International spillovers: It’s mostly in your head

When I was much younger than today, and still enjoyed the benefits of youth like a concave belly, we used to say that when the US sneezes, the rest of the world catches a cold. Today, that still is true, but the same can be said about China – at least if you live in Europe or Asia.

The common explanation for the steeper declines in European asset prices when there was a crisis in the US was the international trade links between Western Europe and the United States. But in 2008, the housing market collapsed in countries like the United States, the UK, Ireland, while Germany or Switzerland had no housing crisis at all. Yet, German stock markets were down more than US stock markets.

In fact, a recent study showed that only about one-third of the spillover from US crises (and I presume Chinese crises) to other countries is explained by macroeconomic ties between countries. The other two-thirds are explained by financial market integration. Countries where institutions and households own a larger share of their wealth abroad and where their assets are held all over the world experience steeper declines in asset prices.

The driver of these steeper declines is quite straightforward. First, when the US economy hits a rough spot economically, US investors think about their investment portfolio. Psychologically, they will reduce their holdings in assets they are less familiar with and that thus appear to be riskier. This means they will keep their US stocks, but sell their foreign stocks. But also, they will tend to sell more of the stocks in countries that are heavily integrated with the US stock market, that is UK, Western Europe, and developed Asia. Why? Because it makes sense. First, these markets are typically the most liquid, so it is easy to sell these stocks at a moment’s notice. Second, because these markets are so integrated with the global markets and your home market, they offer less diversification benefits. Technically speaking, their correlation to the US market is so low that there are diversification benefits to be had, but these diversification benefits are so subtle that for most investors it simply appears as if the correlation between US and European stocks is about 1.0. When the US goes down, so do the UK and Europe. And as a result of this mental shortcut, US investors tend to sell UK and European stocks more than emerging market stocks, for example. And it is this psychological effect that creates a higher correlation and becomes a self-fulfilling prophecy. Because people think European stock markets are highly correlated in a US downturn, they act as if they were and sell these stocks first. And these actions in turn increase the correlation and turn perception into reality.

So the next time something happens on the economic front in the United States of China and somebody tells you that it is all going to be contained because it is a purely domestic problem, make sure you check the list below and look at the financial integration of different countries. The countries with higher financial integration will sell off more, whether that makes sense economically or not.

Financial and trade integration of different countries

Source: Londono (2021)

That’s the point of being active

On Monday I ranted a bit about benchmarking and how it turns businesses and asset managers into mediocre performers. The argument I often hear in favour of benchmarking is that it limits underperformance and the damage done by inferior managers.

On the other hand, in recent years, the evidence has mounted that fund managers generate their performance almost exclusively from their high conviction overweights. 

Average annual outperformance of US equity fund managers net of fees

Source: Panchekha (2019).

So, fund managers have started to create high conviction funds as a way to counteract the trend towards passive investing and closet indexing. But, a new study argues that a key problem for fund managers is that if you reduce the number of stocks in your portfolio you may need a different approach to identifying the right assets and constructing the right portfolio. This is true and I recommend this article as the first stop for those who want to become more active and think about what that means for their portfolios. 

But the study also argues that being active alone is not enough to create outperformance.

No kidding.

That is the whole point about being very active. Both outperformance and underperformance are more accentuated, making it easier for investors to identify which fund managers are doing a good job and which ones don’t. This way the underperformers have fewer places to hide and will hopefully exit the market instead of being able to stay around for years as closet indexers convincing their clients to give them one more chance since the underperformance so far wasn’t that bad and one can catch up in the right environment (which of course is true for a truly active manager but an illusion if the fund is a closet indexer).

If the active fund management industry wants to grow its assets it needs to weed out the unskilled managers that stick around forever and are able to dupe investors year after year. And being highly active makes it harder for the truly unskilled managers to hide and easier for the truly skilled managers to shine.

In my job at Liberum, I run 10 model portfolios with 20 stocks each, so they are highly active and highly concentrated. Yet, since I launched these portfolios in spring 2020, they have outperformed their benchmark by 15% to 35% after transaction costs (and if you are interested in getting these portfolios you have to become a research client of Liberum). Obviously, a track record of 15 to 18 months in my current role is too short to draw conclusions if I am skilled or not, though my previous track record as a fund manager from 2010 to 2016 indicates that this outperformance is no accident. 

