Author: Philip Edwards

Defensive diversification

“Diversification is the only free lunch” is one of the most over-used – and perhaps dangerous – phrases in finance. The idea derives from Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s, for which he shared the Nobel prize in Economics in 1990. MPT provided mathematical tools, in the form of mean-variance optimisation, to help investors maximise their expected return for a given level of risk. In essence, such tools embedded the idea that by diversifying across a range of assets, investors could obtain a more attractive risk-return trade-off.

The legacy of MPT is that diversification has become one of the easiest and most commonly used justifications for any investment decision. However, rather than being seen as a universal good, diversification should more accurately be viewed as a trade-off: we can reduce the downside of being wrong, but only at the cost of reducing the upside from being right. As Buffett once remarked: “diversification is protection against ignorance; it makes little sense if you know what you’re doing.”

Putting this a little less bluntly, we might think of diversification as a useful defence against uncertainty; but one that dilutes the impact of our highest conviction insights and often raises the governance burden. The dilution effect is clear in relation to actively managed portfolios: the more diversified a portfolio, the less impact any high conviction positions can have on overall performance. The governance cost relates to the additional work – in the form of due diligence and ongoing monitoring – that results from adding new assets to a portfolio.

That diversification, conviction and governance considerations are in tension is perfectly natural. However, in the presence of principal-agent dynamics, the temptation is for asset managers to over-diversify portfolios – by moving in the direction of a flawed benchmark – resulting in a less attractive risk-return profile for the end investor.

Defensive decision-making

In his 2014 book, Risk Savvy, the decision-making expert Gerd Gigerenzer defined defensive decision-making as follows: “a person or group ranks option A as the best for the situation, but chooses an inferior option B to protect itself in case something goes wrong.” Much of the literature on defensive decision-making focuses on the medical setting, where examples of “defensive medicine” include ordering unnecessary tests and over-prescribing medications in order to reduce the risk of being sued for malpractice. However, Gigerenzer points out that defensive decision-making is commonplace in the modern world, often arising in relation to political or corporate decisions where blame can easily be assigned.

Defensive decision-making flourishes in situations where decisions are taken by one party (the “agent”) on behalf of, or that impact, another party (the “principal”). The danger is that instead of assessing the risks and opportunities in a balanced way, the agent chooses to focus primarily on managing downside risk, fearing that poor outcomes will be felt more intensely by the principal than good outcomes. Such principal-agent problems abound in the investment industry, where trustees often take responsibility for decisions on behalf of beneficiaries, and trustees invariably delegate stock selection to external asset managers – sometimes further mediated by a fiduciary manager. The aggregate effect of these layers of intermediation is a potentially serious misalignment of interests which creates the conditions for defensive decision-making.

An example of “defensive diversification” would be where an asset manager holds a security primarily in order to reduce the risk of underperforming the benchmark, but where there is little or no expectation of positive long-term returns. Diversifying a portfolio to manage benchmark-relative risk in this way may reduce the portfolio manager’s career risk, but does nothing to improve the end-saver’s long-term return prospects. Indeed, there is a growing body of academic work suggesting that over-diversification imposes a cost on the end saver in the form of lower returns.

In Best Ideas, Cohen, Polk and Silli show that active equity managers’ highest conviction positions outperform the market and other stocks in their portfolio by a large margin (c.4-10% p.a. depending on the methodology and benchmark employed). The results are statistically and economically significant and robust across a range of specifications. The authors suggest “that while the typical manager has a small number of good investment ideas that provide positive alpha in expectation, the remaining ideas in the typical managed portfolio add little or no alpha.”

The authors put forward a number of reasons why managers might proactively choose to dilute their best ideas with what turn out to be value-destructive diversifying positions. These include a desire to avoid extreme benchmark-relative performance; attempts to maximise risk-adjusted returns (as opposed to just returns); or a commercial preference for running a strategy with a large volume of assets (which precludes holding a small number of relatively concentrated positions).

