Key Take Aways

With the purpose, mission and goals in place, a board is ready to take the next step and focus on the design of the investment management process: developing investment beliefs. Investment beliefs are important because they create a context for value-creating investing. What are the core competencies of an investment organization that is aiming for success in the capital markets? How does and how should an institutional investor view capital markets? This is a strategic issue that seems obvious but has seldom to date been addressed in the literature.¹ Research by Clark and Urwin² shows that best practice funds treat investments as a strategic core element, based on investment beliefs that can stand the tests of logic, informed debate, and occasional revision when new evidence comes to light.

In this chapter ³ we define what investment beliefs are; we argue that these are extremely useful for a board. Next, we consider how to use them and we delve into the question of how to develop them.

WHY INVESTMENT BELIEFS MATTER

Investment beliefs matter more than you know, or that you would like them to. Every investment approach is based, at least implicitly, on a set of beliefs. If thoughtfully developed and diligently implemented, investment beliefs are an essential step towards investment excellence, as well as to funds' long-term survival in the financial markets. In financial markets, pension trustees who ponder the “why” as much as the “how” find themselves at an advantage. Well-thought-out investment beliefs, as well as their implementation and organization are instrumental. Investment beliefs address the “why” question by developing views on how financial markets work and what the consequences are for the investment strategy and the organization of a fund. Investment beliefs are implicit in every investment decision or strategy, but it is not common for them to be made explicit.⁴

It is not difficult to find investment beliefs. In fact, investors and trustees pronounce, act on or ignore investment beliefs on a daily basis. This can sometimes be at their own peril. Consider the following (hypothetical) statements made by trustees:

• Trustee 1. “This is such an exceptional situation that the best thing is to do nothing;”
• Trustee 2. “Stocks have plunged so dramatically, we should consider postponing rebalancing of the strategic portfolio for the time being;”
• Trustee 3. “We should keep faith in the long-term prospects of equities;”
• Trustee 4. “We delegate this sort of question to the investment managers because they are able to seize market opportunities;”
• Trustee 5. “Sustainability improves the return/risk trade-off of an investment.”

All these statements represent different possible beliefs about how financial markets operate. Trustees #1 and #2 assume that the past provides no guidance for future events, while trustee #3 might have a strong belief that equities rebound, even under difficult circumstances. Trustee #4, with his remark on delegation, assumes that specialization and being close to the financial markets generates additional information and investment opportunities that other investors cannot see. Finally, trustee #5 believes that the incorporation of non-financial information will help the investor to develop a better picture of the investment, leading to a better investment decision. These examples show that whatever you do as an investor, beliefs underpin your line of reasoning and acting. Before zooming in on the use of investment beliefs, we need to zoom out and ask why there is such a huge variation in beliefs. This question matters, because investors and consultants tend to present a lot of research as evidence, and this influences boards immensely in their choices on strategic asset allocation, investment styles or risk appetite. Indeed, who is the board to question the investment research? However, investment beliefs matter because we are not dealing with a conventional field of science and realizing this has some major consequences: pragmatic beliefs rather than hard theories guide us in our investment decisions.

Investment theory and practice have developed dramatically over the past five decades, but there is still no objective or universal framework for viewing capital markets and applying these insights for investment purposes.⁵ In the 1950s, investment philosophy boiled down to a simple approach: stock selection determined which securities were included in the portfolio, based on a careful analysis of a company's income statement and balance sheet. To founding fathers Graham and Dodd,⁶ developing financial ratios from the companies' accounting records was a key element in investment decisions.

A paradigm shift took place from the 1960s onwards with the work of Markowitz,⁷ which focused on assembling stocks into portfolios to minimize risk at an acceptable level of return—the “don't put all your eggs in one basket” principle. His main conclusion: portfolio construction is more important than picking individual stocks or timing markets.

The 1970s established the concept of systematic risk. Active management–—aimed at earning excess returns relative to benchmarks—met its mirror image in the 1980s in passive management, cleverly combining exposure to different markets to give investors the systematic risk and return they wanted. In the 1990s, new investment strategies were developed at an astronomical pace, based on derivatives markets that had only been in existence for 25 years. Concepts then evolved even further. Since the turn of the century, active management has increasingly come to mean earning absolute returns while leaving benchmarks out of the equation, with investment managers proclaiming they have forged a felicitous union between exploiting inefficiencies in the financial markets (active management) and clever financial engineering to achieve the right degree of systematic risk. This can be seen, for example, in the form of factor investing. All the above-mentioned views of capital markets still coexist, sometimes in harmony and sometimes at odds with one another.

