Having investment belief set is the key to future returns

The lack of a cohesive process in constructing and implementing investment beliefs threatens to further erode returns amid volatile market conditions, according to analysis of a survey conducted by Pensions & Investments and Oxford University.

A clear set of investment beliefs aligned to institutional investors' objectives “gives a logic and coherence to the investment process over time,” said Gordon L. Clark, professor at Oxford University's Centre for the Environment, Oxford, England, who led the survey. “It's an important way of encouraging investment boards of pension funds to be more effective.”

The 2008-2009 global financial crisis “prompted two responses (from institutional investors): One has been to look back at market behavior and patterns for common threads; (the second is) searching for a coherent set of investment beliefs that can underpin (investors') investment strategies going forward,” Mr. Clark said.

“Inevitably looking back informs looking forward; the trick is to be self-conscious about investment beliefs so as not to be seduced by herd behavior and market momentum.”

At the same time, investors are increasingly scrutinizing the investment beliefs of external managers within the selection process (see related story above).

“It's very important to realize that even if you have an investment belief as an owner, there's always an agent who has to act on that belief who probably has a different belief,” said Rob Bauer, professor of finance and chairman of the institutional investments division at Maastricht University, Maastricht, Netherlands. Mr. Bauer, who has co-authored academic papers on investment beliefs, also advises pension funds on formulating investment beliefs and implementing them within an investment process, including manager selection.

About 57% of the 685 asset owners, money managers and investment consultants surveyed by P&I and Oxford said their organizations officially held and used investment beliefs. But 6.5% didn't know whether their organizations even had investment beliefs, while the remainder did not operate within a set of investment beliefs. Individually, however, 87% said they held and used investment beliefs.

If individuals are making long-term decisions that aren't aligned to the skills, capacity and objectives of the organization that employs them, “that could be a recipe for disaster right there,” said Dane Rook, research fellow at Oxford's Centre for the Environment, who analyzed the survey results along with Mr. Clark. Most organizations won't have one unified theory of finance in the way that they view markets. “It's a set of multiple, but comprehensive, beliefs typically,” he added.

In addition, the survey gauged whether respondents agreed, disagreed, remained neutral or had no opinion on 10 investment beliefs. Where appropriate, respondents were also asked what kind of investment returns they expected for strategies based on a particular investment belief.

Respondents most strongly agreed with three of the 10 beliefs:

• “Over the long term, the risk-adjusted returns of public equities will continue to generally outperform those of debt.” About 71% agreed.
• “Long-term investment strategies tend to offer risk-adjusted returns superior to short-term investment strategies.” About 69% agreed.
• “Most asset price volatility is due to investors overestimating the meaningfulness of information in the short term.” Some 60% of respondents agreed.

At the bottom, two investment beliefs garnered 20% or less of the “agree” votes:

• The belief that integrating environmental, social and governance factors generates superior risk-adjusted returns had the lowest percentage agreement — 18% — and the highest percentage disagreement, at 37%. Yet among those who did integrate ESG into the investment process, 66% of the respondents said they met performance expectations and 13% reported outperformance.
• About 20% of the respondents agreed that “over the long term, pursuing primarily passive strategies generates superior risk-adjusted returns.” This belief also had the highest percentage of “neutral” votes, at 38%, and a notable split between money managers and asset owners. Some 52% of the managers disagreed that passive strategies can outperform active ones in the long term, but only 30% of the asset owners disagreed. However, 74% of those who have implemented strategies based on the belief said the portfolio met its benchmark, while 17% reported outperformance.

“We don't seem to have a shared set of beliefs that underpin how markets function or should function,” Mr. Clark said. “So understanding how beliefs are framed and how beliefs are formed — particularly in today's world — is so important both academically and practically.” (Previous research suggests a link between organizations with a coherent set of investment beliefs based on a rigorous review system and improved efficiency in the investment process.)

There were also relatively high percentages of respondents who were either neutral or didn't have an opinion on some of the 10 beliefs surveyed. That could mean many respondents are making investment decisions within “zones of uncertainty,” Mr. Rook said.

