Investment Beliefs That Matter

Kees Koedijk

June 8, 2010

Investment Beliefs

• Questions…

> Is the equity premium dead or alive?

> How long should long term horizon be

> Does active management pay off

> …

• … pension funds and investment managers deal with day in day out

• Answers…

> Are difficult to give. Investing is not a hard science despite the econometric advances

> depend on what you believe and matters for you

Investment Beliefs• But…

> If investment results influence the success or failure of pension funds

> And investment choices are (partly) based on beliefs

> Then thinking about, embedding and evaluating the consequences of investment beliefs are important to pension fund governance

• Seminal work

> Ambachtsheer (2007): “We need a new lens. Its components are a set of investment beliefs grounded in good theory and confirmed by real-world experiences, … an integrative investment model ….[and] a decision making protocol ”

> Raymond (2008): “Without this shared understanding [of investment beliefs], the daily decisions made by investment professionals throughout and organization likely imply a incoherent set of investment beliefs”

> Urwin and Clark (2008) Best practice funds share “strong investment beliefs commanding fund-wide support that align with goals and informs all investment decision-making”

Nice to know which one to adhere to

Outline for today’s presentation

• Investment Beliefs: a recap

• Earlier research

• Research set up & findings

• Discussion

Beliefs = Governance Tool Kit

• Investment management> Investment managers need an investment process in sync with

theory (Damodaran)

> Upward potential for good governed pension funds (Ambachtsheer), best governed pension funds focus on coherence, process and people (Roger and Urwin)

• Strategic Management Similarities

> Companies have to articulate their vision and strategy (“USPs; proposition) for their client(s)

> Especially in markets where different visions co-exist

• If not

> It becomes difficult for trustees to evaluate new developments, and whether to embed them in their own strategies

> More likely to “join the herd”, increasing costs and opportunity costs along the way

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Set up

Investment Belief Theory Investment Strategy OrganizationInvestment Belief Theory Investment Strategy OrganizationInvestment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Grouped investment beliefs

Financial Markets beliefsFinancial Markets beliefs

•Risk premium

•Risk diversification

•(In)efficiencies in financial markets,

asset pricing

•Horizon

•Risk premium

•Risk diversification

•(In)efficiencies in financial markets,

asset pricing

•Horizon

Investment process beliefsInvestment process beliefs

•Impact, focus on management decisions

•Risk management

•Investment management style

•Costs

•Impact, focus on management decisions

•Risk management

•Investment management style

•Costs

Sustainability and GovernanceSustainability and Governance

•Sustainability and Corporate

•Governance in asset pricing

•Role in investment process

•Sustainability and Corporate

•Governance in asset pricing

•Role in investment process

Organizational beliefsOrganizational beliefs

•Teams, role of investment managers

•Out vs. insourcing

•Experience

•Teams, role of investment managers

•Out vs. insourcing

•Experience

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Multiple beliefs & investment governance

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Research Questions

• Steps so far

> 2007: Explicit beliefs & small sample

> 2010: Implicit beliefs & large sample; ICPM sponsored Research

• Relationship between investment beliefs (structure) and performance

• More insight into best practices

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

2007: Explicit & Small

• Survey for explicit, published beliefs

• Small group identified (ICPM members!)

• Clustering beliefs, correlation measures with performance

• 2000-2006

• Results

> Pension funds and asset managers differ• A pension fund focuses on risk diversification, getting its beta right.

• An asset manager stresses the role of risk management and argues for a particular investment style. Asset managers emphasize the quality of their organization.

> Beliefs influence performance• An organization with investment beliefs on risk diversification shows

better return-risk performance, but also lower costs.

• Funds that hold a clear view on how risk management is organized, usually in combination with a view on the management style, realize higher alpha and return/risk ratio’s than funds that do not hold such views.

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

2010: Implicit, large sample

• ICPM Sponsored Research to follow up

> Can earlier findings be replicated in a broader setting?

