Whenever Charles Ellis writes, I take notice. His classic book “Investment Policy: How to Win the Loser’s Game“ was for me the definitive eye opener. Starting out in the investment industry, managing mandates while working through several investment courses, the central ideas hinged on portfolio optimization, efficient frontiers and new innovative instruments. The implicit paradigm: let investment managers do their work, it’s after all a very technical business and client satisfaction eventually follows. Charles Ellis was – and still is – one of the authors who redresses the roles. He writes from the viewpoint of the client, who owns the responsibility for formulating and assuring implementation of investment policy. Truly understanding his own objectives, the characteristics of the financial markets, and work out this knowledge in investment objectives that should be pursued in a disciplined manner. Sounds elementary, but failing to do so haunted pension funds considerably over the past years. Continue reading
Interesting interviews with Daniel Kahneman were recently posted, about prospect theory and other key developments in behavioral finance.
According to Thayer Watkins, Daniel Kahneman and Amos Tversky coined the phrase “Prospect Theory” for their studies of how people manage risk and uncertainty, “for no other reason than that it is a catchy, attention-getting name”. Kahneman and Tversky demonstrate that people’s attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. When choosing between profit opportunities, risk aversion prevails. On the other hand, when confronted with loss making alternatives, people often choose the risky alternative. Although prospect theory is a few decades old, there is still plenty of ground to be covered for pension fund and institutional investors. Just some hypotheses based on prospect theory that need to be explored:
- An active manager with positive alpha will become risk averse, locking in his profits, while the opposite is true with negative alpha. If this this is the case, then prospect theory is a more intuitive explanation of the disappointing results for active managers. In the selection and monitoring of active management this should be a key element.
- Pension fund trustees, when confronted with underfunding, will increase their risk instead of downscaling it. It would therefore make sense to make the risk budget for a pension fund board rules based, with an inverse relationship between cover ratio and risk budget. This is however still the exception, rather than mainstream.
If you have more suggestions on how to fruitful explore prospect theory for pension funds, please let us know!
One of the key messages of the book Investment Beliefs that Kees Koedijk and I wrote, was the importance to articulate your views on how financial markets work. However much we’d like it to be, investing is not a hard science, and academics bicker over the most fundamental tenets of portfolio management. This shifts the burden to investment managers and trustees who simply have to make choices and formulate their beliefs on how the markets work. In our book, we covered beliefs such as risk premia, investment horizon, sustainability, costs, risk management. This is not a complete list. Markets develop, innovate and shed old ideas. Once you start thinking about beliefs that dominate the investment debate, the list tends to grow. Continue reading
Stress testing with scenarios is in vogue. The Financial Times reported that European banking regulators plan to introduce a tougher stress test process as part of a new mechanism to force recapitalizations of banks. How useful is the tool for pension funds? Continue reading
After long deliberations between trustees and their investment managers, the choice is finally made to select manager GoodInvest* to manage the fund’s emerging market equities. The investor relations department has its work cut out. Continue reading