In a new Position Paper , we claim that ‘quantitative easing’ and successive accounting standards changes have led to a ‘false market’ in the sterling bond market.  One impact is to undermine the main methods of risk management in both institutional and private portfolios, which rely more than anything else on weightings in bonds to reduce risk and to demonstrate a match between the portfolio risk and some notional risk tolerance of the investor. What is actually happening is a dangerous increase in short and long-term risk. We have written this paper to draw attention to the fundamental flaws in the common approaches to portfolio risk management and to their particular vulnerability at a time of extraordinarily low nominal interest rates.     

The key points:

1. External intervention in the UK bond market has encouraged an extended fall in yields (2% for long-dated gilts) that is now impossible to rationalise, whether painting future yield scenarios in nominal terms or real terms, leading to losses when rational pricing is restored.
2. This matters to private wealth because bonds are the main source of diversification benefit in balanced management, being the only asset class with reliably low correlation with equities.
3. It matters to insurance and pension portfolios because regulation has created a false sense of security and efficiency when matching long-term liabilities with conventional bonds.
4. For both private and regulated capital, the unrecognised or unspoken trade off being made is between return volatility and inflation risk – a bad trade at the best of times and a shocking one in today’s false market.
5. Inflation-linked bonds have been drawn into the false market by arbitrage effects spilling over from conventional gilts and so they share some of the short-term vulnerability of the rest of the bond market.
6. Index linked gilts are nonetheless the only asset to hedge investors’ liabilities if these are properly defined in purchasing power terms and have long time horizons and so they do not require ‘money illusion’ to justify their current values. Substituting them for equity-type risks is a far more reliable way to manage portfolio risk than relying on diversification.

In most of RDR’s key respects, Parliament’s intervention has come too late, realistically, to delay or scrap it, although we highlight two aspects that it is not too late to work on: Simplified Advice and the proposed new distinction between Independent and Restricted Advice.

The impact of RDR will be to accelerate the widening ‘advice gap’ as rising costs push the entry level for access to advice beyond the reach of more people. The other side of the trade off is higher standards of advice for those that can reach it.  Higher standards are hard to argue with but, in light of the likely impact on access, the FSA needed a high burden of proof that the trade off was worth making. This it failed to do, with barely any rigorous quantitative analysis to support its presumption of better outcomes for consumers.

The paper supports the FSA’s actions on perverse incentives that have clearly damaged outcomes. Indeed, we have long criticised the FSA’s foor dragging on commission bias and its apparent inability to deal with high street banks’ remuneration strategies that clearly encourage mis-selling. The original independent reviews that highlighted these problems (including one I wrote up for the Centre for the Study of Financial Innovation) go back a decade or more. But if action on incentives could change behaviours as the FSA believed, it was not necessary at the same time to risk the trade off it did between imposing a ‘professional business model’ on the industry (a luxury the economics of the advice market simply do not support) and widening the advice gap.

Download Reforming the financial advice market: bridging the gap or widening the chasm

Click No Monkey Business Home truths to download a pdf version of the full paper. We have edited the original version we posted to reflect feedback, including adding a section on the tax effects on the comparison of buying and renting. Only our summary and conclusions are extracted below.

Summary

Popular opinion about home ownership in the UK is that it has created real wealth, more than the stockmarket and with much less risk. By contrast, renting is ‘money down the drain’. Naturally, because people think house prices can grow faster than the economy, young people fear the bottom rung of the housing ladder will tend always to be moving out of reach.

These are false notions, based on imperfect accounting of people’s own experience, gained in a particular period of economic history, and interpreted with a shaky grasp of basic economics, both national and household. Though the popular illusions might well have been shattered by the credit crisis, they appear to have survived largely intact.

In this paper we explain in laymen’s terms the economics underlying decisions about home financing and suggest how they might be applied in different circumstances to reflect the benefits individuals most value.

Conclusion: ten economics-based home truths

1. There are no foregone conclusions about how best to pay to put a roof over your head: buy or rent. It has to be a bet.
2. Be clear about what you most value in life or at different stages in your life. It may not be satisfied by large and inflexible bets. We show how many of the benefits people say they value are actually put at risk by their home financing choices.
3. Comparisons before the event should not (but usually do) exclude the opportunity cost of higher savings when renting rather than repaying a mortgage. Overlooking opportunity costs explains many of the false assumptions people have about buying versus renting.
4. The factors that after the event will prove what worked best are inextricably linked by national economics but can still vary dramatically through time and in different economic environments. Partial interpretation of history, such as your own or your parents’ experience, are likely to be misleading.
5. Individual outcomes will be shaped by entry and exit points, not secular trends that are immutable and known to all. Much of the results of entry and exit points will be down to age and luck.
6. If you really do believe in secular trends, remember that the corollary is that deviations from trend ‘revert to the mean’. That means that if leveraged home ownership was a winner for a long time, it might be about to be a loser for a long time.
7. For most people, the eventual ‘balance sheet’ outcomes count for less than the impact of borrowing on household ‘profit and loss accounts’.
8. Willingness to take on mortgage debt, and the size of that debt, should therefore be more about the ability to bear the additional financial stress that follows from adverse events.
9. We find that the key determinant of long-term outcomes is the different impacts of general inflation on the cost of borrowed money and the return on investment. This makes leveraged home ownership a bet on the economic variable, inflation, which is the hardest to predict.
10. The tax effects of owning versus renting that are widely touted in favour of owning are actually neutral except when either the main home or financial assets are sold to support spending; but the CGT advantage of property in that case is weakened by the scope to shelter, spread and time disposals of financial assets.

Position Paper
April 2008

Debt has unique power in story-telling approaches to investment to feed extreme fear of payday, particularly when it looks too late to prevent it. A popular theme today is that the scale of the credit crisis and its resistance to normal corrective mechanisms means we should dust off our history books and study the Depression economy of the 1930s. The other story in this vein is actually within the living memory of most investors: Japan’s ‘lost decade’ of the 1990s.

In this paper, we argue that the significance of the Japan story for other markets today is not so much the contextual similarities as the fact that long periods of negative real returns occur rarely yet often enough in global stock market histories to be part of any realistic model of possible outcomes from equity investing, whatever the market. It is therefore a story that should have already informed any financial planning where the consequences of different investment outcomes are a key element of the assessment of clients’ true risk preferences. That means pretty much all investment undertaken by individuals as well as institutional investors.

The other significance of Japan’s dire experience is that, on the basis of the same probabilistic model of longer-term investment outcomes, it is the best bet amongst the major equity markets today and should have a significant weight in diversified portfolios.

To make these points, we refer to our own formal modelling approach to equity markets, which does not require analysis of underlying accounting measures, such as those used in price earnings multiples or price to book value ratios. However, even by those conventional measures we can see that investor expectations have rarely been lower in Japan in the past 50 years and even look low by current European and US standards. Buying markets where expectations are low is not a guarantee of superior returns in the future but it helps.

This attractive relative value coincides with evidence that might persuade even the most agnostic of currency forecasters that the yen is undervalued against sterling.

Summary

Japan’s economic malaise of the 1990s was experienced in the stock market as an exceptionally long period (actually more than a decade) of falling and then flat real returns earned. The full extent of the decline from peak to trough in the ratio of actual returns to the long-term trend was as great as the UK’s bear market in 1973/4 but it took 14 years, not two. Other examples in the last century, including the US Depression period and the ‘Eurosclerosis’ malaise of the 1980s, lasted between 4 and 7 years.

Both the full extent of Japan’s underperformance of expected returns since the bubble peak of 1989 and the duration of its underperformance matter. But it is the duration that singles it out as exceptional.

Underperforming the trend means that a market failed to deliver anything like the rationally-expected reward for risk taking. The longer this failure persists, the more investors give up on the assumed equity risk premium, question the entire equity return-generating process and turn to different assets.

Our performance measure is continuously-compounded, inflation-adjusted, total returns (with income reinvested) in logarithmic terms. This measure properly reflects the actual ability of equities in a period to protect against inflation and hold real value in a deflation. It does so without distortion by the case-specific effects of drawing down from capital (which includes consuming income). Working in logs keeps everything proportional, which helps when we illustrate the past graphically.

Our argument about the lesson of this is simple. The possibility of markets reaching absurdly high levels relative to a sustainable and globally-similar trend should be ever-present in investors’ expectations. Indeed, it is a key part of the possible payoffs that make risk-taking interesting. But it is interesting only if the opportunity to sell is grasped, otherwise what is given will be taken away again. The full extent and duration of the decline when it is taken away also therefore needs to be ever-present in investors’ minds, otherwise they will fail to profit from the good payoffs and will be shocked (or worse) by the bad payoffs.