> Interrelationships between investment beliefs and

performance measures; integral approach

• CEM Database

> Unique dataset in the pension fund industry: in scope,

depth and longitude

> Nr funds over 600; period extends to 1992-2006

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Research Approach

1. Distill investment beliefs

> Ideal situation: survey trustees about investment beliefs

> Alternative approach: Deduce investment beliefs from realized actions

2. Find variables that match investment beliefs

3. Analyze relationship between investment beliefs variables and performance measures (Fama & French)

4. Analyze relationship between investment beliefs variables and performance measures (Panel data)

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Deduce Investment beliefs

• Literature review & data analysis suggest that following debates

can be incorporated into the researchInvestment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Debate Stylized Investment Belief Example

1. Long term investing

Long holding periods allow investment in assets with higher risk premiums.

2. Diversification Diversification is the only ‘free lunch’ in investment management. Larger funds can realize additional diversification advantages.

3. Active Management

With the right skills, resources and process, an investor should be able to create excess returns with active strategies.

4. Costs Costs are certain and a drawn down on net returns. Future returns are uncertain.

5. Organization Access the right skills by combining internal and external management, lowering principal-agent costs.

6. Innovation Exploit the early adapter advantage, moving into new markets or strategies that other investors cannot,

Results (1): ranked portfolios

• Lower costs related to higher excess returns & return/risk

• Some variables increase excess returns, as well as return/risk:

> the share of equities,

> the share of illiquid investments

> the share of internal investments.

• More portfolio diversification is associated with a higher return-risk ratio.

• The share of active management increases five-year excess returns, but it does not improve the return-risk ratio.

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Results (2): panel data

• More diversified portfolios tend to report higher excess returns.

• Costs do not play a significant role, which is surprising given previous results.

• Strategies with higher costs do not affect net returns, although they do increase risk

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Combined analyses suggest

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Debate Stylized Belief Research Results

1. Long term investing

Long holding periods allow investment in assets with higher risk premiums.

Share of illiquid and alternative assets has explanatory power for returns, no effect on a risk-adjusted basis.

2. Diversification Larger funds can realize additional diversification advantages.

Increased portfolio diversification is associated with higher return-risk ratios.

3. Active Management

Funds should be able to create excess returns with active strategies.

Overall, funds tend to earn positive excess returns, but not on a risk-adjusted basis.

4. Costs Costs are certain; future returns are uncertain.

Costs play an important part in explaining total returns and risk-adjusted returns.

5. Organization Combining internal and external management lowers principal-agent costs.

Internally managed portfolios have a positive impact on returns and return-risk.

6. Innovation Exploit the early adapter advantage, moving into new markets or strategies

We find indeterminate results of first-mover advantages into new assets.

Investment Beliefs and Size

• Potential to exploit for example illiquidity, costs and diversification is also related to size

• The optimal size of a pension fund is a heated debate in many countries

• General trend: further consolidation

• Size therefore taken into account in analyses.

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Size creates economies

• Size–performance relationship generally accepted for pension

funds

• Framed in our research: investment Beliefs integral part of good

pension fund governance (Ambachtsheer; Raymond; Clark &

Urwin)

• Good pension fund governance leads to better performance

(Ambachtsheer)

• Size lowers costs, frees up resources for better pension fund

governance

• Positive relationships between size, investment beliefs (as part

of) investment governance, and performance.

+

+

=>

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Results suggest potentially diseconomies as well

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Investment beliefs then make sense on either end of the scale

• Pension funds at the lower end of the size scale

> Higher margin of error in their strategic choices. A pension

fund must make clear choices or risk overstretching its

resources, thereby creating monitoring risks.

• Large pension funds

> Size can generate incentives that may diverge from the

pension fund’s objectives. Size also requires a clear vision

on where to add value if the size of the fund leads to a

market impact

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

IBs essential part of governance kit

• Summarizing

1. Investment beliefs address strategic choices in the investment philosophy and process that affect the future performance of the fund.

2. CEM data from over 600 funds between 1992 and 2006 show that the debates in the pension fund industry address the relevant issues: active management, alternatives and new, innovative strategies.

3. The addition of these activities does not necessarily improve the overall performance of a fund, and it may eventually offset the fund’s cost and net returns advantage due to its size.

4. Beliefs to which a fund adheres affect its success; the thorough consideration of the relationships between beliefs is equally important.

Investment Beliefs:

A Recap

Earlier

Research

Research Set Up &

Findings

Discussion

Follow up research

• Potential (dis)economies: Larger pension funds are well positioned but do not always seem to be able to exploit beliefs

• Case studies planned for the governance process, choices made by large funds

• More research in the role of external advisors, role investment committees

The End