Peter Bernstein - Investing for the Long Term

8/12/2019 Peter Bernstein - Investing for the Long Term

1/94

oreworInstitutional investors often are accused ofbeing obsessed with short-termperformanceat the expense oflong-term goals. Such thinking, the argument goes,doesa disservice to companiesand thenationaleconomy. Speakers at this seminar addressed an array ofissues in an attemptto fill in the broad outlines of thiscomplex debate for investment practitioners.These issues include differences between fundamental investment strategiesand quantitative strategies; the effect of manager style on investment objectives; the relationship between takeovers and corporate restructurings as a cause of short-term horizons;the relationship between institutional holding periods and stock market volatility; and the roles ofmoney managers, consultants, and pension sponsorsin setting strategies appropriate for long-term goals.AIMR wishes to thank all seminar speakers forsharing their experiences as well as their perspectives. Their expertise iswhat made the seminar andthis publication-possible.Special thanks are owed to Eugene H. Vaughan,Jr., CFA, who conceived the seminar during his tenure as chairmanof the AIMRBoard ofGovernorsandalso doubled as its moderator. His guidance provedsure both in articulating the need for such a conference and in s he ph er di ng t he me eting t hr ou gh itsvarious developmental stages. The resultwas a sem-

Katrina F Sherrerd, CFAVice PresidentPublications and ResearchAIMR

inarthat far exceeded expectations and a proceedingsthat will receivewide distribution amonginvestmentpractitioners.Finally, the contributions of Arnold S Wood,conference commentator, are especially noteworthy.His introduction to this proceedings helps set thestage for the important discussions that follow. addition, his counsel during the seminar s development and during the meeting itself was invaluable.The speakers contributing to the seminar werePeter 1 Bernstein, Peter 1 Bernstein, Inc.; John Bogle, Sr., The Vanguard Group; John Bogle, Jr.,CFA, Numeric Investors L.P.; Carolyn Kay Brancato,Columbia Institutional Investor Project; John J Curley, Gannett Company, Inc.; Judith D Freyer, CFA,Board of Pensions of the Presbyterian hurch U.s.A.);J Parker Hall III,CFA, LincolnCapital Management Co.; Elizabeth Holtzman, Comptroller oft he City of New York; Jonathan D Jones, Securitiesand Exchange Commission; Norman F Lent, U SHouse of Representatives; Lisa K Meulbroek, Harvard Business School; Thomas M Richards, CFA,Richards Tierney, Inc.; Eugene H. Vaughan, Jr.,CFA, Vaughan, Nelson, Scarborough McConnell,Inc.; c F Wolfe, I M Corporation; and Arnold SWood, Martingale Asset Management.

i


2/94


3/94

Short Tenn VectorsThebest interests of theUnitedStates, I believe, lie inending the debate that has run for years in the eco-

buyout takeover binge, with the occasional cooperation of some of the institutional investors who ownnearlyone-halfofequitiesintheUnitedStates,accentuated corporate focus on near-term results.Whatever the cause, managerial myopia of Ucorporations is widely believed to be the source ofour nation/s lack of competitiveness internationally.Decisionmakers do not have sufficiently longvisionto allocate resources to areas vital to the generationof future income streams essential investmentssuch as in plant and equipment, research and development/ core infrastructure, and education.Another widespread belief is that the primarycause of the short-termbias toward cost reduction attheexpenseof long-termdevelopment ofU industry/ in contrast to its international competitors, ispressure from the investment management and research profession. Although other factors also havemajor impacts as sources of managerial myopia, investment short-termism is doubtless a critical ingredient. When surveying extant research in preparation for this conference, Iwas surprised, consideringthe enormous importance of the subject, to find howlittle work is under way to generate creative solutions. A key goal of this conference is to try to identify some possible solutions that go beyond the superficial tax remedies and governmental fiat proposals generally advanced and to let loose creativeforces ofchange/ particularly in the investment profession.

The mportance of nvesting for the Long TennEugene H Vaughan Jr CFAPresidentand CEOVaughan Nelson scarborough McConnell Inc

The outlook for lengthening the investment vision of theUnited States is bright becauseof three factors: The disadvantages of a short-termapproach arewell-known; it iswithinthe power of corporate chief executives to force the change because of their influencewith investmentmanagers; and a long-term approach jibes with institutional investorslong-term objectives.

A nation is never finished/ wrote JohnW Gardner.You cannot build it and then leave it standing, asthePharaohs did the pyramids. has to bebuilt andrebuilt, re-created in each generation by believing,caringmen and women. is now our tum.This trusteeship is a responsibility of corporateAmerica and Wall Street, and it is highly germane tothe importance of long-term vision and investing.The serious issue before us is the charge that Ucorporate executives, investment managers, and analysts are running aground the flagships of the freeenterprise system and, possibly, our ship of state.Sixty years ago, John Maynard Keynes warnedthat when the capital development of a countrybecomes the byproduct of the activities of a casino,the job is likely to be ill-done. Yet when peopleexperience the massive volatility and the recurringAugust and October free falls or read of the grabit-now cupidity in Liar s Poker Barbarians the Gateand Predators Ball the trilogy of books by which theWallStreetmergers and acquisitionsoperatorsof the1980s will be remembered a rigged casino is precisely what a preponderance of citizens perceive.Indeed, Business Week labeled America the CasinoSociety and then went on to ask plaintively in acoverstory/ WillMoneyManagersWreck theEconomy? In the article, a corporate executive saidthere are no long-term stockholders anymore/ arefrain that has become the theme song of the corporate choir.Many corporate CEOs say the unrelenting pres- _sure from investors to keep earnings consistentlyclimbingquarter after quarter precludes the kinds ofvital investment that payoff in the long term butpenalize earnings in the near term. The leveraged


4/94

nomic and academic communitiesand agreeing thatmanagements of U S corporations generally couldcompete better with competitors abroad i theyadopted longer time horizons. t cannot be provenbeyond any question thatan abandoned new product might have succeeded i the company had absorbed low earnings for a few more quarters. Nevertheless, many convincing cases can be cited:Warner Communications, for example, gave up onAtari, leaving a huge market solely to Nintendo.What to do when the doctors disagree has beena paralyzing puzzle in this matter of vital nationalinterest. To get on with the solution stage of theproblemand quitelaboratingat identifyingthe problem, I suggest we accept generally from a largeamount of research in recent years thatU S corporate investment in key areas that contribute to improvedcompetitiveness newplantand equipment,research and development (R&D), education andtraining has declined during the past 20 years relative to the pastand, important y, relative toGermanyand Japan. For example, although the magnitude isless important than the condition, somereports indicate that U S aggregate investment in nondefenseR D as a percentofgross domesticproduct in recentdecades was as much as one-third less than that ofour major worldwide competitors.Although investor attitudes areour focus, this isonly one of several powerful reasonswhy U.s. executives seem to take a shorter term view than ourmajor economic competitors abroad. Other causesinclude, for example, critical differences in thewayindustries are structured and financed and the wayU S executives are rewarded.orporate Structure and GovernanceIn the United States, the relationships betweenfinancial institutionsand industry areentirely different from those in Japan and Germany. In Japan, thedominant type of industr ia l organization is thekeiretsu networks of corporations with cross-ownership of stock and interlocking managements centered on powerful banks. Mitsubishiand Mitsui areexamples of keiretsu Approximately one-half ofJapan's 200 largest companies are in sixkeiretsusAlthough the arrangements are less formal inGermany, banks have significant holdings in German corporations, and relationships are interlacedfor synergistic commercial purposes.The interlocked financial structures in JapanandGermany protect corporate managements fromthreats of takeover, provide insulation from theswings of the capital markets, create a stable shareholder base, and in general function as a synergisticsupport system. Consequently, managements feel2

