As an investor, how open are you to embracing emergent ideas?
Financial markets and investment have undergone profound changes over the past 40 years, and investors who moved with the times and embraced those developments have felt the benefit.
One of the most revolutionary ideas to take hold over that period has been the efficient market hypothesis. The market, the theory goes, factors into share prices all the known information about stocks, so there is little scope for investors to outperform other investors through rigorous analysis. As a result, most fund managers cannot outperform the market as a whole.
It was only in 1976, when US investor Jack Bogle founded Vanguard and launched the First Index Investment Trust (now called the Vanguard 500 Index fund), that the efficient market hypothesis could be applied in practice by everyday investors. Bogle’s fund simply tracked a market index to give investors the index’s average return.
For years, the fund was called ‘Bogle’s folly’. Many fund managers insisted that investors would never settle for average returns. However, over the past four decades, the popularity of tracker funds has grown massively. Vanguard funds (primarily passive and some active) now hold around $5.3 trillion (£4.2 trillion) in assets.
The appeal of passively following the market was enhanced by the creation of exchange traded funds (ETFs) in the early 1990s. Like index funds, most ETFs replicate a market index to yield the average return for that index. The failure of many active managers to navigate choppy markets in 2008 further boosted the popularity of passive investing.
Growth in the popularity of passive products and increasing acceptance of the efficient market hypothesis have been self-reinforcing trends over the past 40 years. However, the market as a whole has become more efficient over the period because of the expansion of professional asset management.
In his book Capital Ideas, former investment manager Peter Bernstein says: “We failed to recognise that the movement of increasing amounts of money into professional management, a process that was so rewarding to our own pocketbooks, would make it just that much more difficult for us to capture rewards for our clients’ pocketbooks. We could not beat the market because we were rapidly becoming the market.”
Despite markets becoming more efficient, many investors still think active managers still have the potential to outperform passive managers, even if the growth of indexing over recent decades suggests that a growing army of investors are sceptical about active managers’ promises to beat the market.
Passive funds are gaining market share
The development of ETFs also opened the door to ‘factor investing’. Investors have long sought to identify factors common to high-performing stocks. This was at the heart of the work of Benjamin Graham (the ‘father’ of value investing).
But the concept really got going in 1992 when US economists Eugene Fama and Kenneth French identified several features that helped individual stocks produce better returns than the market as a whole, including value and smaller size.
According to Robert Davies, manager of the VT Munro Smart-Beta UK fund: “This led to the idea that passive funds could be designed to take advantage of one or more of these factors in a way that could be rigorously defined.”
He adds: “ Incorporating one or more of these factors would yield the market return plus a bit extra – beta and bit more. This became known as smart beta.”
Investors, in the US in particular, started to question the logic of tracking the market in terms of market capitalisation, as traditional index funds and ETFs do, following the bursting of the tech bubble nearly two decades ago. However, to date the smart beta concept has gained little traction in the UK.
Over recent years, environmental, social and corporate governance (ESG) considerations have become more important for investors. Mark Whitehead, portfolio manager of Securities Trust of Scotland, says: “Embedding ESG into the investment process is a huge shift we have seen in asset management.”
According to Mike Appleby, an investment manager in Liontrust’s sustainable investment team, this approach to investing has a long history. He says: “The earliest ideas behind sustainable or socially responsible investing can be found in the ideas of the Methodists and Quakers in the 1800s around temperance and fair employment conditions.”
Mark Mobius in his book Invest for Good traces modern attempts at ethical investing back to opposition to the apartheid regime in South Africa in the 1980s. During that decade, “a large number of ‘ethical’ trusts and ‘conscience’ funds, as well as scores of state and local governments, proscribed investment in South Africarelated stocks”.
The term ESG was coined in 2005, says Appleby. ESG investing has become more sophisticated and moved away from a ‘negative screen’ approach, whereby supposedly bad companies are avoided, towards a positive screening approach, whereby companies are assessed on their fulfilment of ESG criteria.
It is now commonplace for fund managers outside the ESG umbrella to integrate such principles into their investment processes – because it produces better performance. Whitehead says: “Investors realise working towards a more sustainable investment environment can better deliver long-term value for clients.”
Time will tell whether ESG investing will enter the mainstream. Fund managers are keen to talk up ESG, but investor demand will be key to growth. On that front, ESG funds held £18 billion under management at the end of April this year, which represents just 1.5% of industry funds under management.
Hard-wired psychological biases hinder optimal investing
Another new approach is based on ideas in behavioural finance. Investors have always talked about fear and greed, but the behavioural finance approach attempts to apply more rigour to understanding investors’ biases.
One such bias is the illusory superiority bias. Studies show that most people judge themselves to have above-average ability to carry out tasks such as driving a car. Yet it is clearly impossible for most to people to be above average in this way.
This overconfidence extends to investing. Most people believe themselves to be better at picking winning investments than they really are. This bias can grow after a winning streak, with investment success ascribed to skill rather than luck – the self-attribution bias.
This can lead to all sorts of poor investment behaviours. For example, if you really are the master stockpicker you believe yourself to be, why limit upside potential by diversifying your portfolio?
A recognition of this bias has no doubt convinced many investors to move away from picking shares and accept that they will not be the next Peter Lynch. More than ever, investors favour investing in funds rather than stocks.
Another bias is seen in the greater weight investors give to losses compared with gains.
Again this often leads to poor investor behaviour. For example, the work of psychologists Daniel Kahneman and Amos Tversky has shown that this bias means investors tend, unwisely, to sell out of winning positions and cling to losing positions in the hope of recovering their losses.
Investors and financial service providers now take the psychological biases investors often have more seriously. James Norton, a senior planner at Vanguard, says: “Our research has shown that ‘good’ investing behaviour can add around 1.5% a year to long-term investment returns.” Many fund providers now attempt to coach investors to try to rein in their innate behavioural biases.