Evidence Based Investing
Holborn Assets UK believes that in order to achieve the best return on investments for their levels of risk tolerance, investors should make decisions based on evidence and academic research, rather than on emotions, unsupported beliefs and marketing influence from the financial industry. Many private investors put their money in actively managed funds or even try to “beat the markets” themselves. Unfortunately, academic research has repeatedly shown that vast majority of actively managed funds fail to consistently provide excess return that would justify their fees and transaction costs in the long run. We therefore adopt a different approach, which is introduced below.
Efficient Market Hypothesis
We agree with findings of the Efficient Markets Theory. It is based on the assumption that there are a very high number of participants in the market, trying to assess intrinsic or fair value of securities, such as stocks and bonds, and predict their future prices. Although there are some investors who make irrational decisions or have incorrect or imperfect information, the majority of market participants have access to all information that is freely available at any moment and, as a whole via supply and demand, arrive at a consensus regarding a security’s fair value. This consensus, based on all the available information, is reflected in the market price, which is therefore the best estimate of the security’s intrinsic value.
In reality, we know that there are occasional events in the markets when prices can sharply fluctuate in a short period of time, for example following sudden unexpected news and events (like a terrorist attack or accounting scandal at a large corporation) or release of corporate or macroeconomic data which deviate from expectations. However, these volatile price moves do not contradict the Efficient Market Hypothesis, as even at these moments the price always reflects all the available information and the market’s consensus about fair value of securities. The important condition for the Efficient Markets Theory to hold is that there is no group of investors who are able to consistently predict prices and profit over other market participants, other than in the short term and by chance.
It is hard to find a fund that beats the broad market indices consistently over very long periods of time. The fact that investment managers appear to over- and underperform the market return randomly (when adjusted for risk and costs) supports the hypothesis that markets are efficient to a great extent.
Optimum Portfolio Structure
There is substantial body of academic research that builds on the conclusions of the Efficient Markets Theory and tries to identify optimum portfolio structure with the objective of achieving the highest possible return with the lowest possible risk (the latter is typically measured as standard deviation of return). This is usually done by identifying two or more different factors (types of assets to invest in) and finding the best combinations (weights of these asset types in the portfolio) where the return is highest for a given level of risk or where the risk is lowest for a given level of return.
The best known and classical example of this research is the so called Modern Portfolio Theory, first developed in the 1950’s. Over the next decades this theory was subject to further research and received a lot of criticism for being too simplistic and using assumptions that made it hard to apply in the real world. Nevertheless, more recent research has been able to identify factors which explain investment performance much better and has therefore reshaped portfolio theory to make it more useful for actual investing. These factors are introduced below.
Three Equity Factors
- Market – Stocks have higher expected returns than fixed income (bonds). In other words, investing in entrepreneurial activities with a share of possible profits makes more money than lending, where you only get interest.
- Size – Small company shares have higher expected returns than large company shares. In other words, it is better to invest in (a diversified portfolio of) smaller and less known companies than in the large ones, which tend to be more popular and their shares are more likely to be overpriced.
- Price – Lower-priced “value” stocks (with lower ratios of share price relative to measures such as profit or book value per share) have higher expected returns than higher-priced “growth” stocks. In other words, it is better to invest in stocks which are undervalued with respect to the company’s profits and assets.
Of course, this does not mean that every small company stock or every lower-priced stock always makes higher returns than any large company or higher-priced stock. These trends hold for each particular type of assets as a whole. Diversification (i.e. buying shares in at least 20-30 different companies or a small-cap focused fund, rather than a single stock) is essential to mitigate company-specific risk and achieve the best risk-adjusted performance.
Two Fixed Income Factors
- Maturity – Longer-term debt instruments are riskier than shorter-term instruments.
- Default – Instruments of lower credit quality are riskier than instruments of higher credit quality.
