Product and Strategy Notes: New Research Papers: Benchmark Bias; Investment Horizon; Value Weighted Approach; Active Management Bias; Residential Property; and Commodities for Diversity

Many times an advisor will be presented with a new active strategy idea that is accompanied by impressive backtesting results. A recent paper should cause you to examine these analyses with an even more skepticism than is likely already the case. In "Look Ahead Benchmark Bias in Portfolio Performance Evaluation", Daniel, Sornette, and Wohrmann observe that "most professional databases do not track changes in the constitution of benchmark portfolios." Because of this, most backtesting is based on the performance of the securities or companies that comprised the benchmark at the end of the performance evaluation period rather than the beginning. The authors conclude that this can result in overestimation of strategy performance of up to 8% per year, as well as a gross underestimation of strategy risk.

One of the most frequently heard complaints over the past decade has been that an increasing focus on the short term is (depending on who is making the argument) (a) increasing trading volumes, and reducing the returns earned by fund investors; (b) causing corporate management to make shareholder value destroying decisions; (c) enriching investment banks; and/or (d) all of the above. A new report from the IRRC Institute and Mercer Consulting only adds to these concerns. "Investment Horizons: Do Managers Do What They Say?" examines the investment horizons "of active long-only equity managers across different geographies and styles between June 2006 and June 2009." The authors note that "the overall aim of this research was not to prove that long-horizon investing is good or short-horizon investing is bad (or vice versa), as we recognize that there is a valid role and function for all types of horizons and approaches to investment. Rather, the aim was to examine the extent to which there is a mismatch between the time horizon over which investors think and say they invest and how they actually invest." The research found that "nearly two thirds of strategies have higher turnover than expected....On average, turnover was 26% higher than anticipated, with some strategies recording more than 150% to 200% higher turnover than anticipated." Within the entire sample, the average annual turnover was 72%. Based on this, the authors conclude "short-termism exists and constitutes a material tail risk of investment strategies." Digging further into the causes of short-termism, the authors found that "key themes included volatile markets and changing macroeconomic conditions; the emergence of more short term traders, such as hedge funds; mixed signals from clients; short-term incentive systems; and behavioral biases, such as herding, overconfidence, and recency."

Over the past fourteen years, we have repeatedly noted that the extreme difficulty of consistently successful active management, along with its higher costs, makes a passive approach a far better alternative for most investors to pursue for most of their portfolio assets (we still recognize the undeniable mathematical attractiveness of uncorrelated alpha strategies, particularly for investors who need to earn relatively high compound real rates of return to achieve their long term goals). A recent paper by Bhattacharya and Galpin shows that in practice this view is becoming more widely adopted, even if it is sometime not openly acknowledged. In "The Global Rise of the Value-Weighted Portfolio", the authors devise a new metric to test for investor use of value (market capitalization) weighting. "If every person maintains a value weighted portfolio, the weight of a stock in that portfolio should completely explain its trading volume." By comparing relative stock trading volumes and capitalization weights, the authors infer the extent to which value weighting is used by investors. They apply this approach to markets in 46 countries, and find that between 1995 and 2007, value weighting has become more popular in 35 countries. On an individual country basis, they conclude that value weighting is most popular in Ireland, the UK, USA, Australia, Italy, Sweden, Hong Kong, and the Netherlands, and least popular in Switzerland, Pakistan, Brazil and India.

While market capitalization weighting is becoming more important, a substantial amount of money is still actively managed around the world. Given the track record of active managers, many observers have wondered over the years about the underlying causes of active management’s continuing attractions to investors. In "On the Size of the Active Management Industry", Pastor and Stambaugh make a new attempt at answering this question. They focus on "the role of historical data, and how investors use it in practice." The authors start with the observation that "there are decreasing returns to scale in the active management industry -- any manager's ability to outperform a benchmark declines as the industry's size increases...As more money chases opportunities to outperform, prices are impacted and such opportunities become more elusive...Under decreasing returns to scale, investors learn about the degree of these decreasing returns over time and thereby determine the active management industry's equilibrium size." However, "investors face endogeneity that limits their learning...As they update their beliefs about decreasing returns to scale, they adjust the fraction of their investable wealth allocated to active management, and learn by observing the industry's returns after that follow different allocations...[However], what they learn affects how much they allocate, and how much they allocate affects how much they learn." In essence, this feedback loop makes accurate learning more difficult, and results in an active management industry that is larger than it might be in equilibrium. As far as it goes, this is an interesting paper; however, we believe that it also neglects some other very important explanations for the amount of money that is actively managed, in spite of a substantial amount of accumulated evidence about the odds of outperforming passive investment over the long term. These include the fact that over the past 30 years, an increasing amount of money has been managed by delegated managers (which creates significant agency/incentive problems), the dependence of many media outlets on financial advertising, and, perhaps most important of all, the powerful impact of human emotions, and in particular the envy that is inspired by another's investing success, regardless of whether that success reflects luck, skill, or simply a different set of preferences.