Yet not one can be pinpointed as the right one. Theories in investments and finance simply do not provide the same degree of confidence as theories in natural sciences, for three reasons.⁸

First, finance is a relatively young discipline. Modern finance is roughly 50 years old, whereas other disciplines have been shaped over several hundreds of years. The main theories have not been road tested; basic premises are not (yet) conclusive. For example, for over 30 years, economists have hotly debated whether financial market pricing is efficient or not, and a conclusion is not in sight.

Such a debate has far-reaching consequences for boards. Who to believe? Those who believe that markets are efficient will advocate indexing and other passive strategies such as buy-and-hold, weathering the peaks and troughs of price cycles. Believers in inefficient markets usually invest in what they perceive as undervalued stocks, sectors or assets, and do not shy away from market-timing investment.⁹

Financial data are very “noisy.” It requires a lot of effort to extract relevant information from price signals, and the predictive power of models for future returns is generally low. Investment management is essentially a social science, in that markets are driven by people. A truly scientific investment theory would be based on an equation derived from proven laws of nature that specify how we get from point A to point B in the future.¹⁰ Based on such laws, we have, for instance, a pretty clear idea of when Halley's Comet comes close to Earth, and we can accurately predict how long it takes for a car to come to a complete standstill after hitting the brakes at 120 km per hour. Models are based on characteristics such as mass, gravity and velocity, elements that can be clearly defined and precisely measured, and this enables precise predictions to be made.¹¹ Scientific theories and forecasts for economies and financial markets are impossible for this very reason: there are no proven natural laws underlying the behavior of social systems. Economists therefore opt for a second-best approach, constructing yardsticks such as utility or risk tolerance to emulate hard science. Analysts do make predictions based on theories, but such theories are not laws of nature and are not comparable to the scientific methods available in the natural sciences. Analysts' models have limited applicability because the yardsticks are inherently unstable and difficult to establish objectively: risk tolerance varies immensely per person, or before and after a financial crisis, for example.

The second factor setting investment management and economics apart from the hard sciences is that while physics, for example, can test hypotheses through controlled experiments, this is very difficult to do in the case of economics and investments.¹² Economists are creative in circumventing this restriction by gathering as many data as possible and looking for common denominators (when equities go up, bonds do not on average increase as much in value). Alternatively, we focus on the actor who sets it all in motion—hence the surge in the study of behavioral finance. While general theories are nearly impossible to construct, modeling structural regularities and irregularities in human behavior is a promising avenue, since human behavior has a tendency to endure for very long periods. However, this allows partial insights at best. With human behavior, we have a pretty clear picture of why markets overreact. This brings us nowhere near to answering the question of how much or for how long stock markets will overreact, which is an answer investment managers are craving.

The bottom line remains: we still cannot conduct experiments in a controlled environment and draw general conclusions. At best, our general theories result in forecasts that are little more reliable than mere naïve guesses.¹³ This sobering view should resonate in a wide range of trustee debates on investment management. That is why so many debates never really reach a firm conclusion and keep coming back to haunt both investors and trustees. Proponents of active management – with the ultimate aim of earning more than a benchmark – have just as much ammunition in the form of anecdotal evidence or research to try to prove their case vis-à-vis sympathizers of passive management as the other way around.

This leads to the final reason that tears investment science apart from the natural sciences: certain individuals have the capacity to influence the course of economics and finance in fundamental ways.¹⁴ Policymakers have shaped economic growth, inflation and, as a side effect, competitiveness through monetary policy, while on a micro level ambitious investment managers have the capability to arbitrage away any inefficiency that exists. As we progress, our knowledge accumulates, changing the design of the models. A positive consequence of this is that investors and policymakers may take a more adaptive approach to events. For example, regulators and governments acted swiftly when the severity of the credit crisis in 2008 became clear. While one could debate the effectiveness of the measures, there is no doubt that decision-makers had definitely learned lessons from previous crises. The financial markets and the actors in these markets are learning and adapting all the time. Hence, the modern view that the financial markets form an adaptive, living eco-system. But if investors influence the course of finance and investment, this also implies that we cannot simply take it for granted that the financial markets can be described by the same set of static beliefs. Every generation has a different mental framework for macroeconomic policymaking and for investor attitudes and has also accumulated knowledge from earlier events, which makes it risky or even irrational to assume that history will repeat itself.

Investment beliefs accept the reality that economics and finance cannot be encapsulated in hard, predictive models. Instead, they reflect a view on how market participants learn or fail to learn on the capital market. We argue that an investment belief system or philosophy is made up of four main elements: basic beliefs, beliefs in relation to theory, beliefs in relation to strategy, and beliefs in relation to organization.

