Books: The wheat and the chaff
"Investment Beliefs: A Positive Approach to Institutional Investing", by Kees Koedijk and Alfred Slager, 2011, 205 pages
This book is long overdue. It is as meticulous as it is insightful and its central contention is indisputable - namely: that the previously accepted guidelines and truisms in investments are open to challenge; that proactive, informed investors can positively impact investment outcomes through their actions; and that investment is an art, not a science.
Accordingly, investment beliefs are the new magic wand. Or, as the authors Kees Koedijk and Alfred Slager put it: "Having the right investment beliefs and putting them into practice is key to delivering the right results."
As I read this sentence, I was dumbstruck. Why? Because the term ‘belief' at once conjured up images of self-evident truisms pontificated from on high; something born of conviction rather than facts; something that is invariant across time and space, like a religion.
However, my disquiet soon vanished in the ensuing pages. Beliefs are not static, the authors point out. They are an essential part of adaptive learning resulting from doing things in changing environments. Such experimental learning can result from positive experiences. But negative experiences may be an even better teacher.
For example, in the pharmaceutical industry, new discoveries mostly stem from ‘failing forward' - using the lessons from past failures to progress forward. In economics, it was elegantly summed up by that memorable quote from John Maynard Keynes: "When facts change, I change my views. What do you do?" To implement this adaptive process to investment, the book is divided into three parts.
The first paints the big picture and turns the spotlight on a number of elephants in the room long ignored by the boards of pension funds. Three merit mention. The majority of institutional investors devote insufficient time to formulate investment beliefs: failure to understand investment principles leads to herd mentality. Sound beliefs only make sense within a sound governance structure: governance is the alpha behind alpha. Investment beliefs held by pension plans are not the same as those held by asset managers: misalignment and mutual misunderstanding abound beneath the surface of seemingly cosy relationships.
The second part of the book covers investment beliefs and sounds numerous health warnings. Five merit mention. It is one thing to talk about alpha, quite another to deliver it: alpha is everywhere except in performance numbers. The past may be the best guide to the future, but it's an imperfect one: the relationship between risk and return is volatile and unpredictable. Diversification can be highly elusive: its advantages disappear when we need them most - during a crisis. Long-term investing makes sense when you have long-term contractual liabilities: but ignore the short term at your peril. Costs matter: via their compounding effect over time, they are a key sources of outperformance.
The third part highlights the process for embedding beliefs into the governance structure and communicating them. Here the advice is equally cogent. Know that the investment world is suffocated by jargon: nothing is what it seems. Finance is a relatively young, immature discipline: its claim to scientific precision is spurious at best, false at worst. Market data are limited, biased, or both: the ratio of ‘noise' to ‘signal' is very high. The trustees must learn to ask the right questions: the world of active investment has much chaff and little wheat.
The book has three over-riding merits. First, it gives real life examples of beliefs held by reputable institutional investors around the world and how they implement them to secure decent returns. This helps a lot to put meat on what the authors mean by this normative word ‘belief'. Second, although there are 16 chapters, each stands alone. The reader can home in on any one of them without having read the previous ones. Notably, each one has a common framework: starting with helicopter view; followed by a real life a case study; followed by the theory that touches on these issues; finishing with the debates of which to be aware. Third, the book is jargon free. The hot air that normally suffocates most investment books is mercifully conspicuous by its absence. This is one of the few books I actually enjoyed reading.
So who should read this book? Everyone involved in the food chain of investing: pension boards, endowments, trustees, professional executives, asset managers, and asset servicers.
Having said all that, I would have liked to know the authors' views on three sets of systemic questions that remained unaddressed for me. To start with, is it safe to talk about paradigm shifts in the world of investment which is cyclical and self correcting? In investment matters, there is always a tendency to over-simplify the past, over-exaggerate the present and over-complicate the future. The world of investment is best considered in terms of 10-20 year cycles. There is no ‘old' normal and ‘new' normal: just different normals.
Furthermore, how should the rise of emerging markets change our investment beliefs? These countries will be not only the main sources of funds but increasingly their destinations too. Their long-prevailing savings culture puts a premium on capital protection and income upside. How will their rapid ascendancy affect institutional investors in the West? Do we need new lenses to foresee their impacts?
Finally, how has globalisation added ever more ‘noise' in the financial markets by randomly spreading investment decision-makers across the globe such that our time-honoured investment beliefs no longer work? Economies have decoupled, but markets have not. So how do we revise our beliefs about risk premia? What is driving it now and in the near future?
But this is a credible companion for those trying to make sense of how the contemporary art of investing is fundamentally changing.
Prof. Amin Rajan is CEO of CREATE-Research