Portfolio management is most commonly undertaken as a race with other people’s money. The race can only be won if the client’s agent backs a view of what will happen. The win is experienced by the agent as growth in assets and fees subsequently. Wealth management is different. It is a journey not a race, with the driver in the same boat (car, whatever) as his or her client. In the journey, success is measured by surviving dangers and achieving realistic objectives formed in terms of consequences for the passenger. This description of ‘utility’ holds for most private investors whether risk tolerance is set high or low, set by the personality of the investor or by discreet goals for their money.

In this wealth management context, the significance of Japan’s malaise is that such an outcome needs to be within the bounds of all probable outcomes for any one market, even if it has a very low chance of occurring.

It is interesting to speculate (as we do in our blog) in what context such an extreme outcome might arise in (say) the US or UK today. But that speculation should be independent of the assessment of probabilities. Equally, therefore, we caution against working the other way round: from a view of the context (eg a vicious cycle emanating from a US house-price crash) to a view of the most likely stock market outcome. The latter approach asks too much of even the best forecaster and belongs in the portfolio race not the wealth management journey.

Our measurements of probable future returns are dependent on current market conditions. The mid-point of our projected ranges of uncertain outcomes is anchored on the observed current deviation from the historical trend. How wide the band is around the mid-point depends on the observed standard error of the historical regressions, the amount of historical data we have to work with (50 years for Japan is quite short) and (for foreign markets) the addition of currency risk (where the impact on real outcomes is a function of deviations from the ‘real exchange rate’, being that explained by inflation differences between any two countries).

What our measurements show today is that Japan is still exceptional as being the only market well below its long-term trend (and that after the trend itself has been lowered by 14 years of low returns).

Other markets are quite close to trend, which does at least mean that the downside risk is less over longer periods than it would be if they were starting out significantly overvalued. They have been quite close to trend since the bottom of the bear market in 2003 because the previous correction did not ‘overshoot’ – probably because of the reflationary measures taken after 9/11.

How much an investor should hold in Japan to benefit from the margin of relative safety implied by such a low current valuation depends on the particular approach to diversification. In our portfolio construction process, the band of probable outcomes for a geographically-diversified spread of equity markets allows for the possibility that there will be a high degree of convergence in the return paths – in other words that a Japan-style prolonged bear market can occur globally. But there is still a significant benefit from diversification.

In the absence of any preferred bias to the UK as ‘home’ market, and with long investment time horizons, our process leads to an optimal position of about 30% of a client’s total equity exposure in Japan. With a home bias it falls to about 22%. These positions reflect quite large bets on the information in our measurements of relative value. If we discount the information value, and assume return differences are less widely distributed, the allocation will be about 18% with a home bias and 25% without.

In all cases, these are proportions of the equity component of the portfolio. When we come to customise the portfolio to individual risk tolerance, we ‘dilute’ the equity exposure by holding more of a risk free asset. For most goals, this is index linked gilts, because they provide almost complete certainty of real outcome and can even be matched to a specific time horizon (or to the duration of a series of horizons each with targeted cash flows, such as drawdown). Index linked gilts are the individual’s natural ‘safe harbour’ from which the merit of setting out in search of riskier real wealth outcomes must always be judged. Japan included.

The portfolio construction process generating these allocations is described on our website. The type of portfolio is called “Defined Outcome” because the return-generating process, being based on a narrow set of historically-evidenced assets, allows us to quantify future outcomes. 

It contrasts with a “Defined Path” portfolio which uses a much richer mix of assets, both traditional and alternative, to build portfolios with less predictable real outcomes but smoother return paths. The difference between the two is explained in a paper accessible on our blog (search term: ‘absolute-return investing’ – or archive for 12th December 2008).

1. Lessons for global economies and markets

How the story goes
Japan’s ‘lost decade’ in the story refers to the 1990s when Japan’s phenomenal post-war economic boom came to a sudden end with the collapse of both share prices and land prices. For most observers, there was a strong element of ‘the emperor’s new clothes’ as fear of Japan’s world-beating perpetual-motion machine of high personal savings funnelled into high corporate investment turned almost overnight into derision at its inflexible institutional structures, wasteful capital allocation and poor governance.

A particular casualty of the collapse in share and land prices was the solvency of the Japanese banks, although part of the problem was that many of them also had weak procedures for governance and for allocating capital.

The effects of the bust were felt as a combination of weak asset prices, no more ‘jobs for life’, little growth in consumer incomes and high precautionary savings. But capital formation did not fall and many Japanese companies continued to be highly effective world players.

Japan’s post-war role, as the emerging creditor nation for maturing economies with a much lower savings propensity, continued unabated. Now that it is the Anglo-Saxon model of low savings and high borrowing that is seen to be the naked emperor, this dependency on Japan’s financial strength is being viewed rather differently.

An element of the Japanese story thought to be relevant to other economies now is the fact that conventional monetary and fiscal policy responses did not work, hence perpetuating the weak growth rates in the overall economy and the consumer sector in particular. A mildly deflationary tendency has a lot to do with this. Even extremely low nominal interest rates were quite high in real terms – a feature the ‘lost decade’ shares with the American Depression of the ‘30s.

For equity investors in Japan, the period has been immensely testing. Indifference is the tempting response. It has actually come naturally to the majority of Japanese, who have not invested widely in stocks except for bouts of short-term speculation. Indifference was quite appealing to foreign investors too, who had already been dogged by Japan in the late 1980s when they were reluctant to participate because of high valuations. This writer has been a global investor since the mid-1970s and there was probably only about one decade, at the start, when Japan was not the tricky item on the agenda of strategy meetings, before the event, and even trickier in client meetings explaining, after the event, why the strategy was not working out. In a modern fund management industry it is negligent to ignore the world’s second largest stock market but it has repeatedly punished bulls and bears alike.

In terms of both the lack of economic growth and the direction of the stock market, the lost decade really refers to the period 1990 to 2002. Since 2002 Japan has enjoyed steady quarterly growth in GDP and its stock market has performed quite well relative to others since the global bear market low in 2003.

Real total return: the ‘bottom line’

Knowing the theoretical weaknesses and practical pitfalls of basing investment strategy on conventional forecasting of fundamental factors, and on the resulting valuation measures, we prefer a different approach. It is interesting to see what that tells us about Japan’s lost decade.

The ‘bottom line’ of equity investing for long periods is the real total return achieved. ‘Real’ returns measure the job done in terms of protecting against inflation and creating value even in deflation. ‘Total’ return ignores the artificial separation between capital that stays invested and income that is consumed, treating all dividends as if reinvested as received. As the true measure of wealth creation from investing, real total return is also by definition a ‘common language’ between countries, allowing comparison without the distortion of differences in inflation, accounting or taxation.

When we examine the historical paths of real total returns for market indices, expressed as continuously compounded logarithmic returns, we find that regression trends and standard errors are surprisingly similar, as though not only the language but also the underlying explanatory return process is the same. By regression trend we mean the growth rate that best fits all the observations (as opposed to just the first and the last) and the standard error measures how dispersed the individual observations are and how good the fit.

For the real returns to be so similar at different stages of economic development or between countries with different economic growth rates implies some form of cross-border ‘equilibrium’ model of corporate performance (at the level of per-share measurements of company return) and required shareholder returns. An equilibrium model is one where movement away from some central tendency is self-correcting for good reason and is not just statistical noise.

An example relevant to stock-market returns is the competition between labour and capital. Higher wages imply labour is winning but if they lead to lower profits and thence to job cuts capital will get back the upper hand. There are many versions of equilibrium theories to explain why good companies eventually end up looking like average companies. There are also many equilibrium explanations of why high growth at the level of revenues cannot be pulled through to the level of earnings per share on which share-price valuations depend.

What is more surprising than the similarity in achieved return trends is that the deviations from trend also appear to be very similar, when allowance is made for differences in the amount of data available. Such similarity implies a single, global return-generating process whose theoretical explanation does not require insights into economic growth and risk differences.

Japan’s return history

The dataset which our return-generating model of individual equity market real returns uses includes a Japanese time series from 1957. It is based on the Nikkei average to 1969 and the MSCI capitalisation-weighted average since then, in each case deflated by Japan’s Consumer Price Index. We ignored earlier post-war data as being distorted by exceptionally strong growth.