BASICS OF AN INVESTMENT BELIEF

Investment beliefs are not meant to be a contest to rewrite the Declaration of Independence. Their purpose is more mundane: formulating the belief behind important choices in the investment process, agreeing on the theory or the assumptions that support the beliefs, and deciding on what the consequences for implementation within the investment process are. For example, how does your pension fund view diversification? Is the true purpose of diversification to protect against unexpected financial shocks, downward scenarios, or inflation? Even with a relatively simple concept like diversification, the well-prepared trustee should develop a view of what diversification means to their fund, and translate this into a policy or strategy. Exhibit 4.1 shows the framework for formulating and implementing investment beliefs.

Basic investment beliefs are generally formulated as observations of the mechanisms of human behavior in the financial market place. The idea that “diversification is a free lunch, but not all the time” is an example. Investment beliefs accept the reality that, as a discipline, economics and finance cannot be expressed in solid predictive models. The term “belief” reflects the fact that investors can choose to interpret observations or mechanisms in different ways.

Next, the theory and fundamentals behind the belief need to be sound. Is the belief a lasting phenomenon that could reoccur in the near or distant future? Is there a sound reason why the phenomenon exists? Can we identify performance measures that are directly linked to this investment belief beforehand? If a mechanism is observed in the financial markets but a theoretical basis cannot be found, the pension fund should be reluctant to apply it in its strategy.

There has to be an investment strategy in place, describing how the investment belief can be put to use. Such a strategy will specify (i) the investment rules, (ii) the parameters to be applied with the investment rules, (iii) the investment instruments that can be used, and (iv) the time horizon that applies to the rules. Investment rules can be straightforward and are usually formulated in an “if …, then …” syntax. For example, if an asset class appears undervalued, then the asset should be over-weighted in the portfolio. Once this is done, there has to be an organization to implement the strategy or select and monitor the right managers to do so.

So, an investment belief is workable if it is based on a theory with arguments to defend it, a strategy to exploit it and an organization to support it. But what is there to gain for the trustee? Developing beliefs is firstly about self-discipline, which is worth a lot in terms of governance budget. It saves a lot of time during meetings and leads to subjecting any complex new strategy proposal to some simple questions such as “Does it fit?” and “Does it enhance the investment beliefs?” Investment beliefs are not meant to be overhauled every year, but financial markets and research are dynamic and changing. For investment beliefs to flourish, the pension fund or investment organization needs to allow room for critical debate so that new research and insights can be discussed, when necessary leading to the adaptation of existing beliefs.

An example of this is the Canadian Alberta-based Local Authorities Pension Plan (LAPP), which runs a defined benefit pension plan for employees of local authorities and takes a practical approach. LAPP draws up a table in which each investment belief is followed by its translation into investment policy.¹⁵ One investment belief of LAPP is that “asset mix policy will be a key determinant in the funding risk/return trade-off or asset/liability mismatch accepted to fund the plan.” To apply this investment belief, the “asset mix will continue to be the primary tool for the Board to achieve its investment objectives. The asset mix will be established through an approach that integrates both asset and liability projections.”

DEVELOPING A SET OF INVESTMENT BELIEFS

Developing a sound set of investment beliefs is crucial, as is having an organization to implement and monitor these beliefs. If risk management is a central investment belief, your organization should have a risk budgeting procedure in place to measure and manage all steps of the investment process. This is a no-brainer. Similarly, diversification as a belief only makes sense if you are willing to make the effort to investigate what really drives diversification and understand how adding new strategies can improve diversification. There are several no-brainers in investment management when shaping an investment philosophy—including investment beliefs with a sound footing in practice and in academic literature.

Any scheme needs to suit its investment strategy to its governance resources. Rather than everyone trying to include the newest alternative strategies around, some schemes should stick to buying or tracking market indices in familiar asset classes. It is important to select the most appropriate level of sophistication, not the highest possible level. Switching from active to passive mandates does not only recognize that the index will beat the majority of active managers over the long term; it is also the right approach for funds that are unable to delve deeply enough into the selection and monitoring of active managers to obtain the best available, as is the case with many smaller funds.

In this paragraph, we summarize the aforementioned investment beliefs as a starter kit: if I am a new trustee, or am managing a fund, I need to be aware of how my fund approaches these beliefs. If my fund does not have explicit views, then what is the basic scenario to start with? We will describe eight investment beliefs; these should be the starting point for all strategic asset allocation reviews and discussions.

Exhibit 4.2 presents eight investment beliefs that more or less sum up the discussions that many pension fund boards have held, where the investment belief is supported by one or more arguments why this belief is relevant to the fund and what evidence there is to back it up. In addition, we list the consequences for portfolio management when the investment belief is adopted.

The intention should be to review these on an annual basis, although major changes should not be expected from year to year—in that case you may as well simply return to writing down your investment plan or program for the coming year. These investment beliefs should provide a basis for reasoned debate, not just words to decorate the website. This entails becoming a confident participant in the financial markets, with investment beliefs—strategies—organization fully aligned. Better yet, can sometimes be rejecting some investment beliefs or adapting them to suit your own view of the financial markets.