Nevertheless, the point is that my highly active portfolios outperform their benchmarks by a wide margin after costs both on an absolute and a risk-adjusted basis. So being very active and running highly concentrated portfolios can add enormous value if done right and will mercilessly expose underperformers. And that’s how active management should be. It should be a marketplace for different opinions where fund managers put their money where their mouth is and where underperformers exit and make room for new entrants trying their luck. In my view, we should all encourage more active management but the tendency to benchmark fund managers does exactly the opposite and thus helps to keep the flows from active to passive funds alive and contributes to the demise of active management. It turns the investment world into a world full of mediocre funds.

Do momentum crashes announce themselves?

Many fundamental investors really don’t like the momentum effect. And to be honest, it does feel a bit like an insult to one’s intelligence that after all the hard work of fundamental analysis, one can just go out and buy the stocks that have gone up in the past and buy them it will be fine.

But one criticism of momentum investing is that it is extremely prone to momentum crashes, that is sudden massive downturns that are much worse than what the market experiences at the time. In November 2020, we experienced such a momentum crash after the news of a successful vaccine trial broke, and in spring 2009 when the Fed stopped mark-to-market reporting of liabilities on the balance sheets of banks we had a similar-sized momentum crash. In each of these cases, momentum investors lost several years of outperformance vs. the market in a month or two which is why momentum investing is sometimes compared to ‘picking up pennies in front of a steam roller’.

But what if the steam roller announces its arrival with a loud siren and there was a simple way to get out of its way when it comes too close? That is what a new paper from the University of Münster in Germany suggests. The researchers did something quite simple. They looked at the typical momentum factor (WML for ‘winners minus losers’) which is constructed by buying the stocks with the highest returns from 12 months to one month ago and selling stocks with the lowest returns over the same time period. Then they split this time period into two different periods that vary for each stock. They simply looked at the returns from twelve months ago to the peak share price over the last twelve months (HTP) and the return from the peak share price to the share price a month ago (PTH). And then they sorted stocks based on these two measures and formed the usual momentum portfolios based on them.

The result was stunning. The portfolios formed on the HTP momentum factor not only had a better performance than the traditional momentum factor but showed much fewer momentum crashes. In fact, during the 2009 momentum crash, the HTP portfolios had no drawdowns at all. Most of the stocks that crash seem to be captured by the PTH factor, indicating that before they crash many momentum stocks already stop their advances and start to decline from recent peaks. And by eliminating these stocks from the momentum portfolio investors can drastically reduce the probability and severity of momentum crashes. We need to better understand the causes for this effect but it seems to me that this could be a worthwhile avenue for research since markets often seem to ‘smell a rat’ when they see one.

Avoiding momentum crashes with a simple twist to the momentum factor

Source: Büsing et al. (2021). Note: MKT is the excess return of the US stock market over 3M T-Bills, WML is the return of the traditional momentum factor, HTP is the return of the momentum factor based on historic returns to peak share price, PTH is the return of the momentum factor based on historic returns from peak share price to last month’s share price.

Benchmarking has become circular

Note: This article originally appeared in the CFA Institute Enterprising Investor blog on 18 August 2021.

Time and again throughout my career I have ranted about the nonsense of benchmarking in all its forms. By now I have given up on the hope that we will ever leave benchmarking in business or investments behind, so I don’t expect this post to change anything except to make me feel better. So, indulge me for a minute or come back tomorrow…

I had a conversation recently with a friend about an organisation that we are both intimately familiar with and that has changed substantially over the last couple of years. In my view, one mistake the organisation made was to hire a strategy consulting firm to benchmark the organisation to its peers. Alas, the outcome of that exercise was to be more like their peers in order to be successful and as a result the organisation engaged in a cost-cutting and streamlining exercise in an effort to increase ‘efficiency’. And guess what, thanks to that effort many people now think that what made that organisation special has been lost and they are thinking about no longer being a customer of it.

The problem with benchmarking a company against its peers is that it is typically the fastest way into mediocrity. Strategy consultants compare companies that have a unique culture and business model to its peers and tell these companies to adopt the same methods and processes that made their peers successful in the past. But benchmarking a company that is about to change the world is outright stupid. In 2001 and 2002 Amazon’s share price dropped 80% or so. If Jeff Bezos had asked McKinsey what he should do, they would have told him to be more like Barnes & Noble.

Name a single company that has turned around from being a loser to a star performer or even changed the industry it is active in based on the advice of strategy consultants…

Or as Howard Marks put it so clearly: “You can’t do the same thing as others do and expect to outperform.”

Which brings me to investing, where pension fund consultants and other companies have introduced benchmarking as a key method to assess the quality of a fund’s performance.

