm level, we have to deal with a few problems. Firm valuation is dependent on a large number of variables, not just corruption. We do therefore have to create multi-factor models that unravel the valuation of individual firms in various nations while at the same time ensuring that differences in industry distribution between countries are taken into account. Lee and Ng regressed two valuation variables, the Price / Book ratio in which the market price of a stock is divided by the book value of common equity, and Tobin’s Q, defined as the market value of debt plus equity divided by the book value of debt plus equity, on a set of firm and country variables. The firm variables that they looked at where:

  • Return on Equity (for the P/B analysis)
  • Return on Assets (for the Tobin’s Q analysis)
  • Profit Margin (net)
  • Research and Development Expense / Sales
  • Dividend Payout
  • Beta (systemic risk factor measuring the firm’s stock market return sensitivity to changes in the MSCI World index)
  • Currency Beta (measuring the sensitivity of the stock market return of the firm to changes in the value of the US Dollar vis-a-vis a basked of major currencies)
  • Earnings growth (5 years)
  • Credit Rating of the firm from Institutional Investor Magazine

At the country level, the researchers looked at:

  • Country level average Return on Equity (for the P/B regression)
  • Country level average Return on Assets (for the Tobin’s Q regression)
  • Inflation
  • GDP growth
  • And of course, the Transparency International Corruption Perception Index

For a 10 year research period (1994-2003) the researchers were left with almost 60,000 valid observations. More than enough for a good statistical analysis. If Virtue would add Value, the result should be that in both the P/B and Tobin’s Q regressions higher levels of corruption would translate into lower valuations. I.e. Corruption should have a negative and significant sign in the regressions. This was indeed the case. The Cornell scholars found that – ceteris paribus (all other things being equal) – firms in the high corruption tertile had a 15-20 percent lower valuation than firms in the low corruption tertile. There was not much difference when looking at P/B compared to Tobin’s Q, with the latter being a firm-level analysis and the former looking more at the equity level. Value in Virtue: where does the value loss for firms in a corrupt system come from? When looking at the theoretical discount models, value loss could come from reduction in expected future cash flow and dividend levels, reduction in earnings growth or increases in the required rate of return that a firm would have to offer its shareholders and debt providers. Common belief was that the increase in the required rate of return is the dominant factor. However, Ng and Lee show that this is not true. In a corrupt system firms suffer mainly because the expected future cash flow levels will be lower. Partly because of the corruption (extraction of cash via bribes etc.) itself and partly because of loosing customers and/or translation of the corrupt climate into direct internal fraud (people at all levels in society start to believe that if greed and immoral theft is the standard, then let’s do it ourselves as well). Especially international clients and/or investors might be very weary to do business. The tremendous growth of ESG Investing in recent years is indicative of this trend. Both employers and employees (via their labour unions) on the one hand, and the government on the other, stimulate this trend. Good examples are the large Swedish state pension plans AP1 to AP7, who have a combined ESG investment policy, and the Dutch mega investor ABP, one of the largest pension plans in the world. However, ESG is growing but not so big yet as to guide investment decisions of institutional investors completely. But it is indicative that even private investors are getting more enthousiastic about the idea. Not surprisingly as our analysis shows. There is Value in Virtue for long term investors and firms following an ESG policy. We believe that this can be of special importance in Emerging Markets. It will increase value and enable firms and countries following a good ESG policy to attract more foreign capital which in turn can lead to further growth. CLICK THE LINK BELOW FOR THE FULL NG-LEE STUDY corruption-virtue

Investments 101; What we can learn from Chess Grandmasters

Posted in Behavioral Finance, Manager Selection, Uncategorized with tags , , , , , on March 17, 2009 by evd101

By Erik L. van Dijk

 

Two years ago I had the pleasure to sponsor of a chess team. Not just that: the pleasure even extended to becoming Dutch champion with the team. Even some of the big teams in Russia saw us as serious contestant for the European Club title. Unfortunately we didn’t get the funding right so as to compete with the Russians in that competition. But that we made it to Dutch champion was nice. And to a certain extent not so complicated: analyzing my budget (the cost side), I explored what good grandmasters would cost per game. And then we hired some of the strongest players in the world, using the FIDE (= World Chess Federation) rating list. This rating list was based on a methodology developed by the Hungarian professor Arpad Elo. Basically what that rating system does is giving players points for victories and penalties for losses, while at the same time incorporating differences in playing strength based on earlier achievements. The latter is important: if I join a chess club as a new youngster, and happen to be in the same club as a famous grandmaster, obviously my draw against that guy is not really a draw when trying to calculate my rating score. It is a sensation that should be rewarded with an increase in number of rating points. The same token, the grandmaster should be penalized for this unexpected lousy draw. Et cetera. If you then continue with that performance calculation system for many years, rating all the players in the game, you get a very nice system that will give you quite some accuracy with respect to expected  tournament results. Result: Grandmasters are really Grandmasters! The nice thing was that – both as a sponsor and representative of the board of the Dutch Chess Federation – I met with quite a few of those geniuses. And geniuses they are. Nothing like King Kong beating the professionals here. Top grandmasters can play blindfold chess against you as an amateur having a board, seeing the pieces, in not just one game, but dozens of them! Yep…the incredible quality of a top specialist.

Now back to investments. It looks so simple. All investments are about return (the positive variable), stability of returns (also positive), risk (negative to the extent that it is bigger than what an investor is willing to take), risk preference (who is the investor, what can he afford, what is his investment style, et cetera), investment type, correlation with the rest of the investments in portfolio (the lower the better), sensitivity to outliers, et cetera. Yep, everything in there can be measured to quite some extent.

Now, how come we find it so difficult to distinguish between good and bad investors or investment opportunities? If you talk to the average professional investor and tell him about the chess grandmaster, his first thought is that chess is a far simpler activity than investments and that it is being played by nerdish, mono-focused guys. Most of the time they tell you so, without even really knowing the game. And in the end, it cannot really be true. Take the following example: if we simply ignore the factors in the ”model” that you are using (either an implicit model when you are a fundamental style investor, or explicit when you are a quant), then at the end of the year you either beat the benchmark (be it some kind of index, or your required rate of return if you want to define the game in absolute space instead of relative space), are about equal (i.e. a draw), or you lost (underperformance).