Related research by Cremers and Petajisto (2009) showed that the most active stock pickers – as measured by Active Share – delivered the greatest long-term outperformance. Managers seeking to remain within a certain distance of the benchmark ultimately delivered disappointing long-term returns. This work supports the idea that an overreliance on benchmarks as a solution to the principal-agent problem creates a situation in which diversification undermines managers’ ability to deliver alpha.

This is not to lay all the blame for defensive diversification at the feet of the asset management community. In many ways, managers are simply responding to the instructions and incentives provided by asset owners. In particular, any shared understanding between the asset owner and manager on what would constitute a tolerable limit for short-term underperformance (whether formalised in a tracking error constraint or not) would tend to mitigate against holding a concentrated portfolio dominated by high conviction positions. Procyclical hire and fire decisions on the part of trustees – terminating managers after a bad 3 years, hiring after a good 3 years – also provides a strong motivation for managers to avoid concentrated bets that might give rise to extended periods of benchmark underperformance.

Furthermore, the widely followed and reported Morningstar Ratings disincentivise concentrated portfolios by penalising volatility in their rating methodology. In order to maintain a high Morningstar Rating, managers need to avoid benchmark underperformance over 3- and 5-year periods and to minimise the overall volatility of their portfolio. So while most institutional investors should be able to diversify manager-level volatility themselves, asset managers are presented with a host of reasons to reduce portfolio volatility – both in absolute and benchmark-relative terms – in the process diluting their highest conviction positions.

Mitigating defensive diversification

While MPT has created the impression that diversification is always and everywhere a good thing, asset owners would benefit from a more sceptical attitude. Indeed, the argument outlined above suggests that over-diversification favours managers – giving them the ability to raise larger funds while managing career and business risk – at the expense of returns to investors.

Long-horizon investors, whose beliefs and governance structure enable them to tolerate substantial benchmark-relative risk, may wish to consider whether their managers are running portfolios that adequately reflect their high conviction views. Clearly there is no “right” level of diversification, but asset owners conscious of the incentives leading managers to over-diversify, should be willing to challenge their managers over the extent to which their best ideas can have a meaningful impact on performance.

Concentrated portfolios offer no guarantee of superior long-term performance. But asset owners pursuing an active investment strategy need to ensure that principal-agent conflicts do not undermine their ability to deliver long-term returns in the interest of their beneficiaries. This requires careful scrutiny and engagement with managers at the outset of any relationship, a monitoring approach that identifies performance-chasing and defensive diversification, and a decision-making process that can cope with volatile benchmark-relative performance at the individual manager level.

Asset mispricing: the ignored externality

As part of the growing movement to recognise environmental, social and corporate governance (ESG) risks, the concept of externalities has become increasingly relevant. The English economist Arthur Pigou was one of the first to develop the idea of externalities in the early 20th century, pointing out that sparks from railway engines sometimes ignited nearby woodlands or farmland, destroying timber or crops. Because the owners of the land received no compensation for the damage caused, neither the railway companies nor their customers recognised the social costs associated with their transaction.

The externalities of greatest interest in contemporary discussion typically fall under the E, S and G headings. However, this leaves a critically important externality – that of asset mispricing – largely ignored. As well as polluted air, we have polluted asset prices. In this case, the offending parties are asset management strategies that are driven by prices rather than cashflows, contributing to destabilising positive feedback effects and chronic mispricing.

Adherents of efficient markets thinking will argue that the extent of asset mispricing is so small as to make any negative spillover effects trivial. But the existence of asset price bubbles, large and persistent profits to simple momentum strategies, and the inversion of risk and return across many asset classes (often described as the low volatility anomaly) completely undermines the picture of markets as more-or-less efficient.

If we instead accept that financial assets can be mispriced, and at times severely so, then it is worth considering what economic damage might result from this source. We can think about this at two levels: at the macro level of asset price bubbles and at the micro level of corporate decision-making.

