Beware of ‘investment catnip’
Commentary
In both bull and bear markets, institutional
and individual investors and their advisers
search for investment ideas with the
potential to increase return, decrease risk
or both. They feel a responsibility or need to
consider ideas to improve their portfolios.
or alluring investment idea that is hard to
ignore, but ultimately offers no long-term
benefit. A lot of smart people fall for
investment catnip, in part due to biases
identified in behavioural finance research,
including loss aversion and overconfidence.1
While not all new investment ideas lack
merit, too often these innovations address
a current need or represent a ‘perfect
answer’ to the challenges of the recent
past. Typically, these solutions seek to
help control risk in a volatile bear market
or capture more of a bull market. In
assessing these opportunities, investors
can help themselves by developing a
sound understanding of the assumptions
driving an investment idea and avoiding
emotional decision making based on
projecting historical outcomes. This is
especially true during the heat of a
market bubble or retreat when emotion
can take over. During these periods,
investors can struggle to discern between
real ‘innovation’ and ‘investment catnip’.
‘Investment catnip’ refers to a compelling
This paper is meant as an honest warning
and cautionary note to investors, designed
to build awareness by sharing some
examples of great ideas that didn’t work out
and suggest where the catnip may be
lurking in today’s investment market.
We conclude that investors can avoid
investment catnip by:
• remaining disciplined about adhering to
a clear definition of success: What are
you trying to achieve and why? What are
the implications/costs of failure?
• identifying and assessing the drivers of
performance: Why should it work? When
won’t it work? Is it time-period or
market-condition dependent?
1 For a concise summary of behavioural finance, see: Behavioural Finance: Understanding how the mind can help or hinder
investment success, by Byrne and Utkus, Vanguard Asset Management, 2010.
This document is directed at professional investors only as defined under the MiFID
Directive. Not for Public Distribution. It is for educational purposes only and is not a
recommendation or solicitation to buy or sell investments.
Author
Jeff Molitor, Chief
Investment
Officer, Europe
Know your goals
As Lewis Carroll wrote, “If you don’t know
where you are going, any road will take
you there”. If you don’t have a clearly
defined definition of success and guardrails
to keep you on track, any concept that offers
potentially higher returns or potentially lower
volatility may appear worthwhile. Ultimately
investors should strive to have a clear
understanding of the risk and return
characteristics that are appropriate for a
given pool of assets. In other words, what
returns do they need to achieve over a given
period and what risks are they willing, or
unwilling, to take?
Some questions you might want to ask
when considering a new type of investment
strategy include:
• Do you really understand it?
• What drives the return?
• Does it sound too good to be true?
• Why is a given strategy likely to succeed
in the future?
• Under what circumstances could it fail?
• What implicit assumptions are you making
to believe that this approach will work?
• Talented manager?
• Market inefficiency that can be exploited
(and may disappear over time)?
• Have you challenged your assumptions to
help ensure that you are not basing your
analysis on misconceptions or behavioural
biases?
• Does your organisation have the talent
and capability to implement this strategy,
either directly or by selecting and
monitoring third-party managers?
This paper offers a retrospective review
of some investment innovations that
ultimately proved to be catnip. All of these
strategies / concepts held great appeal for
very plausible reasons, but all suffered from
flaws that led to investor disappointment.
From reading this review, readers will
hopefully have a greater ability
to differentiate between ‘investment catnip’
and a true innovation worth pursuing.
130/30
• Concept – Give a capable equity team (or
a quantitative model) the flexibility to use
its full range of capabilities in evaluating
and selecting stocks. Specifically, allow
the team to hold 30% more of the
portfolio’s assets in stocks believed to
have strong relative upside potential and
short 30% of assets believed to have
significant relative downside potential.
• Allure – This concept offered the promise
of higher returns and a more efficient
portfolio. Investors looked to gain an
additional 30% of alpha on the upside
bets and an additional 30% on the
shorts – all without gearing the portfolio.