The averave chessplayer, when talking to him about investing, never assumes that his game is more complicated, but it is striking that brilliand amateur investors (read: chess players) do often have very smart things to say about the problems facing investors. Reason: they recognize it as another kind of game. And chess grandmasters are game specialists. But investments defined the way we did before are a kind of game too. It is you out there against the competition, i.e. the other investors / the market. There are certain rules, there is a (hopefully level) playing field, there are various competitions (Dutch equities, US bonds, Asian Real Estate and so further), so play if you wanna play.

The main difference is also not the decision models used. Sure, there are a lot of important factors to take into consideration when analyzing your investments. But top-level chess is multi-factor as well. It is just that the factors are different ones. And the number of opportunities in investing is not necessarily bigger than that in chess. Equity strategies, or hedge fund strategies can be compared with playing ‘open’ positions with either not too many pieces on the board anymore and/or pawn structures where nothing or not too much is blocked. Blocked, closed structures are more like fixed income strategies, et cetera.

No, the real difference is that somehow big investors can make far more money than top grandmasters. And investors work in firms/structures led by shrewd managers that are all about indeed making a lot of money, not just for the investor, but for themselves as well. The average chess grandmaster is far less money savvy, and often more interested in playing a nice game, enjoying a nice location when playing a tournament, et cetera. How does that translate into differences between investing and chess? There is more at stake when being ‘bad’. Clients will withdraw money from your portfolio, bad returns translate into lower fees on existing client money, your boss might fire you, et cetera. So basically, whereas chess players didn’t really mind Professor Elo and the FIDE to develop that nice rating system, there is some kind of tendency among the average player (and that is the majority, just like in chess) to avoid becoming the bad guy. Result: smoke screening and a lack of performance measurement in a robust way.

Parties like Morningstar, Lipper and some of the better institutional manager selectors like Bfinance, Russell and ourselves (albeit all with slightly different decision models and goals) try to change that. But, professional investors are most often dealing with money from third party clients. Chess players on the other hand play for themselves. Sure, sometimes they do participate in team matches, but even there you can see that this ‘collectivity’ aspect doesn’t really change things, because it is in the end about the impact on the rating. And rating in turn decides on your position in the World Rankings.

The confusion about performance in investments has been further articulated by the fact, that clients and their advisors are sometimes not really certain of what they want and how they want it. Indeed, that is related to what we said earlier about ”Good Reasons”. They often assume that naive simple performance graphs over the last 2-5 years tell the story about how good or bad a manager is. And the traditional overconfidence aspect is also there: when we ourselves as investor go through a nice series of good performance, we often assume that we are a great investor. But as we saw in an earlier presentation, you need 8 years before 100 naive King King investors flipping coins might be de-masked as charlatans.

So we truly need more objective, Elo-like analysts of markets. A role that we at Lodewijk Meijer try to fulfil. Not to be the standard criticaster standing at the sideline, blaming the professional asset managers for doing a bad thing. It is a fantastic, difficult, impressive thing to outperform the market. So we are full of admiration for the truly strong ones, but only if they do have the investment philosophy and detailed analysis to show that it was skill and not luck. In other words: just like it was in chess, the strong guys like me, the not-so-strong guys that want to learn might still like me (maybe I know some place where they can improve skills in the area that led to the defeat they just experienced!) and some of the sincere bad guys might for the same reason still like me.

But….who really won’t like me, is the big investor trying to look bigger and better than he is. We will do all we can to de-mask him, warn potential clients. Not just in the interest of the client, but also in the interest of the asset manager. If ther is one thing to be learned from markets, then it is that being in there for the quick buck will in the end always hurt you. Tulipomania in the Middle Ages, Daytrading without having either a structured model to exploit small inefficiences and/or a position as broker so that your costs are lower, Insider Trading, Stock Market Fraud, short-term decisions based on short-term factors whereas you are a long-term investor…they all have led to disaster for the investors following that kind of strategy.

And even if you work hard, avoid overconfidence and specialize, you still need to make sure that you do not put all your eggs in one basket. Diversification – one of our core themes as incorporated in the Markowitz-Van Dijk approach to asset allocation – is part of the story as well. Even the strongest of grandmasters, be they Fisher, Karpov, Kasparov, Kramnik or Anand, they all have a so-called repertoire in which they play more than one opening so as to be sure that a) they are less predictable; and b) in case one or the other opening is somehow not functioning, that at least the results in the other opening might probably be uncorrelated.

From the grandmasters mentioned Russian Anatoli Karpov was probably the ”laziest” with the narrowest reportoire. So why was he world champion for such a long time? Was it luck, because the rest was bad? No, I do not think so. He was very much aware of the fact that he was not the hardest worker on new ideas at home. But he also knew that his endgame strength was fantastic. So even if the position during opening and middle game was somewhat inferior, he might still turn the tide in the endgame. Knowing that, he in a way optimized his strategy by focusing on a simple game plan, exchanging pieces relatively quickly, avoidance of hectic turbulent positions with potential for dangerous attacks and sacrifices, all to just get to the endgame quickly. Isn’t that like top specialists in low-beta, low-volatility asset classes? E.g. Fixed Income or Money Markets. On the other hand guys like Kasparov who play every game for a spectacular attacking win, have to work harder at home so as to know much more by heart before the game. Similar to what we can expect from an equity or hedge fund manager, for instance. Or a specialist in Emerging Markets, where often the data set available is still too short.

So, as long as we do not have a rating system like the Elo system in investments, it pays to compare asset managers (either at the firm level or at the level of individual products/lead portfolio managers) with chess players. If they like that or not, we don’t care. It will help us avoid all kind of pitfalls in what is in the end a similar type of game.

From to Chess to Credit Crisis

So why then the credit crisis? Can we still use the metaphor of chess when looking at the crisis? The answer is yes. When alleged specialists turn out not to be specialists, i.e. the players in our championship weren’t the best, there is a big chance that organizers and owners/sponsors (us as end-investors) might freak out and put pressure on our non-delivering ‘stars’ that weren’t stars after all. OK, there are excellent specialists out there that couldn’t help us avoid the crisis, but at least they will ex-post know that the basis for their giant status was laid in periods like the one at hand. When the going gets tough, the tough gets going.

