Week 4: Investment in practice – practices, styles, history and performance

Introduction

Welcome to Week 4 of Managing my investments – a week that further explores investment management practices before moving on to the issue of how investment management performance can be measured. Watch the following video to hear Martin Upton introduce these topics.

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MARTIN UPTON

Welcome back everyone and welcome to Week 4 of Managing my Investments. I’m Martin Upton of The Open University’s True Potential Centre. Last week we looked at the factors you need to take into account when devising your investment strategy. We also looked at how professional investors apply the theories to their decision-making. This week, we first review many of the common strategies that can be adopted when compiling your investment portfolio. We then move on to the key issue of how to assess the performance of investments and those that manage them on your behalf. We also look at the data on the historical performance of different classes of investments and find out which have performed the best over the past century. We complete the week by examining a number of recent historical investment episodes that have attracted public interest. We examine these within the context of the theories about investment management that you have studied so far. The emphasis is on understanding how investment management proceeds in practice and on how we can learn lessons from investment issues that have surfaced in the recent past. So enjoy Week 4!

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Assessing the performance of an investment, or a portfolio of investments, is part of the ‘review’ stage of the four stages model for investment management that you have been using during this course. Finding that your investments have been underperforming their target returns may be the trigger to revising your portfolio or seeking out a new investment manager.

You’ll also look at a number of high-profile investment management episodes in recent history. These are interesting stories in themselves but many also provide guidance or warnings about the pitfalls that can be encountered when investing.

4.1 Investor activity – evidence from the industry

Over the last three weeks you’ve looked at the range of investments and funds that you can invest in. You’ve also looked at the factors that influence how investment portfolios should be structured. You start this week by looking at the pattern of investment activity and the trends in investment behaviour in the UK.

Watch the following video, in which Victoria Nye of the Investment Management Association (IMA) gives a presentation titled ‘Investors’ fund choices: what do they tell us?’

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VICTORIA NYE

This is the growth of the investment funds marketplace retail funds, so it doesn’t encompass all the funds that are in insurance funds and pension funds, which have been discretionary funds, it’s more the retails funds that you see in our various funds sectors we have here at the IMA - 23 fund sectors. What are we seeing there? We’re seeing a significant growth in the marketplace. If you think about the asset mix of those funds, they started off in 1980 being about 85% equity. That’s percentage and equities in the funds that we represent on this table have dropped about 55%. What we’re seeing in that, already, is a balance of asset mix. So funds are being used less about this is my way of getting my portfolio of shares, this is a diversification route. It’s more about; this is providing me with an overall portfolio which will include fixed interest, and maybe a bit of property, as well.

To carry on looking at the statistics, I’ll talk you through it, a bit. What we’re looking at, here, is that the net retail sales, in the industry, from 1994 to 2013, (with some inflation adjustment their, for those of you who would like to see that as well) what happened at the time of the credit crisis obviously a significant drop in sales, so risk, scare, and help, sales dropped, but look what happened on the right hand side of the chart. This is net growth and deposits vs. net retail sales of UK authorised funds. Interestingly, as the interest rate (the base rate) drops from 6% to 1/2%, obviously, the amount of deposits drops, or, people are taking money out of their deposits. Where are the putting it? What you might deduce from this chart is that they’re putting it into funds. Indeed, if you look at various savings statistics, that seems to be what they’re doing. There’s a figure that we’ve got in our annual management survey that says that half percent of people’s disposable income was going into funds back in 2008 and that rose to 3% of disposable funds, after the crash. Some people might say other people weren’t saving as a result of the crash, actually, they were in this vested community that I’m talking about, and they definitely were continuing to keep their money invested, and in fact, putting it into an ostensibly riskier asset - into the equity market.