In other words, it is safer to lend money for a short term to someone who has a good record of paying back and having a strong financial position than to lend for a long term to someone who is more likely to default.
Maturity and credit quality are two factors which drive risk and returns on fixed income securities. However, research has shown that the increase in return that you get from investing in longer term and lower credit quality debt is often too small to justify the increased risk. Therefore, the fixed income portion of a portfolio is best kept short in maturity and high in credit quality, so risk exposure can be increased in the equity markets, where expected returns are higher.
The Importance of Diversification and Asset Allocation
Diversification is widely accepted as a powerful risk management method. Holding only one or very few stocks in your portfolio would make you prone to company-specific risk – the risk of the particular company going bankrupt, having an accounting scandal or simply losing its market position and profitability. Plenty of examples have shown that a single company’s share price can plummet to virtually zero even in a growing economy. Therefore it is important to keep your portfolio diversified and let the gains from your other holdings offset any losses arising from these low probability events. Simply said, do not put all your eggs in one basket.
The same holds for entire countries and regions. Although holding a fund or a diversified portfolio of stocks from a particular country (such as the UK) or region (such as the Eurozone) mitigates company-specific risk, it still leaves you exposed to country- or region-specific risk. There have been numerous examples of individual countries and regions getting in trouble and underperforming the rest of the world. Therefore it makes sense to look beyond your domestic market when selecting investments. A UK-based investor can hold funds focused on the UK market and Europe, but also the US, Japan, emerging markets or funds with global reach.
Moreover, adding fixed income to an equity portfolio can further reduce its standard deviation (risk) while only marginally lowering expected return and improving risk-adjusted performance.
The process of deciding weights of individual asset classes, such as stocks and bonds, is known as asset allocation. An asset class is a group of assets which share common economic characteristics and therefore often show similar risk and return patterns – the prices of securities in the same asset class tend to rise and fall at the same time and with similar magnitudes, although there are of course always exceptions proving the rule (the above mentioned company-specific risk).
Asset classes are often defined broadly – e.g. equities (stocks), fixed income (bonds), commodities or real estate. But they can also be narrower. Small and large capitalization stocks, value and growth stocks, or developed and emerging markets are examples of sub-classes within the broad asset class of equities. Domestic and international government bonds, investment grade corporate bonds or high yield bonds are examples of sub-classes within fixed income.
Investors can achieve better risk-adjusted returns by not only diversifying across individual securities within the same asset class, but also by combining multiple asset classes, with each of them playing a different (but equally important) role in the portfolio.
For example, small company stocks increase long-term return potential, but can be more volatile (risky) on their own. Government bonds have lower expected return, but help reduce the risk, as they are not only less volatile on their own, but also tend to make profits when stocks are losing (and vice versa). This is the power of diversification: the whole is greater than the sum of its parts.
That said, there is no single best asset allocation, because different investors have different objectives, time horizon, risk tolerance and other circumstances. In general, the greater your risk tolerance and the longer your time horizon, the greater weight of stocks and risky investments your portfolio should contain and the greater long-term return you can expect.
How Holborn Assets UK Differs from Other Advisers and Investment Managers
In general, there are two types of investment professionals.
Some believe that they can beat the market by active management, exploiting “mispricings” and overly frequent trading. Unfortunately, evidence has shown that such approach usually leads to higher costs, lower returns, higher risk or all of these.
Managers in the other group believe the Efficient Market Theory (like us), but misunderstand its actual real world implications and give up on any efforts to add value to their clients, keeping entire portfolios in broad market index funds.
Rather than following one of these two extreme approaches, we believe that better investment performance can be achieved by taking the best from each. Like the active managers, we try to identify factors which tend to result in higher risk-adjusted performance when combined in a diversified portfolio. But rather than selecting individual securities or trying to time the market, we focus on more cost-efficient long-term exposures to the right asset classes and factors (such as small company or value stocks), while constantly monitoring and reviewing our strategies based on latest developments and academic research.