The resulting indexed performance is shown below. The green line shows the fitted trend using data up to that point (hindsight-free) and the blue line shows the trend for the whole period, as observed today, which would not have been know at earlier dates.

The whole-history trend is 5.5% pa, down from 7% before the bear market of the 1990s. The comparable regression trends, and the period of observation are shown below. Note that both the trend and deviations (or statistical errors) are sensitive to the length of data history, a factor that needs to be taken into account in the confidence of any future return forecasts derived from these time series.

What marks Japan out in this period is not the extreme ratio relative to the trend (equivalent loosely to a measure of ‘relative value’) of about twice ‘normal’ in 1989. Ratios of twice normal were achieved in several markets in the early 1970s and again in the ‘dot com’ boom in the USA.

Neither is it the bear market decline to a ratio of 60% of normal by the time the market levelled out in 1992. The 1973/4 bear market knocked many markets lower than this, including the UK with a ratio at the end of 1974 of just 36% of the hindsight-free trend.

What really makes Japan stand out is its subsequent reluctance either to extend relative value to perceived ‘bargain’ levels or to revert to anywhere close to its previous mean. It is this debilitating drift, punctuated by false rallies and renewed capitulation, which makes Japan such a potent story for investors in equities. Taken as a whole, the ratio bottomed out in April 2003, almost exactly equal to the two-year bear market in real terms in the UK in 1973/4 but it took Japan 14 years to do it.

Duration matters

Long periods of frustrated risk taking sap investors’ appetite for risk and undermine their confidence in the return-generating process that delivers risk premiums.

Most investors have specific time horizons that shorten as a function of age and so the ability to bear the same level of risk is not constant even if they did not alter their inherent risk aversion. ‘New investors’ (such as new workers or employees of defined benefit pension schemes accruing new years of service) tend not to outweigh the eroding confidence of the owners of the stock of existing assets. Theoretical arbitrage between countries may also fail to work if the perceived risks of being long a poorly-performing foreign market outweigh the expected payoff from a recovery that may be just as slow as the wealth-destruction phase itself was.

Exceptionally long bear markets are likely both to reflect and engender loss of confidence in the institutional structures, corporate management structures and political process. These are all part of the current Heisei era malaise.

In this respect Japan shares much with the persistent disappointment of Continental Europe in the 1980s, a period that gave rise to the phrase ‘Eurosclerosis’. The malaise in Europe’s case also touched political institutions as well as corporate structures and featured problems whose roots lay in the previous exceptional performance of the post-war recovery, much like Japan’s. It is often overlooked that the European stock markets, which fell as much as many others in the 1973/4 bear market (though less than the UK) failed to join in the recovery in equity real returns for another five years, making a total of seven lean years – though still less than Japan.

Much as happened in Japan, a European economy and market ‘going nowhere’ generated a self-perpetuating indifference in the point of equity investing. Many investors therefore missed out on Europe’s powerful stock-market recovery between 1982 and 1987.

Compared with both these examples, the Depression in the USA was a story of extreme sensitivity to stock price falls (because they were the collateral for the excess bank borrowings) but in real terms the worst was over for stock markets in about three years – much more akin to the UK experience in 1973/4. Considering the superficial similarity with Japan’s deflation, the difference in the purchasing power of equities is quite striking. US equity returns in real terms were quite buoyant between 1932 and 1936.

Japan also performed badly in the Depression years although the reasons are more domestic, reflecting a sequence of stockmarket bubble (bursting in 1920), earthquake (1923) and bank runs (1927). Some of the policy responses and their ineffectiveness nonetheless have eerie similarities to its more recent malaise.

In terms of duration, Japan therefore appears unique in the last century. In the 19th century, on the other hand, prolonged slumps were more frequent and tended to be global in nature. But these had their origin in (and owe their durations to) silver or gold standards. Japan, ironically, was a notable exception, escaping these episodes by opting for floating exchange rates for almost all the period since it joined the modern world after the Meiji ‘revolution’ in 1886.

Property and the debt element of the story
What Japan and the US are also thought to have in common is a possible prolonged decline in property prices, on the basis that land and buildings (but not agricultural land, unlike the farming depression of the 1930s) are the main form of bank collateral that is falling in price. This is over-simplistic.

Stock and land prices have a long history of co-movement in Japan, for at least the whole of the post-war period. It makes some sense in a country which supports about 30 times the population per habitable area as the USA. Even with impressive productivity improvement, extraordinarily rapid growth in industrial output and personal incomes has always stretched Japan’s physical construction capacity.

It is commonly thought that the reason Japan’s economic recovery was so slow coming is that banks were not encouraged to write down their property loans realistically fast. This is at odds with the profile of the decline in Japanese property values which was in fact quite shallow: no single year showing a percentage drop in double digits. Consistent with the past, recoveries in land and stock prices have again gone hand in hand since 2003.

The main reason for fearing a deep and prolonged recession in the USA is low personal savings and weak household balance sheets. In fact, during much of the unsustainable deterioration in American balance sheets, Japanese household savings have effectively been recycled, through many financial intermediaries, to support excessive spending and borrowing, particularly home loans, by American consumers.

We do not know what to expect as a recession profile in America simply because the financial imbalances have usually been in the corporate sector rather than households. We know a lot about how companies rebuild liquidity and cut costs and investment spending in a business downturn but we do not know how households will do it except that they cannot do it as quickly. Japan’s example is not directly relevant because it started with strong personal balance sheets but it is relevant in demonstrating how anaemic personal incomes and low consumer confidence can prolong a weak economy.

Assessing the likely duration of the US economic cycle is inextricably linked with the housing bubble and would be easier if there had been precedents of equivalent speculative bubbles since the war. In a country where land is so readily available to support growth as needed, and so with no history of long-term real growth in land prices, it takes a very intense popular delusion to lead to a doubling of prices in real terms in about five years. It also takes delusion on the part of lenders whose collateral has never in the past been unrealistically bloated in this way. The unfamiliarity of the situation makes predictions difficult but also carries the clear risk of prolonged disillusionment on the part of both borrowers and lenders.

Even if prices fall substantially, we do not know what the knock-on effects will be on consumer confidence or employment and whether they are made more vicious by the scale of losses incurred by banks on their property collateral. We also do not know what the feedback effects of the loss of banking capital and lending capability will be on the private sector, both households and businesses. Both need access to credit during the period of balance sheet rebuilding and often the first effects of recession are to increase credit needs, to bridge income interruptions and finance rising inventories.

So whilst the similarities with Japan are not that close they are close enough to suggest the Japan comparison will continue to be made, and made in the context of likely duration as a well as degree.

2. Lessons for wealth management

Being realistic about equity risks
How close the parallels are between Japan in the ‘90s and the US or other countries now does not really matter if you believe, as we do, that it is pointless to try to select precise lessons from history based on contextual similarities, such as property prices or over-borrowing: it assumes too much ability both to define the context correctly and to predict the stock-market implications.

Instead we think the real significance of Japan’s equity market experience in the 1990s is that it tells us what can happen in any equity market: not just an intense period of weakness (which recurs frequently in markets) but also prolonged periods of sideways drift, and hence gradually increasing value relative to the sustainable long-term trend. Both therefore need to be part of the expected possible paths and outcomes from equity investing.

No investment in the good times should have been blind to this possibility: it was always what was risked (and indeed a source of the expected risk premium).

Considering the way equity risk is typically presented to private investors in product literature and even some investment books, we wonder whether the writers are on another planet. Rules of thumb such as investing for a ‘long term’ of five years, or that equity risk declines the longer you hold them, are clearly not informed by an understanding of how slow the mean-reverting feature of returns can be and how random returns are. Even over five years you might as well toss a coin. Unable to calculate probabilities, they fall back on popular heuristics.

A complete set of probabilities also needs to allow for the correlations between markets. The probability of all markets doing what Japan did at the same time is significantly less than a single instance. We know that the actual correlations, measuring the degree of co-movement, between pairs of different markets are highly unstable and period-specific. Nonetheless, geographical diversification remains a good first line of defence against extreme outcomes.

In our own model, the best- and worst-case paths for a diversified portfolio are likely to be those in which extreme return deviations from trend are associated with convergence of correlations. In each case, changing correlations magnify the range of probable outcomes at the portfolio level.

Fitting the portfolio risks to a personal plan

Knowing what can happen rather than what will happen is still very powerful when applied to individual circumstances. Quantifying the possible paths and outcomes allows an investor to consider the consequences of these in terms of the attributes of their financial life that they most value.