This is an old cartoon, but it’s, obviously, demonstrating a point about timing. When would you put your money in the market, and when would you take it out? And somebody earlier, in one of the earlier presentations eluded to the fact that a lot of money could be lost by trading in and out of the market and I think it’s worth saying that the average holding for an investment fund by an investor is well over seven to eight years, so they’re not trading it in and out of the market typically, they’re holding it for the longer term. What is this telling us? One of the pieces of research I’ve found very useful in terms of being an industry person when thinking about what our customers are looking at, is the research that NEST has done which is looking at communications on investment. I don’t know whether you’ve seen that, but it’s a very interesting piece of research. What they highlight in their market, which is not typically the market the investment management industry is used to, is that investment is something that rich people do with their money because they can afford to lose it. I’m not the best person to talk about it, again, Alex has done a brilliant job of talking about attitudes to risk and about the catastrophic, everything looks like a loss rather than a gain and tending to err on the side of the negative. What I found fascinating is a figure that came out that says that 40% of people would go for the lowest risk investment on the plate, as it were, even if it wasn’t in their best interests. That’s NEST coming out with that statement, but I think it’s telling us something, in the industry, about how we produce products and what we say about the products, without deluding people, of course, that we’re giving them something that they haven’t got. I think another point that came out of that research that i thought was also interesting is about whether people want a guarantee or not. I think that when they’re looking at the guarantee and what that does in cost terms, to the value of their investment, some people are actually saying, no, we don’t want it. So there’s an explanation that needs to be done, behind that. Even if you look at that mass affluent, this time, the more typical investment management investor, you’re finding some research that one of our members did that 95% of them see wealth preservation as a top priority. At the same time, 21%, questioned in that research, said they were not feeling well prepared for their savings, for retirement.

What I would like to do now is have a little look, an analysis, of where we’re seeing the changes in investment preferences, over time. To point this out to you in terms of the blocks we’ve got, the first one is outcome and allocation which is typically those funds that are providing you with more spread of risk across different asset classes. That’s what allocation is about. Outcome is those products that are coming through, now, much more popular, which is target date type funds. Fixed income you’ll know; equity income and equity growth, I think you’ve all heard of. The equity income one is the one that generates a higher income, but we’re still within an equity portfolio. What we’re seeing back at the post-crash, that risk period where everyone saw the market tumble, as the case may be, dropped 30%, in the year, is that people went for income. Obviously, that engenders a significant improvement in the amount of money they had in their pocket year-on-year. That’s what mattered to the investment management association type customers.

This is a table, a chart that we’ve got in our consumer website. I’ve given you all a card so you can see some of the information that we’ve put up, as an industry, to sort of help people understand the different products that are around. Three thousand funds is a lot to choose from but they are put into sectors, and this one is the equity income sector and it’s showing us a simple message that we can put through to people who are thinking about investing that while your capital value goes up and down, your income can stay quite steady. It can even get better if they sit on the investment for a long time. What this shows is 10,000 invested in 2002 and how that’s changed in capital value, and what income that has generated for you, over the years. I think, in terms of market volatility is quite a powerful message. You could do the same with a chart which shows what you would do if you put your money into fixed interest, but obviously, the capital value would be steadier; in fact, the income would be steadier, as well.

The second reason we saw this surge in fund sales, post-crash, is because of this move towards outcome and mixed asset type funds of which more and more are being launched within the investment management industry. As I said, the mixed assets is about having a spread of assets in your portfolio, so it would be fixed income, equity mixes and global equity mixes, doing what funds are supposed to do, to be quite honest, in terms of spreading the risk. The outcome orientated ones are those that are working with the attitude to risk type surveys that advisors love to use and providing products that advisers who are using those questionnaires can then slot their clients’ money into, depending on the bands of volatility there might be. Here then to show you is the development of the growth of those funds, over time. The sales we saw in those sectors were well driving the sales for the industry, as a whole, and another sector that is not represented here but which amalgamates a lot of the individual funds was called the funds of funds sector. That has put on 20% of growth, per annum, for the last two years, since the crash. It’s showing you that actually again, people want a packaged; diversified solution.

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4.1.1 Age and lifestyling

Figure 1 Movement in the level of the FTSE-100 between 1984 and 2015

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The figure is a line graph showing the movement of the FTSE 100 index between 1984 and 2015. The index rises from 1000 to nearly 7000 over this time but with sharp falls in the early and in the late 2000s.

Figure 1 Movement in the level of the FTSE-100 between 1984 and 2015

There is a relationship between the age of an investor and the rational composition (or allocation) of investments. This factor relates to the investment principle of ‘lifestyling’.

Let’s look more closely at these influences on investment behaviour.

4.1.2 Cultural issues

Portfolio theory, which you may recall from last week, suggests that diversification is good for investors and it seems logical to suppose that investing internationally will improve the risk–return trade-off. Indeed, if we follow the Capital Asset Pricing Model (CAPM) to its logical conclusion, we should all be investing in the global equity markets in proportion to their market value.

