American research provided guiding principles for success in markets.
As the Scottish oil and gas community converges on Houston for the annual OTC show, it is perhaps appropriate to reflect on what the US has brought to the world of investment.
We owe a lot to our cousins across the Atlantic, as the vast majority of the leading academic work on this topic has come out of US universities.
Over the last 60 years, the collective body of work has resulted in many of the authors collecting Nobel prizes for their innovation.
At Carbon, we use this research to support our evidence-based approach to portfolio construction. As far back as 1952, an article by Harry Markowitz introduced what became known as the modern portfolio theory (MPT). Among other things, the theory stated that blending assets in a portfolio – i.e. diversifying – helps reduce the overall level of risk within the portfolio.
MPT is still often quoted in investment circles and forms a cornerstone of many portfolios. He also proposed that investors were naturally averse to taking risks.
In the late 1950s, a publication by Merton Miller and Franco Modigliani proposed that the cost of capital for business was essentially the same as the expected return for investors, based on the premise that riskier businesses have to pay more to raise capital than less risky businesses, so investors in the riskier business should expect and deserve a higher return for bearing this additional risk. More commonsense perhaps and this principle prevails.
In 1964, William Sharpe published the capital asset pricing model, a single-factor model which defined risk as volatility relative to the market. The Sharpe Ratio remains a key ratio used by fund managers in the measurement of risk-adjusted returns.
Eugene Fama published The Efficient Markets Hypothesis in 1966. After extensive research into stock price movements and patterns this stated that prices reflect information accurately and quickly, therefore to capture returns in excess of the market you need to take additional risk. In spite of this, much of the investment industry chooses to ignore this, instead preferring to devote vast resources to attempting to forecast the future.
The first major study of mutual fund performance was published in 1968 by Michael Jensen. This indicated that active managers underperform indices and was followed by the creation of the first index tracking funds in 1971, when two US banks developed S&P 500 trackers.
Since this time the body of evidence has grown exponentially in support of this conclusion, yet the advisers remain obsessed with the futile exercise of fund picking.
Nineteen years ago, Eugene Fama and Chicago University colleague Kenneth French published The Three Factor Model; work that developed Sharpe’s single-factor pricing model and proposed that three factors – market, size and value were the predominant factors in stock returns.
In other words, almost all of the return in your fund or portfolio is as a result of how much money is invested in the stock market and specifically how much you have invested in small and value companies.
Other risks are simply not worth taking as they don’t reliably add anything in terms of return. What we have learned from this vast body of American research and empirical evidence is that picking fund managers doesn’t work, that forecasting markets is folly and that the best way to capture the returns you deserve from the risks you take is to buy into markets at minimum cost, introduce a bias towards small and value companies and don’t trade.