Of course, if you are a fund manager your performance needs to be evaluated somehow, but why does it have to be against a benchmark set by a specific market index? The result of being benchmarked against a specific index is that fund managers start to stop thinking independently. Having a portfolio that strays too far from the composition of the reference benchmark means that a fund manager creates career risk. If the portfolio underperforms by too much or for too long, the manager gets fired. So, the result is that over time, fund managers invest in more and more of the same stocks and become less and less active. And that creates herding, particularly in the largest stocks in an index because fund managers can no longer afford not to be invested in these stocks.

Ironically, by now, the whole benchmarking trend has become circular because benchmarks are designed to track other benchmarks as close as possible. In other words, benchmarks are by now benchmarked against other benchmarks.

Take for instance the world of ESG investing. Theoretically, ESG investors should be driven not just by financial goals but also by ESG-specific goals. So their portfolios should look materially different from a traditional index like the MSCI World. In fact, in an ideal world, ESG investors would allocate capital differently than traditional investors and thus help steer capital to more sustainable uses.

So, I have gone to the website of a major ETF provider and looked at the portfolio weights of the companies in its MSCI World ETF with the weights in its different ESG ETFs. The chart below shows that there is essentially no difference between these ETFs, sustainable or not.

Portfolio weights of the largest companies in a conventional and several sustainable ETFs of the same provider

Source: Bloomberg

The good thing about this is that investors can easily switch from a conventional benchmark to an ESG benchmark without much concern about losing performance. That helps getting institutional investors to switch.

But the downside is that there is little difference between traditional investments and sustainable investments. If practically every company qualifies for inclusion in an ESG benchmark and then has roughly the same weight in that benchmark as in a conventional benchmark, then what’s the point of the ESG benchmark? Where is the benefit for the investor? Why should companies change their business practices when they will anyway be included in an ESG benchmark with minimal effort and don’t risk losing any of their investors?

ESG benchmarks that are benchmarked against conventional benchmarks is like benchmarking Amazon against other retail companies. It will kill Amazon’s growth and turn it into another Barnes & Noble.

Hold my beer

CEOs aren’t the kind of people that are commonly known for their humility. Instead, many CEOs are type-A personalities who are extremely competitive. But in some instances, competitiveness can go too far and CEOs in an effort to outdo their peers start to make poor decisions. It’s the classic ‘hold my beer’ moment, where one CEO sees some other guy do something stupid and then decides he can top that.

Nowhere is this reaction more dangerous than at the high stakes game of M&A. The sums involved are large and the impact on a company’s fortunes equally so. Yet, because these are events that often attract a lot of media attention, the temptation to outdo your peers is extremely high for some CEOs. So, instead of acquiring smaller companies that may be a better fit to an existing business and can more easily be integrated into the existing corporate structure (and adopt the existing corporate culture), they are going for fewer but larger mergers and acquisitions. That might end well, just as sometimes a drunk at a bar says ‘hold my beer’ and then performs some amazing feat. 

But usually, giving a CEO a lot of liquidity to spend on M&A is like giving a drunk a barrel of beer. You know exactly what is going to happen, you just don’t know which wall he is going to hit.

Examining 751 takeovers in the UK by 202 CEOs between 2007 and 2016, Tom Aabo and his colleagues showed that some CEOs are prone to making fewer but much larger acquisitions for their firms than others. The humbler CEOs made on average three acquisitions during these ten years, each worth about £57m. The high stakes CEOs, on the other hand, made on average one acquisition worth about £351m.

By pursuing these larger takeovers, these CEOs may strike their egos but create costs for shareholders because the share price reacts much less favourably to these large takeover bids than to smaller ones. On the day of the announcement, the large takeovers on average lead to an abnormal share price increase of 0.6% while the smaller takeovers lead to an abnormal share price increase of 2.7%. and because the CEOs who acquire larger targets do so less often than the CEOs who acquire smaller firms, this effect accumulates over time and leads to a better share price performance for companies that make smaller, less costly acquisitions.

So, who are these CEOs that go for fewer but larger acquisitions? How can we identify them as investors? And how can directors of a company identify them in order to limit their acquisition budgets to avoid destroying shareholder value?

In the above-mentioned study, the CEOs that went big were the ones that showed more signs of narcissistic behaviour. And while the study measured narcissism in different ways all of which had similar outcomes, one easy way to measure it is to listen to the CEOs during earnings calls (or rather, analyse the transcripts of these calls). Narcissistic CEOs use more personal pronouns that point to them like ‘I’, ‘my’, ‘mine’ than personal pronouns that point to a group or other people. The higher this ratio of first person personal pronouns to all personal pronouns is, the more likely it is that a CEO will try to engage in dumb outsized acquisitions that will lead to lower shareholder value.

CEO personality and takeover activity

Source: Aabo et al. (2021)