free to adopt a longer time horizon, invest in longterm projects, and are less threatened during drasticcyclical swings. The United States, by lawand custom, has avoided such interlaced industrial structures because Americans have serious reservationsabout adopting systems that would materiallyaffectour nation's long-standing belief in entrepreneurialenterprise, open markets, prevention of abusive fi-nancial power, and protection of small companies.Executive ompensationVariable compensations, such as bonuses thatare tied to accounting earnings,makeup a very largepart of top executives' pay in the United States.Thus, managers during their lastyears in office havea financial incentive to favor current earnings andpenalize long-term investment. Although the practice of tying a significant portion of executive compensation to operating results is good, changingcompensationplans to reflect long-term resultsholdsmuch potential for lengthening vision.Investor ttitudesClearly among themost influential factors in theshort-term orientationofU S industry is the effectofinvestor attitudes and practices. In Japan and Germany, the keiretsu and hausbank systems, respectively,exist for synergisticbusiness purposes.Underthe U S capitalistic system, the primary purpose ofcorporategovernance isto reflect thewishesof shareholders generally c reat ion o f shareholderwealth---even though businesses in fact serve a variety of constituents, including employees, managers,and members of the community.U.S. investors have long sen t mixed signalsabout their desire for short- or long-term emphasis.t is as though their heads know the value of longterm investing bu t their birthright includes get richquick. This has been exacerbated in recent decadesas the rise in volatility and turnover rates gave corporate executives the impression that what theirowners want is short-term earnings results. Stimulatedby the takeoverbinge,concentrated ownership,and a prevalent instant gratification philosophy,particularlyduring the 1980s, the turnoverrate oftheaverage share of stock on the New York Stock Exchange has increased dramatically from 12 percentin 1960 to 48 percent so far in 1991; it peaked at 73percent in 1987, the year of theOctober crash. Thus,theholding periodof the averageshareholderduringthe past 30 years fell from 10 years to 2 years.Many executives view the increased trading asevidence of the market's preoccupation with shortterm earnings, good reason for their companies notto sacrifice for the long term. Simultaneously,invest-


5/94

mentmanagers interpret the focus on quarterly performance measurement as client pressure for nearterm results, reinforcing a vicious circle ofmotivation for myopic behavior.

Stretching the HorizonEmbedded and ignored in this circular process areimportant seeds of redemption. The process can bereversed in the decade ahead ifcorporate executives,ournational leadership, and investmentmanagerssodesire. For several reasons, I believe there is substantial hope for lengthening the vision of Wall StreetAmerica:The preponderance of professional investorsbelieve in and are trained in the principles of longterm investing and would welcomeclient support inthat practice.

The CEOs and directors of America s corporations are in a powerful posit ion to insist that theretirement and other funds they influence be invested soundly on a long-term basis commensuratewith the needs of such funds.The change required ismainly one ofperception and behavior modification. In concert, corporatemanagementsand investmentprofessionals canshift the paradigm successfully. orporate ontrolof Investment PolicyInstitutions own nearly 50 percent of corporatestock in America and account for more than twothirds of trading volume. The investment managerswho invest most of those funds actually are employees of the corporate executives. The corporateCEO,CFO, and investment committee of the board of directors hire the external and internal managers thatinvest their pension funds, which alone account for25 percent of equity ownership in the United States.These same executives populate the boards and investment committees of the universitiesand foundations that also hire investment managers. Powerfulinstitutional investors, who manage more than 5trillion ofassets in theUnited Statesalone, in essencework for corporate executives. Thus, corporateexecutivescan prescribethe investment philosophy theseinvestmentmanagersmust follow and set the criteriaby which the investment managers are evaluated.The logic is straightforward. Corporate executives cannot directly influence how individual investors including mutual funds invest In a market increasingly dominated by the institutionalmanagers of pension funds, endowments, and foundations, corporate executives who want to change theinvestment philosophy of the U S market can makea powerful start by so instructing their present man-

agers and by hiringmanagers, internal and external,who believe in the efficacy of long-term investing.Since the start of ERISA in 1975, many corporateexecutives and directors, with the encouragementoflawyers and consultants, have sought to dilute fiduciary responsibility by taking a hands-off approachto theinvestment philosophywith which theirfundsare managed. Some executives and boards have abdicated altogether. Corporate executives have theopportunity, and arguably the responsibility, to besure that the funds for which they have stewardshipuse the investment philosophy they believe is in thebest interests of their employees and organization.The message to CEOs comes straight from BenFranklin: Driveyour business, or it will drive you.PerhapsGeneralGeorge S Patton had the right idea:Never tell people ow to do things. Tell themw tto do, and they will surprise you with their ingenuity. This applies to investment managers. TheCEOand board must take charge. They must know theactual long-term needs of the pension and profitsharing funds of their employees and place highpriority on communicating by written guidelinesand power of personal conviction directly with theinvestment managers. The matter is too importantto the corporations and international competitiveness of the United States to be left to lawyers andconsultants.Long Tenn Investing for Long Tenn NeedsAnother factor, which seems to get forgotten,undergirds corporate managements need and ability to modify investor behavior. Pensions, endowments, and foundations generally have long-termpurposes and should be invested with carefullyconsidered long-term objectives, not subjected to a raceto see who canbeat themarketbestin the short term.Short-term investing involves high risk, high fashion, and large emotional swings. In the long term,these factorswashout, and talent, training,and judgment have a better chance ofbeing brought to bear.Because of the fashions, fads, and styles thatcontinually come and go in the market, the currentvogue to evaluate managers almost solely on theirperformance relative to a universe of managers andindexes during a period of three years or so makesscant sense. creates huge rewards for taking risksto outperform the attendant hirings and firings areakin to the varying fame and fortune of rock stars-and are contrary to the long-term interests of seriousfunds. Although short-term investing is appropriatefor many purposes and is a valid segment of theinvestment profession, those responsible for seriousfunds with long-term goals should not be confused.Another important factor that seems to have

3


6/94

beenforgotten in the amazing17years ofabundancesince the financial holocaust of 1973 and 1974 endedat 570 on the Dow Jones Industrial Average is thesardonic line that conveyed prevailing clientattitudes during those drastic times: You can t eatrelative performance. Investors learn little, and thewrong things, from prolonged bull markets. A generation has learned that only relative performancematters. Boards, managements, and investmentmanagers responsible for serious funds with longterm needs should keep in focus that superior performance does not come from attempting to outracethemarketand othermoneymanagers in short-termspurts. Rather, it comes from formulating realisticand wise investment policies for the long termwithclearly defined objectives, including absolute returngoals (or, for example, X points above the inflationrate) alongwith relative datum points tobe achievedthroughout all market cycles.Some provision should be made in investmentplanning and evaluation for another 1973-74 situation or,at least, the possibility that the decade aheadcould be more in the zigzag pattern of the 19708What professional realistically expects a continuation of the fabulous markets of the 1980s? A key tosuccessful long-term investing is to avoid the wipeout; that is, to not lose money drastically duringdrastic times, which inevitably recur.Overemphasis on relative performance is an invitation for aggressive risk taking by competitiveinvestment managers, with the danger of a wipeoutwhena drastic market suddenly occurs. In 1973 and1974 the median investment manager was down18 6 percent and 25.0 percent, respectively. Theprofession needs to use someof its intellectual capital tochange from the historic pattern of clients wantingrelative performance in bull markets and absoluteperformance in bearmarkets.With all the brainpower and computer poweravailable, a goal should be to devise blended absolute and relative performance measures that willpermit clients to evaluate interim results on a relative basis as checkpoints while using absolutegoals over several market cycles to encourage managers to keep one eye on the inevitable cliffs ahead;after all,wedo not want to go herdlike over the clifftogetherwith I m first decile stillon the lips oftheforemost. In the interim, the relative universe couldserve as a reference point for an investmentmanager s philosophy or style. This is a worthychallengefor consultants, fund sponsors,and investment managers.In my 30 years in the profession, the wisest advice I have read or heard for successful long-terminvesting of serious funds came from the Roth-

schilds. They said, The House of Rothschild wasbuilt on lettingsomeone elsehave the first 20 percentof profit and someone else the last 20 percent ofprofit. We contented ourselves with the 60 percentin the middle. In other words, they let someonehave the early and late speculative money andcarved out the heart of the Illelon for themselves.Development of an evaluation system that recognizes and encourages such long-sighted investmentstrategies could benefit clients and the investmentprofession.In a rough sports analogy, the real goal ofmostserious funds is to win the marathon, a race usuallywonbyan excellentathlete correctly pacing himself.The current prevalent practice of emphasizing relative comparisons in the short term encouragessprinting. In sports, just as in the world of competit ive investment management , the athlete is frequently faced with the choice of sprinting with thepack, thereby increasing risk of being unable to gothedistance, or ofgetting too far behind ifhe lags thepack for a significant period. In the real world ofrelative measurement, the laggard is all too oftenfired beforebeingable todemonstrate thewisdom ofhis pacing strategy.Noneof this is to demean performancemeasurement, which is as healthy and necessary as divisionreports in business and team statistics in athletics.The key is what message is sent when the measurements are reviewed. Relative performance over theintermediateterm isusefuland validas a checkpointto ensure that an investment manager is being trueto its philosophy or style, just as an outstandingmarathon runner needs to ensure that he is on pace,bu t placingundue emphasis on relative performanceon a near-term basis is detrimental.The nature of U.s. business people, includinginvestment managers, is to say, You set the rules ofthe game, and we will try to find a way to win.Corporations need to ensure that the rules they setfor evaluating performance are consistent with thereal needs and objectives of their funds over the longterm.nvestment anagerProfessionalism