Since the USA has by far the largest market capitalisation, investors, whatever their home country, should, in theory, be putting most of their money in the USA. However, in practice, there is home bias.

US investors tend to invest in US stocks, with very little invested overseas, and even the more internationally focused UK investor will typically invest the majority of their funds in UK equities. Part of the reason is that it is more difficult to invest overseas – some brokers will not let investors buy overseas stocks in small amounts, and information on shares is not so readily available, not to mention the fact that transaction costs are typically higher. An investor would also need a lot of money to gain exposure to all the major stock markets. As a result, small investors typically gain access to international markets through pooled funds, such as Open Ended Investment Companies (OEICs) or investment trusts.

Another difference is the span of investments that investment advisers typically cover. In the UK, investment advice is mostly on equities, pooled funds and some bonds. In France, however, the investment adviser will consider investment in property and stock-market investments as part of one portfolio – this is because tax advice is part of the investment adviser’s role and property can be a tax-efficient investment. In the UK, although tax advice is also important, stock market investment and property tend to be kept separate.

Some countries also have more of an ‘equity’ culture than others. British investors have been happily investing in global equities since well before the First World War. Bonds also fell out of fashion after the high inflation of the 1970s and 1980s. As a result, British investors have been relatively happier to invest in shares than other nationalities.

When comparing countries, there are important differences in how assets are combined into funds. Figure 2 shows the asset mix in 2008 for pension funds surveyed in the UK, Germany and France. Whereas, on average, pension funds in the UK had 58% of assets allocated to shares, in Germany only 19% had shares, and in France only 22% had shares. A much higher proportion was invested in bonds: 76% in France and 71% in Germany, compared to only 38% in the UK.

Figure 2 Asset mix of pension funds

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The figure comprises three pie charts showing the mixture of assets held by pension funds in the UK, Germany and France. In the UK shares are the largest category of the assets held whilst in Germany and France bonds account for close to three-quarters of the total assets. In all three countries shares and bonds combined account for at least 90% of the total assets held.

Figure 2 Asset mix of pension funds

4.1.3 International diversification

Figure 3 How many national badges does your portfolio have?

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The image comprises a large number of badges displaying the flags of various countries and the European Union (EU). Badges showing the Union Jack, the Stars and Stripes and the EU symbol are to the fore.

Figure 3 How many national badges does your portfolio have?

Portfolio theory offers the investor the ability to create efficient portfolios from a selection of investment alternatives, ranging from choosing a portfolio of UK equities or a set of overseas markets in which to invest, to making an asset allocation choice between UK equities, overseas equities, cash and bonds, for example. In each case, a set of efficient portfolios can be created, provided that the investor has a database of the expected returns, risks and correlation coefficients.

In practice, investors tend to use historical data to estimate the risks and correlations, in particular. Expected returns chosen are more likely to be subjective estimates. The risks and measures of correlation might be calculated from, for example, the past 12 monthly periods, the past 20 quarters, or the past 10 annual periods.

The financial publication Money Management, for example, publishes the standard deviation from the most recent 36 monthly periods. Each choice of data will give a different answer and, to make matters worse, the efficient frontier portfolios that the analysis provides may be difficult to sell to investors in practice.

Suppose that an international equity market analysis suggested that US investors should place 50% in Belgian equities, 5% in the UK and the remainder in Chile. This might appear too different from a market-capitalisation-weighted global equity index to please investors. So analysts tend to play it safe and constrain their models to give answers that are not likely to change too much, and that are not that different from a popular benchmark index.

The Capital Asset Pricing Model (CAPM) is also based on assumptions that do not hold in practice. Investors based in different currencies will not all be looking at the same opportunities; investors cannot in practice both borrow and lend at the risk-free rate; and the market indices used to represent the market are not very good approximations to estimates of all marketable assets.

However, the conclusions that the CAPM reaches – that there is, for passive investors, an investment alternative based on index funds and cash, that active managers can be judged relative to that passive investment alternative, and that investors can analyse what kinds of risk investment funds are taking on – have meant that investment managers have to be very careful to implement the investment strategies that they put in their marketing literature.