Asset price bubbles are the ultimate manifestation of mispricing and are widely regarded as economically disruptive. However, the conventional wisdom in central banking – epitomised by the Greenspan doctrine – had been to use monetary policy to limit the damage after a collapse in asset prices, rather than attempting to head off the damage as a bubble inflates. This view remained intact in the aftermath of the Tech bubble of the late 90s, but was fundamentally challenged by the experience of the financial crisis. In a speech in 20091, Janet Yellen said that “not dealing with certain kinds of bubbles before they get big can have grave consequences. This lends more weight to arguments in favour of attempting to mitigate bubbles, especially when a credit boom is the driving factor.” It remains to be seen to what extent central bank policy will embrace this more interventionist mindset and how effective the approach will be.

While less obvious than asset price bubbles, the damage done by the impact of mispricing on corporate decision-making may be just as great. If prices do not reflect fundamental value, corporate executives are faced with a dilemma: do they maximise the share price in the short run or cashflows in the long run. In the presence of lucrative share option schemes, many choose the former. There has been much hand-wringing over the causes and effects of corporate short-termism, with the focus often on egregious compensation packages or the problems of quarterly earnings guidance. But the effects of asset mispricing on the private sector have received relatively little attention.

Asset owners have an opportunity to reduce both the macro and micro level social costs described above through their investment strategy choices. As we have argued elsewhere, investment decisions based on past price movements, as opposed to a thoughtful assessment of future cashflows, can cause asset prices to depart substantially from fair value. Common examples of price-only strategies include momentum and trend-following, tracking error constraints, and procyclical performance-chasing by both asset managers and asset owners. Performance-chasing is more a by-product of career risk considerations than an explicit strategy choice, but nonetheless deserves more attention than it typically receives. By identifying and removing such strategies from their portfolios, asset owners could help reduce the feedback effects that contribute to asset mispricing and thereby reduce the externalities that accompany it.

Amidst the broader shift in attitudes towards business – with a greater expectation that companies should behave in a socially responsible and sustainable way – investors need to be cognisant of the externalities that arise from their investment approach (and not just from the underlying companies they hold). Attention has so far been directed towards environmental and social issues, but over time, questions will increasingly be asked of the social utility of various aspects of finance – especially if financial market excesses contribute to an economic downturn in the years ahead. Asset owners and asset managers therefore have good reason, on both private and social grounds, to review the wider impact that their investment approach has on the world around them.

The transparency fallacy

“Sunlight is said to be the best of disinfectants; electric light the most efficient policeman”
-Louis Brandeis

The above quote is taken from Other People’s Money And How the Bankers Use It, a collection of essays published in 1914, criticising what Brandeis (later to become a Supreme Court Justice) saw as anti-competitive collusion between investment bankers and large corporations. Ever since, this expression has been used to support calls for greater transparency in everything from finance to politics and the media.

The most recent demands for greater transparency in the financial sector have arisen from work undertaken by the UK Competition & Markets Authority (CMA) as part of their Investment Consultants Market Investigation. Their final report highlighted a greater need for comparable performance information across the industry, especially in relation to fiduciary management offerings. The proposed solution – the Fiduciary Management Performance Standard – aims to allow trustees to compare the performance of different fiduciary offerings in a consistent fashion. The proposal enjoys widespread support, with a survey of trustees on the social media platform mallowstreet apparently showing 100% support for the idea.1

With modern computing power, demands for greater transparency are easily met by simply monitoring, measuring and publishing ever greater quantities of data. Indeed, measures and targets have come to dominate management practices across both the public and private sectors in many western economies. The New Labour UK governments of the late 1990s and early 2000s famously embodied this trend with centrally determined performance targets implemented across vast swathes of the public sector.

Unfortunately, this “measurement culture” created numerous unintended and damaging consequences. In particular, an excessive focus on targets and peer-group comparisons (usually in the form of league tables) led to participants gaming the system and engaging in performance-chasing behaviours in order to produce the “right numbers”.2 In hospitals, for example, there were reports of corridors being relabelled as “pre-admission units”, and wheels being removed from trolleys so they could be re-designated as beds. In schools, the intense media focus on league tables has resulted in widespread “teaching to the test” and a narrowing of the curriculum to focus solely on those subjects that count towards performance measures used in league tables. The problem is neatly captured in Goodhart’s Law: when a measure becomes a target, it ceases to be a good measure.