Another factor that undergirds an authenticmove to lengthen investment time horizons is that,perceptions to the contrary, a large portionof investmentmanagersand researchanalysts,as seriousprofessionals, would welcomemajorbehavioralmodifications toward a longer term orientat ion. Impressions can be misleading. For example, duringthe past decade, a person would surmise from thepublicity given insider information scandals thatmost institutional investors indulged. The truth is


7/94

that only a few members of AIMR were implicatedin insider information dealings during the 1980s.Similarly, despite the impression that no long-terminvestors remain, the preponderance of institutionalinvestors are solid, long-term-oriented, fundamentally sound investors.I believe thatmostprofessionalinvestmentmanagers and analysts would welcome a longer termmandate from their clients. They could then practicetheir profession as they have been trained to do:applying the basics by analyzing balance sheets,searchingou tvalue, and developinglong-term strategies instead ofpsychoanalyzing the emotions of themarket over the short term, outguessing each other

on meaningless next-quarter earnings, or looking fora quick kill on a takeover.The marginal cash flows that move the marketarethemain force that hasbeenwhippingthemarketaround. The preponderance of professionals wouldrejoice in the knowledge that clients support longterm commitment professional investingat itsbest.oard ommitmentMy suggestion to corporate executives is that you are serious about long-term investing, beginimmediately by writing what you believe in yourinvestment policy guidelines, get your board committed,and call your investmentmanagers toa meeting of the board to tell them that you want them toinvest your retirement funds the way you invest inthe future ofyourowncompany. Gettingyourboardcommitted is of vital importance. The success of thelong-term plan resides in the authentic and continually renewed commitment of the board of directors.The career of a CEO is finite, bu t a board is inperpetuity The key to a long-term investment plan lies notjust in setting up an intelligent program bu t also instaying with i t during near-term shocks and underperformance. Lord Keynes explained why: t isthe long-term investor, he who most promotes thepublic interest, who will in practice come in for themost criticism,wherever investment funds are managed by committees or boards or banks . . . f inthe short run he is unsuccessful, which is very likely,he will not receive much mercy. Worldly wisdomteaches that it is better for reputation to fail conventionally then to succeed unconventionally.Commitment to the long term will take greatresolve at times of extreme optimism or despair,when the proper investment course is to go againstthe crowd. A trained, highly disciplined, long-termprofessional investor fits the definition of the rational man in an irrational world.Corporate executives should be encouraged that

some of the finest performance results have beenachieved by money managersknown for a long-termphilosophy. There are many. Perhaps the bestknown are Warren Buffett, whose turnover rate isminuscule, and the legendary Sir John Templeton,who is renowned for his patient investing, searchingoutwhat is being thrown awayby others and willingto underperform while his values prove out. f corporate executives believe this kind of investing forthe long term is appropriate for their companiesandfor our nation, it should follow that it is appropriatefor their pension funds, foundations, and endowments. They have the power to make it so.Investment Managers on orporate oardsMuch of value would be accomplished by having broad-gauged investment managers serving oncorporate boards. They would bring to corporatedeliberations a deep knowledgeof capitalmarkets; atrue understanding of what institutional investorsare seeking and not seeking which has been badlydistorted); a keen appreciation of the trade-offs between short- and long-term investing; broad perspective, because of the nature of their work on national and global trends in industry; and a particularly high sense of ethics and business practices.Where seasoned investment managers serve on corporate boards, I am told they are particularly effective directors.Thecurrent practice inmany, i f notmost, investment organizations is to forbid or strongly discourage their people from serving as corporate directorsbecause of the largeamount oftime required and thepotential conflict of interest, which effectively precludes an organization from investing in the stockofthe corporation. This is reasonable. Nevertheless, Ihope AIMR will encourage the organizations towhich its members belong to permit their seasonedinvestmentmanagerstoserveon a verylimitednum-ber of corporate boardsas a form ofpublic service. feachorganization permitted a few directorships, thecumulative impact could be enormously positive.Bringing seasoned investor knowledge and judgment into corporate governance would be a majorservice to corporations, the investment profession,and to the United States itself.Research on Investment Decision MakingThe Research Foundat ion of the Institute ofChartered Financial Analysts previously the Financial Analyst Research Foundation) in i ts historysponsored a sizable amount of outstanding cuttingedge research that has advanced professional capabilities. Much of this research probably would nothave been done anywhere else. I suggest that the


8/94

foundation undertake to develop analytical techniques by which research analysts and professionalinvestors can readilyascertainhow the decisionsandinvestment practices of corporate managements affect long-term, as opposed to short-term, values.Whendefinedadequately, thesemeasures couldalsobe of substantial use in conveying to proxy votershow managements are building future values. Thisresearch would be of such practical importance thatcorporations would probably join with investmentorganizations in funding it.egislative SolutionsLet me injecta caveat: The mounting frustrationabout the corporate/Wall Street myopia problempresents a danger of damaging quick fixes.In the tradition of if you are a hammer, everyproblemlooks like a nail, Washingtonhas proposedsuch remedies as transfer taxes, taxation of shortterm trades by pension and foundation funds, andother variations. Some, such as lowering the capitalgains tax for successively longer holding periods,would help, but others would do more harm thangood. One of the worst proposals is to repeal theauthority of the Securities and Exchange Commission to require quarterly reports. In the name ofcurtailing the short-term investment mentality, reducing market volatility, and homogenizing worldmarkets, such legislation would cut the heart out ofthe frequent and full disclosure of investment information that has been fundamental to the development ofthe world's mostliquidand efficient market.Elimination of the quarterly report would removethe most effective monitoring power small shareholders have and would further alienate them fromthe market. Insider information would become away of market life, as it is in Japan. Imagine thevolatility when year-end reports are released.One of the chiefobstacles to corporate long-terminvesting is the information gap between whatcorporate managements know about the benefits oflong-term investments in R D, plant and equipment, training, and so forth, and how these investments are understood by external investors. Withperfect knowledge that is, a totally efficient market by definition,short- and long-runprices wouldbe the same, adjusted for present value. The objectof corporate reporting to encourage long-term investing should be to increase reporting and understanding, not to diminish it.

onclusionI am optimistic about the chance of lengthening theinvestment vision of the United States, because of a6

confluence of factors:Themagnitude of the negative consequencesto the United States and its industries of prolongedpreoccupation with the short term is widely recognized. Recognition of a problem, and a sense ofdespair, are essentialconditions for solving the problem. I believe the forces of change are being freed.

f CEOs wish investors to take the longerview, they have the power to encourage and to forcethe changebecauseoftheirvirtual control over institutional investors, which dominate the market. CEOs resoundingly state this message to the investment managers they hire, it will be heard like aclarion call.Investing for the long term coincides withsound investment principles and thesenseofprofessionalism of the preponderance of institutional investors.Much of what I have said so far is directed notonly a t our profession but a t what corporate CEOsand boards of directors can do to help create conditions for longer term investing. Butmy final messageis for myself and my fellow professional investmentmanagers and analysts.Whenmanagingother people's money, we needto think and act like owners. In the management ofour own funds, we devalue lost opportunity andvalue preservationof capital inbuildingpersonal networth. Yet in our businesses, we follow the Italianproverb: Since our house is on fire, let us warmourselves.

