Archive for Manager Selection

The World is Changing: Also in Asset Management

Posted in Emerging Markets, Financial Markets, Manager Selection, Uncategorized with tags , , , , , on March 20, 2009 by evd101

By Erik L. van Dijk

The world is changing. On the one hand, we see that the relative importance of Emerging Markets is growing. When looking at the relative market value of stock markets of these nations, we see that the percentage went up to some 10-15 percent in 2006-07. True, due to the credit crisis this percentage dropped back to about 7-8 percent recently. And although that number is more or less in line with percentages seen in the decade before, one thing is totally different since 2003. Market values of stocks represent the price of economic activity in a country (albeit as a rude proxy). But the gross domestic product (GDP) of a country is an indicator of the underlying asset base / fair value of that economy. Robert Shiller’s excellent book on Market Volatility contains a few papers that clearly indicate that prices are far more volatile than fair value. Result: we move from periods in which prices are far too high to periods when they are more or less in line with fair value to periods when prices are way too low, et cetera. With the GDP weight of the Emerging Markets now being close to 30-35 percent of world GDP, it is obvious that the market value weight underestimates their current importance. More than ever so. We do therefore believe that the bulk of conclusions drawn by Jim O’Neil and his Goldman Sachs economic research team in their book ‘Brics and Beyond’ do still hold. This is going to be the era of Emerging Markets. Sooner or later China and maybe India will be bigger economies than the US one.

But it is not just the economic world that is changing geographically. A similar phenomenon is going on in the asset management world. As an asset manager selection specialist, I would say that up until the beginning of this century the bulk of real best-of-breed asset managers was Anglo-Saxon. Within that group, the US asset managers got the lion’s share. This was especially true when looking at so-called quantitative asset managers. In the fundamental zone there were some good British asset managers active as well. Local parties in other nations were mainly of interest to local end-investors to the extent that the local factors were of importance. Be it legally, or because of the local presence. In terms of performance track record they couldn’t keep up with the best-of-breed specialists from the UK and US.

Now, with the world getting smaller due to globalization, the number of products growing and international complexities increasing, something has happened. The dominance of the Anglo-Saxons in the best-of-breed major league is far less prominent than it used to be. In the case of the Americans part of this is understandable. The Americans were always best in domestic products, and I would still be more than surprised to see a top-notch US equities or bonds manager not being from the States. It can be done, but it is hard. But their attitude to label products elsewhere as ‘International’ and put them alltogether in one mandate/fund was illustrative of how the US saw the world: us, the US, versus the rest. In terms of a world divided by market cap this was actually quite understandable. The US’s relative weight in terms of market cap was indeed about 40-50 percent for many years. If you add to that the fact that the Wall Street stock markets were the best-regulated and most-liquid ones, this approach was more than OK.

But with the shift in economic activity, and with the world becoming a more equally-weighted place with the US now being approximately 30-35 percent of the total pie, Europe and other developed nations (JAP, CAN, AUS, NZL, SING, HKG) representing a similar percentage and the Emerging Markets also, things are changing. And not just that, it is also clear that with this shift in economic power two important trends have helped to change the balance of power in asset management:

  1. The increasing role of London as center for international asset management. With Americans being less internationally-oriented than the Brits, major banks, insurance firms and asset managers from all over the world realized that London was an excellent alternative as world hub for international mandates. Not just in terms of available knowledge, but also in terms of time zone, being neatly placed between Asian time zones and the US time zones. The UK also followed an active strategy to grow the London Stock Exchange and attract as much as it could this type of new business. And with it came the shift of knowledge to this market. Even big American institutional investors and financial services firms accepted it and the growth in the City of London was to a large extent caused by American institutions understanding that ‘London was the place to be’ for non-US asset management. It was not surprising that the brightest talents in the asset management community followed this trend. Sure, when thinking in terms of academic study in Finance or Investments the US was still the hottest place to be, although levels in European schools like the London Business School, London School of Economics, INSEAD or even Asian ones like the Indian Institutes of Technology, top universities in Israel, Hong Kong and Singapore are definitely not considered much lower by recruiters anymore.
  2. And not just that. With the economic balance of power shifting, it became clear that there were areas of the market in which foreigners could do at least as good a job as their American colleagues. The ‘investment game’ is not the same in every asset class. Equities, Fixed Income, Hedge Funds are different games. And that is definitely true when looking at running portfolios of securities in these markets in different countries. This has led to the rise of excellent asset managers in other nations as well, also on a performance basis.