These observations bring us to the next key aspect of investment management: how to judge investment performance – including the performance of fund managers who look after your investment portfolios.

4.2 Relative returns

Figure 4 Funds make it easy to spread your investments around the world.

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The image is a globe of the earth with the flags of various nations displayed around it.

Figure 4 Funds make it easy to spread your investments around the world.

The traditional way in which fund manager performance has tended to be judged is against the performance of other fund managers with similar investment objectives. This means that pension fund managers are judged against other pension fund managers, and unit trust managers investing in UK shares are judged against other fund managers investing in UK shares. The table set out at the top of Investment funds: alternative risk profiles shows how funds are grouped by the Investment Association (IA) to allow performance measures to be applied to peer groups of funds.

The IA maintains a system for classifying funds, as there are over 2000 investment funds. The classification system contains 30 sectors grouping similar funds together. The sectors are split into two categories, those designed to provide ‘income’ and those designed to provide ‘growth’. The sectors are designed to help investors to find the best fund(s) to meet their investment objectives and to compare how well their fund is performing against similar funds. Each sector is made up of funds investing in similar assets, in the same stock-market sectors or in the same geographical region.

Similar frameworks have been put in place by the Association of British Insurers for life company funds and other groups of investment funds. Whatever the framework, the aim of each fund manager is to be top of the league tables, so that new investors will choose them based on past performance. For such managers, success is about relative not absolute performance, and this can affect fund managers’ behaviour.

For example, suppose that you are trying to compare funds investing in cash and UK equities (shares). In a bull market, a top performer relative to the peer group is likely to be the fund most heavily invested in equities. Because of this, there will be a temptation on the part of all the fund managers in this peer group to increase their equity participation. So, over time, the typical fund’s equity exposure will rise, increasing its risk. When the bear market comes, the funds in the group will suffer more than if they had invested relative to a benchmark linked to cash and equity indices, say 50% in each. Staying close to this benchmark would have meant that their equity market risk stayed more or less the same over time.

Retail funds can also be judged against a suitable benchmark index, say an Indian stock market index for an Indian equity fund, or the MSCI global equity index for a global equities fund. This makes it easier to measure that all-elusive outperformance, as it is a specified, calculable benchmark return, and allows funds to be judged relative to an established alternative investment strategy.

The further away from the benchmark, therefore, the greater the risk taken on by the fund manager – individual funds deviate from the benchmark to try to outperform in different ways. As you have already seen, some take on more beta, others more specific risk, in order to earn what is called ‘positive alpha’. The next section shows which performance measures can be used when comparing performance against a peer group or when comparing against the performance of a benchmark index.

4.2.1 Alternative measures

Figure 5 How fit is your portfolio?

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The image is a drawing of a sprinter with numbers, percentages and pie charts portrayed on the body.

Figure 5 How fit is your portfolio?

4.2.2 Analysing a fund’s performance

Using the internet, you can find performance measures based on portfolio theory and the CAPM to analyse funds such as the Newton Balanced Income Fund. This particular fund achieved a three year positive mean return and a positive Sharpe Ratio over three years, meaning that it returned more than the risk-free rate over the period. The beta is 0.93 compared to a benchmark index, which makes the fund slightly less exposed to market movements than its benchmark comparator. The negative alpha means that the fund’s return has been penalised for taking on specific risk through stock selection and not just mirroring the benchmark index (Table 4.1).

Figure 6 shows the ten-year performance of £1000 invested in the Newton Balanced Income relative to the chosen peer group and the chosen benchmark index. The peer group included several hundred other income funds with the same investment objectives. This shows the fund’s superior performance over the period until 2013 compared with both the index and the average performance of the peer group. Consequently the investment analyst firm Morningstar awarded it a 5-star rating for the 10-year performance – but a ‘below’ average 2-star rating for its 3-year and 5-year performances.

Figure 6 Ten-year performance of £1000 invested in the Newton Balanced Income

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The figure is a line graph showing the performance of the Newton Balanced Income fund against two comparative benchmark indices between 2004 and 2014. For most of the period the Newton fund outperforms the two indices.