Investors’ own time horizons are clearly important to the calculation of the probabilities and to the consequences. Being able to quantify horizon-specific real outcomes is likely to lead investors to tighten up their exposure to risks as their horizon shortens, even though their risk preferences are not otherwise changing. In addition, the consequences of bad outcomes are likely to be specific to the goal assigned to that money.

If the risk of a Japanese-style ‘lost decade’ of real investment returns means that retirement income is reduced intolerably, exposure to equities has to be diluted until the consequences are bearable. If the impact is that income before retirement, or even the ability to work to the preferred retirement age, are at risk in such an economic malaise, the level of acceptable investment risk may need to be tightened even further.

A young investor accumulating assets can counter-intuitively welcome long periods of low valuation in equity markets as it means that each investment has a higher range of probable outcomes attached to it when that capital is eventually used. This assumes the investor keeps faith with the slow mean reversion to some equilibrium trend. If the investment approach is built around a formal, rational model, with constant reprojection of real outcomes, keeping faith is more likely.

By contrast, clients drawing down from capital, such as those in retirement, are damaged by bear markets. They are also far more damaged by a Japan-style bear market than by a brief but severe bear market such as experienced by the UK in 1973/4. Even if they believe in the eventual mean reversion, if it comes when they have already steadily depleted their capital at a rate that assumed a ‘normal’ recovery, it may be too late to avoid running out. In drawdown, this is the worst-case scenario.

3. Japan as an investment opportunity

The lesson of the ‘90s for Japan in the future
One of the most important reasons for understanding whether what happened in Japan is really consistent with a sustainable, global, equity return model is that it tells us what to think about future returns from investing in Japan. There are two dimensions to this:

• The reasons for including Japan as a core component of a diversified portfolio
• The appropriate exposure to Japan, to reflect its long-term real return potential relative to other markets

The diversification context
Any portfolio approach that uses diversification, or a mix of risk exposures, to improve the expected risk-adjusted return of the equity portion of a portfolio should start with the presumption that it will gain in ‘efficiency’ from including Japan. The gain in portfolio efficiency can be thought of as a higher expected return per unit of risk or a lower level of risk for a particular level of expected return. This holds true whether other risky assets are combined with equities or not.

These general observations tend to override particular assumptions about the expected return, the uncertainty associated with that return assumption and the expected correlation with other assets in the portfolio opportunity set. When they do not, it is likely to mean those estimates are wrong!

Even if the return assumption is ‘knowing’ and predicated on a continuation of its economic malaise, leading yet again to lower expectations than other markets, the diversification effect should logically hold, as the implied correlation with other markets is also then very low. A feature of the malaise in stock market terms is that Japan for most of the period did not behave like other markets, even to the point that for some of the period it has been negatively correlated.

The portfolio problem addressed by diversification is often solved using short-period returns (say three years) and monthly standard deviations (or volatility of nominal returns) as if relating to a ‘decision time frame’ rather than an ‘outcome time frame’. Optimising allocations on a decision time frame is part of the race approach, suiting agents more than their clients. However, clients who believe there is useful information about their selection of the agent contained in short-term performance may think that breaking the journey down into a series of legs of a race suits them too.

If expected returns, standard deviations and cross correlations used in the portfolio-building process are instead based on real outcomes at planning horizons relevant to the client’s goals, the benefits of diversification could be either greater or lesser depending on the correlation assumption. Logically, outcome correlations will be closer, notwithstanding the small chance of a single market like Japan behaving differently for a very long time. The long-term payoffs from a mix of developed equity markets are likely to be very good or very bad because most of the individual market payoffs were very good or very bad.

This leads to an unusual but logical solution to the portfolio-building problem when optimisation based on risk-adjusted returns is being used. Whereas high correlation of long-period real returns is the most realistic assumption for calculating the distribution of all possible payoffs, such as when jointly deciding with a client what combination of resources, risk and target outcomes works best for them, the portfolio diversification benefits will be greater if low correlations are assumed. In each case, goal-planning and portfolio building, the more conservative assumption is adopted.

Rational, mathematical processes for building portfolios at the asset allocation level run into powerful practical resistance due to non-rational factors. These could be agent-driven (such as ‘clients never think me clever when Japan goes well but they think I’m stupid whenever it goes badly because any idiot could see the whole country is a mess’). They could also be client-driven (‘I may be wrong but I think the market will never recover’). Non-rational factors are real. There is no point planning a super-rational journey if, when some emotive expectation appears to have been borne out, the client bails out of the portfolio or the agency relationship. Some practical accommodation needs to be found for including client or agency biases into the process. It helps if the effects of this on risk-adjusted portfolio returns can be quantified, so the bias is open and collaborative. Whatever the accommodation made, it should resist strongly the outright exclusion of Japan.

Forming return expectations for Japan

Knowing how badly Japan has done relative to other markets and to its own ‘expected’ trend (in other words, compared with the returns if after falling it had actually managed to revert to its trend), what should we now expect as returns in the future?

We answer this question two ways: our way, using the information contained in its own real return history, and the conventional way, using widely followed measurement of fundamental value as a proxy for future returns. Both make the same presumption that a low ‘valuation’ now is associated with higher returns in the future. What we find is that both support the case for low current valuation, high ‘value’.

No Monkey Business model
Our expected returns are generated from historical data for achieved real total returns: a single factor. The standard deviations are derived from the same data with an adjustment for currency risk relative to the pound and for the length of data. The projection process draws on historical market data for all the major markets to model the uncertain (‘stochastic’) path of continuously-compounding, logarithmic, real total returns. The data characteristics that influence the simulated path are randomness (the next period level is correlated with the last plus or minus a random innovation) plus a correlation with the observed trend (the ‘mean reversion’ coefficient) whereby the trend acts against the random effects like a weak magnet.

Our expected returns and standard deviations are specific to the planning horizon. In the comparison below, we take two horizons, of 10 and 20 years. The contribution to the return of the assumed mean reversion is greater for 10 years because the historical data shows that most of the correction of large deviations is usually complete by 10 years and that further gains from it are then likely to be very small.

The comparisons are for each of the four major equity markets or regions with long historical evidence of their real return behaviour.

There is a mathematical connection between price to book multiples and return on equity that is captured in the price earnings multiple. A low price earnings multiple is not necessarily cheap if the return on equity is also low, as this suggests future growth will also be low. Likewise, high return on equity does not make a market cheap if the price to book ratio is also high. The relationship between market value, book value, profitability and growth in per share earnings is one of the reasons why big differences in ‘top line’ growth (GDP for a country, sales for a company) narrow considerably when calculated in per share growth in earnings and (via retentions) in the book value.

Japan has the lowest price to book ratio of all the markets. In fact, on some indices the ratio is now below 1. The only occasion when the ratio for the Nikkei Stock Average was below one at both the highest and lowest point for the year was 1957. Between 1958 and 1985 the ratio was between 1.1 and 3.1. 1985 marked approximately the start of Japan’s irrational stock and land price boom. Between then and the 1989 peak, ratios were between 3 and 6 times.

However, Japan’s return on book value is currently quite low at 10.4% versus a world average of 17.1%. Where different indices produce a higher or lower price to book ratio this is likely to be offset by differences in the observed return on book.

It is reasonable to assume that Japanese profitability is relatively low because its poor economic performance is out of step with the rest of the world. This would appear to be confirmed if the price to sales ratio were quite competitive with other countries. In fact, Japan’s ratio of 0.8 is the lowest in the table, implying low expectations for future relative profitability as well. If investors took the view that profitability in Japan was due to improve relative to other countries, both price to book ratios and price earnings multiples would be higher than they are. Lower valuation measures suggest there is no expectation of catch up or indeed no expectation other countries are about to contract a similar economic malaise resulting in declines in their profitability to Japan’s level.

By Japan’s own standards, earnings-based valuations are also low. Obviously, they are much lower than in the 1980s but that alone does not denote good value. But the current multiple of around 16 (or 11-13 on various other Japanese indices) is not a lot higher than the lowest multiples at intra-year levels of the market between 1957 and 1970. Even in 1974 the ratio was about 12. Intra-year highs back then were typically between 16 and 25.

We do not attach much significance to yield. It results from choices about the financing of corporate expansion (as between retentions, new equity or debt) and these choices are not necessarily qualitatively different. The choice often reflects investor preferences that may be driven by tax differences or simply changing culture. From the investor’s point of view, too, income is an artificial construct which is why we have to look to total return for information. However, yield is part of the message about other investors’ expectations.