In the mean time we have to go through the motions and make sure that we filter out the bad guys. As long as the ideal rating system is not there, we might use ”bonus” and ”fee levels” as a proxy. Research has indicated that the best money managers are not the ones charging the highest fees. On the contrary, true specialists want to attract a large portfolio so that they can earn their excess return fee over a larger Assets Under Management base. Attracting a large portfolio is easier when fees are not too high. Lousy players pretending to be good know that the likelihood of earning that performance bonus is small. Therefore it is better to charge a high ex-ante fee.

And about performance bonuses in banks. Nothing wrong with it if the bonus is related to TRUE outperformance. But too often do we see that bonus structures in big financial institutions are not related to a definition of performance that is in the end in the best interest of their clientele. Not even is it in many cases based on benchmark levels that are really difficult to beat. And in some cases there are no high watermarks assuring that lousy performance in the past will have to be compensated for in the future, before being entitled to a new bonus.

Obama was right to be angry to many bankers and to investigate what he could do. What we can do in the mean time is use eagerness to score bonuses or fees as a negative proxy with respect to future performance.

I hope that this chess-based reflection gives you some basic ideas concerning what you could look for if you do not have a full-fledge rating system.

Note:

Within the chess world there is a lot of discussions going on, indicating that even there people are not fully satisfied with the Elo rating system. However, it is far better than nothing, and far better than what we have in the financial world. There is still a long way to go. And it is good to see that there are a lot of intiatives going on that will help you to distinguish good from bad much better than you could in the past. I will be more than pleased to brainstorm about this more, if you desire.

In our next entries we will of course go from metaphor back to daily market movements and hands-on analysis of products and markets.

Fund Manager Selection Part 2; The Institutional Investor

Posted in Behavioral Finance, Financial Markets, Manager Selection with tags , , , , , , , , , , , , , , on March 15, 2009 by evd101

By Erik L. van Dijk

During the last few days we discussed topics related to the behavior of Private Investors. We analyzed how they choose their fund managers, individual stocks, how their decision processes work and even addressed differences in style between the genders. Now, for analyzing the behavior of Institutional Investors we first had to study the Private Investor. In the end, decision processes of investing institutions are always processes in which individuals act together. In other words:

Whatever we derive for private investors, will – one way or another – have an impact on decision taking in institutions, because in the end every professional working in an institution is a private person as well.

We can add a bit more detail. Professional investors are often mainly involved with fulfilling their tasks on portfolios of third-party money. This implies two things:

  1. The existence of agency-related problems. Unlike the situation that we discussed a few days earlier when analyzing the investment behavior within investment clubs, we are dealing here with group processes similar to the ones studied by Jensen and Meckling. The bottomline was and is that agents – when not controlled in a sufficient manner – can and will incorporate their own goal variables in the decsision process. This could lead to ‘style differences’ (see also below) with respect to the investments done, or even to outright acting against the interests of the principal. See our entry on the behavior of investment clubs for more details.
  2. Group psychology plays an important role on the decisions taken. Group size and composition are therefore  important variables.

From these 2 points we can therefore derive 4 important elements to study:

  • Investment style differences (Agency element nr 1)
  • Agent-related goals (Agency element nr 2)
  • Group size
  • Group composition

But we have to add two others:

A) Management and control structure within the institution

B) Type of institution.

With respect to A) and B), investment decisions are just one part of the overall activity set of institutional investors and its relative role is not the same in banks, insurance firms, investment banks or pension funds. Management boards in banks and insurance firms are often filled with non-investment-specialists who – as a controlling body – work together with ”respected colleagues” from other firms filling the ranks of the board of directors. The higher ranks in investment banks are often filled with the most successful and toughest guys with investment knowledge. They used to do what the specialists are doing now, but moved to management plus the bigger deals. In a pension plan the governance structure often implies a controlling body with a lot of non-specialists, be they representatives of the sponsor, employees or government. A very complex control structure that is far more sensitive to public opinion and daily news gathering and information dissemination than the others. And to make things even more complicated, there is also the difference between so-called ‘Defined Benefit’ (DB) schemes and ”Defined Contribution” (DC) plans.

Defined Benefit (DB) versus Defined Contribution (DC); a sub-categorization within the institutional investor category Pension Plans

In a Defined Benefit structure pools are created in which one investment style / portfolio applies to the whole group of members, be they young or old, men or women, high-income or low-income. Obviously, this middle-of-the-road investment style might be sub-optimal for many, but the social aspect of it (”we all stick together”) has certain benefits as well. As we saw in our earlier contributions, investment success is not something easy and since in the end a pension plan is about making sure that you have enough money when reaching old age, this kind of pooled structure ensures that no one can be the victim of his/her individual mistakes caused by non-professional bad investment decisions.

For more information about Defined Benefit (DB) plans CLICK HERE.

It is probably no surprise that the ideas behind DB were quite popular in nations with a culture of social cohesion. European nations like the UK, the Netherlands and Scandinavia are good examples of markets with large DB plans. Actually, a relatively small country like the Netherlands with just 16 million inhabitants is the fourth largest pension market in the world. And this is directly related to the creation of big DB plans that has been started in the 1950-60s.

The social aspect of DB plans is strong and attractive, and it is therefore not surprising that Emerging Markets that have achieved a certain wealth status are contemplating the introduction of similar structures. E.g. the IR Iran is working on a pension structure similar to what has been created by the Dutch in the 1950s or the Norwegians during the last 10-20 years. The existence of gas and/or oil reserves in both these countries and in Iran is not coincidental of course.

Now, the big problem with DB is exactly that: DB. Defined benefit….you know upfront what the end-result is supposed to be. However, there are uncertainties in the world. The end result is a function of: a) investment results; b) demographic factors and c) economic factors, with the premium inflow being covered in the economic category. With demographic factors working against pension plans by definition in the West (people get older and a smaller relative number of people is working), obviously pressure on the structure will be huge whenever economic and or investment factors work against it. And that is what is going on at the moment. Social cohesion is under huge pressure in DB countries simply because of that. In all these nations, younger generations are pressing for either full-scale DC alternatives or DC components as an add-on next to a minimum-level DB structure.