Figure 6 Ten-year performance of £1000 invested in the Newton Balanced Income

So, for the overall period from 2004 to 2014, we would have been happy to have invested in the Newton Balanced Income Fund instead of another fund in the same peer group. By contrast, over the 10-year period there was little to choose between this fund or the index fund tracking the chosen benchmark index. But the problem is how to identify the best performing funds before the event and not after. The figure above shows that the average peer group performance was worse over the 10-year period than that of the Newton Balanced Income Fund. Furthermore, some funds would have performed worse than the peer group since this is an indicator of average performance. So, only if we were very lucky, and had picked a fund manager who did well, would we have achieved our target return, as measured by the index, or more. Tracking the benchmark index therefore offers a strategy of avoiding investment in the weaker performing funds.

[Note that while the analysis above covers the performance of the fund between 2004 and 2014, the discussion of how to assess fund performance remains relevant today.]

By far the most common indicator of performance is simply returns over the past year, three years and five years. Since markets may well experience a bull or bear phase over more than five years, aggressive funds will look good in the good years and defensive funds will look good in the bad years. An example of an aggressive fund is a growth fund, a fund that looks for companies with growth potential but may be expensive in earnings terms (that is, have high price–earnings ratios, P/E – a measure you looked at in Week 2), as did internet companies in the late 1990s. An example of a defensive fund is a value fund, which invests in companies that look relatively cheap on fundamental ratios such as P/E, dividend yield or Tobin’s Q (which we also looked at in Week 2).

Indeed, some fund management groups make sure that they have a wide range of different types of fund to make sure that they always have at least one or two near the top of the league tables, whatever the state of the stock market. This is another example of how diversification informs investment strategy.

4.2.3 Absolute returns

Figure 7 Investors have an array of fund managers to choose from.

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The image shoes the logos of four fund managers – Aviva Investors, Direct Best Invest, Excellence, Gerard Reid and BNY Mellon.

Figure 7 Investors have an array of fund managers to choose from.

The relative approach to peer groups or to benchmarks does not always work well.

In the dot-com crash of 2000, for example, when pension funds suffered badly as the equity market fell, pension fund managers argued that they had all lost money, so it didn’t really matter. This included even those who outperformed the benchmark (which in this case means that they lost less than the benchmark), but this was a matter of concern to company directors, who found that their company pension funds had to be topped up to cover the stock market losses. They decided to turn to fund managers who promised absolute returns, that is (hopefully), positive returns whatever the economic situation.

So, for example, the fund might promise not to outperform the FTSE All Share Index by 2% – a 10% fall in the index would still mean a loss of 8% – but rather to earn, say, 4% more than the risk-free rate. Two types of investment that promise absolute returns are some types of hedge fund and structured products.

4.2.4 The reporting of performance

The reporting of performance measurement varies from cursory to detailed, depending on the size of the investment. Managers of large pension funds have to provide their clients with detailed breakdowns of the risk and-return characteristics of their portfolios, and there are a number of consultants who specialise in such analyses. They also use the key measures such as tracking error and alpha.

When it comes to funds, such as investment trusts, OEICs and life assurance funds, more complex measures tend to be combined into a star-rating or number-rating system. This allows investors to identify good recent performers and high- or low-risk funds relatively easily.

It is rare to find a fund that significantly outperforms an index benchmark over the long term. It is very difficult to spot future winners, and past performance is not a guarantee of future performance, but analysing performance can and does say something about how the performance was earned and what kinds of risk an investor in the fund is likely to be taking on. It can also force investors to face the truth of their investment performance.

To finish this section, watch the video and hear Anthony Nutt’s observations on fund management performance and on whether chartism (that you studied in Week 3) is an aid to good performance.

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MARTIN UPTON

Looking at performance: The last few years, in fact really the last decade or so we’ve seen low investment returns. Interest rates are at rock bottom levels and performances of certain of the key stock markets have been not particularly impressive. So what sort of problems does that present to fund managers?

ANTHONY NUTT (Retired investment director and fund manager)

Well it does present problems because when returns are not very strong it’s really quite difficult to generate added value. That would be my argument. I mean there are some good reasons why economic growth is more modest that it has been in the past: population is declining, consumption waning, too high levels of debt - the sort of issues that we talk about in the economic pages of the press each and every day. So those excessive returns, those high returns rather than excessive, are much more difficult to achieve over and above the prevailing rate of economic growth within a given economy.

MARTIN UPTON

Does that then make fund managers take more risk than they should with their portfolios of investments?

