The conclusion to this two part series looks closely at investment firms and who actually decides where and when to invest; it also considers the other players of the investment game and who takes the big decisions, and whether they get them right
LEVEL THREE: REGULATION
a) Fund managers
Over the past half century the proportion of US shares held by institutional investors has risen from 7% to 50%. The dominant effect has been the spreading and maturing of pension funds, which have grown from virtually nothing to nearly a quarter of all US shares at present.
While direct share ownership has increased in the US, it has not grown as fast as indirect ownership, where fund managers usually make the big decisions.
Over the decade to 1998, when the NYSE last undertook a comprehensive survey, the number of direct shareholders grew modestly from 27 to 33 million, but the number of indirect holders increased much more rapidly from 52 to 84 million.
In some countries, such as the UK, the institutional effect has been so strong the number of direct individual shareholders has fallen. This compares to the 1960s when more than half the population owned some shares directly, now the proportion is barely above a 10th, according to Thomson Datastream.
Through their advisers, the fund management industry makes investment decisions on behalf of pension trustees and mutual fund investors. However, in practice the industry mainly devotes its extensive resources to investment minutiae.
When not burdened with administrative chores, typically individual managers will spend the vast bulk of their time researching individual companies rather than planning their overall investment strategies. Because of this, the number of investment professionals engaged in stockpicking is generally much greater than those interested in investment strategy.
In a typical asset allocation meeting, the basis for discussion would be how far the group's weightings should diverge from those of its peer group.
After recent developments have been reviewed, each of the teams will put in its discrete bid for a larger slice of the cake, over-weighting. The higher the star of each team, the less discrete the bid. However, because they are all team players, nobody can be put out of work, so no team receives a low allocation, irrespective of market conditions. The chairman seldom actually forces a decisive vote but ensures general agreement to allocate slightly more to him with the hottest hand.
This is justified on the basis that nobody can predict the future. As a company we cannot make any forecasts about what we think the market will do over the period because we do not know. However, we structure our client portfolios so whatever happens they have the best opportunity of meeting their financial objectives.
Acting on the doctrine of marginal product differentiation, all that is required is to depart from the middle ground to attract the marginal buyer. For example, if opinion on Japan is bearish there may be discussion about adjusting the weighting from 10% to 9%, but no discussion about reducing it to 5% let alone 0%. For the largest funds this has the logic of liquidity, but for everything else it has merely marketing logic. In terms of investment logic, such weighting games imply a degree of spurious precision, which is misplaced in a world of uncertainty.
Intellectually disguised, this emerges as a policy to focus on alpha rather than beta. This message is then marketed both internally and externally as portable alpha but hopefully the alpha is not so portable that star fund managers can walk off with it.
While there is, therefore, a slight pro-cyclical bias to the investment strategy, this pales when compared with the bias shown from marketing departments, which look to sell things fast and easily. In terms of investments, this inevitably means what is most over-priced.
Therefore, with monotonous regularity, investors are encouraged to make the wrong decisions at the wrong time, for example technology in 2000 and fixed interest in 2006.
This too is intellectually disguised in discussion about the performance of unit prices. While these accurately reflect the results of an investor who held a constant position throughout the period, it does not represent the performance of a typical investor, who is more likely to hold large cash balances at the bottom and become fully invested only near the top.
This is not the only mechanism through which decisions are made without regard to market conditions. In the search for pseudo-scientific justification for selecting managers, the weakness of one-year performance statistics is supposedly corrected by five-year accumulation, weighted three-year or consistent consecutive discrete periods of outperformance.
So, when should one change one's bets from large to small companies, or growth to value shares?
Among retail investors this shows up in new purchases directed not just to the top performing asset classes, but to the top-performing managers within them. In the pension fund business, it shows up in beauty parades, where only the hottest hands are invited to participate.
Research by Watson Wyatt, shows changing managers is generally counter-productive because losers are sacked after they fail and winners are hired after they succeed. Subsequently, the sacked underperformer, outperformed, while the hired outperformer only performed averagely.
b) Asset Allocators
Marginal product differentiation explains why the so-called balanced fund managers performed so poorly during the great bear market, despite their widely touted global research resources. It was not that they lacked bright people capable of making decent bets, but they lacked the courage of their convictions. As a consequence funds now flow instead to every imaginable specialist type of fund and fund manager.
Exchange traded funds are the most relevant beneficiary for asset allocators. Indeed the market has grown so large there are now 275 on Investors RouteMap. This helps asset allocators make the big decisions.