1985 also marks the first time Japanese equity yields were below 1% at both intra-year lows and highs for the market. The current level of 1.5% is still quite low by international standards but is not out of keeping with the period from 1975 to 1985. Yields were substantially higher in the period of more rapid economic growth in the late 1950s and 1960s but yields were generally higher in other markets too at the time. Yields may also be lower now because of disinflation – indeed they are now higher than Japanese Government bond yields. This implies very low or even negative long-term growth in nominal earnings from Japanese corporations.

Disinflation is likely to be part of the disillusionment with Japanese equities. If as an investor you think consumers think there is no hurry to buy goods and services because they may be cheaper and will certainly not be more expensive tomorrow, you will be less interested in buying the shares of the producers of these goods and services. It may be too simplistic but investors probably do associate inflation (or at least moderate inflation) with the real wealth-creation function, and risk-premium function of equities.

The observations of mean reversion in real equity returns on which we rely are entirely consistent with similar reversion in the fundamental measures of corporate performance, consistent with an equilibrium model of the economy: return on capital, real earnings growth and real book value growth. It is because these corporate measures are not random that other investors rely on the derived valuation measures (price earnings, price to book) as sources of information about future investment returns. But neither our measure of value nor these conventional measures translate into accurate projections of higher share prices over any specified time period. This is unknowable.

Currency considerations
Currency forecasting is also a challenging pastime. The best long-term explanation of exchange rate movements is purchasing power parity theory, based on trade competitiveness, but it is notoriously weak as a short-term predictor.

Economists attempt to calculate purchasing power parity from data about costs, selling prices and import and export volumes for traded goods. They do not agree about much. No Monkey Business prefers a naïve approach. With nearly forty years of history of floating exchange rates, we can deduce the purchasing power parity from a regression, in much the same way that we calculate the long-term sustainable trend in real equity returns, on the basis the ‘collective wisdom’ of millions of people participating in currency markets will, with enough time, produce a normal, unbiased distribution of estimation errors.

In the chart below we show the yen against the dollar ‘real exchange rate’, calculated as a monthly series where the actual exchange rate change is adjusted by the difference between inflation in each country. When the line is rising, the yen is getting more expensive and less competitive and vice versa.

In Japan’s case, a regression trend for the whole period will not fit well as for most of the period, as there was an upward bias to the plots up to about 1993. A good fit will (as for other major currency pairs against sterling) have no directional bias in the trend. But in fact for the whole period parity around the mid point of the chart (150 on this index scale) could be the best estimate of parity. It is much easier to argue that, now we can see that the implied overvaluation of the yen did correct, between 1993 and 2007.

It is also tempting to suggest that the sharp rise in the yen’s real exchange rate between 1992 and 1996 was a contributory factor in Japan’s prolonged economic malaise and that the subsequent correction, connected with the ‘carry trade’ (borrowing yen to invest in high-yielding currencies), has helped its steady GDP growth in the last few years.

Has the yen now fallen too far? If the market cycle we have identified in real equity returns was exceptionally long, these currency deviations from ‘fair value’ are even longer – hence purchasing power parity is not much use for forecasting. But at extreme levels there may be some information in the ratios which is useful over, say, an intermediate investment period of 5-10 years. In that case, the present level of the yen against sterling appears to be extreme. If this is right, the gains of UK-based investors in Japanese equities will be boosted by currency gains. This has already been an important factor for relative returns in the first quarter of 2008. In sterling terms, the stronger yen has exactly offset the relative weakness of Japanese share prices in local currency terms.

The same approach to measuring currency value for the yen:dollar and yen:euro implies a less extreme under-valuation of the yen for the dollar but against the euro it is as extreme as against the pound. One implication is that the carry trade is yesterdays’ strategy. It may not occur again on such a scale in the lifetime of today’s currency traders.

Fans of absolute-return investing claim it represents ‘the future of asset management’, its attackers that it is just a fad. Most investment fads are intellectually lazy: they describe concepts but appeal to emotions. The most appealing of investment concepts are versions of the free lunch: the ‘something for nothing’ culture. For absolute-return products, the claimed USP is that you can generate much more upside return than you risk in absolute loss and that this is more efficient and rational than harvesting long-term risk premiums from volatile assets by accepting large interim losses. In this position paper, we put the claim to the No Monkey Business ‘no nonsense’ test.

Absolute-return investing is faddish. It is not the new industry paradigm. It is mostly not even absolute. But a hybrid form of absolute and relative investing is emerging as a lasting addition to the diversity of approaches, whose mix is ultimately decided by investors (as much because of their experience as theory).

Fund managers compete as if the two approaches are mutually exclusive – either philosophically or economically. They are not. Investors and their advisers do not need to look for inherent superiority. The differences need to be clear enough to choose between them or decide how to combine them. They can do this by relating them either to suitability for different tasks or to their own view of how the world probably works, since this ‘model risk’ is at the heart of the differences. To be this discriminating, investors have to get beyond the sales pitch.

No Monkey Business offers an alternative for each of the best of absolute-return and the best of conventional asset allocation. What makes each the best is a focus on risk management. We reject as suboptimal the vast majority of other industry solutions, both conventional and new.

Scope of the paper

The investment products that are typically marketed under the umbrella of absolute-return investing are

• capital-guaranteed structured products
• ‘target-return’ unit trusts and OEICs and enhanced cash funds
• hedge funds and funds of hedge funds

Whilst the new 130/30 funds use some of the same techniques as hedge funds, they are not intrinsically absolute funds as the net exposure to some benchmark asset is neutral relative to its long-only counterpart.

The first part of the paper, summarising our position, assumes some familiarity with the industry as well as with investment theory.

The second part starts by explaining the context, and the language, for the benefit of individual investors who need that for clarity about different approaches. The arguments are then developed for their benefit – but also for professional investors willing to be challenged.

Our position

Absolute-return investing is not what it appears to be, either in theory or in practice. It is no different from any investment approach that reduces downside risk to tolerable levels by traditional asset-allocation techniques – unless it can live up to its claim that it reduces upside volatility more than downside volatility.

Lower short-period downside risks, and the effects on compounded long-period wealth, are often advanced as reasons for giving up on harvesting conventional risk premiums with a buy and hold strategy (as in ‘relative-return’ investing). The latter describes fairly well the state of the art in the UK retail investment marketplace, where both the return estimates and the risk-management dimensions of asset allocation are poorly developed. This is not surprising since advisors and wealth managers have only recently adopted asset allocation as either a theoretical or practical basis for key decision making.

However, absolute-return investing also has to compete with modern approaches to liability-driven portfolios that are fairly conventional in terms of their asset building blocks but apply better-developed risk-management techniques.

For instance, if the asset-allocation approach is one based on an assumption of ‘mean reversion’ (which harvesting risk premiums logically implies), then a dynamic allocation approach that responds to those changing market conditions and changing expected returns, whilst always observing a defined risk tolerance, will generate much higher risk-adjusted, compounded, wealth outcomes. This is the basis of the No Monkey Business dynamic asset-allocation model.

Adding exposure to more risk sources, and changing the distribution (or weights) can certainly produce more efficient risky portfolios, whether we choose to call these exposures ‘conventional’ or ‘alternative beta’. But that can still be matched by a combination of a less-diversified risky portfolio and a risk free asset, particularly if the risk free asset guarantees a contribution to a targeted wealth outcome (in the way, for instance, that an index linked gilt guarantees a certain real outcome at maturity). We refer to this combination of risky and risk free as dilution, as a deliberate contrast with the reliance on diversification alone as a means of managing risk.

To be superior, the alternative of absolute-return investing has reliably to generate asymmetrical risks, as neither a passive nor a dynamic conventional asset allocation, constrained by the same risk tolerance, can beat that.

Downside risk can be limited in a purely passive way using options, as do capital-guaranteed structured products. Their payoffs are a function of interest rates and volatility, both of which are time-varying but ultimately systematically tied to market efficiency. That means that stringing together a series of short-period structured contracts cannot generate the same wealth outcomes for a given level of risk as unprotected, but diluted, market exposures. Structured products represent opportunities for active managers at times but not an efficient long-period wealth-building strategy – or even a long-period alternative to rolling over cash deposits. This inconvenient fact should become apparent when low interest rates combine with higher volatility. But the full impact, in opportunity cost, will be slow to emerge and too late to reverse.

The claim of absolute-return investing to asymmetrical returns must therefore rely on forms of active management. To be different from benchmark-constrained asset management, these must mostly relate to ‘market timing’. The ability to short securities or swap exposures (new forms of ‘relative bets’) is not enough to transform the shape of the payoffs.