For a number of institutional investors,
the prospect of 60% more value added
without additional volatility appeared too
good to miss. An environment of
widespread acceptance and positive
reinforcement also played a part. 130/30
strategies featured as a prominent topic
at numerous conferences, received
broad positive coverage in the trade press
and were endorsed by many consulting
firms. The strategy offered an approach
typically found in hedge funds, but – while
more expensive than traditional long-only
funds – at a discounted price vs. a true
hedge fund.
• Outcome – Few providers generated the
alpha expected from their models’ backtested results. Many of the approaches
used were based on models that had a
value style bias. When many quantitative
models lagged in the latter part of the
last decade, investors in 130/30
portfolios lost twice – the additional long
positions lagged the short positions,
creating a negative alpha generation
machine. As a result, investors paid a
higher fee than a traditional long-only
portfolio for worse results.
Portfolio insurance
• Concept – Developed by highly
respected professors at the University
of California Berkeley, the strategy
synthetically replicated owning a ‘put’
option on a portfolio. It allowed investors
to increase exposure (or allow their
allocation to grow out of proportion) to
‘risk assets’ (e.g., equities) above long
term targets, while they rose in value.
The exposure would be unwound as the
relative performance of stocks weakened
and could be stopped out when desired.
• Allure – Many pension officers and fund
committees found this approach highly
alluring as they believed it could boost
total returns without additional risk,
allowing them to appear strong relative
to peers. Portfolio insurance appeared to
offer a win-win scenario.
• Outcome – The approach assumed
and required continuous, liquid markets.
However, the pressure to sell shares
held in portfolio insurance programmes
caused stocks to ‘gap down’ on
October 19, 1987. Managers of portfolio
insurance programmes could not reduce
their clients’ equity positions quickly
enough. With lots of sellers and few
buyers stepping up, investors could not
move into the safety-net of bonds, as
they had anticipated. As a result,
portfolio insurance fell apart and
contributed to the 1987 crash. The
promised free lunch failed to materialise.
Funds of hedge funds
• Concept – Sophisticated, well staffed
endowments such as Yale had earned
the admiration of many investors for
their successful diversification into
‘alternative assets’ including hedge
funds. The successful selection of top
quality hedge funds helped top flight
endowment and foundation pools to
earn attractive returns with lower
volatility than if they had used
conventional long-only portfolios.
Smaller institutions and individual
investors were eager to find a way
to participate in a strategy that offered
attractive returns and a low correlation
with stocks. Lacking the staff and talent
of the top endowments, smaller and less
sophisticated investors needed to take
a different path to get exposure to a
diversified array of managers.
• Allure – Smaller institutions would have
the benefit of a professional team able
to evaluate, select and monitor hedge
funds, allowing them access to expertise
they didn’t have in house.
• Outcome – Investors made the mistake of
accepting assertions that ‘hedge funds’
represented an asset class. In reality
hedge funds represent a collection of
active strategies with no inherent returngenerating mechanism as there is with
equities, bonds and cash. In addition,
many of the hedge fund ‘packagers’ were
better at selling the concept than they
were at analysing and selecting managers.
Adding their own fees (e.g. 1% of assets
and 10% of gains) on top of the
managers’ robust charges (e.g. ‘2 and 20’)
left very little for clients. The mix of
managers was not nearly as diversified or
as uncorrelated to equities as portrayed.
In the end, only a limited universe of fund
of hedge fund managers earned their
keep, while some turned out to be
nothing more than Ponzi Schemes.
Momentum
• Concept – At least once in every
generation we see a period when a single
concept captures investors’ attention.
One element these concepts have in
common is recent historical success; they
outperformed just about every other idea.
The early participants typically earn
outsized returns and those who were not
in the early group look to see if the
concept ‘has legs’. No investor likes being
on the outside looking in. In virtually every
case, there is apparently an attractive
basis to rationalise or justify why this
investment idea is likely to be sustainable,
if not enduring. The early 1970s had the
‘Nifty Fifty’, a collection of companies
deemed to be so strong that they were
considered to be ‘one decision stocks:
buy and hold forever’. Twenty five years
later, technology stocks were all the rage,
as the companies in this sector were
considered to be at the leading edge of a
powerful new era in communications,
retailing and other disciplines. From 20012007, mortgage backed securities
appeared to offer a wonderful,
sustainable, low-risk yield advantage.