Over the past five years the multi-manager global sector returned an average 14.5%, which compared with 11.1% by the international sector among unit trusts. But how many asset allocators really do make the bid decisions? Clearly there are some that do, but a majority see their role differently.
For the fund of funds (Fof) manager there are two parts to the job - choosing mandates and selecting managers. Many share the view that anonymous investment managers can not predict the future. Therefore, the typical Fof manager will often aim to replicate the weightings of his peer group just as fund managers do. The only difference is this is external not internal.
By describing this investment philosophy as best of breed, such Fof managers suggest it is possible to avoid making qualitative judgements about asset classes and convert the investment process into a purely quantitative process based on fund performance within each class.
Once again, it proves impossible to wish away the big decisions. Top performance of a North American fund manager may have more to do with his weightings in Canada or Mexico than picking individual US stocks. Similarly that of a UK manager, where it may be largely explained by a preference for smaller companies.
Some attempt to match the best value with the best growth fund in any particular sector so as to obtain a market weighting without any style bias could be made. However, that too has its drawback.
In recent years, while value has been the game to play, the best value manager played value most aggressively, while the best growth manager may turn out to be the one that played growth least aggressively. Once the fashion changes back to growth, both will underperform, unless they can change their game, and very few even try because that would destroy their marketing differentiation.
c) Investment Banks
There is little doubt that these are both the most knowledgeable and aggressive of the regulated institutions. Unlike other regulated participants, investment banks are primarily concerned with managing their own capital. Advisory activities are becoming steadily less important as regulation becomes more onerous and competitive pressures lower commissions.
From the publicity earned by their investment strategists, one might think their profitability was based on taking large positions on the big investment decisions, however, they would be wrong. Their approach is essentially deal-orientated and, as such, they are more concerned with investment minutiae.
What profit can be earned on placing this block of shares that they have been asked to sell by one client? What margin can be earned by structuring that deal? The name of their game remains match buyers and sellers, rather than taking long-term positions, if possible.
LEVEL FOUR: INSIDERS AND OUTSIDERS
a) Commercial Hedgers
As insiders in their own businesses, few can beat them for knowledge. Followers of futures markets know that the net long or short positions of these participants are powerful indicators as to the likely trend of prices over the next few months.
Even so, some have performed spectacularly badly. Typically that happens when the pain of not hedging becomes too great for senior management.
Daimler's plight as Germany's leading exporter led it to start its highly publicised Dolores hedging policy, but only years after the dollar had peaked in 1985. Similarly, the world's leading gold producer Newmont only began hedging after the 1980 gold boom had collapsed.
However, their role is limited to those markets in which they qualify as hedgers.
b) Hedge Funds
Free to go long or short, unconstrained by benchmarks and rewarded by profit-sharing, they are ideally placed with both the knowledge and motivation to make big bets.
Even before the great bear market exposed the strategy of balanced global fund managers as flawed, growing suspicion about closet index-linking began drawing both the most sophisticated clients and smartest managers away to these boutiques. Their growth has now reached the stage that hedge funds account for around half the revenues of investment banks.
Again, one might believe these participants use their resources for making the big investment decisions. This is true for some but not for all, because the hedge fund industry is split into many different specialisations. Of the eight categories for which FTSE provides indices, only two focus on such decisions, namely global macro and managed futures.
c) Large Speculators
Again the futures markets provide ample evidence that large speculators are successful investors, but who are they? For the CTFC, they are those who are sufficiently active in the marketplace that they are obliged to report their dealings, but do not qualify as commercial hedgers.
That tells us little and their mystery is part of their success for it gives them the freedom to be courageous in making big bets that institutional investors lack. Some are hedge funds, mostly in the global macro and managed futures categories. Others are private investors, who require no outside capital and therefore do not produce public accounts that would identify them.
Unfortunately, this also means there is no way for members of the public to participate, but that is the point. Public participation requires regulation to protect customers. That brings the law of unintended consequences into effect as professionals protect themselves against legal risks by avoiding decisions where the outcome may be guessed but cannot really be known, namely making big future bets, which is what successful investment is about.
One alternative is investment in global macro or managed futures funds, but that means sacrificing regulatory protection. The other alternative is to carry out individual asset allocation, but that would mean subscribing to independent research services.
Over 50 years , direct shareholders in US grew modestly from 27 to 33 million, but the number of indirect holders increased more rapidly from 52 to 84 million
Number of direct shareholders in UK fell over the same period
The number of investment professionals engaged in stockpicking is generally much greater than those interested in investment strategy
Futures markets suggests large speculators are successful investors
Greater regulation would be burden to big decision takers
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