WHEN, IF EVER, IS THE TIME TO CHANGE INVESTMENT BELIEFS?

A frequently recurring debate in the boardroom is how it can be sure that the investment beliefs developed are robust and will stand the test of time.

Judgments about evidence and recommendations in investments are complex. Investment evidence and subsequent recommendations leave investors and trustees with varying degrees of confidence. Sources of evidence can range from studies based on small data samples or case reports to well-designed studies with large data sets that have been repeated many times to minimize bias; or simply sound reasoning if there is not much evidence to base the belief on.

When discussing investment beliefs and deciding how much faith (and assets) to place in them, an analogy with the medical profession is useful.¹⁶ There, a system was developed and implemented as a common, transparent and sensible approach to grading the quality of the evidence (also known as “certainty in evidence” or “confidence in effect estimates”) and the strength of the recommendations underpinning the investment belief. The approach distinguishes recommendations depending on the evaluation of the evidence as strong or weak. A recommendation to adopt or not to adopt an investment belief should be based on the balance between desirable and undesirable expected consequences of following a recommendation. The degree of uncertainty associated with this balance will determine the strength of the recommendation. The criteria for this are listed in Exhibit 4.3.

So the question here is, how do you scale the investment beliefs? A simple rule of thumb can guide the board.¹⁷ The higher the quality of the evidence underpinning the investment belief, the more the board can allocate strategies and assets to it. And vice versa, the lower the quality of the evidence underpinning the investment belief, the fewer strategies and assets the board should allocate. This is a useful starting point for a review and evaluation. In the review, the board or investment committee can “downgrade” the quality of the belief when serious risks of biases emerge, when the outcome increasingly deviates from the expected effect, or when a publication bias is expected. On the other hand, when the data sets increase, or the effect seems to be more persistent than predicted, this might suggest an upgrade in the quality of the investment belief.

HOW (NOT) TO USE INVESTMENT BELIEFS

Beliefs are useful from an investment governance point of view, for sorting out the major relevant decisions for the pension funds, and for guiding the investment process. But investment beliefs can also challenge the design and performance of the organization in a negative way. An organization runs into trouble when its beliefs and investment process fit into one or more of the following categories:

• Beliefs that are merely copied from industry leaders without a real grasp of why these beliefs matter. This can be a smart move in many sectors, but not necessarily in the investment industry. Josh Lerner investigated the success of Yale University's endowment and found that a lot of it had to do with the special quality of the staff and resources, as well as their “first mover” advantage in adopting new assets and strategies. Any other funds copying the Yale model tended to have an average quality of staff, and a “second mover” disadvantage in adopting new assets and strategies. This could in some ways sum up the situation of many pension funds that diversified into alternative strategies and hedge funds in the late 1990s, only to wind down these investments a decade later after the financial crisis, due to disappointing results.
• Beliefs based on results. It is possible that an idea might have been bad to start with, but that if the results are all right, then trustees and investment managers gradually warm to the notion that the idea was probably good after all. This is known to statisticians as type I (false negative) and type II (false positive) errors. For example, a pension fund has allocated 15% to commodities without much thought. This is a high proportion, which might not be deemed to be prudent. The price of commodities rises, apparently proving them right, and triggering the debate as to whether the board should not allocate more to commodities. The dilemma here is that a good result is misinterpreted as a good idea. If the board cannot make its assumptions clear, it is rudderless when the investment returns move the other way.
• Beliefs without acting on them. This creates a reputational risk. This is nothing new for Dutch pension funds. In 2007, they were chastised for stating their commitment to sustainability while journalists quite easily found non-sustainable funds. Either you have beliefs and act on them, or you don't act on them, in which case they cannot be very strong beliefs.
• Simplification is the enemy. One cannot validly simply conclude that they are for or against active or passive management. It depends on its place in the investment process, the markets, and the skills required, to name just a few factors. In the search for returns, Europe and the United States have been labeled the old countries, and emerging markets the new—and more attractive—ones. Emerging markets do indeed play an important role. However, there is also a large amount of literature on financial structure, the quality of governance of a country, and economic growth that contains unpleasant information for emerging markets believers. Yet, that people still view emergent markets as more attractive is evidence that they like to discard information in their simplification process. This makes simplification dangerous.
• “I strongly believe in…” There is a quote from Yeats that includes the following lines: “The best lack all conviction, while the worst are full of passionate intensity.”¹⁹ With weaker convictions, research and arguments can become centered on what the outcome should be, rather than on challenging the assumptions in the first place. Conversely, beliefs without sensible assumptions or clear evidence should also be treated with suspicion. A lot of money rides on these investment beliefs, so it is important to establish a process to discuss and evaluate them as objectively as possible.