We have about 15 years of hedge-fund data we can check to see whether active management has produced asymmetrical payoffs. Provided we limit ourselves to diversified groups of funds, the evidence is just about supportive – and that even after high (but partially contingent) fees. But it mainly depends on one period: the 2002-3 bear market.

Moreover, the results are not consistent with the avoidance of loss implied by the use of the term ‘absolute returns’. Asymmetrical payoffs to active bets have required much more, regular exposure to volatile assets than is consistent with that claim. Since 2003 (a bull run with relatively short-lived sell-offs), the payoffs look very similar to a diluted conventional risky portfolio with a relatively moderate risk tolerance (but certainly not highly risk averse).

This also suggests that in migrating from banks to hedge funds, proprietary traders formerly constrained by a bank’s absolute risk budget have gradually slipped into the relative-return world, albeit its region represented by lower risk tolerance.

Does this represent a sustainable basis for generating the payoff characteristics capable of supporting endless growth in hedge funds assets, let alone a new paradigm for active management? From an industry-wide perspective: almost certainly not.

So what do they represent? They are definitely credible alternatives to conventional asset allocation, at some equivalent risk tolerance, where implemented using active, but benchmark-constrained, managers. No Monkey Business will always prefer a long/short equity manager to a long-only active manager, within some limited active management budget for both risk and cost.

Provided an investor can estimate the likely future risk level of an absolute-return fund of funds (or portfolio of funds), it will be superior to its conventional dynamic asset allocation, if it achieves its hoped for alpha, as this is the source of its winning asymmetry.

If the investor has no access to a dynamic asset allocation matched consistently to a given risk tolerance and utility function (such as if relying on IFA-advised portfolios of packaged products), an absolute-return approach with the right risk level is probably better. However, the same lack of adviser skill that means you could do better also prevents the degree of risk in the alternative approach (though almost certainty greater than ‘absolute’) from being correctly identified.

We can conclude, therefore, that the successful adoption of this alternative approach requires agency changes:

• improvements in the identification of risks by agents, from pension consultants to IFAs
• better targeting of risk levels by managers themselves

There is always the risk that, though necessary for greater market penetration, these agency changes also interfere with the management process itself and, ironically, maim or kill the goose that lays the golden alpha egg. Such self-defeating dynamics may account for the durability of conventional approaches to harvesting risk premiums.

Finally, our own experience, offering two different approaches to risk management for the same risk tolerance, suggests that intuitive preferences will ensure both survive to compete with each other.

Our argument that conventional asset allocation can be dynamically matched to a quantified risk tolerance, using dilution of predictable risky assets by a risk free asset, implies a particular view of the world based on ‘mean reversion’ in real equity returns. Reliance on a multi-asset class approach implies a different and more anarchic view of the world, such that the more risks are added the greater the chance of controlling downside risk. Each involves a particular ‘model risk’: that the view of the world will prove wrong. We observe that new clients select between these model risks based either on objective suitability or on pre-existing preferences. We also observe that some prefer to split their hand and adopt both.

1. Language defines the debate

A feature of No Monkey Business thinking is that clarity usually starts with the terms: distinguishing between the language of the sale pitch and the language we can consistently rely on to break down investment products and styles into understandable components. This consistent language tends to be anchored on investment theory.

If you are confident about meaning, you can skip this section and go straight to the arguments about the ‘transformation’ of risk and return (page 8).

Conventional use of the term

Before ‘absolute return’ was hijacked by a new concept, within the last decade, it had a single meaning and usage. It was, quite simply, the return earned (or expected to be earned). As such, it hardly needed a term except to differentiate it from ‘relative return’. Relative return was the absolute return expressed as a ratio of a comparable return, usually that earned by a ‘benchmark’ that is representative of the pool of all investment opportunities from which the absolute return was derived, as a function of the actual investments picked from the pool. Whatever the benchmark, its return was also an absolute return.

An absolute return divided by another absolute return becomes a relative return. Relative returns in consecutive periods can be compounded to create a multi-period relative return, such as to show comparative performance over three months, three years or thirty years.

Absolute returns are by common usage, but not by definition, ‘nominal’: expressed in money terms. A nominal return deflated by inflation, which makes it a ‘real’ return, is technically a relative return. A measure of inflation becomes, in this case, the basis of comparison. This is not very constructive, however, when considering this investment fad. For this purpose it is better to assume that an absolute return for an investment or a benchmark can be either nominal or real. For example, a real return on an equity investment can be compared with a real return on a bond to capture the different effect on each of inflation and the difference in effect according to the period considered.

The common use of relative return that justifies a single meaning is some form of performance assessment, whether the basis of performance is competition between:

• asset types
• managers of the same asset type
• an active manager and a ‘passive’ investment in the benchmark

Conventional usage and investment theory

The conventional use of absolute and relative returns is integral to the dominant theory of capital market behaviour.

This makes a separation of its own between three components of return:

• return explained by exposure to a pool of opportunities (‘the market effect’)
• risk relative to the risk of the pool of opportunities (the two combined, the sensitivity to market movements, being expressed by the Greek term ‘beta’)
• a residual, or unexplained, return component

If the benchmark used to measure the market effect really is representative of the pool (often a big ‘if’), the unexplained return variance is a reasonable proxy for manager skill (or value either added or destroyed), with which its Greek name, alpha, has become synonymous.

The separation of alpha and beta uses the maths of ‘regressions’ and also introduces relative risk to the return comparison. But otherwise it serves the same general purpose as absolute and relative returns: to provide information that clarifies contributions to achieved returns.

Both recognise the important truth that most of the absolute return is earned simply by exposing capital to a particular opportunity set with particular risk and return characteristics. The theory only admits the chance that a portfolio can generate pure alpha if its beta exposures have been perfectly hedged.

In modern portfolio theory, exposing capital to the absolute risks typical of equities is a conscious policy choice an investor makes. A diversified equity portfolio could be predicated on a set of expected returns and variance of returns based simply on historical evidence. Or it could further rely on a theoretical explanation, such as that the expected returns are a reward for the uncertainty of outcome and volatility in the short-term path of equities. Whatever the true explanation, the ‘systematic’ return behaviour of a market cannot be completely diversified away: it comes with the exposure.

If, as a matter of high-level policy, I choose to expose my money to the systematic returns of UK equities, represented, say, by the FTSE All Share Index, my absolute return will be largely explained by that policy decision. Logically, therefore, I should attribute to myself, and my policy choice, the performance of the index. To whichever UK equity manager I choose to implement my exposure, I logically attribute only the relative return against the All Share Index.

In this case I am making no value judgement between the policy decision and the implementation decision, between myself and the manager, or between absolute and relative return. Like beta and alpha, each serves a different purpose.

How investor preferences changed

During the long bull market that culminated with the bursting of the technology bubble in 1999, investors were generally happy to bear equity risk and harvest a risk premium that was very generous relative to cash and quite competitive with bonds (which enjoyed a bull run of their own). In this period, absolute returns from a wide range of assets were highly satisfactory. The conventional usage of absolute and relative returns described above was not much questioned.

Hedge funds represented the vanguard of a challenge to conventional approaches but at this time only those hedge funds with equivalent risk to equities, and similar high achieved returns, were at all successful in gathering assets. In fact, even conventional managers who left the party too early were punished by having assets taken away from them. There is no evidence that investors were prepared to give up equity-type returns for the sake of avoiding downside risk.

All this changed in the bear market of 2000-2003. Unless investors were heavily exposed to technology and media stocks (which they could not all be), the fall they endured was not in fact exceptionally large by previous standards. But it is possible that a long bull market and reduced volatility (derived mostly from lower and more stable inflation) had lulled cautious investors into more risk-taking than they could really tolerate.

Amongst institutional funds in many countries another set of changes was occurring that genuinely altered investors’ rational risk preferences: regulatory reform that called for explicit assignment of capital to different levels of risk taking (‘risk budgeting’) and accounting reform that created significant adverse impacts on balance sheets and income statements if funds experienced ‘paper’ losses due to short-period volatility. The importance of this shift in institutional ‘utilities’ (which simply define how decisions about risk should most rationally be taken) cannot be over-emphasised.

In long-term institutions and the upper levels of private wealth, hedge funds were the main beneficiaries of flows from conventional to alternative assets as they moved their investment objective to reducing volatility relative to equities and to increasing upside volatility relative to downside volatility.

