Transforming personal finance since 2011

#61 — Two Finance Professors Explain Why our "Tortoise" is Winning


March 25th, 2020

By Andrew Craig

Reading time: ~ 7 minutes

Today's article is a departure from the norm' in that it has been contributed by two guest authors.

I am delighted and more than a little honoured to be able to share the following piece about the strategy that informs our Fund, written by Professors Andrew Clare and Steve Thomas of the Cass Business School in London. To tell you a little bit about the two of them:

Andrew is the Professor of Asset Management at Cass and the Associate Dean for Corporate Engagement. He was previously a Senior Research Manager in the Monetary Analysis wing of the Bank of England supporting the work of the Monetary Policy Committee (MPC) and the Financial Economist for Legal and General Investment Management (LGIM) prior to that. Andrew is co-author of “The Trustee Guide to Investment” and in a survey published in 2007, was ranked as the world's ninth most prolific finance author of the past fifty years. He serves on the investment committees of corporate pension schemes worth several billion pounds.

Steve is Professor of Finance at Cass and Associate Dean of their MBA programme. He is a member of the editorial board of the Journal of Business Finance and Accounting and in a 2006 review was ranked 11th in Europe for finance research. Since 1988, He has been consulting editor of a range of credit publications for the FT and Interactive Data. Steve is also an examiner for the Investment Management Certificate of the CFA UK and author of the accompanying Official Training Manual - that is to say that he is one of the people who sets the exams for a decent chunk of the UK finance industry!

I am incredibly grateful that they have taken the time to pen the article that follows. I hope you find what they have to say interesting and instructive, particularly at such a difficult time for markets...


Investing in the short- and long-term:  The science which guides our strategy

Professors Andrew Clare and Steve Thomas

Since the abject failure of conventional investment portfolios in the Great Financial Crash of 2008-10, we set about rethinking how to help people create cheap, effective protection against severe market falls, while at the same time offering the prospect of earning reasonable longer-term returns.

A defining moment for us was the realisation that the 30% or more losses on so-called ‘Absolute Return Funds’ (meant to protect wealth) were an abuse of the English language… Similarly, at that time the increasingly popular Target Date Funds, which reduce the percent of shares in your portfolio as you approach retirement and so deliver a (not guaranteed) hopefully "target amount" of money on a particular date, also lost large quantities in the year prior to the targeted retirement (Don Ezra's book "Retirement" tells us this was around 30% for the biggest three Target Date Funds in the US).

Such funds are still being recommended by advisers on a large scale in many countries. The research evidence is increasingly challenging the efficacy of this retirement solution.

Was there an alternative to the above (failed) approaches? With colleagues we researched and published a series of articles on a particular method of "smoothing" returns and hence avoiding falls of more than about 10% from previous highs. This method has been successful for a wide range of investment classes, particularly equities and commodities, across many countries and historical time periods.

As is clearly explained in the VT PEF Global Multi Asset Fund overview documentation, the mechanism involves switching part or sometimes all of the portfolio into cash or an equivalent risk free asset, when the price of an asset enters a systemic downward movement, and reversing out of cash and back into the asset when the asset price starts rising.

This protects against big falls and facilitates earning positive returns when sentiment changes and markets rise. Most importantly it requires investors to follow well-tested, pre-set rules and to stick to them through all stormy conditions. This is difficult for investors who are predisposed to all sorts of human biases and psychological frailties… such as herd investing (following the leader!), anchoring (letting arbitrary numbers such as the price you paid for a share enter your decision-making, or regret (your reluctance to accept losses and sell an investment for a price below which you bought it) and so on. All of these affect investor decision-making in a potentially harmful way.

Quite simply we know that investors tend to "buy at the top" and "sell at the bottom"… how can we resist these natural human "failings"?

The answer lies in investing using very well researched rules rather than letting discretion by individuals (i.e. us or fund managers) take over. It lies in ignoring the clamour for "glamour" themes and high profile managers - as the recent past has proved a painful classroom for retail investors!

And all this is underpinned by real scientific advances from psychology and the associated behavioural sciences. Possibly the greatest advance in investment insights of the last thirty years has been this integration of psychology and finance in the form of Behavioural Economics, which identifies and investigates the biases mentioned above.

As a result of this work there is a strong strand of thinking that in many walks of life following simple rules beats the results obtained from "experts", and this includes studies in the legal system, education, medicine, and, we believe, investing. Many of you will be familiar with Thaler and Sunstein’s wonderful best-selling book "Nudge".

There are over one hundred and fifty empirical studies comparing experts and rules in these contexts. In every case the "rules" win. Why? Because experts have human biases and these are so hard to overcome! This includes the observation that we tend to think that more research and information is better than less in this context: And this is incorrect.

Only a fund such as the VT PEF Global Multi Asset Fund has such rules embedded to take away the temptation of overriding the investing decisions and interfering in the process!

And also, very importantly, the VT PEF Fund does not trade too often as many high-frequency hedge funds (CTA’s) do - often as much as several times a minute… Comprehensive evidence shows that "over-trading damages your wealth".

Conventional failures…

Below we show the fall in the fund so far this year versus the UK and US stock markets and, crucially, the upside required to get back to break even that these falls imply.

It is also worth highlighting that, based on historical data, all the traditional investment structures such as target-date funds, mixed equity / bond portfolios (e.g. 40/60, 60/40 and 80/20) and risk parity portfolios (target volatility), have failed together. Risk parity portfolios suffered their worst week ending March 13th since 2008, down nearly 10% in just a week.

Source - Plain English Finance / Valu-Trac. Data as at 24/03/2020. Past performance is not a reliable indicator of future performance

Looking forward with optimism and a short history lesson

The success of Plain English Finance-type strategies lies in both diversification across asset classes but also in switching to cash as markets retreat. The first lesson of finance is that "diversification is the only free lunch…"

Today the VT PEF Fund is already over 60% in cash or risk free assets, and thus well-protected against any further drift into bear market territory. Those who advocate staying in assets through thick and thin - such as the big global index investors and the "always passive" crowd - are now advocating closing stock markets! There is a much better way - the ‘"smoothing" we advocate here which is found in the VT PEF Fund.

We do not believe in attempting to forecast either economies or asset returns but recognise with growing confidence that today’s pandemic world is unlikely to see durable "bounces" as has happened in (very) recent history where central banks support the risk appetite. Hence such protection should be more valuable than ever (unfortunately for many!). All the central bank and government stimulus will be great for morale but cannot turn house-bound folk into rampant consumers again sadly!

Not many investors realise that even in a prolonged recession, depression or crash there are substantial cycles in asset prices and techniques such as those employed in the VT PEF Fund will allow investors to benefit from these upswings and the relative opportunities given by the downswings…

In our original research in this area a decade, ago we discovered that investors in the S&P500 in the 1930’s in the USA could reap substantial positive returns by using simple rules to move in and out of the stock market. The same was true for Japanese equities in the 1990’s.

For us, using these simple rules, gives investors the opportunity to both protect wealth and see real growth over the medium to long-term.