“The neutral camp tends to include those who may have actually sat down and thought about (investment beliefs); they're effectively the swing voters. They're the ones that perhaps would dictate long-term market functions once they come off the fence,” Mr. Rook said. “Those who don't know are the problematic part of the market; they're the noise. They're the traders that might react without having any particular forethought on investment beliefs.”

Among other survey results, about 36% of the respondents were neutral on the belief that “contrarian investment strategies tend to generate superior risk-adjusted returns,” while 9% didn't know. Among those who have invested in contrarian strategies, 33% reported their portfolio performed in line with its benchmark while 53% claimed outperformance.

About 30% remained neutral on the investment belief that “diversification across risk premiums, rather than across asset classes, generates superior risk-adjusted returns.” Another 15% didn't know.

Messrs. Clark and Rook said one reason for the relatively high percentage of respondents still sitting on the fence could be the barriers to implementing strategies based on risk factors. “Asset classes are easy to identify, you can tell debt from equity. But actually being able to identify one risk premium to the next is much more difficult,” Mr. Rook said. “It's definitely the more difficult route, but it's also potentially more rewarding.”

Of those who have implemented investment strategies based on this belief, 52% reported that the strategy met its return target while 38% saw outperformance.

The investment belief that “risk premiums drive the bulk of long-term investment returns” received a “neutral” vote among 29% of the respondents, while 6% didn't know. For the belief that rules-based investment strategies generate outperformance, 27% of the respondents said they were neutral and 5% didn't know. And about 23% were neutral as to whether global integration of financial systems has decreased the proportion of easily accessible assets with true long-term diversification benefits. A separate 6% didn't know.

“Investment beliefs help anchor investors to make sense of an uncertain world,”said Carl Hess, global head of investments at Towers Watson & Co. based in New York. In a difficult market, “thinking clearly and doing the right thing arguably become more important. ... Beliefs during a bull market don't really matter as much, since anything you do then will probably work.” (In the survey, investment beliefs were defined as “conjectures and working assumptions about the investment world, including the economy, the financial system, social environment and other risks that inform the underlying investment decision-making.”)

In comparing the coherence level of investment beliefs with the investment horizons of respondents, Messrs Clark and Rook found the longer a respondent's investment horizon, the more organized his/her investment belief system.

“Simply the act of focusing on the long term appeared to prompt a little more introspection about how investment beliefs fit together for the long term,” Mr. Rook said.

There are some beliefs that are more highly correlated with each other, according to the survey. For example, about 70% of the respondents believe there is a public equity premium over the long term and that “long-term investment strategies offer risk-adjusted returns that are superior to short-term investment strategies.”

For the belief that a public equity premium exists, about 7% disagreed, 16% were neutral and 6% didn't know. About 5% disagreed with the belief that long-term investment strategies outperform short-term strategies in the long run, while 21% remained neutral and 4% didn't know.

Simply having investment beliefs is not enough, particularly if market conditions change and certain investment beliefs are no longer valid.

“Not only do (institutions) need to articulate beliefs and interrogate beliefs, they should also return to those beliefs for their coherence and the ways in which experience might undercut or reinforce those beliefs,” Mr. Clark said. “There must be a process to revise beliefs. Otherwise, (investors) face the danger of locking into a suicide mission.”

Holding on to beliefs based on “models that aren't necessarily true in the real world” could have detrimental effects to fund performance, Mr. Hess of Towers Watson added.

“Let's take the strong form of market efficiency,” Mr. Hess said. “We can point to the global financial crisis and see how that belief can go really wrong. If we believe in something very strongly, the danger is that we can collectively get things very wrong, especially when the belief may be based on models that aren't necessarily true in the real world.”

Investment beliefs are also conditional, Maastricht's Mr. Bauer added. “For example, (an institution) may believe that private equity” can deliver superior risk-adjusted returns, he said. “But if the organization doesn't have the necessary due diligence capacity and monitoring capacity, then it might invest in the wrong projects and is not able to reap the benefits of that belief. ... Investment beliefs are very tightly linked to organizational realities.”