• Allure – For institutional and retail
investors, it can be very difficult to avoid
being unsettled by questions such as
“What have I missed? What do they
know that I’m missing? What if I am
wrong by avoiding .... ?” The reality is that
all good investors exhibit a sense of
humility and a willingness to question
their own assumptions. What’s more, as
these concepts continue to outperform, it
becomes more difficult for investors to
resist the temptation.
• Outcome – From the era of Holland’s tulip
bulb mania in the late 16th century
through to the current day, momentum
trends end badly. The collapse of the Nifty
Fifty in 1973 - 74, the ‘tech wreck’ in 2001
and the start of the global financial crisis
in 2007 all bear witness to the cost of
joining momentum trends. Once again,
the discipline of focusing on why an idea
may work is far more important that
looking at what it has done.
Portable alpha
• Concept – Derivatives can be used to
harvest the alpha, e.g. the fund manager’s
security or asset class selection skill,
independent of market beta, be it positive
or negative. In other words, it attempts to
separate a manager’s selection skill from
changes in the underlying market by
hedging away the beta.
• Allure – The strategy promised to deliver
positive returns regardless of market
conditions. By hedging away market
exposure, the alpha generated by a
skilled fund manager could be harvested
whether markets were positive, negative
or just volatile. For example, if a given
market returned -8.5% for a given year,
but the fund manager returned -7% after
costs and had sold futures in the
underlying market at the beginning of the
year, the portfolio would return 1.5%.
the past can predict return, volatility and
correlations. Historical Sharpe ratios are
terrific at illustrating what worked over a
given period of time in the past.
Unfortunately, markets and environments
shift, so what may have worked in a
given time period may not work well at
all in subsequent periods. Many who
used the ratio to pick investments,
managers, or strategies paid a price for
assuming that tomorrow would be like
yesterday.
• Outcome – The results were mixed at
best. When the managers were wrong,
the magnitude of the error was
significant due to the gearing involved. In
fact, there really wasn’t a set of
managers able to add value. There was
no alpha ‘sitting in the corner’ waiting to
get ported onto a stock or bond
exposure.
Absolute return portfolios
• Concept – Investors should be far more
concerned with generating a consistent
absolute rate of return than strong
relative results. Since broad asset
classes can go up and down, investors
are better served with portfolios that
will exhibit reasonable results regardless
of the investment climate.
Sharpe ratio security selection
• Concept – A cornerstone of modern
portfolio theory is the concept of
maximising return per unit of risk. In
fact, Bill Sharpe won the Nobel Prize
in economics for his work. Moreover,
there is a clear intuitive appeal to the
concept of receiving the best reward
for the risk taken.
• Allure – In the aftermath of the 2008-9
financial crisis, the attraction of portfolios
and portfolio strategies that somehow
could have steered a smoother course
than traditional portfolios during the
crisis was significant. The potential to
withstand market shocks was a key
criterion for many investors.
• Allure – The Sharpe ratio is easily
calculated based on historical return.
It is simple and easily understood
because it can be used to create a clear
ranking. The name also resonated with
investment committees.
• Outcome – The Sharpe ratio was never
designed as an investment selection
tool. Using historical data implies that
• Outcome – While some strategies
delivered, very few portfolios provided
the promised safety and an ability to
serve as ‘all weather’ strategies. There
simply aren’t tools (or enough insight
into the future) to allow managers to
see around corners and hold the ‘right
portfolio’. In simple terms, most
providers of absolute return portfolios
over-promised and under-delivered.
Avoiding catnip
It’s much easier to identify ‘catnip ideas’
after you’ve been burned by one than at
the time. Too often, investment decisions
are overly influenced by an idea’s concept
and allure – often dictated in part by how
successful it was in a recent period. The task
for investors is to look beyond the flash and
allure and focus instead on a thorough
assessment of what made the strategy work
before and why it may or may not work in
the future.
For any investment opportunity, it is vital
to start with a clear, unbiased vision of
where you stand (e.g., assets vs. liabilities
or spending commitments, ability to accept
volatility, capability to identify investment
talent, ability to assess ideas) and how you
define ‘success’. After all, pools of
investment assets only exist to meet a
future need.