In asset management, the perils of a measurement culture are clear. Despite being regularly confronted with the warning that “past performance is not a guide to the future”, investors consistently display a performance-chasing bias – hiring outperforming managers and firing underperforming managers – that is ultimately wealth-destructive.3 The proposed Fiduciary Management Performance Standard risks introducing a new possibility for performance-chasing at the fiduciary manager level.

While the details are yet to be finalised, it is easy to foresee a world in which trustees are encouraged to regularly compare their scheme’s performance against similar schemes under the auspices of good governance. It doesn’t then require a huge leap of imagination to envisage trustees moving their business (and assets) away from fiduciary managers who have shown the weakest levels of performance in recent years, and towards those with the strongest performance. This will simply have the effect of amplifying existing trends within financial markets, with the best-performing asset classes and the best-performing managers seeing asset inflows (and vice versa).

Moreover, a highly publicised performance database will have an impact on fiduciary managers themselves. Just as asset managers respond to the threat of termination due to sustained underperformance by seeking to reduce their divergence from the benchmark (known as benchmark-hugging), so consultants and fiduciary managers are likely to limit the extent of their divergence from their peer group in order to avoid being seen as an eccentric outlier.

Rather than being a cure-all for the ills of the fiduciary management marketplace, directly comparable performance information is instead likely to exacerbate the problem of momentum-driven markets and their associated social costs.4 This is not to say that the way in which trustees select consultants and fiduciary managers cannot be improved – it surely can – but rather to argue that a performance database is likely to create more problems than it solves.

The fundamental problem identified in the CMA report is that of “low customer engagement”. In particular, the CMA found evidence that less engaged trustees end up paying higher fiduciary management and investment consulting fees. This is a highly intuitive finding; but providing lowly engaged buyers with a performance database that gives them a very easy (and supposedly diligent) way of making their decision is a recipe for simplistic backward-looking decision-making.

Improved decision-making will only follow from addressing the low engagement problem. On this point the CMA make some very sensible recommendations, such as mandatory tendering of fiduciary appointments and additional trustee guidance from The Pensions Regulator. Ultimately, what trustees need from a good consultant or fiduciary manager is a combination of integrity, expertise, humility, and an ability to listen and communicate well. None of these characteristics lend themselves to being easily measured and performance data will provide little or no indication as to whether a consultant has these qualities. Transparency can be valuable up to a point, but it is possible to have too much of a good thing.

Chapter 12 for the 21st century

Chapter 12 of Keynes’s masterpiece The General Theory of Employment, Interest and Money has long been recognised as a brilliant articulation of the tendency towards short-termism in financial markets, containing some of the most widely quoted passages in all of finance and economics. However, the problems that Keynes highlighted have proved stubbornly resistant to change and it is striking that the short-termism he described has, if anything, intensified over the 80 years since his account.

Chapter 12 provides the first clear analysis of the dysfunctionality of capital markets, where Keynes explicitly highlights the social costs of highly liquid financial markets. In many ways, the work undertaken at the Paul Woolley Centre for the Study of Capital Market Dysfunctionality has formalised and extended the ideas first discussed by Keynes in the 1930s. By creating Ricardo Research we hope to build on this work in order to effect change through the behaviour of large asset owners. In this short article, we outline some of the parallels between the ideas contained in Chapter 12 and the research that motivates our work at Ricardo.

The importance of asset prices

Keynes was acutely aware of the role that asset prices play in acting as a signal to corporations and entrepreneurs in the real economy:

“the daily revaluations of the Stock Exchange … inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem like an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit.”

Keynes asserts here that asset prices play a crucial role in determining whether potentially profitable projects are ignored or wasteful projects are funded. It follows that asset prices are central to the efficient functioning of the economy and if the pricing process is corrupted this can have damaging economic and social consequences. It is therefore essential to look in detail at how asset prices are determined and under what conditions severe asset mispricing might arise.