Examples: the top-level French asset managers are true specialists in Fixed Income. Somehow the French specialists, often relatively quant-oriented play a ‘game’ in Fixed Income that makes it very hard for the big Americans to compete. Germans also are strong in Fixed Income. Good quantitative managers are now also not a rare thing in the UK anymore, albeit that it is mainly in boutiques (with the exception of large powerhouse Barclays Global Investors, albeit that BGI is especially strong in index products). Average knowledge levels in the Netherlands and Scandinavia have gone up spectacularly.

This increased competition between a growing number of international players with far more knowledge dissemination than before has led to:

a) growing numbers of strong asset management boutiques, that exploit a specific, specialized skill set on a relatively narrow market segment;

b) finally (!), some downward price pressure on asset management fees, with unfortunately brokerage fees still not following quickly enough

c) the demise of parties that didn’t really add value, but simply leveraged their ‘brand name’ image / ‘size’

d) a growing interest in manager selection, because – with the non-existence of reliable ratings similar to what we described about rating systems in the Chess World in a previous entry – a larger number of providers in a growing number of sub-categories of asset management made things less overseeable for the average investor.

That is where we stand. An industry getting more mature at a time when the financial world seems to be burning. Investors do not just have to analyze carefully which asset manager has products in a specific category that are truly outperforming on the basis of skill, no, he/she also has to make sure that the provider itself will be there one year from now. Especially asset managers that are part of large banks or insurance firms have to be analyzed carefully. Before you know the asset management operation is sold as part of the restructuring operation, with all the turmoil that goes with it. What will that do to the team of specialists that you think you are hiring when opting for a specific product that you like? Will they stay with the entity? Leave to another one? Start their own?

Asset management in a grown-up financial world is more important than ever, but separating the good guys from the bad ones will itself prove to be a new, specialized quality as well. A quality that can make or break overall portfolio results. Those of you that were hurt by investments in the Madoffs of this world, or in asset management products that underperformed indices by 100s of basis points know what I talk about.

The end result of this new development is of course good: they are all signs of maturing. But as long as end-investors do not realize what is going on and think that the old world is still there, it will take quite some time before end-users – be they pension plans or private investors – will be provided with a full opportunity set of good products, with bad products having no chance at all. In the mean time the grey zone will continue to make victims, because penny-wise, pound-foolish market participants might continue to follow a DIY strategy of selection without realizing that it is really true that results in the past are not necessarily in-and-of-itself indicators of success in the future.


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.


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.


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.

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.


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.

Fund Manager Selection Part 1; The Private Investor

Posted in Manager Selection with tags , , , , , on March 11, 2009 by evd101

by Erik L. van Dijk

On days like today, when stock markets bounce back like crazy and fears about the deepest recession in decades (that were talk of the town one week ago!) seem to have been forgotten, it is good to lean back and analyze some older research material. One of our specializations at Lodewijk Meijer is fund manager selection, based on our best-of-breed selection methodology. Our clientele consists of institutional investors like pension plans, banks et cetera. If there is one thing that we can learn from this crisis it is that both institutions and private investors make mistakes, albeit different ones. Private investors are prone to tunnel vision and myopic decision taking as a result of which they tend to take the same decisions at the same time, often guided by panic, fear and greed. Professor Hersh Shefrin’s book Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing should be made mandatory reading material for serious private investors. And that behavioral topics remain fascinating year after year, both in investing and other issues in life, was also shown last October when I organized a seminar in cooperation with French asset manager Ed. Rothschild Asset Management (EDRAM) for a Dutch audience of institutional investors. An old friend of mine, Professor Shlomo Benartzi of UCLA, was one of my keynote guests and Shlomo did what he always does: delivering a great speech, showing the audience what kind of amazing mistakes people make especially under stress or when faced with fear or greed situations.

