Secrets Of Success: The long and the short of investments

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The Independent Online

If you are a pension fund manager, your time horizon is about the same as your average liability structure, which is around eight to 12 years. For some endowments - say a well-funded Oxford college that has no plans to go out of business in the next few hundred years - the time horizon can, in effect, be forever.

Logic suggests that in each of these cases, the investment strategy you adopt should be appropriate to your objective and time horizon. That, in practice - though far from perfect - is what happens.

There are discernible differences in the way that hedge funds and endowments, say, manage their assets. The mix of assets they own and the rate at which those portfolios are turned over vary enormously. There can be big differences, too, in the extent to which different types of investor rely on generating income from their assets.

For individual investors, the same differences apply. Those who rely on their investments to generate an income are often driven towards a strategy that forfeits some degree of long-term capital return in order to meet their annual requirements. In the case of those who are merely looking to save for some uncertain future eventuality, the urge to change portfolios is much smaller. That has advantages and disadvantages, depending in part on whether the management of your portfolio has been delegated or not.

For those who take their own decisions, changing a portfolio too often can be costly. If professional investors cannot, on average, beat the market over time, the odds that know-little individuals will be able to do so are well below 50 per cent, and probably as little as one-in-10.

A passive investment strategy, diversified across property, bonds and shares, and implemented at low cost, is the obvious, optimal solution in these cases.

In effect, you are giving up the small chance of outperforming the market in return for the certainty of not doing materially worse than the average. In turn, a passive strategy has the effect of lengthening your time horizon as an investor and minimising your annual holding cost - two positives.

Delegating your choice of strategy and trading decisions to someone with the professional knowledge can be a viable alternative if you are lucky or smart enough to find the right person or organisation to delegate that work to. But there are two main problems to consider.

One is that seeking professional help is expensive; the risk is that what you gain from the help is offset by the cost of execution. The second is that there may be agency issues between you and the professional; that the interests of brokers and clients are not aligned - the former having a vested interest in much higher rates of turnover than is optimal for the latter. Commission-driven advisers suffer the same disadvantage.

Jack Bogle, the founder of Vanguard, makes a distinction between what he calls the investment profession and the investment business. The former is characterised by a commitment to deliver superior long-term returns for clients. It tends to produce an investment approach that is patient, long term and contrarian. The investment business is primarily driven by the need to generate fees and maximise the earnings of the investment firm. The investment approach tends to be much more active and costly.

There is much evidence that if you are going to delegate, you should look for those who operate on the specialist professional model. The narrower the range of funds that a firm offers, the better on average its performance.

Privately owned firms, on average, produce much better results than large, publicly quoted companies, where the need to sustain year-on-year earnings growth - and the scope for conflicts of interest - is much greater. The corresponding risk is that professional firms may be over-reliant on particular individuals.

The good news, says Michael Mauboussin, the strategist at Legg Mason, is that so many players in the markets today are driven primarily by short-term considerations that it is creating opportunities for those who operate on a longer-term horizon.

While hedge funds are the most extreme example of a short-term approach, performance-chasing unit trusts and Oeics, and pension funds that dance to a regulator's tune rather than long-term investment considerations, are contributing to the phenomenon.

The bad news is that individual investors seem oblivious to this opportunity. The data on stock and fund flows suggests that most of us continue to push money into those sectors that are hot or have the best short-term track record rather than into investments that can be plausibly justified as being cheap on a longer-term perspective. The investment industry, with its focus on sales, has no interest in stemming this trend.

If you are operating with a long-term investment horizon, it makes sense to judge your results on the same timescale. It may be no accident that it is still pretty difficult, say, to find 10-year performance histories on fund websites.

By a neat coincidence, as of the end of May, the 10-year performance figures show that the stock market has returned a compound 8.3 per cent a year, which, allowing for inflation at say 2.5 per cent, is remarkably close to its long-term real return of 6.5 per cent a year.

jd@independent-investor.com

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