A new chapter in the history of investing


By Fazila Manjoo
Head of Research at STANLIB Index Investments

“The only constant is change” – Heraclitus

The world of investing has changed since the 2008 global financial crisis, just as it has through history. To understand this evolution one can look at how perceptions have changed over the last half-century.

In the early 1970s it was becoming increasingly known in the financial press that most investment funds were not beating market indices. Burton Malkiel published academic research in 1973 titled “A Random Walk Down Wall Street”, on the failure of mutual funds to beat the market. The response to him was “So what? You can’t buy the averages.” Malkiel thought it was time the public could. A year later, John Bogle founded the Vanguard Group, now the largest mutual fund in the United States. When Bogle started the First Index Investment Trust in 1975, it was ridiculed by competitors who even called it “un-American”.

At the time, most investment mandates were balanced mandates, with investments allocated to a single fund manager that held assets across different asset classes. This was the traditional form of diversification, where keeping your eggs in different asset class baskets (like equities, property, government bonds and global investments) were thought to smooth out investment returns over time.

Over the two decades that followed the scope of investing changed with regulations on retirement funds and the rise of the investment consulting industry. It was argued that allocating money to a single investment manager exposed investors to a high degree of manager risk, the risk that the manager performs poorly, and multiple balanced fund mandates were increasingly used. Investments were benchmarked to liabilities, and against broad market indices or peer groups to assess performance. Index tracking portfolios that had been ridiculed and strongly opposed in the past gained momentum and affluent retail investors in the market were able to venture further away from single strategies into specialist portfolios.

In the 2000s the global economy was shaken by two of the four worst bear markets in history. The sell-off in global markets in 2008 hit everyone indiscriminately. Traditional forms of diversification that worked in the past did not work when it was most needed. It turned out that asset class correlations were less stable than investors had realised. Using multiple investment managers also demonstrated inadequate diversification and poor protection from market volatility.

Unconventional monetary policies since have resulted in conventional investment wisdom being challenged. The consequences of central bank interventions has been a challenging investment environment with random “risk-on” and “risk-off” cycles, increased market volatility, and negative real yields. It isn’t surprising that the biggest changes we have seen since the last global financial crisis have been centred on risk.

 

The growth of investment vehicles and tools
Figure 1: The growth of investment vehicles and tools

 

 

Challenging investment environments have encouraged investors to use new vehicles like smart beta funds and exchange traded funds (ETFs). Smart beta funds, also called factor funds, are used to capture risk factors and market inefficiencies in a transparent and rule-based manner. A risk factor is simply the underlying exposure that drives the returns of an asset class. Typical examples of these are strategies that weight towards value (cheap) stocks, stocks with momentum, quality stocks or stocks that exhibit low volatility. ETFs are securities that are traded on an exchange that track a basket of assets, like an index fund of stocks, bonds, commodities, or a smart beta fund. An example of an ETF is the Stanlib Top 40 ETF that tracks the performance of the FTSE/JSE Africa Top 40 index.

Old methods of portfolio construction, like the core-satellite model, have been refined to include new investment vehicles. Another tool used is diversification by risk factor, where the aim is to reduce risk by combining assets on the basis of factors that drive market returns. Examples of risk factors include equity risk (like value and low volatility), interest rate risk (duration), credit risk (spread duration), currency risk (FX exposure), and momentum.

With these vehicles and tools investors now have a richer investment opportunity set that they can use to cope with changing market environments. In some circumstances new approaches have complemented the old ones. The choice of approach will vary among investors depending on their circumstances and desired outcomes.

A new chapter

The financial crisis of 2008 started a new chapter in the history of investing. While old approaches continue to exist, new investment vehicles and tools have emerged that have the ability to deliver different investment outcomes. The biggest changes we have seen have been centred on risk. The normalisation of global monetary policy is likely to be a lengthy rollercoaster affair that favours risk-based strategies. Conventional ways of investing worked in benevolent market environments of the past. Those conditions are unlikely to return in the foreseeable future while politics and central bank interventions fuel markets and random “risk-on” and “risk-off” cycles.

Investors now have richer investment opportunity sets to target returns and cope with volatility than ever before. The growing importance of these approaches is indicative of the prevailing investment environment. As the decade progresses, further advances in computing and technology will improve the efficiency of these strategies and ensure their continued relevance.


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