Our businesses are built on thinking like agents,earning fees for competing primarily on a relativebasis rather than consistently building valuethroughout good and bad markets alike, for ourclients. Corporate executives and investment managers/analysts now have a great opportunity to helpeach other think and act like owners. Owners buildlong-term value.As Benjamin Graham admonished, we mustnever forgetour responsibility to educateour clients.We understand the nature of the capital market, itsgreatness and foibles, better than anyone. We mustnot abdicate ourduty to educate our clients on whatis in their long-term best interests.I believe with Sir John Templeton that, properlypracticed, our profession isa ministry. We would dowell to heed the words of Woodrow Wilson: Youare not heremerely to make a living. You are here inorder to enable the world to live more amply, withgreater vision, witha finer spiritof hopeand achievement. You are here to enrich the world, and youimpoverish yourself if you forget the errand.


9/94

ntrodu tionIn the hustle nd bustle of investment managementlong-term investment has nearly become n oxymoron. To the process-driven investor it m y be thenext tick; to the fundamental investor it c n be alifetime.In Washington D.C. on October 16 1991 moret ha n a hundred people spent the d y thinking aboutinvesting for the long term. Instrumental to the success ofthiseffort was thefounding chairmanof AIMREugene H. Vaughan Jr. CFA. His cornerstone address starts these proceedings with inspiration. Distinguished speakers representing varied clients managers regulators company management nd journalists all made contributions to the gathering.

For some long-term investing represents moralgood. t carries a fiduciary atmosphere. To buy ndsell stocks with impunity is a travesty. Price m ybeall we really know t nyone time but for long-terminvestors patience for fundamental expectations toplay themselves out is paramount.For others long-term investing is a cruel hoaxperpetrated by those who actually think a client willw ai t years for t he g oo dn es s o f n investment to be

Arnold WoodPresident nd CEOMartingale Asset Management

priced accordingly. price changes the investmentjudgment must become decision. a m an ag er cancapture small increments of return isn t that a longterm process nd synonymous with long-term investing?Essential issues explored within these pol rviews are these:

Does short term investing cause unw r-r nted volatility which causes regulatorybacklash?What is the potential impact of proxy activism on social issues?Whatis the influenceof investors short-termdem nds on corporate planning?Are clients nd consultants forcing managers to be short-term oriented?

What follows is a selection of wh t people discussed t this gathering. What follows will help usall sit back nd think something very precious ndvery missed in the hustle nd bustle of investmentmanagement.


10/94

Investing for the Long TennTheory or Just Mumbo Jumbo?Peter BernsteinPresidentPeter L Bernstein nc

Moving from the short run to the long run transforms the investment process in waysthat are more profound than most people realize. New rules involving volatilityliquidity and investment income come into play.

The meaning of long term is in the eye of thebeholder. Forinvestors infestedwith quarterlymeasurements a year canbe the long run and five yearsis the outer limit. For enthusiasts of the dividenddiscountmodel the long run is the indefinite future.Most of us fall somewhere in between. Yet each ofus defines the long run with a different time span inmind which means that yours will be appropriatefor me only by coincidence. No matter how wefigure it the longrunmeansmore than shuttingyoureyes and hoping thatsomegreattidal force willbringyour ships home safe sound and laden with just theright merchandise for the occasion.I am going toapproach the issue of investing forthe long run from two different viewpoints. First isthere sucha thing as thelongrun? Second assumingthat we can identify and define the long run I shalltry to show that moving from the short run to thelong run transforms the investment process in waysthat arefar more profound than most peoplerealize.

How Long Is t Long Run?Whenpeople talkaboutthe long run they aresayingthey can distinguish between the signal and thenoise. And the world is a noisy place. Discriminatingbetween themain force and the perpetualswarmof peripheral events is a baffling task that humanbeings must face and can never duck.Do twounusuallywarm wintersin a row signifythe onset of global warming or are they a normalvariation to be succeeded by bitterly cold winters intheyears following? When a championship baseballteam loses threegames in a row is that the beginningofthe end of its leaguedominanceor a briefinterrup-

tion in its string of victories? When thestockmarketdrops percent isthat thestartofa newbearmarketor just a correction in the ongoing bull market? WasOctober 1987 the beginning of the end or the end ofthe beginning?Those long-run investors who believe they candistinguish signal from noise scorn the traders whoare so busy chasing the wiggles and the ripples thatthey run the risk oflosingthe maintrend. Thewatchwords of the true long-run investor are regressionto the mean. In the long run everything will evenout; main trends are identifiableand dominate. Thisconcept rules much active investment management.The very idea of undervaluation or overvaluation implies some identifiable norm to which values will revert. Other investors may choose to succumb to fads whims and rumors but investorswhohang in there will win in the long run.

Or will they? The lessonof history is that normsare nevernormal forever. Paradigmshifts belie blindfaith in regression to the mean. This is precisely theproblem with which Alan Greenspan is now wrestling: Has thelong and reliable relationshipbetweenM2 and nominal NPfinally crumbled or is thecurrent disturbance just an anomaly? Here is another. For 170 years the highest quality long-termbonds in theUnited States yielded an average of 4.2percent within a standard deviation of only a percentage point. In 1970 yields broke through the oldupper limits and started heading for 7 percent. Investors stared. How could they decidewhether thiswas a blipor a new era? Then there was the momentin the late 1950s when the dividend yield on stocksslipped below bond yields. Again investors had nohandy rules to tell them whether this totally unex-

7


11/94

govern daily events. Betting against them is dangerous when they look solid, but accepting them without question is the most dangerous step of all.

That investing for the long run is different fromshort-term trading is a truism. Because time is sucha critical variable in the investment process, the differences between short- and long-term investing arefar more profound than most people realize. Thelong-termgame isso unlike the short-termgame thatyou need a whole new set of rules when you areplaying. Volatility, liquidity, and investment income are three areas in which this requirement applies. olatility The first difference is in the impact of volatility. Volatility is noise. The short-termtrader bets on the noise; the long-term investor listens to the signal. Thelong-term investorwho thinksthat the main trend willeven ou t volatility over timeis in for a shock, however. Volatility is the centralconcern of all investors, but it matters more in thelong run than the short run.Volatility matters because it defines the uncertaintyoftheprice at which an asset willbe liquidated.Ibbotson Associates' data tell us that the expectedtotal return on the S&P 5 for a one-year holdingperiod is about 12.5 percent, but you should not besurprised if you come out somewhere between -8.0percent and +32.0 percent, a spread of 4 basispoints. The range for individual stocks is muchwider. So volatilityappears tomatter a lot if youaregoing to hold for onlya year.Stretchyour holding period out from1yearto10years and the range of the expected return narrowsto about 5 percent and +15 percent a year, a spreadof only 100 basis points, which implies very littlechance of loss for the 10-year period. Although volatility now seems less troublesome than it did withthe one-year horizon, and although the odds on losing money when you liquidate are now greatly reduced, do not be lulled by that relatively narrowrange of annual rates of return. What matters is notthe annual rate of return but the final liquidatingvalue at the end of10years. A dollar invested for 1years at 5 percent compounds to $1.63; at 15 percent,it compounds to $4.05. As a dollar invested for oneyear is likely to end up at the end ofthe year between$0.92 and $1.28, the spread in liquidating value overone year is far narrower than the probable outcomesover a lO-year holding period, despite the greaterstandarddeviationof returns. So where is the uncertainty greater in the short or the long run? Talkabout the ocean being flat It could be very flat.