In the private-client marketplace, it was structured products, guaranteed to preserve the nominal value of capital but paying out a proportion of gains in an underlying benchmark over the life of the structure. Guaranteed equity bonds, with a life of typically five or six years, were the main beneficiaries of ‘mass-affluent’ capital but more esoteric benchmarks, such as commodities, joined the array of products offering to provide upside potential with no downside risk.

How conventional language was hijacked

The language of the new innovation was important to its successful marketing. A key part of its sales pitch was to trash relative-return investing, as if it was dumb of investors to encourage managers to be lazy about doing anything to control or change systematic risk exposures. Why follow the market down when you could sell the market? Or why hold the market when you could replace it with options, to protect some or much of the upside? Who cares if a manager outperforms the market if the absolute return is still negative?

From the perspective of correct usage of the terms, these were all criticisms not of relative returns but of the chosen risk level associated with the absolute returns. Differences in risk appetite affect the policy choices made at a high level and so belong in the category of appropriate beta and absolute return risks.

What has happened is that the term ‘absolute-return investing’ has come to mean investing with a particular risk preference that emphasises preservation of capital, as if ‘absolute’ described only positive returns.

The second attribute commonly associated with absolute-return investing is a wider range of strategies, and resulting sources of risk and return. This can be viewed as bringing structural advantages (better scope for diversification benefits) or potential performance advantages (more bets for a manager to make).

The third attribute is that the returns from absolute return investing are mainly derived from alpha.

In hijacking the language that has served us very well for over half a century, the new fad risks a great deal of confusion about where returns come from, how to make choices and what we should pay for and why.

2. Transformation

What we have learnt from the distinctions using language based on investment theory is that the key to the sales pitch is a claimed transformation of investment risks and returns. It is time to examine what this really means.

How are the risks and returns altered?

The high-level choice to accept equity risk in order to seek equity reward assumes a trade off between risk and return in order to maximise some utility, such as a level of future desired wealth which is consistent with both tolerable paper losses along the way and a tolerable shortfall from the desired outcome. The trade off is only made because the possible wealth outcomes without risk taking are not satisfactory, since we all start out wanting to avoid risk.

Whatever the level of risk that maximises our utility, we can obtain it by controlling exposures to risk – in other words, by the dose of risk. Usually we do this by holding more or less of risky assets relative to risk free assets.

For any alternative investment to be superior to a conventional asset allocation with the right risk level, it has to alter the risk and return trade off. The implicit or explicit claim made by so-called ‘absolute-return investing’ is that it does alter the trade off: by giving up more risk than expected return compared with its conventional equivalent.

This claim relies on two types of effect.

1. Diversification benefits are increased, by introducing more return sources that have low correlations with other portfolio components: they do not behave the same way at the same time
2. Specific strategies are pursued that put a floor under downside risk that allows for capital preservation while still offering probable gains.

Diversification effects
The first assumes that, for a given level of satisfactory return achievable from either type of portfolio, the risk of the more diversified one will be lower. The risk-adjusted return is therefore superior. This claim relies both on the return predictability relative to conventional strategies and the assumptions about correlations.

Diversification benefits can be increased by adding conventional long exposure to unconventional systematic risks and returns. Provided the new exposure genuinely has lower correlations with the existing components, it should be possible to arrange the mix of assets to produce the same return with lower risk or to take the same amount of risk for a slightly higher return.

What might these unconventional additions be? There are actually few assets that can be relied on for this structural diversification effect.

• Direct property holdings through some packaged investment (as distinct from property shares) already form part of many conventional portfolios
• Private equity exposure can be easily acquired through a few quoted securities but these are also part of the broad market
• Commodities, though not an asset class, generate a genuinely different set of risks and returns when combined in an index-fund structure (combining cash collateral and index futures to create an ungeared portfolio of commodity exposures)

However, by using derivatives in a portfolio, a manager can further increase the range of risk and return sources that are not highly correlated. Ironically, the additional sources arise largely from relative returns: betting on the difference between two assets by being long one and short another, such as the relative return of oils stocks against the market or Royal Dutch Shell against BP.

To the extent it is relative bets that mainly differentiate absolute return portfolios, it is reasonable to argue that the expected risk-adjusted returns will be better than can be achieved by mixing conventional assets. Many of these relative bets work mainly by rearranging risk exposures already present in a conventional long-only portfolio, such as movements in interest rates, in option volatility and the pricing of credit risk. Thus the scope to add new risk exposures is less than generally assumed but there are still benefits from changing the distribution of exposures (since diversification is a function of weights as well as numbers of different exposures).

It is debatable whether relative bets have the same ‘normal’ payoff distribution as conventional asset combinations, which is what the comparison between risk-adjusted returns assumes. It is likely that the main difference is occasional losses much greater than normal. This is true of many so-called low-risk, low-return asset strategies in finance that are as old as markets: bank lending, insurance underwriting and arbitrage. In the 15 years or so of true history of alternative investing, these ‘fat tail’ events have arisen within individual products but have not been in evidence in diversified exposure to alternative products.

If, consistent with the loss-averse utility, we assume diversified exposure is the most rational way to use alternatives, it is reasonable to assume that the underlying mix of risk factors in this richer mix produces normal and symmetrical returns. In that case, the payoffs can be matched by those of a mix of conventional risky assets and a risk free asset at some equivalent risk tolerance.

Something other than diversification is required to transform the distribution of payoffs.

Achieving asymmetrical payoffs
The desired portfolio effect, increasing upside relative to downside risk, requires one or both of two quite different activities on the part of the manager:

• active management that consistently pays off
• option strategies

Each has shaped the absolute-return industry to date in quite different ways and each poses a very different threat to the conventional asset-management industry. They may both produce asymmetrical payoffs but investors adopting either will experience quite different opportunity costs.

Active-manager skill

Asymmetry relies on managers being able to judge when to be ‘long’, ‘short’ or ‘neutral’ in terms of the conventional or alternative risk factors in their opportunity set. Research has shown that market timing in conventional investment management is unpredictable, in other words past wins do not predict future wins. So for skills to be a predictable means of reducing downside more than upside, they have either

• improved dramatically (perhaps because of being freed to operate without the constraints of a long-only, benchmarked portfolio), or
• migrated from activities outside mainstream portfolio management where they already existed (as in banks’ proprietary trading desks or commodity firms)

A less obvious implication of presuming skill is that the investors on the wrong side of trades with predictably skilled investors do not learn. This was possibly a factor in the early days of hedge funds but it has probably already been negated. Three examples can be cited of ‘sucker’ money wising up:

• central banks are more careful about advertising their exchange-rate policy
• equity investment funds have sharpened up their dealing capabilities
• index-tracking funds have tried to avoid predictable rebalancing patterns

Option strategies and capital guarantees

Options are the only systematic and predictable means of ensuring asymmetry, by providing upside potential coupled with limited downside risk. Whereas futures and swaps can be used to implement exposures (long or short, with more or less gearing), or to create relative exposures (or differences between two absolute returns), we have decided they probably still generate symmetrical payoffs, with equivalent upside and downside risk.

Whereas hedge funds can use both active management of their risk exposures and option strategies to try to generate asymmetrical payoffs, structured products that guarantee the capital subscribed are limited to option-based strategies.

The issuer of a structured product that guarantees to return your capital, on a worst case basis, at the end of, say, six years, is not offering you a free lunch. On the contrary, the structure uses assets priced in some of the most actively-traded, liquid and efficient markets in the world.

The first element is a discounted six-year bond, ie a bond that at the prevailing interest rate will repay both the capital and rolled-up interest at par in six years. If, as a function of interest rates at the time, this requires only 70% of the money you put up, 30% of it is available for two other elements:

1. the issuer’s and promoter’s cost and profit
2. a call option on whatever underlying asset or index the structure gives upside exposure to

The interest rate (on which the discount depends) and the implied asset volatility (on which the option cost depends) together dictate the possible upside participation and the probability of gain.

Since the discount is equivalent to the opportunity cost of a cash deposit, the value of the structure must be a function of volatility. If we assume that over any long period the market’s errors in estimating actual volatility will even out, there is no long-term value to be obtained from rolling over call options. The best forecast for a long-term compounded return from a series of rolled-over structures is the cash return less issuers’ and promoters’ margins.

What there may be are rational trading opportunities for investors backing a particular view on volatilities relative to the prevailing interest rates.