In a pure Defined Contribution (DC) plan, the pension fund is nothing more but a provider of various investment opportunities, be they funds or pools, in which members can invest according to their own belief (what mix to choose?) with or without guidance by the pension plan. The minimum achieved is cost advantages, since the DC plan uses its scale to get the funds chosen against some kind of fee rate not available to members individually. But hopefully, the DC plan did also use its knowledge about fund manager selection when pre-selecting the funds in its choice portfolio for the members.

The DC structure is most popular in countries in which some kind of individualism was and is strongly developed. The US market is of course the most important one. The main certainty is that you save for your own old age. But, with the contribution being sure, the uncertainties now are the economic and investment ones. Whenever you invested the wrong way, your end result will be disappointing. Maybe even insufficient to avoid poverty!

For more information on DC plans CLICK HERE.

Investment and selection style by Type of Institutional Investor

In the remainder of this blog entry we will now analyze the various components mentioned above for the three different groups of institutional investors that we can distinguish.

I) The aggressive guys; Investment Banks and Hedge Funds

Investment bankers and hedge funds that also use substantial parts of their own money are the real risk takers. You can classify their styles based on what we told you in our blog entry on differences between men and women (see here) as typical ”macho”. They are in there for the quick buck, fast deal, and aren’t afraid to take big risks. High, often excessively so, leverage is a typical characteristic of the style of these guys. When successful they think that they are the best and can get away with everything. Yes, to a certain extent you could say that they are the guys that caused maybe not the whole credit crisis, but definitely the momentum and exuberrance that in the end made the system explode. As long as they do it with their own money, or with that of investors that do understand some investment basics, that is all fine. However, when they label themselves ‘investment magicians” and attract money by others while at the same time not being controlled carefully enough, because the regulatory authorities do not understand the difference between a ”miracle investor” or ”magician” or ”someone just having plain luck” this can be very harmful. And that is what happened. Even smart people seemed to have forgotten how long it takes before guys with casino strategies are not part of the alleged magician group anymore.

Example: Assume that there are 100 investment bankers/hedge funds out there that do only one stupid thing. They flip a coin and when it says heads they go long with all their money in dangerous stock investments. When it is tails they go long with all their money in some kind of fixed income, gold or other defensive investment. After one year there are still 50 coin flippers labeled good investors. After 2 years 25, After 3 years 12, after 4 years 6, after 5 years 3, after 6 years 1.5 /2 and after 7 years there is one of our 100 guys who can say that he outperformed the whole 7-year business cycle. And believe me, he will attract a lot of money when capable of doing business with people that don’t ask him too many nasty questions about his investment ”strategy”. And yep….you do immediately see now why Madoff could happen!! Admiration without checking results.

With respect to investment style and manager selection, these guys are not afraid of anything. They will actually love the most risky deals. They like frontier markets more than defensive solid investments in fixed income in established nations. They prefer distressed firms over mature solid ones. Et cetera. It is good to go with them up to a certain extent, because they often use their own money. But, to the extent that they might be sensitive to overconfidence (the macho thing), always make sure that they hold the best-possible, diversified portfolios. In our case, we would require them to be Markowitz-van Dijk compliant, i.e. true champions in diversification. To the extent that they have invested in talented small managers, they are good for the system in that they are not afraid to give money to these talents. But only to the extent that the talents are really talents of course, and – as shown by the previous example – that is difficult enough when you don’t know how to ask the right questions and perform the right performance analyses.

II) Banks and Insurance Firms; Non-specialists with Investments not being the main activity

They earn their main money with other products, be they banking/savings related or insurance products. But because of developments in the financial industry, all of these products got a larger linkage with the investment world. In the end you will have to invest money – be it your own, or that of your clients – somewhere. After the collapse of the pure savings banks back in the 1980s and the transition from pure insurers into bankassurance in the 1990s we did indeed see some indications of diversification understanding. So, being non-specialist, the decision takers here – who have probably the relatively largest amounts to invest due to their scalable product offering to the economy at large – do diversify. But it is definitely not the top-level, diversification and risk management activity that can be labeled Markowitz-van Dijk compliant. It is amateur diversification and risk management as a result of which disasters like the investment in securitized mortgage portfolios in the US could happen. They really believed that having a portfolio of large amounts of mortgages from all over the US would be diversification. That there are more dimensions to this thing than just plain geography and that correaltions between Seattle and Florida are pretty high in a time of crisis and economic malfunctioning was totally forgotten. They have never seen the work of French top professor and diversification specialist Bruno Solnik on the relationship between crises and correlations. Or they saw it and didn’t believe it was important, because they sticked with the big names. Non-specialsts always overesimate themselves not to the extend of taking too much risk knowingly, but to the extend of thinking they know what to do and how to do it. Result: huge investments in investment vehicles and structred products created by well-known, allegedly successful institutions. Be they large asset managers, investment banks or hedge funds.

Or: they translate their alleged knowledge into the belief that they should have their own asset management branches to develop these products internally! And to some extent you could say that this ”strategy” might also partly explain why – on average – good boutiques outperform large houses. Too often do large houses start things when not being a specialist. The ”macho” overconfidence of a bad boutique is replaced by ”breadth” overconfidence!

So in a way, using money from external clients and with a mind set that focuses first and foremost on risk reduction, these institutions should have invested like women do. Study information thoroughly, dig into the details, take not too much risk, diversify and avoid overconfidence. Unfortuately, women decision takers are a very small percentage of the boards of these instituions. Therefore, we cannot be too surprised that the big failures happened in this group of institutional investors during the 2007-now credit crisis. Out of synch with their own style and goals, and not capable of distinguishing between sharks and frauds on the one hand and true specialists on the other. It is not a surprise that it is especially true that investment affiliates of these entities invested a lot in Madoff!

III) Pension plans

As a group, the true specialist pension plans that basically act as a kind of end investor (definitely so in the DB case, and to some extent in the DC case) or his direct advisor through pre-screening (DC plans) are normally when looking at the return-risk profile the best institutional investors. Logically so, because they do have all the information available, they do have armies of specialists working for them and they do work structurally with consultants.