pecteddevelopment wasa fundamental shift inmarket structure or just a temporary aberration thatwould soon correct itself, with the normal spreadof stock yields over bond yields reestablishing itself.John Maynard Keynes, who knew a few things about investing, probability, and economics, took a h mpact On nvestment anagementdim view of the idea that you can look through thenoise to find the signal. In a famous passage, hedeclared that the long-run is a misleading guide tocurrent affairs. In the long-run, we are all dead.Economists set themselvestoo easy, toouselessa taskif in the tempestuous seasons they can only tell ustha t when the storm is long past the ocean will beflat.Keynes is suggesting that the tempestuous seasons are the norm. The ocean will never be flat soonenough to matter. In Keynes' philosophy, equilibrium and central values are myths, not the foundations on which we build our structures. We cannotescape the short run.These considerations explain why I asserted atthe outset that the long run is in the eye of thebeholder. The way you feel about the long run andthe wayyou define itareultimatelygut issues. Theseissues are resolved more by the nature ofyour basicphilosophy of life, or even how you feel when youget up each morning, than by rigorous intellectualanalysis.Those who believe in the permanenceof tempestuous seasons will view life as a succession of shortruns inwhich noise dominates signals and the frailtyof the basic parameters makes normal too elusivea concept to worry about. These people are pessimists who see nothing in the future bu t clouds ofuncertainty. They make decisions based onlyon theshort distance ahead that they can see.Those who liveby regression to the mean spendtheir time differently. They expect the storm to passso that one day the ocean will be flat. On that assumption, they can decide to ride out the storm.Theyare optimistswho see thesignalsby which theywill steer their ships toward that happy day whenthe sun shines through.My own view ofthe matter is a mixture of thesetwo approaches. Hard experience has taught methat chasing noise leads me to miss the main trendtoooften. At the same time, havinglived throughthebond-yield/ stock-yield shift of the late 1950sand thebreakthrough of bond yields into the stratospherebeyond 6 percent in the late 196 s just to mentiontwo such shatteringevents ou t of many I look withsuspicion at all main trends and all those means towhich variables are supposed to regress. The primary task in investing is to test, retest, and test yetagain the parameters and paradigms that appear to8


12/94

iquidity When you buy something tomake a few points, or even 10 or 20 eighths andquarters matter. Good execution counts for a lot.When you buy to hold for the long run, even a fewpoints on the price will not matter a great deal.Liquidity is a concern of the short-term investor anda minor matter for the long-term investor.The point is obvious, but it receives too littleattention. How much does pricing matter for assetsthat are no t about to be liquidated? you are amultibillion dollar investment management organization that has no choice but to acquire and holdindefinitely Exxon and IBM and other major highcap companies, what difference does the daily pricefluctuation make? Why bother to watch their dailyaction?Throughout our financial system, many moreassets aremarked to market than is necessary. Whenthe markets are depressed this obsession withyesterday s price creates serious distortions as to thesoundness of the institutions involved, which mayhave no need to sell, and no intention to sell, theassets they hold. Assets held for the long pull aresimply not the same thing as assets tha t are to beliquidated in a matter ofweeks or months.

ncome Investment income is an important link between the short and the long run. Incomeis also a dramatic illustration ofan important principle of Hegelian dialectics: Changes in quantity ultimately become changes in quality.

Forthe short-term trader, thedividend on a stockisa gauge tovaluation, but the actual money incomefrom the dividend is irrelevant. The trader s returnwill be dominated by price change, because pricestend to move in ranges tha t far exceed one year sincome receipt. Now expand the time horizon. Income payments pile up over time, altering the character of the return structure. Investors who can reinvest income now begin to have the opposite desirefrom short-term traders: Traders want prices to riseso they can sell, while investors reinvesting incomeare buyers who want prices to fall while the buyingprocess is going on.For bonds, this story is obvious. Current coupons beingwhat theyare, interestand interest-on-interest soon win over price change and, for long-maturity bonds, account for an overwhelming share ofthe total return.The story in the stock market is similar in character, but few people take notice of it. you had puta dollar in the stockmarketat the end of 1925and justlet it appreciate, spending all the income you received over those 66 years, you would have 30today. you ignored the price appreciation andsimply piled up 65 years worth of dividends, with-

outany reinvestmentincome, youwould have a pileequal to 20. In fact, given thestarting period in 1925and the intervening stock market crash of 1929 to1932, your growing pile of dividends would haveexceeded the market value of your portfolio for 35years from 1930 to about 1965; the dividend pile fellbehind the portfolio value by a meaningful amountonly after 1982 57 years after the purchase.Let me go back to the end of 1925 for a momentto give you the full flavor of this. According toIbbotson Associates data, a dollar invested in thestock market at the end of 1925, with all dividendsreinvested and no taxes and brokerage paid, wouldhave grown to about 600 today, far above the 30from appreciation alone. The difference of 570comes from the receipt and reinvestment of that pileof income, swelling the total to the sum of 600. Aninvestor who came into themarket at the top in 1929would have had towait until 1953 before stock priceswould have returned towhat the stocks cost to purchase. Yet, with income reinvested, breakevenwould have arrived in 1944, nine years sooner.Therefore, the role of price in determining totalreturn diminishes steadily in importanceas wemovefrom the short run to the long run. Themean annualincome return since 1925 has been 4.7 percent a yearwith a standard deviation of only 1.2 percentagepoints. Theannual appreciation returnhas averaged7.1 percent, but with a standard deviation of 20 percentage points. These facts explain why the incometurtle puts up such a good race against the appreciation hare. They also help to explain why the standard deviation of returns tends to shrink with thepassage of time.Quite aside from the demonstration that volatili ty mat ters a lot more in the long run than conventional wisdom would lead us to believe, there is animportant lessonhere for investors. Do notsimulateequity portfolio returns with the familiar long-termIbbotson figures of 10 to 12 percent a year unless theportfolio can accumulate and reinvest all the incomethat it earns.

Investorswho mustpay taxes on their incomeor,even worse, are not able to accumulate and reinvestevery penny ofdividend income they receive cannotrely on the long run to bail them out of the inherentvolatility of equity investments. There have been 561O-yearrollingholding periodsbeginningwith 192535. In nine ofthose cases ofwhich only three werein the 1930s stock prices ended up below wherethey started. Inanother 12 cases, the increase in stockprices for the decade lagged the rise in the cost ofliving, so the portfolio lost real value. This meansthat the market s price performance was negativeone-third of the time in these 10-year holding peri-

9


13/94

ods even though over the whole sp n of 66 yearsprices rose 3D fold or 5 percent a year. Those arefrightening numbers without the precious support nd smoothing of income accumulation. Equity in-vesting is risky business even in the long run.

oisesSignals and Tempestuous SeasonsThe long run in the popular view is a process thatsmooths the bumps cuts through the clutter ndcaptures the main trend. this story has a moral itis that the long run is a complex ambiguous even

elusive concept often better in theory than it is inpractice. We cannot escape those difficulties. Theyare p rt of life.Despite the complexity ambiguity nd elusive-ness of the long run another mor l nd a usefulone is that time matters. Quantitative changes be-come qualitativechanges nd basic transformationstake place s the time period lengthens. Although I m not sure where the short run ends nd the long-run begins I do know that the character of my ex-pected investment results depend on the length ofthe holding period. That t least is a beginning towisdom.


14/94

Question and nswerSessionPeter BernsteinQuestion In an article about years ago, you discussed efficientmarkets and how information isabsorbed quickly. You have proposed dealing with these attributes of the market by investingin slow ideas -ideas in whichinformation is not absorbedquickly because they are not inthe daily news and requiredeeper analysis than is typical inthe investment community.Have you changed your opinion,and how do you identify slowideas that work?

ernstein This is JackTreynor s idea, and I have alwaysbelieved everything he says.Treynor thought if you invest insomething that is not now visibleto other people, or that the natural bias ofother investors createsopportunities for, you may havetowaita while for your ship tocome in, but itwill come in big.Hence, a slow idea. Another sideof that, which gets less attention,is that if you think ofa slow idea,then it is slow forever. You arenot in an absolute sense likely tolose. The theory is to buy something cheap, already in the discard heap. na realistic risk-reward basis, this is an attractiveway to invest. I know peoplewho have tried to implement thisstrategy, and it is very hard. you are capable of doing that,which not all ofus are, then it isthe right way to invest, becausethis is a very efficient and fastmoving market.Question Is there any evidencethat the incredible changes incomputers, telecommunications,and other technologies haveshortened the time horizon?

ernstein Over the years Ihave found that subjects of conversation change, bu t the patternsdo not. Originally inmy speech,Iwas going to mention the firstInstitutional Investor conferenceheld in February 1968. The proceedings of this conference included a speechby David Babson, in which he said there aretoo many Freds in the business.Also, Gerry Tsai said that theManhattan Fund was now beginning to take a more long-termview and was beginning to lookat 969 earnings. In the 1960s,much less attention was given tothe long term than is the casenow. The long term probably receives more respect now than itdid before because of academicwork, positive experience, andthe growth of quantitative techniques. Certainly in the 1920sand earlier, the marketwas a casino. I think that has changed.Question Is there one singleasset allocation of stocks, bonds,cash for portfolios with similarobjective-for example, endowment funds? Once you identifyan allocation, howmuch wouldyou vary it? ernstein The answer to thefirst question is no, at least for afoundation. Robert Merton published a National Bureau of EconomicResearch paper attemptingto address this, specifically for college endowment funds. Hepoints ou t that college endowment funds tend to have a lot ofbonds because theywant income.

l R Merton, Optimal InvestmentStrategies for University EndowmentFunds National Bureau of EconomicResearchWorking PaperNo. 3820 (August1991).