But to what extent are there differences between Private Investors on the one hand, and Institutional ones on the other? Are the professionals really better? On the one hand one could say that pension plans and other institutions did at least not overreact when the credit crisis was on its way. When markets plummet and you cannot stop things anymore, because the fearful and panicky colleagues wanna hear just one word (SELL!!), you can better sit and wait and make sure that you hold fundamentally strong stocks in your portfolio, that will rebound as soon as markets come to realize that the overreaction has gone too far. The relatively low trading volumes of the recent months indicate that at least quite a few institutions are indeed playing their waiting game in a discplined manner, be it directly or indirectly when they have outsourced their investments to an external asset manager.

So that leaves hedge fund managers that have to unwind their excess leverage and the private investor as the main source of the incredible negative momentum of the last 12-15 months. They were selling, Western institutional investors – in as far as they weren’t banks that were struggling to survive after being fooled into terrible over-levered products by hedge fund managers or their own internal, ignorant staff – were doing nothing and the highly liquid wealth fund investors from China, Singapore and the Middle East were basically still waiting (with a few exceptions like Ping An, the Chinese insurance firm that stepped into Fortis at exactly the wrong moment).

But what was also clear, was that there was a separation within the Private Investor community. On the one hand, we had the private investors that invest directly in individual stocks and on the other hand we see fund investors. Now, research has indicated that it was especially the latter group that has caused the negative momentum. As if they did not want to hear the words ‘investment’ or ‘mutual fund’ anymore. It is therefore nice to analyze how this group of investors ‘thinks’. Jones, Lasseig and Smythe wrote an interesting article in the Journal of Financial Planning back in 2005 entitled Financial Advisors and Mutual Fund Selection. It is interesting to link their results to what we witness in today’s credit crisis. Markets that go down like crazy, many percentage points a day, when there is one negative piece of macroeconomic information, to markets that like today go up like crazy because of an email by mr Pandit, the CEO of Citibank, indicating that results of the first 2 months seem to be more than OK. Relief follows and there we go: 5-7 percent positive return in a day. Both are equally insane: the sudden drop (that didn’t kill us) and this ‘Phoenix from the ashes’ style price increase. The end of the world was not near, and neither is everything solved now. Only things we can be sure of:

a) There is liquidity out there, and it is in the hands of the wealth funds in Asia and the Middle East;

b) When interest rate cuts continue, we end up with an almost zero interest rate and that will trigger a return to stocks from the side of private investors and their advisors (including the mutual funds they use); and

c) The same interest rate cut will also make the cost of capital for firms so much lower that even the most risk averse might start to think about direct investments again.

When we add the effects of a, b and c up, we can be sure that the downward overreaction will be reversed. But unfortunately: it is almost equally certain that we will then move back to an also exaggerated positive momentum. In other words: excess price volatility around the volatility of the fundamental or fair value of stocks will remain, as already indicated many years ago by scholars like Robert Shiller and John Campbell. Compare for instance Shiller’s book Market Volatility.

So it seems that we have to ride the bandwagon and go with the flow. It is therefore good to know how the private investors using mutual funds take their decisions. If you cannot beat your enemy by being the only sane, rational guy out there, you better understand them and predict them! So let us get back to the Jones, Lasseig, Smythe (JLS) paper and study their results. Earlier research had already indicated that private investors focus strongly on a) mutual fund marketing and advertising when deciding which fund to buy (with later rumours and bad news being a strong beacon in mass selling actions); and b) raw returns. High absolute returns are proof that one should buy, and low absolute returns are a selling signal. Now, with studies showing that the average returns on asset classes are relatively stable, we can only conclude that this is exactly wrong! It is much better to buy when things are cheap and sell when things are expensive! The old work by De Bondt and Thaler on overreaction, as published in 1985 and 1987 confirms this. Only over shorter time frames (e.g. up to a year) are momentum strategies useful as part of a technical trading tool box.