Long-term investors and game-players

In Chapter 12, Keynes lamented that an increasing proportion of equity was:

“owned by persons who … have no special knowledge of the circumstances, either actual or prospective, of the business in question”.

The problem Keynes is pointing to here is that when an increasing proportion of equity investors have no special knowledge of the businesses in which they invest, there is no reason to expect market prices to be a fair reflection of company fundamentals. Furthermore, we should expect markets to be more volatile than would otherwise be the case, “since there will be no strong roots of conviction to hold it steady”.

He goes on to say that:

“it makes a vast difference to an investment market whether or not they [long-term investors] predominate in their influence over the game-players.”

Keynes’s game-players “are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at … three months or a year hence.” In other words, they are focused on anticipating short-term market movements rather than assessing long-term value. We believe that the weight of money engaged in momentum and performance-chasing behaviours has created a situation in which “game-players” now almost certainly predominate in their influence over long-term investors, contributing to the dysfunctionality of financial markets.

Keynes also reminds us not to rely on “expert professionals” to help bring prices towards fair value:

“the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.”

The outcome – famously described in Keynes’s beauty contest metaphor – is a situation in which investors focus their efforts on second-guessing each other rather than making independent judgements about long-term value.

Building on his earlier reference to “game-players”, Keynes develops an important distinction between two approaches to investing. The first involves making an assessment of the fair value of a business based on a thoughtful analysis of the company’s long-term cashflow generation prospects – what Keynes calls “enterprise” and we, at Ricardo Research, refer to as “cashflow investing”. The second approach is based on an extrapolation of past price movements – often described as a momentum or trend-following strategy – what Keynes calls “speculation” and which we refer to as “price-only investing”.

In practice, most strategies are a combination of the two approaches (some intentionally, others inadvertently), but we argue that incentive structures create a bias towards price-only behaviours that amplify trends in markets and carry prices away from fair value.

Succeeding unconventionally

Turning to the plight of the long-term investor, Keynes is at his most pessimistic:

“Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable.”

The situation has not improved since Keynes wrote these words and one shudders to think what he would have made of high frequency trading and trend-following strategies. He continues:

“it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.”

Here Keynes presciently highlights the challenge that institutional investors face when adopting a long-horizon approach. The increasingly regulated and litigious environment for fiduciaries has only intensified the risk of criticism (or worse), creating a barrier to the adoption of strategies that run the risk of looking ill-judged in the short run. Keynes adds an insightful footnote relating to performance monitoring processes:

“The practice, usually considered prudent, by which an investment trust or an insurance office frequently calculates not only the income from its investment portfolio but also its capital valuation in the market, may also tend to direct too much attention to short-term fluctuations in the latter.”

Research undertaken at the PW Centre formalises this argument by establishing a clear link between the constraints and incentives faced by asset owners and asset managers, and the momentum and performance-chasing dynamics that result.1 Investors that “direct too much attention to short-term fluctuations” – both asset owners and asset managers focusing on short-term benchmark-relative performance – create destabilising market dynamics and impose a social cost in the form of market crashes and lower returns to the end-saver. Keynes’s widely quoted remark that “it is better for reputation to fail conventionally than to succeed unconventionally” maps neatly to our distinction between short-term performance-chasing (failing conventionally) and long-term cashflow investing (succeeding unconventionally).

Getting back to social purpose

The balance between short-term and long-term investors has a significant influence on the social utility of financial markets. With price-only activities – such as momentum and performance-chasing – now arguably the dominant influence on markets, the resulting mispricing and volatility acts as a costly externality on society. As Keynes put it:

“When the capital development of a country becomes the by-product of a casino, the job is likely to be ill-done.”

Shifting the balance in favour of long-term investors will not be easy, but we are optimistic that by working together, asset owners and the asset management community can foster a healthier and more socially useful financial system. We hope that by directing attention towards the underlying drivers of market dysfunctionality – including misaligned incentives, benchmarking and performance-chasing – we can stimulate a debate that promotes both the private and social interests of the end-saver.