Kevin Coldiron of BGI reviews some of the literature of note on investment topics
Portfolio Advice For A Multi-Factor World, John H Cochrane, Federal Reserve Bank of Chicago Economic Perspectives, Third Quarter 1999, Volume XXIII, Issue 3, http://www.frbchi.org/pubs-speech/publications/periodicals/EP/1999/ep3Q99_contnt.pdf
Since the financial economics revolution began in the 1950s academics have tried to convince sceptical practitioners that asset returns are not predictable. If you want more risk, borrow money and invest in the market portfolio, but don’t bet on individual stocks, sectors or styles. Furthermore, market timing isn’t a good idea either. Given a certain appetite for risk the theorists claim you should always hold the same mix of stock and bonds. Ironically, as this line of thinking has become more accepted in recent years the academic consensus has changed. Some finance researchers now believe things that practitioners have known (hoped?) were true all along – there may be some limited return predictability and time horizon should influence the portfolio you hold. Cochrane examines the implications of these and other effects from the point of view of an individual investor attempting to design a sensible financial strategy. The last section in particular offers a clear and well-presented road map for making sense of the opportunities – real and imagined – presented by new portfolio theory. While the earlier dogma that everyone should hold a passively managed market portfolio is relaxed, there is little here to encourage internet day traders. The effect of transaction costs and taxes swamp the other effects discussed. Minimising these costs remains the only certain way to improve returns.
Asset Allocation and Stock Selection: On the Importance of Active Strategies, A. Craig MacKinlay, The Journal of Investment Consulting, Vol 1, No 1, December 1998, pp 18–21.
This paper revisits the idea that the strategic asset allocation decision – that is, the choice of a long-term benchmark – is the primary determinant of a fund’s returns and that active management, even when it works well, is just tinkering around the edges. This conclusion comes from empirical research showing that the variation of a fund’s benchmark return is usually very similar to its total return. MacKinlay does not argue with this result but argues that the interpretation is wrong. Benchmark returns may explain a very high degree (90% or more) of a fund’s total return variability, but active market and stock selection bets are still important. Indeed an ideal active strategy is one that delivers the same pattern of returns as the benchmark but at a consistently higher level. Of course identifying managers who can run such strategies is difficult at best. But the view that it is not worth trying is wrong.
Kevin Coldiron is head of European research at Barclays Global Investors in London