Core Investment Principles
  The information on this page is of a general nature and is not intended to be personalised financial advice. The information on this page is provided for general edcation purposes and is not intended to be a substitute for personalised professional advice. If you are seeking personalised financial advice (or any financial advice), you should aproach an independent and preferably fee-only AFA.

On this page I have set out some of the issues faced by portfolio managers and investors in their approach to investment management and provide a high-level view of Modern Portfolio Theory. 

Core Investment Principles
Investment  outcomes are actually determined by a small number of things, whether you are an institution or a private investor:

 There are two other guiding principles that impact on portfolio management and performance:

Investor Behaviour
US mutual fund data-collector, Dalbar, Inc published research covering the 19 year period from 1984 to 2002 that showed the average US investor in managed funds had achieved an annual return of 2.6% in those 18 years.

graph showing average US Investor Returns

This study (confirmed by similar studies in other countries) confirms 2 matters of importance to investors:

  • By chasing ‘hot’ funds and bad timing decisions, investors didn’t even get the average returns delivered by managed funds.
  • Due to high costs and bad timing, the average managed fund didn’t deliver market returns either.
The Remedy:
Disciplined investing – take proper advice, develop a plan based on disciplined asset allocation and stick to the plan. 

Investment Policy
Investment policy comprises the choice of asset classes (shares, bonds and cash) and the weighting of them in a portfolio. These two decisions are the overwhelmingly dominant predictable contributor to total return. A US study by Ibbotson and Kaplan found that, on average, asset allocation explained a little more than 100% of the level of returns across funds. (What this means is that many fund managers were actually subtracting value - because of timing, security selection, management fees and expenses)
Ibbotson, Roger G., and Paul D. Kaplan, 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal 56(1):26-33

The proper construction of an investment portfolio will involve varying allocations of cash, bonds and growth assets (normally shares or property assets). The proportions are determined by the investor’s risk tolerance. This risk tolerance can be measured reasonably reliably but historically in NZ, the financial services industry did not bother too much with this and over-exposed clients to excessive levels of growth assets. The consequence of this is that investor’s overload on growth assets at market peaks and sell out when periodic market downturns occur, leading to poor returns. Portfolio construction is the platform upon which good investment behaviours are launched.

Costs Matter
Costs arise in wealth management in a number of areas – up-front commissions, fund manager fees, fund management operating costs, transactions costs associated with buying/selling securities in a portfolio, the buy/sell spread on transactions and adviser fees.

Reducing costs makes a huge difference the long term accumulation of wealth.

A Vanguard study of 803 US equity funds over the 10 year period to August 2003 found that low-cost funds significantly outperformed high-cost funds.

graph showing cost matters

Source: John C. Bogle speech of October 2003 to Society of American Business Editors and Writers

Underperformance of Active Management

cartoon about underperformance of money managers

There is a huge gap between what is promised and what is delivered by many active managers.

“There’s no evidence managers can beat markets; if there was, then somebody would find it”  
Rex Sinquefield

Much of the fund management industry promotes a myth that they are actually adding value (by determining 'themes' and by constantly reviewing industry and geographic exposures) when most of the international evidence is that they do not.

" The fund management industry's dirty little secret: most actively managed funds never do as well as their benchmark"
Arthur Levitt (Chairman of the Securities & Exchange Commission from 1993 to early 2001)

Over 40 years there have been nearly 100 studies looking for persistence in managed fund returns. The few that find positive performance, find it for only short periods. Generally beyond 5 years, almost no managers have beaten markets after allowing for the costs and taxes of trying to do it. There is however considerable evidence that bad performance persists.

For a general analysis of the issues, here is a presentation by Aswath Damodaran - Professor of Finance at the Stern School of Business at New York University.

There are many US studies on fund performance persistence.  One of the most often cited is Mark Carhart’s study of the returns of 1,892 US funds in the period 1962 – 1993 that found no evidence of ‘hot hands’.

Mark M. Carhart, ‘On Persistence in Mutual Fund Performance’. The Journal of Finance, Vol. 52 No. 1, March 1997.

A recent US study looked at actively managed US funds in the period 1975 through to 2006. This study found that, after expenses, 99.4% of fund managers demonstrated no genuine market-beating ability (i.e.‘skill’). One of the authors, Professor Wermers from the University of Maryland says his advice has evolved significantly as a result of this study. Until now, he says, he wouldn’t have tried to discourage a sophisticated investor from trying to pick a managed fund that would outperform the market. Now, he says, “it seems almost hopeless.”