So when we concluded that on average institutional investors have better returns than private investors, see our earlier entries, we should at the same time add that the difference is shockingly small. When investments are at the same time art and science, the specialists should outperform the non-specialists by a wider margin. That this is not the case, is the result of overconfidence on the one hand, and lack of honest, sincere performance measurement and analysis on the other. The difference between true investment professionals and their performance on the one hand, and the amateurs on the other, should not be as small as to make funny stories about King Kong throwing darts and beating the specialst possible. Definitely not when analyzing diversified portfolios created by true specialists.

Now, how come things can go so terribly wrong, also when we look at the pension plan investors? To one extent this is directly related to the agency argument. Pension plan investors are not using their own funds (like the co-investing investment bankers and hedge fund managers) and that could probably lead to some agency aspects playing a bigger role than they should. It is good that new governance structures and control- and regulatory mechanisms are being created that will further mitigate this problem. But it is still there.

On the one hand this leads a lot of pension plans to investment styles similar to that of banks: overweighting of established ”big names” with middle-of-the-road products (the ”you never get fired for hiring IBM” argument), whereas actually they do know enough about investing to go for a best-of-breed approach with more bold products on an individual basis linked together into a well-diversified overall portfolio.

And also: although they are the true specialists, their boards do also contain large components of non-specialists with quite an impact. Be they government-related or labor-union related. Amidst fear and panic, the relative importance of these groups within the decision structure grows bigger. As a result of this, there might be a tendency to sell the most risky investments at exactly the wrong moment. And that was happening in 2008! Instead of buying low and using the crisis as a once-in-a-life-time opportunity, these investors were actually in Q3 and Q4 of 2008 selling in many nations where we have good information about the buying and selling of DB investors. And obviously, the same pattern was even more prominent in DC plans, because there the end investors (individual members) were panicking themselves.

The whole system of calculation of how DB pension plans in this structure are doing, through the use of so-called coverage ratios makes things even more compicated. The average time to maturity of liabilities of pension plans (measured by the duration) is higher than that of its assets. That leads to the weird paradox that – when interest rates decline to bottom levels, like right now – the net present value of the liabilities goes up to such an extent that the coverage ratio will probably decline to levels not acceptable for regulators or boards.

That leads to tension and increased relative importance of the non-specialists within the board exactly at the time when the true specialists should take the lead. Result: what is sold is NOT the parts of the fixed income portfolio that made above-average returns during the period just finished (e.g. investment grade bonds that went up in value due to interest rates moving to zero), but actually stock components of the portfolio are being sold in a period of total sell-off of stocks in the first place. And even worse: within the stock component of the portfolio stocks from markets that are fundamentally strong in the long run (emerging markets) are sold first and foremost before selling-off the stocks of firms in your own country. Reason: ”we cannot – often for political reasons – start with a sell-off of our own stocks, because this might hurt local firms and therefore also employement and the economy.

Conclusion

Institutional investors, and that holds especially for those that are willing to co-invest with their own money or the ones that are true professionals, should generate above-average returns at a far better scale than they actually do. King Kong and individual investors / investment clubs shouldn’t be competition when looking at their results. It is a disgrace that they often seem almost as good. Amateur base ball clubs from let’s say a high school in Anchorage, Alaska are just a ridicule when trying to compete with the Florida Marlins and that is how it should be in investments as well.

Credit Crisis: Post-scriptum

What does this mean for the credit crisis? It means that it is not so clear that institutional investors as a group will get us out of this mess soon. True, some of the bold investment bankers that survive the current liquidity squeeze and de-leveraging will be among the first to try to use the (almost)zero interest rate situation to buy into deal portfolios with above average prospects. But are they big enough to move the market? We at Lodewijk Meijer believe they are not. Only when the so-called Sovereign Wealth Funds will join them, will the system switch back into optimistic gear. In a next entry we will therefore have to pay separate attention to this new phenomenon that became important during the last 10 years.

Men versus Women; The Impact of Gender on Differences in Investment Style and Results

Posted in Behavioral Finance, Financial Markets, Manager Selection with tags , , , , , , , , , , on March 12, 2009 by evd101

By Erik L. van Dijk

In our last two blog posts we analyzed how private investors take their decisions. With our without the help of financial planners, the non-professionals seem to struggle in the financial market place. Before concentrating ourselves on the institutional side of the industry in later blog entries, we would like to ask the question: but what about gender? When looking at the TV, or reading a newspaper, it seems clear that the financial world is (still?) mainly male-dominated. This is especially true when it comes to the main executive and ‘content’-related positions in the industry. In marketing and sales things are slightly different, for obvious reasons: when the industry is male-dominated, and not just that, but even dominated by alpha males that exert some macho characteristics, then don’t be surprised that it pays off to overweight the percentage of good-looking, eloquent, nicely-dressed and -heeled women in your marketing/sales staff.

But is this gender pattern in line with investment qualities? During the last 10-15 years there has been quite a bit of behavioral research into this question. And now, with the group of Wall Street, London or elsewhere-based crooks (be they big bankers or frauds) that have or should apologize for the Credit Crisis being male-only, it is interesting to summarize the results. A remarkable, but clear pattern evolves:

i) Gender and Investment Confidence

It will not come as a big surprise that all research seems to indicate that one important difference between the sexes is that men tend to believe that they understand investments, whereas women have less difficulty explaining that they are not so sure about their abilities. And in and of itself this lower ego is not a wrong thing: investment analysis and portfolio management is a complicated thing. A far larger number of disasters were the result from overconfidence than from lack of confidence. The result of this difference in confidence is first and foremost that less women trust themselves to start investing (as amateur) or even consider a career in investments. But what remains to be seen is if the confidence differential translates into quality differences between those men and women that start to invest.

ii) From confidence differential to style differential: women care more about the details

The lower confidence levels in women translate into an approach in which women want to know far more about their potential investment than men. Men ‘think’ that they understand things much quicker than women do. Result: women will dig deeper when it comes to the information-gathering phase before deciding if they buy/sell an investment.