Each portfolio should have a clear definition
of success, such as funding a pension plan in
a given time period, or providing an enduring
operating stream for an endowment. In
assessing new proposals, start by asking
how an idea would help or hinder the odds
of achieving success.
One of the clear examples of the risk of
not clearly defining success was the
historical reluctance of many DB plans to
adopt an ALM (asset liability management)
strategy. Many US DB plans suffered from
the Lewis Carroll dilemma as they failed to
define success in terms of a clear
investment outcome measured against the
plan’s liabilities. Instead, many focused on:
• Maximising absolute return to stay above
the plan’s assumed rate of return; or,
• Wanting to stay close to a ‘peer group’
of pension funds.
In reality, the only reason a DB pension
fund exists is to fund a set of liabilities.
There is no upside to not minimising the tail
risk – the explosion of liability levels with a
decline in rates – when it is relatively simple
to align the duration of the assets with the
duration of the liabilities. However, it was
far easier to find plan sponsors interested in
portfolio insurance in the 1980s or 130/30
strategies in the 2001-2008 period than it
was to find plans that were willing to use an
asset-liability framework. The decisionmakers too often focused on the wrong
targets, which allowed them to justify the
use of new total return strategies.
Today’s ‘catnip’?
With all of these retrospective observations
in mind, it’s worth considering what
alluring ideas in today’s market might be
viewed years from now as catnip.
Possible candidates might include:
index proliferation, catastrophe bonds
and ‘smart beta’.
Catastrophe bonds
Catastrophe (or cat) bonds offer a
particularly interesting example. The
potential appeal is clear and reflects the
current urge to diversify away from
traditional asset classes, coupled with
an attractive potential return.
What are they?
A ‘cat’ bond is a high-yield debt instrument
issued by an insurance or reinsurance
company. It pays a yield to the buyer unless
or until the issuer suffers a loss from a predefined catastrophe, such as a hurricane.
Often both the principal and interest are
either deferred or completely ‘forgiven’ by
the buyer/investor when a catastrophe
occurs.
What’s the allure?
Because the amount and severity of
weather-based catastrophic events drives
the investment return of cat bonds,
it should be wholly independent of
economic factors and therefore the return
on conventional equity and bond markets.
In addition, the incremental yield offered by
cat bonds over conventional bonds stands
in stunning contrast to an environment
where high quality sovereign debt offers
a negative real yield.
Questions to ask
It’s understandable why institutional
investors might find cat bonds appealing.
Closer examination, however, reveals that
cat bonds introduce some serious questions
that investors need to answer before
including cat bonds in a portfolio.
Firstly, on what basis is the investor
assessing the risk premium embedded in
the yield in respect to the potential for a
weather or other catastrophe? Does the
committee have the expertise to ensure
the yield premium adequately reflects the
underlying risk? It’s difficult for
meteorologists to properly assess the
likelihood and magnitude of severe weather
events and effectively impossible for
amateurs. In assessing this opportunity,
investors might also ask themselves some
specific questions:
• Who is issuing these bonds? Does the
investor have a significant knowledge
deficit relative to the issuer?
• Why are they issuing them? Cat bonds
are designed to protect the issuer in the
case of risk, which means the investor
accepts ‘tail risk’ and is selling insurance
protection to the issuer. Do you really
feel knowledgeable enough to sell
insurance to an insurance company?
Smart beta
It seems like everyone’s talking about ‘smart
beta’, but what is it really? Is it like a ‘smart
phone’ – a revolutionary breakthrough
destined to transform an entire industry and
lifestyle? Perhaps not.
Referring to these strategies as ‘smart’
suggest that they represent superior
segments of the broad market. But in reality,
markets are too efficient to ever really offer
magic rules-based bullets. There are simply
too many smart people looking to identify
and exploit perceived inefficiencies.
The idea of tracking a non-market-capweighted index begins with the basic
assumption that market-cap indices are
somehow ‘flawed’, because of a belief that
markets are inefficient. Proponents of this
view point to their belief that the market
overweights ‘expensive’ securities as proof.