Structured products might initially have been popular because interest rates were very low and investors were desperate for yield improvement. It did not require much upside potential to look enticing. But they have exploded in popularity since interest rates have risen, as this has increased the participation rates. The only common element has been that volatility has remained low. The recent combination is perfect. It can only get worse, probably because credit-induced risks to economic activity allow interest rates to fall but only at the cost of higher volatility in financial assets.

Most buyers of structured products are probably not shown a probability distribution for the payoffs of each product at the point of sale. Such illustrations have become more common but are not a regulatory requirement. These would reveal the bunching of outcomes around the cash return and the very low probability assigned to eye-popping upside.

After the sale, profits on the contract open up downside risk that logically is inconsistent with the risk appetite at point of sale. For example, a successful Xinhua contract on Chinese stocks at one stage implied a possible loss (for supposedly loss-averse investors) of 36%. Even though some of the contracts are reasonably liquid, many buyers and their agents act as if unaware of this and so do not trade out of in-the-money contracts to new on-the-money options.

Even knowledgeable investors are unlikely to be aware of the compounded payoffs of a long-term strategy of rolling over products, as these require modelling of the two time-varying and partially dependent factors: interest rates and volatility. These cumulative results need to be compared both with cash and with some level of exposure to risky-asset returns, to demonstrate the potential opportunity cost over long periods.

Clearly, capital-guaranteed products will survive for those able to use them discriminately. But they cannot possibly replace either conventional asset allocation, for a given risk tolerance, or a dynamic alternative to absolute-return investing, such as hedge funds.

This reinforces the observation that absolute returns are a misnomer, since structured products have been the only saleable combination of absolute capital protection and upside potential. Hedge funds have required downside risk, to be saleable.

Target-return funds
There is a third category of absolute-return funds that has emerged in Europe, in both onshore and offshore jurisdictions for regulated funds. Marketed as actively-managed against a cash benchmark (typically either £, Euro or $ 3-mont LIBOR cash rates), these adopt absolute-return techniques but are constrained by the product rules of their jurisdiction. Until these constraints are removed, they are unlikely to challenge either their conventional equivalents or retail funds of hedge funds.

These funds are found within a number of categories according to the benchmark or the instruments mainly used:

• Money Market (funds normally also termed ‘enhanced cash’)
• Global Bonds
• Cautious Managed (and its life-company equivalent: Defensive Managed)

Their performance has been disappointing in their early stages but they set themselves a much harder target by including a return on cash instead of capital invested.

Valuation issues
One of the new risk factors that any diversified approach to alternative investing is likely to introduce is illiquidity. Portfolio theory requires this to be remunerated by a risk premium, so it is another example of an increment to the diversification of multiple risks.

It is something else as well. Holding less liquid or untraded positions, including derivative positions that call for some benchmark reference for ‘marking to market’, introduces issues about price discovery that have a bearing on the return path of the fund, and hence its observed volatility.

Confidence about pricing is also important for funds that remain open to new investors, to ensure equity between them.

The trend is for illiquidity to increase, for example as hedge funds match the strategies of private-equity partnerships. For absolute-return investing to challenge conventional asset management, these issues will need to be addressed much more convincingly than hitherto.

How we advise clients
We have adopted two alternatives that we believe cover all the investment needs we encounter when organising, co-ordinating or managing investments for individuals and their families.

1. Goal-based, model-driven portfolios dynamically matched to target outcomes and time horizons
2. Multi-asset class portfolios which are absolute/relative hybrids

1 Goal-based portfolios
Our model-driven portfolios use a lean mix of assets whose return behaviour is (unusually) evidenced by long data histories: the major equity markets. Risk tolerance for each client goal is determined in a collaborative, planning process in which some quantifiable terms of reference that unequivocally describe the goal are ‘solved for’. The process forces them to be internally consistent, excluding any possibility of a mistaken free lunch or unrealistic expectations:

• probable real outcomes (the targets) expressed in terms the client can relate to
• resources required or assigned
• the planning time horizons (as opposed to decision time horizons)

The risk tolerance results from the selection process, as the client directly exhibits how they value the different attributes of success and failure, such as how upside potential is traded off against a floor outcome.

Once discovered, that risk tolerance becomes the basis for us to manage the portfolio, as market conditions alter and time horizons grow shorter (unless set to roll forward).

Ensuring consistency with the risk preferences requires us to dilute the exposure to risky assets using a goal-specific risk free asset. We cannot rely on diversification because the risky assets are few and too highly correlated.

This is a much tougher competitor for absolute-return investing because it provides the formal, well-thought risk-management process that absolute-return managers rightly say is missing from conventional approaches to asset allocation. Absolute-return investors want to give greater value to loss aversion. We translate that into shortfall aversion: outcomes that will cause regret or hardship.

2 A multi-asset class portfolio
What we organise here is not an absolute-return portfolio but as we have seen is closer to the reality of much of the market, where downside risk corresponds to a risk-diluted portfolio with a relatively moderate risk tolerance for a long horizon.

Changing the risk tolerance further, up or down, requires either dilution (probably with cash) or gearing (which is usually part of a total balance sheet approach and therefore implemented by means of a mortgage secured on property, not the portfolio).

For its assumed risk tolerance we still want maximum diversification of risk exposures, hence the use of the term ‘multi-asset class portfolio’ rather than absolute-return portfolio or ‘alternatives portfolio’. We delegate both the risk-factor structure and the manager selection to a third party but if we cannot secure the full diversity we want we complement that core manager with some cost-effective exposure to the missing factors. At the moment, our solution requires some complementary exposures to property and commodities (which we select).

We hope for asymmetry due to active-manager skill, but we do not assume it. Our preferred core manager targets a mean annualised 3% of beta return and 2% of alpha return but we would be happy with 1% and overjoyed if it all arises when we most need it.

How clients select

They select by

• ‘Model risk’: which implied view of the way the world works they trust most
• Suitability for the goal in hand Cost (a model-driven portfolio relying on index tracking is much cheaper)
• How they value the ‘option’ of earning positive alpha

They also split their hand: diversifying between the two.

Model risk
Our goal-based model generates stochastic simulations of thousands of possible paths and outcomes. These reflect a view that equity real returns are volatile but not entirely random: they have a tendency to revert to a mean, or trend, real growth rate.

We observe that both the growth trends and the dispersion around the trends are remarkably similar for those markets with long histories of real total returns for a diversified index of securities. The paths are also quite similar most of the time but deviations can diverge at times, so the correlations between the markets vary – but not predictably. Projections requiring a high degree of confidence (as high as 99%) therefore need to allow for close convergence of correlations.

As noted, we control the range of outcomes by dilution: holding more or less of a risk free asset matched to the target outcome. If, for instance, the target is expressed in real terms (because its purchasing power must be maintained), the matching risk free asset is an index linked gilt.

This view of the world stakes a lot on the relative predictability of a few markets with long histories of their behaviour in real terms. It might be as few as four markets or regions: UK, Europe, USA and Japan. Together these represent 90% of the world’s opportunity set by value but much less by number of investable opportunities. It is a view that trades off predictability against diversification, where adding assets leads to diminishing certainty about the return, risk and correlation assumptions.

It is also a view that places more importance on outcomes than on paths, or interim volatility. This is self-evident in the use made of index linked gilts which, though they match the outcome with certainty, are nearly as volatile as equities if both long-dated and very low-yielding.

It is an approach more naturally suited to goals where predictability, horizon matching and quantified tests of goal progress are all highly valued.

The multi-asset class approach implies a radically different view of the world in which the future is much less predictable, even where evidence is most plentiful. The Darwinian process of change that is implicit in an index of equity securities over long periods (which though called ‘passive’ is actually constantly being refreshed) counts for less in this world view than a Darwinian process of manager adaptability. Managers compete, rather than markets competing.

It is a view that values being ‘in with a chance’ of outsmarting other investors, even other smart ones, even if there is relatively little total available alpha that all these investors are fighting over.

It embraces Grinold’s Law of Active Management that holds that the chance of earning positive alpha is a function of the number and frequency of independent bets made: bet little and often.

It is a view that suits an investor (or an investor’s goal) that requires low downside risk, not just because they want to avoid it (don’t we all) but because there are particular adverse consequences that weigh more heavily than lower cumulative outcomes. Examples are individuals (or bodies of trustees, including unknown future trustees) who fear that they will not be able to stay the course in the event of a very deep fall in portfolio values.

Splitting the hand

Not surprisingly, many clients choose to embrace both world views, as another contribution to their diversification. They may choose differently for the same type of task, but at the level of their entire balance sheet they benefit in similar ways from splitting their hand.