Secrets Of Success: Academics made money from 'passive neglect'

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The Independent Online

Readers with elephant-like memories will recall that a few years ago I wrote a couple of columns about an anonymous Cambridge college which had shown great savvy in investing its endowment fund. For a while, the results were regularly written up in the Investors Chronicle under the carefully guarded pseudonym Academic Investor.

It did not take long for me to discover that it was Clare College, Cambridge, and the man who deserved the credit for its impressive long-term performance was Professor Brian Reddaway, an economist who took over as chairman of its investment committee in the early 1950s and continued in that post until his retirement five years ago.

The key insight Professor Reddaway brought to the task of managing the college's investments was the transforming power of what the great Warren Buffett likes to call "passive neglect". The key pillars of its investment policy were: (a) to own a diversified portfolio of shares for their superior long-term growth; (b) to buy and hold those shares, keeping turnover to a minimum; and (c) to avoid trying to do anything "too clever" (as academics are naturally prone to do, unless restrained by common sense).

Of these three, the single biggest practical impact came from the commandment not to trade often. In fact, the investment committee made a strict rule to review its portfolio only once a year, to minimise trading and transaction costs, and to stop itself from making radical changes in its portfolio.

As those who have followed and absorbed the lessons of index funds will know, this approach is guaranteed to produce better-than-average results over the long run, though it seems Clare College was able to produce returns that were not only better than average, but also materially better than the stock market over the same period.

The college has now, it seems, added a new weapon to its armoury in the shape of Andrew Smithers's research into long-run market returns, which centres on the belief that equity returns ultimately revert to the mean.

His "q ratio" measures the degree to which the FTSE All-Share index is overvalued relative to its long-term intrinsic value, as measured by the replacement cost of its component companies' assets. The "q ratio" does not tell you what will happen to the stock market from year to year; the only thing we know for sure about that is that, as JP Morgan said, "it will fluctuate", but it does give you a measure of the risk you are taking by investing in the stock market for the long term in any current year. When the "q ratio" is high, as it still is today, it increases the risk that your long-term returns will disappoint, and vice versa.

By a nice coincidence, Professor Smithers came out this week with his latest piece of research which suggests the UK stock market is still some 40 per cent overvalued at present levels (Wall Street is even more highly overvalued). And as for Clare College? It is out of US equities altogether, and has only 22 per cent in all in the UK stock market via tracker funds, with a further 7 per cent in overseas equity markets, 28 per cent in commercial property and 40 per cent in cash and short-term bonds. The college is genuinely investing for the long run, and enjoys advantages ordinary investors do not have. But in 20 years, you can be at least 90 per cent certain history will report (with hindsight) that the college has done another wise thing.

Everyone will have their own take on the great drama which unfolded this week at Standard Life, claiming the scalp of their personable chief executive, and I claim no great originality for my own observations (though I declare an interest as a policyholder). It is next to impossible for any outsider, even a trained financial analyst, to understand entirely the "true" financial position of the venerable Edinburgh mutual society, and how far it is from being able to meet the necessary solvency tests, even on the so-called "realistic" basis that was introduced a little while ago. (Nobody disputes that the officially required figures are a long way from reflecting the reality of a life company's balance sheet).

What one can say with confidence is that a combination of legal and regulatory requirements are gradually eroding the last remaining pillars on which the once-proud principle of mutuality stood. First it was the Law Lords in the Equitable case, who ruled (in effect) that a majority of policyholders and their board were powerless to act in a way that balanced the interests of members with competing claims against the society's assets (although many of those making the claim for guarantees did not even know they were entitled to them).

Now, if the reports of the Financial Service Authority's dealings with Standard Life are to be believed, we have the regulators to thank for (in effect) adding so many constraints on the society's ability to deploy its capital, for fear of damage to the value of the guarantees on its with-profits policies, that the society has to consider a flotation to survive.

In both cases it is possible to defend the logic behind these initiatives, but only those with a touching faith in the ability of governments to run businesses better than shareholder-appointed managements will feel confident that they will deliver the optimal result for the policyholders concerned.

The legal drama at Equitable has made all policyholders worse off than they would have been if the judges had left the society to sort its own affairs out as a going concern (though some policyholders have clearly suffered more than others). Will the same thing now happen at Standard Life? Possibly not, because the business can eventually be sold, though not perhaps before the new management has embarked post-flotation on a disastrous Abbey National-style experiment with new lines of business.

Although the management has much to answer for, and could certainly have done with some of the investment savvy of Professor Reddaway over the years, I am not personally much heartened by the thought of demutualisation being forced on me at the behest of an arm of Government that appears to be more interested in risk-aversion and stable-door closure than in letting policyholders decide their own future.

jd@intelligent-investor.co.uk

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