iii) Women: the careful investors. From less confidence and more detail to lower-risk strategies

And even when studying a larger information set, women don’t get rid of their initial negative confidence level gap. They remain prudent and translate knowing more into a larger interest in investments in asset classes with lower risk. I.e. fixed income securities, real estate et cetera. Men like to go for higher beta (more systematic risk) and higher volatility securities. This implies that – if we will find a return differential between men and women in favor of portfolios created by men – we will have to make sure that portfolio returns are corrected for differences in risk, before making our final judgment.

iv) How the lower ego of women translates into a larger willingness to incorporate mutual funds in

the portfolio

When your personal SWOT indicates – after careful revision of the available data – that you don’t know enough, then it is far better to outsource the decision to a professional with proven track record than to gamble. Women do therefore use a larger percentage mutual funds than men do. Sometimes up to 40 percent larger allocations to mutual funds. This does translate into a larger diversification of women portfolios and it adds to the risk differential between female and male portfolios, even when looking within a specific asset class.

v) Style drift: women are more style consistent

One of the problems with investing is that you will go through periods of success and lesser periods. When doing so, investors will also be exposed to external information from news media, so-called experts et cetera indicating where the real profits were. This will create an innate tendency to shift your style bets away from the original plans into new territory that might seem to generate better results. Men are far more sensitive to this style drift than women are. To some extent this is caused by the fact that women in general won’t embark so quickly on a new path. They are less afraid to miss out on that so-called ‘unique opportunity’. They have a longer-term investment approach and understand that a new chance will always follow.

vi) Men are better for their brokers: excess trading

The overconfidence of men and the eagerness to follow the quick buck leads them into strategies that involve a larger amount of trading. Studies seem to indicate that the average annual turnover of male portfolios is some 25-50 percent higher than that of female portfolios. This larger trading activity in male portfolios is the result of overconfidence (‘I understand the market and feel that this is the right time for a timing-related switch!’) and to another extend to the shorter-term focus of men. It will obviously lead to higher trading costs, that will eat away part of the gross return on the male portfolio. Note that the male portfolio should – based on what we found so far – outperform the female portfolio on a gross basis, because of the excess risk taken. If you have a larger tilt towards higher risk instruments, you should earn a higher gross return. And net return as well, unless the trading wasn’t smart in the first place. Interestingly, some studies seem to indicate that this was indeed the case: the net results of the male and female portfolios would have been higher had they refrained from intra-year trading and concentrate on an annual buy-and-hold strategy instead!

vii) The Return Analysis, who wins: men or women?

One of the most important studies analyzing the return differential on female and male portfolios was the 2001 Barber & Odean paper Boys will be boys: Gender, Overconfidence and Common Stock Investment as published in the Quarterly Journal of Economics. Barber and Odean were also (together with Heath) writers of the paper that we used in yesterday’s blog on ‘Good Reasons’ investing. It is quite likely that women – fed by a larger information base with more details – use more complicated decision models that are to a lesser extent prone to the ‘good reasons’ fallacy. And indeed, studying the investment behavior of more than 35,000 households over the 1991-1997 period the authors conclude that single women score portfolio returns on a risk-adjusted basis that exceed those of single men by 3.0% annually. In marriage couples that decided to have men and women invest separately the differnence is still there, but to a lesser extent: in that case the women outperform by 1.4%. And this is not a pure US result. A 2005 study in the UK corroborated these findings. Actually, UK blokes are relatively lousier investors than their US counterparts were, or, UK women were better than US ones, or a combination of both. But more research is needed, since the Barber-Odean study was more rigorous and robust than the UK one.

Another study by Kuenzi and Riessen (University of Cologne, Germany, 2006) came to the conclusion that the differential net return did not exist when looking at mutual funds that were either led by a woman investor as leading portfolio manager or a man. In other words: the overconfidence of men leads to disasters when it is not based on some kind of background knowledge. Male amateurs seem to forget that they are just that: amateurs. But when taking a closer look at the Kuenzi-Riessen paper the result is still surprising. First, we should not forget that there are far more mutual funds led by men than there are by women, and the funds that men manage are much bigger too. As if there was an innate tendency in the professional community to mistrust women that didn’t want to focus on selling and looking good, but on fund returns instead. Now, Kuenzi and Riessen show that on a gross basis male mutual funds do indeed outperform. However, the outperformance was to a large extent directly related to the fact that they take more risks. So part of the excess return was eaten away after a proper risk-adjustment. There was still a bit of outperformance left though, but that gross outperformance was consecutively eaten away by excess trading. Final result therefore: equal net returns, but the women got there with excellent style consistency. Knowing that style consistency is in and of itself also important in asset management (because you should always assume that you are not running the whole portfolio of the client, so that if you don’t stick to your job his/her overall portfolio risk-return profile might start to be hurt), the conclusion should again be that – if anything – women win.

viii) Give women more space and investment responsibilities

So women should feel a bit more confident about their investment qualities (as long as they don’t become overconfident!), and the men that dominate the investment community or their married amateur counterparts that still believe that they are best-equipped to do the finances at home should give women more credit for their hidden investment qualities and give them more space.

In a slightly different setting, Harvard professor Boris Groysberg corroborates these findings. In the August 2008 Harvard Business Review he gives a nice interview to reporter Martha Lagace, explaining that based on his research ‘star’ women (be they financial analysts, lawyers, investment managers, accountants, investment bankers et cetera) are more successful than men when changing their job. The ‘star’ women that are hired by a new employer who wants to pay more or offer other fringe benefits for the new divas are far less disappointed than employers who hire male ‘stars’ from another company. Groysberg explains that there are two reasons for this:

a) Portable Relationships

Women are good in having both internal and external relationships and this phenomenon is part of the same process that made them look for more details when it comes to taking investment decisions (see above). Never wrong to know more (be it about things or be it people). Result: they can easily adjust to new circumstances, with their external network helping them cope with it. Men on the other hand are more inward-looking (either alone or with their smaller group of buddies), and do therefore struggle when switching to a new, unknown situation.

b) Smarter Evaluation

Women use ‘multi-factor’ approaches in which they probably are not totally aware of the exact weights of factors in that decision process (they are not necessarily more quantitative than men, on the contrary!), but they know damn well that it is wrong in complicated situations to use an oversimplified decision procedure. In other words: they are less senstive to Barber, Heath and Odean’s ‘Good Reason’s Fallacy’ that we explained in yesterday’s entry. This implies that women take better decisions about when to switch jobs and to what employer to go.

ix) It was a man’s world. Will James Brown’s song become past tense in the credit crisis and the years ahead of us?