ANTHONY NUTT

It’s unlikely but it may do. Fund managers, as professional practitioners, should, do, I would argue, understand risks. They look at the companies they invest in, if they’re an equity investor, or indeed a debt investor. They follow those companies really quite closely. In some cases fund managers will have followed the company a lot longer than the people running the company. And they build up research, they build up information, they build up knowledge about the businesses they invest in with the intention of recognising any risks which might undermine the return that they’re expecting or indeed enhance it.

MARTIN UPTON

OK. One last question on performance: There’s a lot of talk about technical analysis or chartism, as it’s alternatively know, as a means of enabling outperformance of the market. Charts enable you to predict, if you take the view of those who are fans of chartism, enable you to predict future market movements - future price movements. What are your views on chartism?

ANTHONY NUTT

Well, frankly it’s changed over the years and I would say sitting here today I am not a huge fan of chartism. The reason being, what does it identify? It identifies what has happened to investing patterns; who’s been buying, who’s been selling in terms of volumes, what’s been happening to the share price of a given investment. So for me it’s much more about historical patterns rather than predictive patterns. And to then look at the historical patterns and argue that can be predicted and send signals as to what may happen in the future, I think is a pretty tenuous argument to my mind. So I don’t really look at charts. I think they tell me a lot about historical behavior in the share price of a given company.

MARTIN UPTON

Do you think that it is a trend whose time is past, basically? I seem to remember back in the 1980s, 1990s there’s a lot of coverage of chartism in the specialist financial press, a lot of courses were offered on chartism.

ANTHONY NUTT

Indeed, I know people ...

MARTIN UPTON

But I don’t seem to see as much focus enthuses these days.

ANTHONY NUTT

No, I think that’s right because I think investing patterns and investing behavior during those times was more uniform, more understandable, and less sophisticated products were on offer. Now that’s not a particularly good point. The point I’m making there is the investment arena, the investment banks, the providers of investment products have offered more and more esoteric products to the retail investor and indeed the institutional investor and I think that’s complicated the expectation of returns.

MARTIN UPTON

Anthony, my most recent experience with chartism was not a good experience. I looked at the charts of a particular share and said, ‘This share has to be sold.’ So I did and low and behold within weeks it had soared upwards in price. So it was not a sell it was a hold or buy. So perhaps in the future I’ll be putting the charts to one side, hey!

ANTHONY NUTT

There you go Martin. Did it meet your criteria though?

MARTIN UPTON

Um, possibly not really on reflection.

[Laughs]

Thanks, Anthony.

ANTHONY NUTT

Thank you.

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4.2.5 Assessing a portfolio’s performance

Figure 8 How highly do you score your fund manager?

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The image shows a gymnast performing on the beam. In the background the judges are holding up their scores for the performance.

Figure 8 How highly do you score your fund manager?

Most retail investors or traders judge performance against the cost of the shares that they have bought, ignoring the opportunity cost of their money – what they would have got from investing in an equivalent-risk investment, including dividends, for the whole five-year period.

You can only really judge performance relative to a benchmark. This might be buying an index fund linked to the FTSE All Share index and holding it for five years untouched, but if you included non-UK shares in the portfolio, a more international benchmark would be appropriate. It is all too tempting to set yourself an easy benchmark and to forget the bad investments that you have made, concentrating only on the successes.

4.3 Historic returns from different asset classes

Tables 4.2 and 4.3 summarise the historical evidence of returns from different types of investment ‘asset classes’.

While evidence suggests that there is no guarantee that what has happened in the past will happen in the future, historical performance of products is still informative. Table 4.2 shows the average annual returns on UK equities, gilts and cash deposits for the periods 1899–2015 and 2005–2015. Note that when we talk about ’cash deposits’, these are investments whose returns are akin to those on bank or building society savings accounts. They are similar to cash in that they are liquid assets, and ‘cash deposits’ is the term that you will come across in this kind of product analysis in advanced personal finance literature. Note that the table is looking at a portfolio of equities – in this case the performance of the FTSE All Share Index, which includes around 1000 companies’ shares listed on the London Stock Exchange. Note also that the table shows real returns – in other words, the return over and above the amount needed simply to keep pace with inflation in order to maintain the buying power of the capital.