Some educational institutionshavebig endowment funds relative to their budgets, and othershave a harder time getting moneyfrom their alumni, so they havesmall endowment funds. Clearly,the two types should have entirely different kinds of portfolios.You can stretch the idea to pension funds.I find the foundations I workwith to be as heterogeneous as individuals the only differencebeing that I have to spend themoney. Longevity is a very important consideration for bothfoundations and individuals. Inworking with foundations, I wrestle with this all the time. Do wewant to give this money away inour lifetime, or is this a foundationwe want to last into perpetuity?Clearly, the investment strategywill differ depending on the answer.

One foundation I work withhas a president everyone is veryfond of and some projects underway they thinkaregreat. The president will retire in the next fiveyears, however, and they do notknow what they will do next.Enoughmoney is inthe pot,evenifthe stock market goes way down,to fund the foundation s expenditures for the next five years. Theydecided to take this fund and try toshoot the moon with it, because ifthey do badly, they can still takecare of what they know is ahead,but ifthey do well, maybe they cando more beyond.To answer the second question, ifa normaldistribution exists,vary it modestly. I say this becausemy gut feeling is that the future isvery hard to predict and the onlyprotection against uncertainty isdiversification. Therefore, Iam notinclined to make big bets in asset


15/94

allocation or vary my bet verymuch. Trying makes sense bu t 10percentage poin ts is probably anice number for the outside limit. uestion I was intrigued bythe statement that if you were along-term stockholder you mightwant to be in stocks that go downso you could reinvest the income. the stocks had not gone to 30between 1925 and today bu t hadstayed the same and you had reinvested the same amount of dividends would you havemorethan 600? ernstein they stayed at 1thewhole time you would have1 plus 20. So the dividend payments would be the same. Hadthe market gone down and thencome back to 1 you would havesomething more than that. Inmyexample it went to 30 and I am

12

not denying that had a lot to dowith the 600 bu t the 20 alsohad something to do with it thetwo together. Had you spent allthe income you would only beworth 30. the prices had notgone up the number would be alot smaller. uestion At some point doesdiversification diminish in valueas an economic strategy? Whydoes Elizabeth Holtzman hold2 000 companies and WarrenBuffett very few? Is there somerange beyond which diversification does not pay? ernstein I do not know the answer bu t i f Iwere HarryMarkowitz maybe I would. Heinvented the idea ofmean-variance. I do believe that there is apoint beyond which more diversification does not reduce risk very

much. There are administrativetype costs to owning things andthose costs rise as the number ofholdings increase. But there isanother advantage to broaddiversification beyond its function as a means of reducing risk.Diversification also exposes us tothings to which we would nototherwise be exposed. One ofmy former associates PeterCarman once said that you arenot properly diversified untilyou own things you do not wantto own. you feel safe witheverything you hold the chancesare that your holdings shareattributes and that you havefailed to diversify to spreadyour risks among assets with thelowest possible covarianceconsistent with maximizingexpected return. That iswhatmean-variance analysis is allabout.


16/94

Is Long Term Time Frame for InvestingAffordable or Even Relevant?John C. Bogle Sr.hairmanThe Vanguardroup

Wheninvestmentadvice isformulated ina climate thatdemands urgentaction, the resultoften is counterproductive or worthless. One answer is to diversify investments broadlyand to maintain a strategic balance among asset classes.

To paraphrase thewords of the lateCharles DudleyWarner, editor of theHartford ourant on the subjectofweather: Everybody talks about long-term investing, but nobody does anything about it. Too manyinvestment advisers and securities brokers and toomany financial mavens of the press and televisionperhaps for obvious reasons) thrive on short-termforecasts, expected market trends, and hot and,less frequently, cold ) stocks. Thus, we invest in aclimate that seems to demand urgent action.How valuable is this cacophony of investmentadvice? Far too often, theanswer is that it is counterproductive, if not worthless. To ask the question inthe obverse way, what is the chance that short-termor even intermediate-term) changes in investmenttactics or strategy will add any value to long-termreturns? The answeris thatthe probability ofaddingvalue is 50/50 before the payment of advisory fees

and portfolio transactioncostsand aboutone inthreeor one in four netof such costs. The conclusion, then,is that the odds do not favor the investor who salliesforth to conquer the financial markets.The implicationfor the long-term investoris thatthemostsensibleway to investis todiversifybroadlyand to maintain a relatively consistent strategic balance among asset classes. I shall t ry to prove thispoint in the following manner. First, I shall examinehow the simple logic of the efficient market theoryof common stock diversification, and the obviousextension of this logic to tactical asset allocation,together make a powerful case for passive investing the ultimate long-termstrategy. Second, I shallpresent empirical evidence that shows how difficultit has been for investment advisors as a group to

exceed the long-term results achieved by passivemanagement. Third, I shall provide additional evidence that market-timing, more often than not, hasled to inferior returns. Fourth, I shall consider trulylong-term historical return data and demonstratehow it can be used and abused. Finally, I shall present an investment strategy that, based on historicaldata, canprovide above-average returns withbelowaverage risk.My comments are focused on long-term investing from the perspective of the client, including bothindividual and institutional investors. In essence,both have a lifetime investment horizon--elearly sofor individuals, and a rolling lifetime horizon formost institutions. The remarkable efficiency of theU.S. securities markets rapid response to new information, liquidity that is broad and deep, and lowtransaction costs results mainly from the hightransaction volume generated by short-term professional investors actively engaging in the purchaseand sale of financial instruments of every stripe. Ina paradoxical sense, then, short-term investmentstrategymakes long-term investment strategy possible.

The Efficient Market Theory in PrincipleThecalculusof theoriginal efficientmarkettheoryofthe academics was quite complex and difficult forindustrypractitioners to follow, let alone agree with.Even Paul Samuelson one of the brilliant proponents of this great body of theory admitted that hemust confess to having oscillated between regarding it as trivially obvious and almost trivially


17/94

vacuous) and regarding it as remarkably sweeping. lSuffice it to say that the complex formulation ofwhat has become known as modern portfolio theory is reduced to two obvious facts: 1) Because allinvestors own the entire stock market, if passiveinvestors holding all stocks, forever---ean matchthe gross return of the stock market, then activeinvestors as a group must match the gross return ofthe stock market as well. 2 Because the management fees and transaction costs incurred by passiveinvestors are much lower than those incurred byactive investors, if both provide equal gross returns,then passive investors must earn the higher net return.

f ever there were two elementary, self-evidentcertainties in a financial world permeated by uncertainties, surely they must be these. Although weshould applaud the extensive equations and elegantproofs developed by such Nobel Prize winners asSamuelson, Tobin, Modigliani, Sharpe, Markowitz,and Miller, we should also recognize that one neednot drive to the farthest reaches of the efficientfrontier to find simple solutions that, like the proverbial Acres ofDiamonds, often lie undiscoveredin one's own backyard.The syllogism set forth above relates essentiallyto the ability of investors as a group to engage insuperior stock picking. Although I have never seenthe obvious logic of this reasoning extended to superior market-timing---ehanging a portfolio's asset allocation of stocks, bonds, and cash reserves it iseasy to draw a parallel syllogism: (1) Because allinvestors own all securities of all types in the financial universe, total market risk is, at any given moment in time, fixed. Thus, passive investors whomaintain all-market portfolios must inevitably earna gross return tha t is equal to tha t of the market intotaL Activeinvestorsengaged in the transferenceofrisk among one another must then earn this samegross return. 2 Because management fees andtransaction costs incurred by passive investors withfixed asset allocations are much smaller than thoseincurred by active, market-timing investors, if bothprovidean equalgrossreturn, then passiveinvestorsmust earn the higher net return.Full disclosure compels me to point out thatNobel laureate William Sharpe is a fervent advocateof the first syllogism; however, he seems skepticalabout the second. He recently formed a firm to provide asset allocation advice to pension funds. Hisresults should be interesting.

