Active Involvement by Fund managers helps overall valuation

Active Involvement by Fund managers helps overall valuation

With the ferrous competition in the financial industry within India and overseas, Investment as with many other products that need to be sold to customers, is about marketing and branding. Find the right catchword or slogan and the brand might catch on. There by giving a USP there by creating a niche product which help selling it to new customers or existing customers as a product that is different there adding to their portfolio and helping the financial institution make the sale.  this is not just about appearance the search for an effective re branding might also reveal the critical change to a product that will give it appeal and deliver value to customers.

The field of what was once known as “ethical” investing may be at the early stages of a makeover. Once thought of as a form of risk mitigation nobody wants to own the company that commits the next big scandal, ethical investing has become an attempt to generate a superior return. In its old form, as a screen to exclude the sin sectors such as tobacco and alcohol, it signally failed.  Excluding the sin stocks merely made them cheaper for those with fewer scruples, and the net result was that ethical funds underperformed.

But ethical investing has since been superseded by periods of SRI (socially responsible investing), ESG (environmental, social and governance) and sustainable investing and the latest term “engagement”.

From a marketing point of view, there is nothing much wrong with ESG at present. The amount of institutional money managed according to some kind of environmental or social mandate is continually growing, and they funds are    actually making money. Companies that show up with good sustainability practices, for example, tend to outperform in the long run.

World over many large institutions and some of them even in India in the last couple of years have been speeding time and money in building up their ESG practices. ESG is seen as a defense of the active management industry against passive investing, although it has also become a focus of indexing groups. All the main indexing groups have a suite of indices that purports to capture ESG factors best. In this way it is being treated almost as a smart beta risk factor that can generate returns and take advantage of a market anomaly, such as value or momentum.

A focus on engagement could rescue ESG as a form of truly active management. The hope is that it will be a strategy that makes money for savers while helping to improve the world into which they will eventually retire and that their descendants will have to inhabit. Due to the ultra-low and negative interest rate regime that the world is witnessing at present.

The argument in favor of intervening with companies is that if you can persuade a company to behave in a way that is more appealing to investors then the price will go up, there by yielding a better overall return and creating the alpha in the portfolio.  Those who engage with companies have an opportunity for superior returns. Those who ignore companies and veto them will be too late to the party and could lose out on the relative out performance.

Anecdotal research with data from large institutional investors showed that a marked out performance by stocks it held, once the investor had successfully intervened on an environmental or social issue, such as reducing carbon emissions targets. There was no downside if the engagement was unsuccessful, the company merely tracked the index there by showing that probability of creating the alpha was significantly higher.  Significantly, there were no such clear cut returns after engagements on corporate governance issues.

This shows a difference between engagement and activism, where investors take stakes in a company and then enter into often aggressively hostile fights with the board. This demanding approach is far less likely to work in emerging markets, where many companies are still controlled by their founding families and where local regulations are often unhelpful to minority investors.

There is a lot of value add that a private equity investor does to a company, one of the significant ones is the one on engagement on such issues there by adding a premium to the valuation and helping the founders make a good exit price.

With active fund managers seeing the advantage of the additional return that the overall market gives for active involvement, increasing number of fund managers on Wall street as well as Dalal street are interested in active improvement with companies.

_ Farzan Ghadially  

Negative Interest Rates: Blessing or Pain for real long term Investors.

Negative Interest Rates: Blessing or Pain for real long term Investors.

There were plenty of warning signs that the Bank of Japan’s policy of negative interest rates was doomed and the world over the new phenomenal of negative interest rates really been questioned. 

The first sign was a rise in the yen in January, when the policy was introduced. It was both unexpected and unwanted since a handful of exporters such as Toyota, which benefit from a cheap currency, have been a significant source of growth for decades.

Then there were also sounds of distress from Government Pension Investment Fund , the Japanese pension fund, and Japan Postal Savings. They feared that the prices of financial assets were increasingly artificial thanks to central bank policies. Invest today and lose tomorrow when the stimulus policies cease or reverse.

By April, there was a lot of criticism from number of quarters. In the month of September the central bank announced a review of its actions, which culminated in its decision not to push interest rates further into negative territory.

Across all markets that central banks have been engaged in unconventional monetary policies, there have been many victims in the financial community. They include pension funds, insurers and asset managers, as well as ordinary households hoping to earn something on their savings but that don’t have access to the leveraged opportunities of the wealthy. Yet it was not until the banks started feeling the pain that central banks seemed to reconsider.

It is interesting, albeit somewhat puzzling, to note banks clout, which contrasts markedly with that of others in finance. And the muscle of banks persists, despite them mattering less and less.