I think that it is impossible to believe that the gender divide will continue in its current form. Especially so after the credit crisis in which the male species played such a dominating role. Coming from a family of strong women, where men were never inclined to think that they were the dominant species and blessed with a sister that is indeed a savvy, smart investor who – based on qualitative reasoning – was always capable of challenging my ‘quant’-based work and making sure that I didn’t forget to incorporate qualitative factors in our decision processes at Lodewijk Meijer, I don’t find this shocking. However, I cannot exclude the rise of some kind of countermovement that wants to maintain the existing glass ceiling that is hindering upwardly mobile women in society in general and in investing in particular.

On a global scale the sign of times is that women will  become more important in our industry and based on what we just mentioned, that is a good thing.  Last month, the Financial Times published a nice article about female Japanese investors. Contrary to what many Western outsiders might think, women in this Asian country do already play a far stronger role when it comes to managing the household budget and savings than their western counterparts do. Actually, Kyoto professor Noriko Hama believes that Japanese women have played a significant role in recent arbitrage trends in the fixed income and currency markets. During the last 10 years interest rates in Japan were almost zero, a situation similar to the one the Western nations are now facing due to the credit crisis. In the Japanese case it was directly related to the multi-year Japanese recession. Now, with interest rates so low, the women were afraid that they could not balance their household budgets. Different investments were needed. Knowing that interest rates in favorite countries (for holiday and shopping) like Australia, the UK, Singapore or even Turkey were much higher than in Japan they steered money out of Japan into those countries. Of course, the Yen is normally a stronger currency, but with international investments almost being non-existent the combined acts of Japanese women (and men) led to a money outflow that created a self-fulfilling prophecy. It generated downward pressure on the value of the Yen, which in fact made this strategy less risky. The strategies were solely coupon/interest rate driven, without too much worries about the principal and with this positive surprise and – in the end – always the possibility to ask for payout in the foreign country where it can then be spend on a nice holiday or some shopping, it is already a clear indication that women are here to stay in investing. Be it in the Western world or in Asia.

Best of both worlds; smart gender diversification within the investment team

It is surprising to see that this plea for more women in investing is NOT the same as saying that women dominate men to such an extent that we should get rid of the overconfident, alpha-male investors alltogether. Research does also indicate that the best solution is a mixed team with both men and women. Men are good in the high risk zones of the market that require alertness, speedy trading and strong nerves. Women are better in the low-risk zones of the portfolio and when acting combined one group can be a useful control set for the other. It is in the end all in the mix!

Conclusion: MEN SHOULD LEARN TO LIVE WITH THE FACT THAT WOMEN ARE MUCH BETTER WITH INVESTMENTS THAN MOST OF US ARE WITH HEELS. MIXED TEAMS WILL TAKE THE BEST DECISIONS BECAUSE THEY COMBINE THE STRENGHTS OF BOTH GENDERS.

How do people invest? The difference between group and individual decision taking – with a small side-step to the credit crisis

Posted in Behavioral Finance, Financial Markets, Manager Selection with tags , , , , , , , , on March 11, 2009 by evd101

By Erik L. van Dijk

In our previous entry on Fund Manager Selection we noticed what the typical flaws of private investors and their advisors are. Now, before turning to decision taking by the so-called specialists in part 2 of the series on Fund Manager Selection, it is good to take into account resulst from a great paper by Barber, Heath and Odean from the Haas Business School at the University of California Berkeley. In their paper Good Reasons Sell; Barber, Heath and Odean, published in Management Science in 2003 they point out that individual investors take different decisions when being part of an investment club. 

A lot of the research focusing on differences between private and institutional investors incorporates agency-related factors in one form or another. The Agency Theory, going back to the original work of Mike Jensen and Bill Meckling in the mid-70s, indicates that situations in which a principal / decision taker is working in his own self-interest can lead to different outcomes when – for example because of the decision framework or company structure getting too large – he/she outsources part of the decision taking to an agent. Supposedly the agent is required to act totally in the interest of the principal / decision taker, but one can never exclude that the agent will incorporate his/her own agenda with goals/targets in the overall decision framework. Consequence: the end result can easily be less good than what the principal expected.

Before turning to investment decisions by institutions in a future post on Fund Manager Selection (part 2 of the series started yesterday), it is good to re-analyze the Barber et al. paper. In their paper they publish results from tests in which they distinguished between individual investors who took their investment decisions alone, and those who worked together in a group. Now with investors in an investment group still being the sole owner of their share of the overall group portfolio, the agency aspects don’t apply. Any difference in investment style of people in groups versus people on their own is therefore the sole result of behavioral factors.

The results are astonishing. People do decide differently when in groups. And not just that: people in general use decision processes in which ”good reasons” are guiding them more than conscious cost-benefit-analysis-based decision taking! Both the individual investors and the clubs in the Barber et al. study underperformed the benchmark, both on a net and gross basis. In other words: professional investors as a group do outperform. And that implies that the fun, anecdotes about King Kong beating the specialists with stocks picked by throwing darts are demagogic. The tests of monkey versus specialist do always incorporate 5 or less stocks and one ot the key characteristics of a good specialist portfolio is diversification. Taking away the diversification from the specialist, is like taking away bananas from the monkey. If you don’t give him his yellow, curvy food, he won’t be able to pick any stocks, let alone outperform.  

But the differences between the good, bad and ugly in both investor categories can be substantial. And that holds for both the professionals and the amateurs.