1RobertC. Merton, PaulSamuelson'sFinancialEconomicsin Paul Samuelson and Modern Economic Theory C. Brown and Solow,eds. (NewYork: McGraw-Hill BookCompany, 1983).

The fficient arketTheory in PracticeAbout the first syllogism: The hypothesis that passive equity management should, in theory, outpaceactive management turns out to work, wi th someconsiderable accuracy, in practice. n overwhelming body of data confirm that, on a long-term basis,the average investment advisor has been unable tooutperform the stockmarket.I should note here a distinction between passivemanagement and indexing. The former termimpliesowning a participation in the entire stock market,while the latter implies owning a participation in aparticular segment of the market. Even the broadlybased Standard Poor's Composite Stock PriceIndex represents only about 75 percent of themarket's capitalization. t is a very good but inevitably imperfect proxy for the total market.

Figure shows the equity returns achieved bytwo of the largest institutional investors mutualfunds and pension funds relative to the wholestock market, as measured by the all-encompassingWilshire 5000 Index. The stock market return averaged 11.2 percent yearly during the 20-year periodended December 31, 1990. (The Standard Poor's500 Index return was 11.1 percent.) The averageequitymutual fund achieved an annual return of9.8percent during the same period, a shortfall of 1.4percent.2This actual margin in relative return is remarkably close to the theoretical margin of roughly 1.8percent, comprising, broadly stated, a 1.0 percentexpense for fund advisory fees and operating ex-

2LipperAnalytical Services, Inc.

Figure 1 Indexes of Returns: Stock Market EquityMutual Funds and Pension Equities9 ~

2,0001,00080

500e-x 200

10050 71 73 75 77 79 '81 '83 '85 '87 '89'90 StockMarket'- - Pension Equities- - - - - EquityMutual Funds

'Wilshire 5000 Index

Source Lipper Analytical Services, Inc. SEI (1971-78) andINDATA (1979-90).


18/94

penses, an estimated 0.5 percent for fund transactioncosts, and a 0.3 percent reduction resulting from thefact that the Index is 100 percent invested in stocks,while the averagemutual fund carried the drag ofa 10 percent cash position. (In the past two decades,of course, stocks returned more than cash.)For theaverage pensionequityfund, theaverageannualrateofreturnwas9.6 percentafter transactioncosts bu t before advisory fees, custodian costs, andother out-of-pocket expenses.3 we assume thatthese costs averaged 0.5 percent annually, the netreturn for pension equity accountswould be 9.1 percent. This return, then, reflects a shortfall of 2.1percent to the market.t may be just a curious coincidence that theperformance of equity mutual funds and pensionequityaccounts, with respective shortfalls of 1.4 percent and 2.1 percent to the market, almost exactly

bracketed the theoretical margin of 1.8 percent. Toseetheir respective performancesdiverge verymuchwould be surprising, however, because it is difficultto conceive of any reason why a higher level ofcompetencewould prevailinonearea than theother.What is more, most major advisory firms manageboth pension fund and mutual fund assets.3SEI (1971-78) and INDATA (1979-90).

Theaverageannualreturnsofpensionfunds andmutual funds reflect a wide rangeofindividual fundreturns; therefore, many managers outperform themarket. Some of these fund managers have donesuch a good job for sucha long timethatwe can fairlyassume that they have unusual talents. WarrenBuffett and Peter Lynch would surely be in thisgroup although even Peter Lynch believes thatmost investors would be better off in an indexfund. John Neff and Sir JohnTempletonwould alsobe preeminent candidates, although their recent relative returns (during 1990 and in the 1985-90 period,respectively) suggest thatwe might observe themfora few more years before inducting them into thepantheon.Such extraordinary managers are few. A majors tudy by Jensen suggests that, on a risk-adjustedbasis, only about one of every three equity mutualfunds has outperformed the market over time andonly about one ofevery four has done sowhen salescharges are taken into account.4 (Sales charges wereignored in the earlier mutual fund data.) The figuresfor pensionfunds show that, duringthe past20 years,theS P500 hasbeen in thefirst performancequartile

Jensen, The Performanceof Mutual Funds in the Period1945-1J4, Journal of inance(December 1965):20-26.

Figure 2. Percent of Pension Funds OUtperformed the S P 500 Index 1971-91

' 0Q)S-


19/94

FFOORRSSAALLEE&&EEXXCCHHAANNGGEE

wwwwww..ttrraaddiinngg--ssooffttwwaarree--ccoolllleeccttiioonn..ccoomm

MMiirrrroorrss::wwwwww..ffoorreexx--wwaarreezz..ccoomm

wwwwww..ttrraaddeerrss--ssooffttwwaarree..ccoommwwwwww..ttrraaddiinngg--ssooffttwwaarree--ddoowwnnllooaadd..ccoomm

JJooiinnMMyyMMaaiilliinnggLLiisstt
http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.trading-software-collection.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.forex-warez.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.traders-software.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-download.com/http://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-collection.com/www/subscribe.htmlhttp://www.trading-software-download.com/http://www.traders-software.com/http://www.forex-warez.com/http://www.trading-software-collection.com/


20/94

Table 1 Perfonnance ofMutual Fund liming Newsletters

Period Number ofNewslettersAdvisorsOutpacingMarket

AdvisorsFallingShorfMedianTimingReturn MarketReturn

+336.9271.504June30, 1980June 30, 1990January 1,1989-June 30,1990 85 8 77 +17.1 +31.5Source M. Hulbert, The Hulbert Financial igest(New York: New York Institute of Finance, 1991).

in 3 years, the second quartile in 11 years, the thirdquartile in 6 years, and never in the fourth quartile.5So the consistency of the S&P Index is compelling.As Figure 2 shows, its ability to outperform pensionfunds is impressive as well.The question of consistency is significant, because even the few above-average managers are almost impossible to identify in advance and onlyerratically do they repeat their past success in thefuture. Indeed, the20 top-performing equitymutualfundsofthe 1970shadanaverafe rankof137(among309 funds) during the 1980s. That they droppedfrom the top of the list to the middle strongly suggests that luck is a major factor in the selection ofthe best equity advisors.One final problem in selecting a winning manager is that, accordingtoRichardBrealey,a respectedpioneerofcapitalmarkettheory,youprobablyneedat least 25 years of fund performance to distinguishat the 95 percent significance level whether a manager has above average competence.,,7 Anothercommentator, Gilbert Beebower of the SEI pensiondata firm, accepted the 25-year timeframe, ' 'but onlyif the pension executive is using the perfect [italicssupplied] benchmark for thatmanager. Using a lessthan perfect benchmark may increase the observation time to 80 years.,,8 that is in fact the case, thelogic of adopting a strategy focused on indexingequities seems almost overpowering.

Market Timing as an Investment Strategy

the stock market, investors have intuit ively suspected that theycould effectively outsmart the stockmarketbymoving their financial assets in and outofstocks and bonds, and by so doing, ride the bullmarkets and sit out the bear markets. This strategyof tactical asset allocation has come to be describedas market-timing. As evidence of the increasing pervasiveness of market-timing gurus, consider thatonly 14 mutual fund market-timing newsletters existed in 1980 compared to 104 in 199O-a sevenfoldincrease.

How has all of this shuffling of assets workedout? Significant evidence indicates that it did notadd value. The performanceofmutual fundmarkettiming newsletters has been recorded, and the evidence logged in able 1. Certainly these numberswould suggest that the theoretical odds against successful market timing dramatically understate theactual dimension of the challenge.