Especially in Japan, banks still depend on the gap between the short term rates at which they borrow and the long term rates at which they lend for their profits. The Bank of Japan’s latest measures, are intended to steepen the yield curve and address banks’ anxieties about their after tax profits. That is especially true of Japan’s many smaller regional banks the shares of which foreign fund managers are now shorting due to the current interest rate scenario.

There is a similar dynamic elsewhere. Virtually all those who have been hit by central bank policies have, eight years after the crisis that gave rise to them, been reluctant to point out that they have proved ineffective and costly.

One of the few larger investors to speak out and destroy the myths has been Swiss Re. Indeed, 18 months ago it attempted to quantify the costs in foregone income to both US savers and European insurers as a result of the respective central bank policies on both sides of the Atlantic.

That is why earnings of US insurers have dropped well in advance before those of the banks. One such example is Metropolitan Life warned in its most recent quarterly results that it needed to bolster its reserves by $2bn largely because of a squeeze from low interest rates. Many research reports by leading brokerage houses have mentioned that low growth and low rates weigh on active manager performance.

In the US, one reason insurers are so reluctant to criticize the policies of the Federal Reserve, is that the insurance industry currently falls under the purview of local state regulators and they fear above all else coming under the much more critical eye of a national regulator such as the Fed, hence would prefer to refrain to comment on the policy as such. But in reality the plight of their clients, average Americans, continues to worsen, and as they age, their standard of living will drop further.

There by now making it impossible for retirees to ensure quality of life and others to save for secure retirement through the deposit and investment options suitable for and available to low/modest income households.  Current income distribution distortions are thus likely only to get worse faster as savings fall into ever deeper holes. Contemplate rising inflation without rising savings returns and be particularly afraid and leading to further problems.

_Farzan Ghadially

Chasing beta can get better results, but not without discipline

Chasing beta can get better results, but not without discipline

Often said smart beta is in danger of getting frightfully silly. The fund management industry’s brightest idea of the past few years has opened the real chance to improve returns and reduce costs.

Smart beta is the term for funds using techniques developed by passive index funds to make active attempts to beat the market. Some take standard stock market indices, which are weighted according to their market value and reweight them according to fundamental characteristics, such as the dividends paid, or the sales they make.

Others aim to harness the investment anomalies or factors that have outperform the market in the long term. The most popular include value, stocks that are relatively cheap when they are bought and outperform over time, momentum winners tend to keep winning while losers keep losing, and size smaller stocks tend to beat larger stocks.

Like index funds, their costs are low, with lower trading costs and little need to pay for ongoing research. And yet they stand a good chance of beating the market. This makes them an intelligent improvement on traditional actively managed funds, which often traded on these same factors, but in a less systematic way.

The problem is that as the industry sells smart beta funds, and investors buy them, they are in danger of committing the same mistakes.

The first issue is data mining. As the arms race to find new factors continues, historical data are being tortured. When a factor is publicized, and a fund launched, it tends to have performed well in the past even though there were no funds in existence to follow it. In practice, their strategy is shown to have great performance at the point of publication.

A separate problem is timing. Over a long period, valuation gives an idea as to what might be best to buy at any one moment even if it gives no help to identifying a top or a bottom. If a stock or bond is expensive, compared to its own history, it is a good bet that it will perform worse over the following years, and vice versa.

The same applies to factors. Some factors perform well at times when others do not. Buying a factor when it is relatively expensive when the stocks it contains are relatively expensive compared to their historical norm, is as bad an idea as buying a stock when it is expensive.

According to extensive research, a strategy within US stocks of continuously buying the three most expensive factors would have unperformed the market while continuously buying the three cheapest would have beaten the market by 3.7 percentage points per year. This looks like a plausible model for funds that could form the backbone for long term pension savings.

But here lies another problem; performance chasing. The fund industry revolves around looking for the funds that have performed best recently. It is always a safe thing for an adviser or consultant to recommend.

Quite an industry is developing around timing and recombining factors. It risks falling prey to the same mistakes made by the active equity management industry.

None of this means that smart beta is not smart, as first advertised. The logic behind exploiting market anomalies in a systematic way and reducing the costs in the process, remains intact. But such strategies work primarily because they impose a discipline to avoid the endemic errors that we tend to make, both because of our own psychology, and because of the perverse incentives at work on the sales practices of the investment industry.

We risk using smart beta funds to make endemic errors in a new way and with the Sensex almost at the all-time high and valuation of stocks looking stretched a number of fund managers are looking at chasing the beta to get the extra return but need to be extremely discipline in their overall approach.

_Farzan Ghadially