There is something of the Pot Noodle about short-term investing. Yes, clearly both suit those who feel themselves pressed for time but there is also the fact that, while there are evidently many people who indulge in Pot Noodle and many who indulge in short-term investing – and presumably even a fair few who indulge in both – you rarely meet anyone willing to own up to these practices.
So who are they? Leaving the Pot Noodle element of that question to others more qualified to comment, from here we will concentrate on the identity of short-term investors and once again, as we were in Spur of the momentum we find some enlightenment with Dimitri Vayanos and Paul Woolley of the London School of Economics and their new paper, Curse of the benchmarks.
“Short-termism in financial markets has been a periodic worry of policymakers, usually surfacing in the wake of a crisis,” they write before going on to point the finger at a couple of suspects with a common characteristic: “Momentum and benchmarking share the defining feature of being influenced by fund flows rather than cash flows.”
What motivates momentum investors, explain Vayanos and Woolley, is short-term gain while, for benchmarkers, it is the desire to avoid short-term underperformance against their benchmark. “Both focus on current price and valuation to the exclusion of what ultimately matters to long-term investors, which is the future stream of earnings and dividends,” they add.
As we saw in Spur of the momentum, the paper is pretty damning about benchmarking and momentum investing, arguing they contribute to “mispricing across the spectrum of asset markets, notably the inversion of risk and return, bubbles and crashes and secular overvaluation” and lead to “the misallocation of capital at the micro level, and crises and contraction in the macro-economy”.
According to Vayanos and Woolley however, the remedy lies not in “a barrage of regulation” but in changing incentives for investors and this begins with an understanding of the strategy options they face – essentially momentum, benchmarked ‘value’ and inverted comma-free value. To that end, the pair were able to use a “rational framework” or model they had developed to explain asset mispricing.
The model’s central prediction is that “momentum delivers higher risk-adjusted returns in the short term but value dominates in the long term”. The paper contains plenty of supporting evidence but a key point is that “mean reversion confers on value its main advantage that long-run risk is less than the sum of the short-run risks”.
In contrast, “returns to momentum in the model, as in empirical studies, are based on investors buying and selling on a fixed cycle of lookback and holding period regardless of fundamental value. This makes momentum a succession of independent bets so that long-run risk is equal to the sum of the short-run risks”.
As Curse of the Benchmarks goes on to explain, there are a number of factors here that work in value’s favour – the first being that “the distribution of outcomes for value is narrower than that for momentum because they depend on expectations of future cashflows, which generally cluster around the consensus view”.
On the other hand, returns to momentum “vary widely” because the outcomes are sensitive to whether investors sell before or after a trend reverses, which is clearly not something that can be predicted. The paper even notes: “Theory, as in empirical studies, compares returns from the best outcomes only, thus flattering the performance of momentum.”
Another – related – factor is that, by definition, momentum investors “buy late and miss the initial gains whereas value investors face no comparable handicap”. Also – and importantly – theory and empirical studies generally exclude transactions costs yet trend-following is, by its very nature, a high-turnover strategy and so necessarily involves more costs.
As you might expect then, the conclusion – “qualified by practical considerations” – is that “value beats both momentum and benchmarked value for medium and long-term horizons. Only for short horizons, equivalent to the formation period of the average bubble, do momentum and benchmarked funds stand a chance of outperforming value, depending on the state of market valuations at inception.”
Course of best returns
That being so, why – as we saw in Full tilt – are so many fund managers and other investors apparently going out of their way to avoid following a true value strategy? For its part, the paper focuses on pension scheme trustees – a principal source of employment for fund managers – and suggests a number of reasons why they are not adopting “the course that yields the best returns”.
One is that, as trustees are agents for – and thus beholden to end-investors – they pay more attention than they perhaps should to shorter-term performance. The paper also suggest trustees tend to live by “Keynes’ aphorism that ‘worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally’ and stick to what they have been taught to do”.
There is a line of thought, write Vayanos and Woolley, “that ‘homo economicus’ will always find the best and cheapest way of fulfilling his needs”, which “for the vast majority of investors should mean investing on the basis of value”. So should any short-term investors have been persuaded by this piece, how can they go about identifying a true value manager?
One suggestion the paper makes – and with which we would agree – is that the level of a fund manager’s portfolio turnover is an unambiguous indicator of style. If your manager’s turnover is high, there is little room for doubt he is following a momentum strategy. If your manager’s turnover is low, however, well – congratulations on your good judgement.
Another tip would be to look at a manager’s past trading patterns to see when stocks are being bought – is it as prices are, in aggregate, rising (again, momentum) or falling (again, congratulations)? And, admittedly more woollily, does the manager sometimes see bouts of underperformance against non-value? Here on The Value Perspective, we know it is in those times you sow the seeds of future gain.
Just by looking at some quite simple metrics, therefore, investors should actually be able to tell the managers who are practising what they preach from those who are merely paying lip-service. The value from the ‘value’. The slow-cooked meal from the Pot Noodle.