Table 4.2 shows that, over both periods, a diversified portfolio of equities outperformed gilts, which in turn outperformed cash deposits on a yearly returns basis. This outperformance is reinforced by the data in the second table on the value at the end of 2015 of £100 invested at the end of 1899.

Compounded over a number of years, the differences in annual average returns between equities, bonds and cash can make a huge difference in money terms.

If investing in shares makes higher returns, why don’t people put all of their money in UK equities rather than in gilts or cash? One point to bear in mind is that such returns are only an average on a portfolio of shares, achieved over the period shown in the table. The actual return on a portfolio of shares in any one year has ranged from a staggering −51.7% (the loss of more than half of the capital) in 1975 to a rebound the following year of a 150.9% gain!

A person’s attitude to investment risk will determine how much someone invests in equities (shares), in bonds and in cash (or savings products). If someone is highly risk averse, they are more likely to stick to savings products and bonds – although the evidence here shows that they will be likely to lose out over the medium to long term by being under-invested in shares. If someone is less risk averse, they will be happy to focus more on shares when it comes to the composition of their investment portfolio – provided their investment time horizon is not too short.

4.3.1 Historic returns: proof that the time horizon is crucial

You have already learned that risk also relates to the length of time of any investment. Normally, the longer someone intends to invest without needing to sell, the more risk can be afforded. Table 4.4 uses past data to show how likely it is that the shares will beat cash deposits or gilts as an investment over two different time periods or horizons – five years and ten years, without withdrawing any money, that is, allowing for compounding of interest.

The probability (from 0–100%) is based on the number of periods in which equities outperformed either cash or gilts expressed as a percentage of the total number of periods between 1899 and 2015. Therefore, if we consider all possible five-year time periods between 1899 and 2015, there were 112 of them. For those 112 time periods, equities outperformed cash deposits 84 times, giving a probability of 84/112 × 100 = 75%. For the ten-year periods, the outperformance rate was even higher – 91% against cash deposits.

So, past evidence suggests that the longer the time period, the more likely it is that equities will outperform bonds and cash – assuming that past returns are good predictors of the future. Studying the past seems to say that, with as short a time horizon as five years, there is a three-in-four chance of doing better if you held all equities rather than all bonds or all cash deposits. With a ten-year time horizon, there is more than a nine-in-ten chance of doing better with equities than with cash deposits. Put another way, the risk of underperformance with an equity portfolio over ten years is less than 10%.

History would seem to suggest that someone is unlikely to lose when investing in equities compared with buying bonds or putting their money in a savings account. Nevertheless, the past would not have been a good forecast of the future if someone had been investing £1000 for ten years in 2000. This was the start of a bear market with share prices falling for a sustained period. The FTSE All Share Index started 2000 just below a value of 3000. By September 2010, the index stood some 100 points lower at just under 2900. The investor’s £1000 would have fallen to £967. This highlights that the probabilities in the table above are calculated over a very long time period and may not take into account more recent changes. Consequently, the past is not necessarily always a good indicator of a particular future.

4.3.2 Bubbles

Periodically, periods of manic buying affects financial markets – particularly share markets.

There have been many examples of share prices ballooning skywards on upbeat speculation about the prospects for certain companies, only to plummet on discovery that these prospects are more a mirage than a reality.

In these circumstances, the share price movement is like an expanding bubble that, at some point, will inevitably burst.

Watch the following video, in which a number of specialists in personal and corporate finance discuss what is meant by the term ‘bubble’.

Download this video clip.Video player: ou_futurelearn_mmi_vid_1127.mp4

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Transcript

[Sound of bubbles]

NARRATOR

So what exactly is the definition of a bubble?

DAVID LLEWELLYN (Loughborough University)

People buy simply because they believe that everybody else is going to buy. You get what is called a bandwagon effect and from time to time you then get a situation where prices go far too high and that is really what we call a bubble.

NARRATOR

Bubbles are characterized by volatility with shares swinging from wildly over to wildly under priced often in a matter of minutes.

MARIANA MAZZUCATO (The Open University)

Robert Shiller from Yale University talked about bubbles arising from irrational exuberance and what he’s done to actually measure bubbles is he’s defined excess volatility to mean the degree to which stock prices are much more volatile than the underline fundamentals, which in theory they are tracking.

NARRATOR

There are also more specific types of bubble.