 ‘False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas’ L Barras, O Scaillet and RR Wermers, May 2008

Portfolio Construction and Modern Portfolio Theory

The academic basis  – Modern Portfolio Theory
Just as scientific research has transformed and improved many aspects of modern life, a significant body of academic research has transformed and improved the practice of investment management.  Some of the landmarks in the historical development of investment science include the introduction of Modern Portfolio Theory by Harry Markowitz in the 1950’s, the Capital Asset Pricing Model by William Sharpe, the Efficient Market Hypothesis by Eugene Fama and others in the 1960’s and the Three Factor Model of Fama and French in the 1990’s.

Markowitz and Sharpe received the 1990 Nobel Prize for Economics for their contributions to Modern Portfolio Theory.  Their key insight was that the risk of an individual asset is of little importance to the investor. Instead, what matters is the asset's contribution to the portfolio’s risk as a whole. In other words, adding one risky asset to another can reduce overall risk, without diminishing return. This is diversification.

There are four components to Modern Portfolio Theory:

  1. Investors are risk averse. Given a choice between two assets with equal rates of return, rational investors will accept the asset with the lower level of risk. Investors expect a positive relationship between expected return and risk. 
  2. Securities markets are efficient. Although prices are not always correct, markets are so competitive that investors cannot expect to consistently beat the market by picking individual securities or by “timing” the market.
  3. Focus on the portfolio as a whole and not on individual securities. Optimum investment portfolios are not created merely by combining a lot of unique individual securities that each have desirable characteristics. They are created by combining assets with superior risk/reward characteristics and whose correlations act so as to reduce volatility, give the highest return for any level of risk or minimize the risk for any given level of return. Negatively correlated assets are extremely valuable in a portfolio.
  4. Risk and return are related.  Riskier investments, when properly measured and managed, have higher returns than less risky investments. The following chart illustrates the concept:

    graph showing efficient frontier

The portfolio represented by point A is inefficient because there are portfolios with the same return but less risk (Portfolio B) and portfolios with the same risk but more return (Portfolio C).

Perfectly efficient portfolios can never be knowingly constructed in advance, but the theory has general applicability for portfolio design – by using asset classes with measurable risk/return attributes, portfolios can be constructed that are highly efficient.

Dimensions of Equity Returns
There are three primary factors influencing portfolio returns:

  1. Market Factor – the mix of shares v’s bonds and cash.  Over time, shares have higher expected returns than bonds.
  2. Value Factor – the percentage invested in value v’s growth shares.  Over time, value shares have higher expected returns than growth stocks.
  3. Size Factor – the mix of large company v’s small company shares.  Over time small company shares have higher expected returns than large company shares

These three factors are generally referred to as the Fama & French 3 Factor Model - a reference to two leading researchers in academic finance, Eugene Fama (University of Chicago) and Kenneth French (Dartmouth College). These factors have explained much of the variation in US stock returns for the past three-quarters of a century.  The value and size premiums have been observed in most other countries, including emerging markets. While the small company premium does assert itself only in spurts, it does seem to exist. The value premium appears to be very robust and has been observed in nearly every country that has been studied. 

graph showing increased expected return

Dimensions of Fixed Interest Returns
The role of fixed income in a portfolio is to reduce volatility. Equity markets give an appropriate reward for risk – low grade fixed interest investments do not. The key dimensions of fixed interest returns are associated with credit quality and term.  Research suggests that the risks associated with reduced quality and longer terms are not adequately rewarded.

Index Funds
Index funds started in the US in the 1970’s. Whilst widely used international, they have had little visibility in NZ. The early US funds were designed to mimic well established indexes such as the S&P500.  The number of funds expanded as awareness increased of the inadequate performance of the typical actively managed fund.  The manager of an index fund makes no decision as to timing or stock selection – they just duplicate the index either by holding a portfolio of all the shares in the underlying index, or hold a representative sample that gives the characteristics (return and volatility) of the whole index.

  • Index funds reliably harness the respective return premia (equity or fixed interest), provide global diversification and minimise volatility.  With low management fees, reduced turnover and tax efficiencies, index funds have always ranked highly in long-term performance studies.
  • Whilst index funds performed well, they have some limitations.  Indices are designed to measure performance of a constituent group of shares/bonds, not provide tools for managing portfolios.  As academic research provided a greater understanding of equity and fixed interest returns, enhanced index funds were developed.   These employ more rigorous eligibility rules than the traditional index fund and give a more style-pure exposure to each asset class.  These funds minimise turnover, maintain low cash levels and manage tax exposure.  The enhanced index funds are producing returns superior to that of traditional index funds, which in turn are consistently outperforming the average active fund manager.

"A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth." Warren Buffet

"I was not always an obnoxious indexing zealot. Ten years of believing in and selling active management strategies in the brokerage industry made me this way." Rick Ferri,CFA, author, financial adviser

The US Securities and Exchange Commission has a useful summary of fundamental investment principles here: Beginners' Guide to Asset Allocation, Diversification, and Rebalancing