Three Interesting New Papers on Residential Property. In "Housing Risk and Return: Evidence from a Housing Asset-Pricing Model", Case, Cotter and Gabriel test an asset pricing model for residential property wherein "the expected returns of metropolitan area specific housing markets are equated to the market return, as represented by an aggregate U.S. house price time series." The authors also test the impact of augmenting this basic single factor model with a number of other risk factors, including stock market returns and momentum. They find that the single factor model works quite well, and points to a clear relationship between risk and return in different U.S. housing markets. Specifically, high beta (high risk) markets tend to be found on the east and west coasts. They also find that betas are time varying and that the housing risk/return tradeoff shows evidence of non-linearity. This non-linearity is also found in another recent paper, "Chartists and Fundamentalists in the U.S. Housing Market" by Kouwenberg and Zwinkels. Similar to other agent based market models, the authors allow a group of heterogeneous agents to switch between using a trend following (chartist) or fundamental valuation model when forecasting housing prices, and the seek to fit their model (and the underlying agent behavior rules) to historical U.S. data between 1992 and 2005. They find that historically the proportion of agents using each forecasting strategy has been roughly equal. However, the chartist share began to significantly increase towards the end of the sample period, and as a result housing prices climbed well above fundamental values based on capitalized rents. As we all now know, the results of this shift have been disastrous. A third paper, "Housing Options: For Sale By Owner" by Louis Odette of Moody's Wall Street Analytics, proposes a new approach to solving the problems we face today in the housing market. In essence, the owner of a home whose value is significantly below the value of the mortgage on it, could sell a covered call option on its value, assuming the house is sold. This could be done as part of a reduction in the principal of the existing mortgage. This is a very similar approach to one we have proposed before (based on our experience in post-Latin American debt crisis restructurings) that would convert a portion of existing mortgages into equity, which the lender could then pool and use to back the issuance of new investable index products that track the value of residential property as a broad asset class. Frankly, Odette's approach strikes us as operationally easier to implement than our approach, but very similar in terms of its ultimate economic impact. We hope his paper gets wide reading in Washington, D.C., because we don't think the initiatives that have been undertaken thus far are up to solving the very large housing and mortgage market problems that still confront the United States and other countries.

We couldn't help but notice an interesting article in the 7Feb10 Financial Times. In "More Managers Turning to Commodities to Diversify", Ruth Sullivan writes that "recent research by Bank of America Merrill Lynch into nearly 300 commodity investment vehicles with $123 billion of assets under management shows low interest in actively managed funds. Only 18 percent of commodity investors put their money into actively managed funds. The rest are passive, with the majority of those (60 percent) choosing exchange traded products. However, the research also indicates that 76 percent of actively managed broad based commodity hedge and mutual funds have outperformed their benchmarks since launch." We think this article highlights our choice last year to switch from a passive long-only index product (based on the Dow Jones UBS Commodities Index) to implement our allocation to this asset class, to LSC, an ETF based on the S&P Commodities Trend Index, which takes both long and short positions in different commodities, based on an underlying formula. In our view, LSC and similar "semi-active" long/short funds should have a long-term advantage compared to commodity funds that can only take long positions in futures contracts (which causes futures contract prices to become elevated -- or contangoed -- relative to spot prices, which in turn generates negative roll returns, as the assets in these long-only funds increase). However, funds like LSC are still much less expensive than most actively managed products. In short, this approach continues to be attractive on both a macro and micro basis.