For most asset allocation, the performance results havebeendepressingly similar, although therehave been some solid long-term performers. Sinceits inception in 1978, one major asset allocator, Mellon Capital Management, has turned in an averageannual return of 16.9 percent, exceeding the marketreturn of 14.6 percent, all the while assuming lowerrisk (an average equity exposure of 60 percent). Byway of contrast, the asset allocation fund of a majorTable 2 Comparative Perfonnance: nsset

Allocation Fund and the S P 500With regard to the second syllogism, the hypothesisthat a consistent stock-bond-eash mix should, intheory, outpace tacticalasset allocationschemesalsoseems to work in practice. Since the earliest days of

SSEI (1971-78) and INDATA (1979-90).Bogle, Selecting Equity Mutual Funds, The Journal ofPortfolioManagement (Winter 1992):94-100.

7R. Brealey, PortfolioTheoryVersusPortfolioPractice, TheJournal of Portfolio Management (Summer 1990 :6--10.BCBeebower, Editorial, Pension and Investment ge(February 8, 1988):10.

Total ReblmAssetAllocation S PPeriod Fund Index

Second half 1986 +2.4 -1.8First half 1987 +18.9 +27.4Second half 1987 +8.7 -17.4Calendar 1988 +17.8 +16.5Calendar 1989 +10.5 +31.6Calendar 1990 -4.7 -3.1First half 1991 +10.5 +14.2Average +12.7 +11.9Source TheCommonFund Annual Report, June 30,1991.

16


21/94

Rgure 3. sh Flows Into and OUt of Equity Funds, 197 ..S110

8

6

4


22/94

70 r

Source Investment Company Institute research department.

The Use and buseofStatistics

igure Annual Investor Tumover of quity undShares, 9 7 ~

/ \/ \/ \/ /

50

20

60

exchanges ou t of equity funds into other fundswithin the same fund family have risen from 2 percent of equity fund shares in 1976 (when the exchange phenomenon began to take hold) to 19 percent currently. As a result, as Figure shows, fundshareholder total asset turnover has increased to 37percent annually-nearly five times the 1967 ratio.In 1987, it rose to an astonishing 59 percent, hardly atribute to the stability of themutual fund investor ina bearmarket. Apparently, witheach passingyearand especially in down-market years-the buy-andhold philosophy has become less persuasive.Iwould notwant to leave theimpression that thepeccadillos ofmarket-timingare the exclusive province of the individualmutual fund investor. Financial institutions are guilty of the same sins. For example, as shown in Figure 5 corporate pensionfunds held 71.4 percent of assets in stocks as 1973began, justbefore the onset of theworst bear marketsince the Great Depression. Then, fighting the proverbial last war, these pension funds substantiallyreduced their equity commitments, touching a lowof 50.5 percent at the end of 1981-just before thegreat 1982-87 bull market began. This equity ratiohas now rebounded to64.1 percent, and I expect thatwewillalsohavemany opportunities to test whetherhistory will repeat itself in this case as well.14

10o : = : : .L.. . _.L.. . . . . . . .L L _.. l . . . L. l_. . l . . . . l'67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 Redemptions - - Redemptions Plus Exchanges Ou t

40P 30

return of 12.1 percent annually; worst timing (thereverse) would have provided a return of -6.4 percent annually. Thus, the upside added 6.1 percent toannual return, while the downside subtracted 12.4percent.ll So the odds against success appear long,and risk-reward relationships unsatisfactory.Despite the discouraging record of most assetallocation schemes, a good deal of data on mutualfund shareholder activity suggest that investors areignoring the diversify and stay on the course thesisI am presenting here. Sheeplike, they persist in addingto their equity fund holdings immediatelybeforethestockmarketreachesa high pointand thenreducing their holdings immediately following significantmarket declines. Figure 3 illustrates this pattern ofbehavior.Following the 46 percent market decline in 1973

and 1974, investors made withdrawals from theirequity holdings aggregating 17 billion 64 percentof their initial holdings) during the subsequent 27quarters through the third quarter of1981. Then, justbefore the market began a five-year rise of 227 percent in the fourth quarter of 1982, cash flow againturned positive, totaling 78 billion 143 percent ofinitial fund assets) through the third quarter of 1987.The cash inflow was heaviest during the latter partof the period, after most of the easy money hadbeen made. The October crash promptly caused areversal of the trend, with 30 billion withdrawnduring the next six quarters 11 percent of the initialasset base). Since the first quarter of 1989, after stockprices had begun their sharp recovery, cash flowagain turned positive, aggregating 35 billion, withthe only negative quarter occurring in the marketdecline during the third quarter of 1990. In the second quarter of 1991, the 7.4 billion of cash inflowwas the second highest since the third quarter of1987.12 We shall have many opportunities to see ifthis baneful pattern of history-selling after bearmarkets, buying prior to bull market peaks-willrepeat itself in the years ahead.This counterproductive responsiveness to market changes by mutual fund shareholders seems tobe endemic and is perhaps unsurprising. Whatmaybesurprising,however, isthat the turnoverof investments by the shareholders of equity funds has beenon what appears to be a long cyclical rise since 1975.Annual redemptions as a percentage of equity fundassets have more than doubled-rising frpm 7 percent in 1967 to 18 percent currently.J3 What is more,

11R. Jeffrey, The Folly of Stock Market Timing, Harvard usinessReview (July/August 1984):102-10.12InvestmentCompany Institute research department.13InvestmentCompany Institute research department.

What may well be the most sensible and effectivelong-term investment program in which to engage14Goldrnan Sachs Co., Equities: Supply and Demand

Portfolio Strategy (September 1991). 8


23/94

Rgure 5. Equity Position of Corporate Pension Funds 1970 9175 ~

70

65


24/94

Table 4 Returns on U S Stocksand Treasury onds1802-1990 Table 5 Stock atrix for the 19905 rojectedAnnual Total ReturnsStock ReturnsNominal Real Treasury Bond ReturnsNominal Real

PriceEarningsRatio 4.0EarningsGrowth Rate

6.0 8.0 10.01802-18701871-19251926-1990

5.87.49.8

5.76.86.4

5.04.54.6

4.93.9 2

10 2.7 4.5 6.5 8.414 6.1 8.0 10.0 12.018 8.7 10.7 12.7 14.822 10.8 12.9 15.0 17.11802-1990 7.6 6.2 4.7 3.3Sources: G. Schwert, Indexes of U.S. Stock Prices from 1802 to1987 Journal Business (July 1990):399-426. Siegel, HistoricalR ~ t u m ; ; The Case for Equity, Rodney 1. White Center forFmanclal ResearchWorking Paper (October 1991).percent bonds, and 10 percent reserves, with variations around these levels based on risk preference.Curiously, I have been unable to find any statisticalstudies that support such a balance as optimum:So I can only suppose that it is based largely oncommon stocks providing greater returns thanbonds or cash over extended periods of time-modified by the fact that, in shorter periods, stocks carrya significant risk of underperformance as well assubstantially higher volatility.. So ~ x a c t l y how long must long term be to provIde relIable data? JeremySiegel has done a remarkable study calculating Treasury bond returns andlinking historical stock return data calculatedby others to provide statistical series going back to 1802.16As ble 4 shows, real returns on stocks proved tobe comparable in each of three extended periods.The return data provided by G. William Schwert17for 1802-70 largely echoed the results of the morerigorous statistical data of the Cowles Commission1871-1925 and the still more reliable data proVIded by the Center for Research in Security Prices(CRSP) for 1926 to the present. (The CRSP datareflect annual returns about 0.3 percentbelow thatofthe S P 500 StockIndex, which I regard as the mostreliable ~ n d i c a t o r ofthereturns on the stocks of largecompames.) The major deviat ion from the normduring these three eras was the shortfall in the realreturns onTreasurybondsduring the 1926--90 periodrelative to the earlier periods.

the returns shown in Table 4 had been compounded for the full period, based on an initial investment of$10,000, the nominal terminal values forstocks would have been $10.3 billion and for Trea-1 Siegel, H i s t ~ r i c a l ~ e t u r n s TheCase for Equity, Rodney WhIte Center for Fmanclal Research Working Paper (October19

Documents

Peter Bernstein - Investing for the Long Term