One standard mistake made by private investors is that they forget to diversify. Research has indicated that it is best to diversify a portfolio over 15-20 different, if possible not too-correlated holdings. In case your portfolio is too small: stick to funds and avoid individual stocks or other securities. The average investor club or individual diversified his/her portfolio over 5-10 holdings. The excess risk that results from this is one reason for the relatively meagre performance. Diversification was a bit better in the groups, but there diversification did not follow the lines of correlation reduction. It was more a way to ensure that everyone in the group had something funny and interesting to do, with others being able to mingle in the discussions. I.e. we diversify the research, but please make sure that the group discussions in the meetings that decide on portfolio changes are ‘fun’ with all respected members being able to show how knowledgeable they are.

This phenomenon can explain why securitized portfolios that were so instrumental in explaining the credit crisis were not diversified enough. A good group process would be one in which bottom-up specialists prepare things, bring their research into a meeting with eachother and with top-down specialists, with the latter than deciding ultimately about allocations. That is not what is happening in the case of investment clubs I am afraid. Actually, it is not even true for most institutional decision processes either. As top-down specialists, we believe that our cooperation with Noble Prize laureate dr Harry Markowitz (mr Diversification if you like) has helped us to take an objective stand by using a helicopter view in which we give credit to the bottom-up specialists that we categorized as best-of-breed.

No, decision taking in investment clubs follows a different path. Barber et al. show that ‘good reasons’ are the dominating factors explaining buy decisions. ‘Good reasons’ are labels and categorizations providing a seal of approval / quality stamp to individual stocks, albeit that the same could apply to mutual funds. Factors that fall under the ‘good reason’ definition could be; i) incorporation in a most-admired list (e.g. the one by Fortune); ii) strong sales growth of a firm over the last 5 years; or iii) strong stock returns over the last 3 years. With respect to the incorporation in most-admired lists: compare what we wrote in our previous contribution about advertising by mutual funds! And the 3-year return track record is of course one-on-one in line with what we wrote about raw returns in our previous post. ‘Good reasons’ are useful quality stamps, but not necessarily so for achieving above-average investment results: you have to pay for them. ‘Good reasons’ firms are more expensive, so that net results on ‘good reasons’ portfolios can be lower than on a contrarian one. That is how markets work: if something is more desirable, more people want it. And this higher demand translates into a higher price.

The fascinating thing is that people in an investment club are not agents, but principals! So, why do they decide the way they do? In our contribution on Fund Manager Selection by institutional investors we will show that the old adage ‘No one ever got fired for buying IBM’ is an important explanation in an agency setting. But the Barber et al. research indicates that there is more at stake. Group decision taking incorporates innate behavioral problems that can lead to sub-optimal investment decisions with or without agency complications. Investment portfolios should – in the end – lead to diversified mixes of individual holdings or mutual funds that are sufficiently different. Selection of different things involves different qualities. Different qualities require different type of people/specialists. Group processes with different people might lack the ‘social fun’ or a group process in which all like each other, respect each other, have fun working together. And that is where things go wrong. It is most likely that this problem plays a bigger role, the bigger the organization is. Investment clubs are normally limited to just 10-15 people, and already with those small numbers, the problems are tantamount.

Interestingly enough, it is not true that this problem arises solely in groups. Be they institutional (with agency problems included) or private (principal-only). Barber et al. show that the ‘good reasons’ problem is also bothering most individuals on a stand-alone basis when selecting stocks, albeit to a lesser extent. We can extrapolate this behavioral finding into another plea for making sure that boutique, smaller asset management firms in which a charismatic set of key personnel plays a leading role are not forgotten within a diversified portfolio of funds.

Bottom line: taking the right investment decisions – be they the selection of fund managers or the buying or selling of individual stocks, bonds or other securities – is a complicated thing. Too often, do we show weakness to quality-related factors, or non-investment-related agency factors, or do we fall prey to naive extrapolation of historical results. The ‘good reasons’ work by Barber et al. confirms this.

Conclusion: good investing requires a complicated skill set, that is unfortunately less readily availabe than we would like. It is not very helpful that the average marketing or business development executive of big financial institutions tries to make us believe that they are big because they are the best in everything they provide. The same holds for investor relations personnel (or the CFO or even CEO) of stock-market-listed firms trying to convince investors to buy their shares and hold them longer. The difference between ‘the good’, ‘the bad’ and ‘the ugly’ is complicated when it comes to finding the best investment portfolio. Avoiding ‘bads’ and ‘uglies’ alltogether will lead to underpermance. Buying the bads is not an option either. The best strategy should lead to a diversified mix of ‘goods’ (‘quality’) and ‘uglies’ (contrarian strategy components), but as a decision taker you need a strong stomache to defend the latter category, especially in harsh times.

POSTSCRIPTUM

Application example 1; Emerging Markets 2008

The fact that Emerging Markets – even the ones with strong fundamentals – lost more in the credit crisis than struggling but bigger (‘good reasons’) developed markets gives you an idea about what we mean here.

We at Lodewijk Meijer continue to believe that only a robust, cost-benefit-based approach in which all pluses and minuses are made transparant to the final decision taker (‘principal’) can lead to structural outperformance. That is why we combine ‘best-of-breed’ specialist products of a mix of large firms and boutiques in a framework in which we only play the top-down, objective outsider role based on a framework that we developed together with Noble Prize laureate dr Markowitz. Humble when necessary, bold when based on something and boring when it comes to risk: that is the right way to go for investors in this new era. Unfortunately too many decision takers didn’t come to that conclusion yet.

Application example 2; Will our leader be capable of getting us out of the current crisis?

And that does also seem to hold for the ones that are trying to lead us out of this credit crisis. Initially the G7 leaders and ministers of Finance tried to do it themselves. With the smaller developed nations playing copy-cat in their own country. But hey guys, if you let liquidity first flow towards the Chinese and Arabs through the acquisition of products, oil or direct investments, don’t be surprised that – when suffering a problem – liquidity is somewhere else. The receivers of liquidity in the aforementioned nations did not automatically send it back to Wall Street or London. Sure, sooner or later it will come, but at their convenience. Only now, months down the road do we see markets slightly improve and leaders change talk from G7 to G20. Finally! The initial money spent was printed money of future tax payers. If we want it or not, cost-benefit-based thinking would imply direct talks with the Chinese, the Arabs and other sovereign wealth investors. Our leaders have to be bold and humble at the same time when doing so. Difficult, but possible.