They support their assertion with back-tested
data designed to show that ‘if only’ an index
had existed that weighted or selected
securities by some other criteria, the ‘revised
index’ would have outperformed a
conventional index.
The problem with such solutions is that they
are typically appealing because of how well
they would have withstood yesterday’s
challenges. The equity market is a ‘zero-sum
game’, which means for every winner there
has to be a corresponding loser. If a strategy
based on simplistic rules wins for a period,
market efficiency and mean reversion
will take hold in due course and erode
the ‘winnings’.
Smart beta strategies generally fall into
one of four categories:
• Rules-based active strategies
• Factor beta
• Strategy beta
• Data-mining wonders
Rules-based active strategies
These strategies use rules to select a subset
of the overall market beta or to re-weight the
broad market. Such rules provide one of two
types of selection:
• Negative selection – excludes stocks with
undesirable characteristics, such as high
price/earnings ratio, or large market
capitalisation
• Positive selection – selects stocks
with desired characteristics, such as
sustainability or ‘fundamental’ indexing
The rules often define portfolios that
represent attractive answers to what worked
extremely well over recent history. You can
compare it to preparing for the last war,
which rarely represents a successful way
forward.
Data-mining wonders
Some portfolios are constructed based
on guidelines that can seem odd in
isolation and even stranger in combination.
For example, some ‘smart bond betas’
combine variables such as land mass driving
country weighting, but include a hefty
exposure to emerging-market currencies for
unclear reasons.
Active by another name?
Effective use of most smart betas requires
an active view on the risk/return outlook
both of the segment represented by the
smart beta and the portions of the market
that are excluded as, by definition, no
segment will be permanently in or out of
favour. In many regards, playing the smart
beta game resembles the ‘sector rotation’
fad of decades past – popular, but rarely
successful. It is market timing under a
different guise and the record of investors
who try to time the market is dismal.
Tempting though it might be, smart beta
should never be thought of as a ‘perpetual
motion alpha generator’. Some of these
approaches look like winners for a while,
but rules-based strategies or factor biases
that will beat the market over long periods –
before or after expenses – do not exist. If
they did, the benefit would be arbitraged
away.
Use of smart beta tools and products –
rather than conventional market-cap
weighted beta – reflects an investor’s risk/
return outlook for segments of the broad
opportunity set and a conviction of being
rewarded for implementing that view to
over or underweight those segments.
Essentially, most investors using smart
beta must believe that they are smarter
than the market or are willing to accept
a different risk/return profile based on
distinctive needs or biases.
For those who believe they know more,
the bet is that the subset selected will
outperform on an absolute or risk-adjusted
basis over the period when the smart beta
position is in place. By contrast, some
investors may accept a return lower than
the market due to a preference for lower
volatility, or for an SRI-consistent portfolio,
or for some other consideration.
In sum, smart betas generally should not
be viewed as better answers to market
exposure. They should be used carefully,
as they will have periods when they lead
and lag just like other strategies. If the
history of market timing teaches us
anything, it’s that attempting to time smart
beta plays is unlikely to provide a winning
solution. For investors, the best advice is
‘buyer beware’. Understand what you are
emphasising with a smart beta, recognise
what you are avoiding, and – above all
– be candid in assessing your or your
organisation’s ability to judge when to
buy or sell.
Conclusion
Successful investing is challenging.
It requires insight, discipline, a consistent
focus on clearly defined objectives and
knowledge of investment markets. Looking
upon investing as a race or contest, rather
than as an effort to fund a future goal,
introduces the risk of succumbing to
‘investment catnip’. Know what you’re
buying and how it may help you meet
your objective.
Many investment innovations – such as
futures and credit default swaps – represent
terrific tools to help investors manage risk
and return. The key, however, is to dissect
new ideas to identify and understand the
premises and assumptions that underlie
them. Only after assessing these drivers
can investors determine if they are looking at
a sound opportunity or the latest round
of ‘investment catnip’.
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Important information
This document is directed at professional investors only as defined under the MiFID Directive. Not for Public Distribution. It is for educational purposes only and is
not a recommendation or solicitation to buy or sell investments.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
© 2014 Vanguard Asset Management, Limited. All rights reserved.
VAM-2013-11-21-1277