Updated: May 19
At Aberdeen we believe there is enormous scope to enhance returns through global investment. To some, this has meant allocating funds passively to a spread of markets; to others, chasing the latest theme, be it technology or emerging markets.
"We’re not sure if Mr Buffett’s proposed act of terrorism would have helped"
To us, it is about enhancing returns by investing for the long term in reasonably priced, well managed businesses around the world, uncovered through careful research, and in the process diversifying country-specific risks.
In this and the next two articles we identify eight ill-conceived preconceptions about global investing in the hope that, by debunking these myths, we gain a sound appreciation of the true benefits of investing beyond one’s shores.
Myth 1: Benchmarks are a good starting point for active equity investors
In the investment world, there is a temptation to use benchmarks, not just as measuring devices but to construct portfolios. Yet anyone using this approach would have invested 40.3% of his global portfolio in Japan in December 1989 and only 1.5% in non-Japan Asia. With perfect hindsight, we know that Japan experienced a ‘lost decade’ of economic sloth that arguably continues to this day, whereas non-Japan Asia surged following the Asian financial crisis. As disturbing, the same approach would have seen 56.9% allocated to the US in December 2001 and ownership of Enron and Worldcom, not to mention exposure to the perennially weak US$.
Index funds and ‘benchmark-hugging’ strategies now account for a sizeable portion of ownership in most markets. Such short-sighted investing, born of the misguided belief that markets are efficient and diversification is always a good thing, helps prop up poor companies and leave good ones ignored. The problem with benchmarks is that they are backward-looking and do not say anything about the prospects for the companies that comprise them. Thus by joining the herd, one ends up owning over-valued companies while missing the gems.
Myth 2: Risk reduction is about having a large number of portfolio stocks
The belief that diversification is a good thing has its roots in modern portfolio theory and most misguided, assumptions: that markets are efficient. If markets are efficient, it was argued, one should aim to eliminate specific risk - through diversification. Although Eugene Fama demonstrated that there were different strengths of market efficiency, and Warren Buffett has shown that it is possible to outperform consistently, the Efficient Market Hypothesis (EMH) remains on the curricula of most business schools.
EMH states that all knowable information is reflected in share prices. But some better-read people may know more than others. And, even if you have the same knowledge, how you interpret and act on it may differ.
So it is possible to have an edge, by running a concentrated portfolio reflecting one’s convictions. John Maynard Keynes said that “to suppose that safety-first consists in having a small gamble in a large number of different [companies] where I have no information to reach a good judgment, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.”1
Myth 3: Economic factors should dictate investment strategies
Warren Buffett remarked that even if you knew what was going to happen to the economy, you still wouldn't necessarily know what was going to happen to the stock market2. We can read this in two ways. On the one hand, it says the market is a great discounting mechanism and your beliefs about the economy’s future path, even if correct, may have already been discounted. On the other, corporate profit growth does not necessarily follow economic growth.
This latter observation is particularly relevant for emerging markets in which high economic growth may require huge reinvestment of cashflows by companies, often without regard for the rate of investment return. Add in the generally poor corporate governance and the result for shareholders can be an unhappy one. A good example would be China where stock market behaviour in the first half of this decade did not follow the very high levels of economic growth.
Myth 4: Thematic investment is the future
With the invention of the jet engine, one did not have to be a genius to foresee the huge growth in commercial aviation. But investing in airline stocks, particularly in the US, would have been a very distressing experience. Buffett noted in Berkshire Hathaway’s 2007 letter to shareholders that in the airline industry “a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.”2
We’re not sure if Mr Buffett’s proposed act of terrorism would have helped but we do know that thematic investing, the airline industry being a case in point, is often unprofitable, particularly if approached from a top-down perspective. Thematic sectors, essentially new industries, tend to attract large numbers of participants and require massive capital investment. Thus they are often unprofitable.
Themes also attract huge media attention, which in turn fuels speculative investor interest, driving valuations to often absurd levels. One must therefore remain very level-headed to avoid getting sucked into the stampede and crushed by the inevitable fall out. Investors in green technologies and climate change funds be warned!
Myth 5: Emerging markets investing is risky, but straightforward
In the last two decades we have witnessed crises relating to the Mexican peso, Russian debt and Asian currencies. The perception that has arisen from these, and others, is that emerging economies are high risk. Part of the problem rests with the way in which investors have tended to approach emerging markets, not with the markets themselves. Certainly emerging markets are more volatile than their developed counterparts. But getting involved only once bull markets are well underway could mean missing out on the early, and profitable, part of the cycle.
