With hindsight, most experts in the institutional investment business admit that the boom of the latest investment cycle spawned many malinvestments, with the unsustainable growth of dotcoms, and the TMT (technology, media, telecommunications) industries generally, only the most notorious examples of a much wider phenomenon. In this article I argue that some cherished portfolio investment theories will themselves go bust, and concentrate on two in particular; one already looking rather frayed but the other so far untouched.
In principle, the boom phase of an investment cycle, propelled largely by central bank credit expansion and artificially low interest rates, misleads entrepreneurs in particular and the community in general to believe that more long term projects can be undertaken without detriment to the economic activity already in place, including the production of immediate consumer goods. The inevitable recession which follows is simply the unwinding of (i) those projects which were never viable in the first place plus (ii) those which were viable but became irrevocably damaged due to the bidding away of resources into unviable projects1.
None of this is recognised during the boom. Looked at in this way, it would be most surprising if no malinvestment took place in the investment consultancy and education industry itself. One such was the rise of ‘momentum’ investment (buying high, selling low) disguised as ‘index-tracking’ or even ‘growth’. The reason why this so-called investment theory is now beginning to crack is that astute observers can already see that it exacerbated the boom, and hence the bust. Other malinvestments in the same industry have yet to be questioned; the exampleI examined here is the increasing elevation of ‘asset Allocation’.
Index tracking
Index tracking has its roots in an incontestable truth; since investors collectively determine the (capital-weighted) indices and their behaviour, investors collectively cannot outperform them; those with greater expenses and no greater ability will therefore underperform. There is no need to resort to dubious statistics over dubious time periods to prove this, but it constitutes no more of an argument for index-tracking than it does for using a pin to pick secretaries, chief executives, professional advisors, or motor cars.
Index tracking is far from passive – typically it will churn around 10-20% of assets. If you have no confidence in anybody’s fund management then it is far cheaper to buy say 50 stocks of equal weight and rebalance them only occasionally.
It may be argued that the largest institutional investors are severely shackled by the market impact of sales and purchases. There is some truth in this but far more severe shackles for the vast majority of UK investment institutions are the largely absurd index benchmarks and tracking errors foisted upon them by their own advisers. (“Tyranny” is not an uncommon word.) Yet, as a few perceptive writers such as Barry Riley and John Plender – both of the Financial Times – have pointed out, index-tracking is enormously risky, as indeed recent stock-market movements have demonstrated. It is concentrated, not diversified, and highly volatile. Its very nature makes it so; the more a stock rises, the more you must buy and vice versa; the antithesis of rebalancing, caution, rationality, and doing your homework.
With regard to the economy as a whole, significant capital-weighted index-tracking encourages bad governance and leads to wanton misallocation of resources. The same is true for ‘closet index tracking’, ie, active management with low maximum tracking errors relative to the indices.
Certainly, in the UK the extent of these practices is indeed significant, and constitutes a far greater threat to the much vaunted ‘socially responsible investment’ than all the other usual suspects combined. The reason is that bosses of big companies can raise more capital for any purpose at any time. Who can believe that exploitation and massive malinvestment (and some highly unsavoury attempted cover-ups) will not be the result? Do not expect the investment activism being foisted on the bosses of big fund management companies to offer much of a cure to this problem. More generally, index tracking exacerbates the immensely harmful boom and bust cycle.
For a healthy economy, index-tracking must always be a minority sport (in which, even then, the trackers are free-riders on the rest) unless the Stock Exchange’s role as an efficient resource allocator is to disappear. The rewards for the few pursuing active management would then be immense – as the country slides into poverty.
Typically, this process is arrested as extreme valuations appear. We have seen this in the last two years or so and something of a correction, in the shape of a return to ‘value’ investment, is underway. But there is no cause for complacency. Tracking in both its automatic and closet varieties remains at a dangerously high level. Imagine how much society would lose if 99% of all motor cars were picked with a pin, and how much better would be the other 1% and those who used them!
Asset allocation
My second example of boom-time malinvestment, the deification of index-tracking’s near relation, namely ‘asset allocation’, as yet shows no sign of abating. For an investment consultancy to remain buoyant, something has to be active; if investment within asset classes is on autopilot, then one must foster interest in the asset classes.
There’s value to be had in asset allocation rather than stock selection say the pundits2. This statement is not self-evident, however. First, we should note that the argument that collectively investors cannot beat the average applies to asset allocation just as it does to stock selection. How, then, has it achieved its accolades? An answer to this lies in cooking the books of the respective contributions to performance of asset allocation and stock selection. Thus stated asset allocation performances are greater than stated stock selection performances because investment consultants have decreed it to be so! Not only has stock selection itself been marginalised in many funds, but also where it remains significant it is nevertheless calculated as insignificant by performance measurement tools which themselves adopt a top down technique. Thus even if stock selection contributed 100% of performance it would be calculated as whatever is left after false attributions to asset classes.
The anecdotal evidence against active asset allocation is strong; certainly it is rare to find senior pension fund figures claiming long-term gains from asset allocation. The only clear evidence for asset allocation is that it should be passive, configured to reduce risk in the light of liabilities. Broadly speaking, for most pension funds this means little more than a split between suitable bonds and the rest of the universe.
Going beyond this is futile, and indeed raises the question ‘what are asset classes?’ Asset classes are a function of performance measurement methods, and what constitutes an asset class is a matter of the fashion of the day. One could argue very easily, for example, that a division into highly geared and lowly geared equity is far more important than a division according to the geographical location of the stock exchange concerned.
Furthermore, asset classes are interdependent to a very large degree. The characteristics of an ‘equity’ depend on how much in the way of ‘bonds’ stands in front of it, and vice versa. Even in aggregate, the equity/bond ratio changes over time; it has fallen strongly, perhaps even halved, within a generation in the UK and US, so both are far more risky than previously. Equity without bonds in a stable business may be far less risky than bonds without equity in a volatile business. Many equities are primarily property. And so on; the list of interconnections and misleading categorisations is endless. It would be only a minor exaggeration to argue that all asset classes are available within the quoted UK equity market! Yet we now have distinct asset classes running well into double figures and rising, together with asset/liability studies purporting to give each a unique risk/reward profile.
A generation of mal-education
Perhaps the biggest danger in this dislocated approach to investment lies in education. It is not possible to learn about investment by studying asset allocation. One must always start with companies and their balance sheets. Asset allocation is an aid to thinking, not an investment method. Thus a generation of investment consultants brought up in a bull market is seriously deficient in investment skills. The process of correction must apply not only to the markets but also to their experts.
1. See, for example, Roger Garrison’s entry ‘Business Cycles: an Austrian approach’ in An Encyclopaedia of Macroeconomics, Edward Elgar, Aldershot, UK, 2002
2. The pundits include the authors of two UK government-commissioned reports on investment, by the now eponymous Paul Myners (2001) and Ron Sandler (2002)
Terry Arthur is an actuary who has spent most of his career in investment consultancy for institutional funds and is a director of four institutional investors including one of the largest pension funds in the UK. He writes in a personal capacity.

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