But it is clear that a large part of the private investor community investing in mutual funds is not taking decisions alone, or they might not even be involved at all. There is a large financial planner and bank advisor community out there that ‘helps’ the unsophisticated private investor when picking or selling mutual funds. The JLS paper focuses on these advisors. About two-thirds of the private investor community uses such advice. Are these specialists mitigating mistakes that private investors themselves are prone to make?

The answer is yes. First of all, the advisors are not mislead by fund advertising as much as the DIY investor is. Second, they often have at their disposal comprehensive datasources like Morningstar or Lipper. Third, unlike many private investors they don’t make the mistake to look at raw returns only, but they also check relative return (i.e. return in relation to the return of a peer group or investor benchmark).

But were the advisors without flaws? Not at all! What went wrong is the following: advisors to private investors were sensitive to two common mistakes, namely

a) They paid not enough attention to fund costs and fees. Earlier research by Mark Carhart, now a big guy at Goldman Sachs Asset Management, has indicated that – if anything – the best funds were not the most expensive funds, but the cheaper ones. Reason: a good fund manager doesn’t want to make money via some kind of above-average fixed fee. No, he wants to attract money with a relatively low base fee, so that his assets under management become bigger (larger fee base) and then consecutively, he really likes to score through an excess-return related performance fee.

Isn’t it strange that the advisors paid so little attention to fees? Yes and no: on the one hand it might be logical to think that expensive is better, just like it is in for instance the car industry. A Mercedes is more expensive than a Hyundai and yeps, on average it is a better car. It is also logical when thinking about the following: advisors are also human, and they have to eat. To some extent higher fees might be higher, so as to allow the fund manager to pay a kickback fee to the financial planner/advisor. That would then explain a compensating effect that neutralizes the fee level factor. On the other hand, it is illogical not to look at fees according to Carhart. High returns from the past are no guarantee for the future. On the contrary, there is some mean reversion going on. Good managers of the past become on average less good in the future, and the lousiest of the past are on average not so bad in the future. Now, with fee levels being far more stable than returns, it is not logical not to take a more sophisticated look at them and incorporate them in the analyses. Remarkable: in most of the 18 asset classes in our proprietary selection system we did indeed derive quantitatvely that there is a negative correlation between fees and future results. We embedded the cost factor within our decision framework, and would be more than happy to provide you with more information about this, if you are interested in our manager selection services.

b) Fund reputation. Size matters far less than the advisors thought. Again, advisors are human. They are on the one hand – as we indicated above – better than their clients in that they are less sensitive to fund advertising and raw returns, but on the other hand did they turn out to be more than sensitive to ‘fund family size’. Big institutions with well-respected names got a much larger appreciation rating than they actually deserved when compared with nice boutique asset managers. Good fund boutiques need to score better results and work harder to convince financial planners/advisors than well-known big, fund factories do. And this is a big mistake. If anything, we often see that strong teams of investment managers working in big firms leave the big firm to start their own boutique.


* Private investors that follow a DIY strategy in mutual funds are too much advertising and raw return focused. It is therefore logical that their ignorance is quite often translated into big disappointments, like in the 2008 credit crisis period. Nothing like the expected returns and nothing like the promises from the advertising really materializing!

* Financial advisors did a reasonable but not fantastic job in helping the private investors that felt that they couldn’t do the job themselves with their selection process. On average they did improve that decision process in some areas. However, a mix of potential agency problems (do we buy what is good for the client, or what provides us with a nice distribution fee?), status-related factors (we love to work with the big guys) and ignorance about cost related factors in the selection process, makes them far less effective than they should. In other words: manager selection is a special field, and just like stock picking not something every or the average accountant, bank employee, or broker is capable of. The good specialist selectors like ourselves, Russell, Bfinance, SEI and the likes have to be distinguished from the average advisor to private investors.

* There is a market for better, transparent and objective advice to Private Investors. Here in the Netherlands SNS Fund Coach is playing a helpful role, and there are many of those sites in the US. However, objectivity would imply that the data base manager hires some specialist to distinguish between ‘good’ and ‘bad’. Sure, that would still bear the innate risk of the advisor making mistakes, but the alternative – leaving too many things in the database so that the private investor cannot find what is good or bad – is worse.