Anyway, the belief that emerging markets companies are more risky is itself being challenged. Lately, balance sheets at both a country and company level have improved. Furthermore, more attention is being paid to corporate governance. One need only observe the absurd levels of executive pay in many western boardrooms to conclude that the turnaround is perhaps even faster relatively than it is in absolute terms, as standards in developed economies deteriorate.
However, overweighting emerging markets does not lead to higher returns per se. In fact in no other area of investing is a bottom-up approach more important and, indeed, effective. While companies in developed markets are like competitors in a 100 meter dash, tending to cross the line at roughly the same time, those in emerging markets resemble participants in a marathon, strung out over a long distance, some not making it to the finish at all. High growth does not pull everyone along at the same rate, but tends to separate the strong from the weak.
In some respects this makes emerging markets investing less challenging as the victors in this natural selection process are often easier – or rather less difficult - to identify. Furthermore, emerging stock markets tend to be less efficient, so mispricing can be more apparent. That said, such anomalies can persist for several months, even years, and thus emerging markets investing requires discipline and patience: one must take a long term approach.
Notwithstanding the above, emerging markets investing is not for just anyone. The tens of thousands of emerging markets companies, combined with the numerous potential pitfalls, require one to have a well-resourced, highly-skilled team of researchers. Thorough due diligence is crucial and statements by company management should never be taken at their word. A criminal prosecution that relied solely on witness statements would be doomed to failure; hard evidence is everything.
Myth 6: Volatility is your enemy
Thanks to Harry Markowitz and the pioneers of modern portfolio theory, who needed a precise measure of risk to make their theories work, we have been programmed to associate risk with the standard deviation of historic returns. This quantitative measure, often referred to as volatility, mostly follows a normal, predictable, distribution. But is such volatility really risky? As an airplane’s wings must bend during turbulence, to prevent them being subjected to dangerous levels of stress, so too must stocks and markets fluctuate.
Of course, turbulence during a flight can be an uncomfortable experience but we have no choice but to sit tight, knowing deep down that we’ll reach our destination. In the world of investing, however, there is little to stop us bailing out at the slightest wobble as our emotions get the better of us. In fact one should welcome volatility as shares do not go up without it. Risk that should really keep us awake at night relates to permanent loss of capital such as bankruptcy, not the temporary loss of capital associated with the roughly 50% of days on which share prices fall.
Furthermore, volatility can provide opportunities for global equity managers with an eye for the long term. It can allow investment managers to top-slice on the highs and top-up on dips, backed by the confidence in their long-term convictions.
Myth 7: Active management is about high turnover
Active management, the alternative to passive strategies, is not guaranteed to outperform the benchmark. If anything the opposite has been the case. In most markets roughly 70 per cent of actively-managed funds underperform their benchmark, which has only provided further ammunition for the “indexers”. Many active managers attempt to outperform by making predictions about market movements over short time frames (three to six months), then acting on them, resulting in high levels of turnover. Not only is such an approach costlier but it also tends to underperform, even without transaction costs. Short term market predictions can sound intelligent, but movements on this timescale are essentially random.
Nevertheless, many funds do operate on this basis, as evidenced by an average turnover rate of around 100% per annum, at least for US funds, compared with 20% fifty or so years ago. But a study by Credit Suisse3 of US mutual funds showed that funds that were turned over less than 20 per cent outperformed those turned over more than 100 per cent by a staggering 3 percentage points per annum, equating to 34 per cent over ten year periods.
Being an active manager does not necessarily mean trading for short-term gain; it is about holding on to stocks in which there is strong confidence in the long-term prospects. Doing nothing, while hard, can be an active, and wise, decision.
Myth 8: The aim is to have all stocks performing strongly
Aiming to have all stocks performing strongly at the same time is an unrealistic expectation. What matters is good overall performance over time. Bill Miller’s Value Trust outperformed the S&P 500 index 15 years running – though the streak ended in 2008 – but a number of his stocks performed poorly during this period, and he certainly wasn’t trying to outperform each and every year. It’s a little like golf, in which trying to hit the ball deliberately tends to result in a duff shot. Much better to swing the club and let the ball contact be the passive consequence, not the active intent.
1 John Maynard Keynes, The Collected Writings, Letter to F.C. Scott, February 6, 1942
2 Berkshire Hathaway annual letter to shareholders, 2007 p8
3 The Consilient Observer, 18 Nov 2003
Published in Lian He Zao Bao
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.