JAMES MONTIER (Author, Behavioural Investing)

The first form of bubbles are what we call bubbles of belief or fads. These are bubbles that are really driven by hype.

NARRATOR

The tulip bubble in seventeenth century Holland was a good example of this. Flowers were traded for up the ten times the annual wage of a skilled craftsman or in exchange for a six bedroomed house. One bulb sold for six thousand Dutch florins at a time when a ton of butter was just one hundred. In 1637 prices collapsed meaning they were no more valuable than onions. Britain’s South Sea bubble of 1720 was another bubble of belief. Set up to trade in South America, the South Sea companies’ promise of huge growth lead to fevered speculation.

MARTIN WOLF (Chief Economic Commentator, Financial Times)

Sir Isaac Newton who bought shares in the South Sea bubble, made an enormous amount of money, sold the shares. He was fine and then he saw it going on up and he bought again and he lost it all.

NARRATOR

After losing twenty thousand pounds he observed that he could, ‘Calculate the movement of the stars but not the madness of men’. James Montier calls the next type of bubble an intrinsic bubble.

JAMES MONTIER

These are bubble in fundamentals rather than actually bubbles in prices. So behavior of the financial sector in the last seven or eight years might be regarded as an intrinsic bubble because they geared up - so it looked like they were actually profitable but in fact it was all just leverage.

[CRASH]

NARRATOR

Another type is known as an informational bubble

JAMES MONTIER

Certain parties in the market will know things that other parties don’t and they may not transact on that information. So not all information is properly reflected in prices. They tend to be very stock specific rather than market level events.

NARRATOR

On a wider market level, the price increases in the U.K. housing from the mid 1990s until 2007 are seen by many economists as a classic bubble.

JOHN CALVERLEY (Standard Chartered Bank)

In my view the big rise in house prices in the U.K. and some other countries in the last ten years is a bubble. Some people argue that with the low interest rate environment we’ve had in the last several years, with the lack of housing supply and so on that the high prices of houses are justified. I don’t think that’s right. I think that what’s happened is we’ve seen people convinced that house prices would forever raise and they’ve been buying bigger houses and more expensive houses that they otherwise would need. And so we’ve had an excess demand created by the view that house prices would always go up. I think, for me, that justified calling it a bubble.

[Bubble sounds]

End transcript

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The origin of the term ‘bubble’ is thought to emanate from the fate of the South Sea Company. The saga of the South Sea Bubble in the eighteenth century has great similarities with other more contemporary bubbles, such as the so-called dot-com bubble in the early 2000s.

The South Sea Company was formed in 1711 and was given a monopoly to trade in Spain’s South American colonies. The overhyped prospects for this business in the New World built up a frenzy of speculation in the shares issued by the South Sea Company. This reached a head in 1719 and 1720. The company’s share price rose from £128 in January 1720 to £1000 by August, only to collapse to £150 in the subsequent month. The extent of involvement in this share price bubble, including members of the Government, and the sharp decline in the share price resulted in widespread bankruptcies and company failures. Curiously, the South Sea Company itself survived, albeit in a restructured form, and traded for another century.

Spotting bubbles is a crucial skill in investment management. If you have invested in a share whose price is rising rapidly, you need to determine whether this is because of the company’s performance or simply hype, based on unrealistic expectations about the company’s potential. If it is the latter, get out before the bubble bursts!

4.3.3 Google: success story or a bubble yet to burst?

Figure 9 Don’t be caught out when an investment bubble bursts!

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The image shows four bubbles with a question mark in each.

Figure 9 Don’t be caught out when an investment bubble bursts!

The internet search engine company Google, established in 1998, adopted a very different approach to their IPO on the NASDAQ stock exchange in August 2004.

Controversy accompanied the run-up to the launch, with Google encountering problems with SEC regulations for public offerings by issuing shares to staff prematurely and by talking about the issue to Playboy magazine. The company also declined to market the issue of shares by road-showing it to potential investors – something that is commonplace when companies enter a market for the first time. The greatest interest, however, focused on Google’s approach to pricing their IPO: they decided to use a Dutch auction to allocate the shares. With this method, shares are distributed to investors whose bids are at or above the price that sells all the shares available. In effect, Google was asking investors to say what they thought was the right price for the shares, rather than vice versa. In theory, this method should mean that at launch the issuer extracts the maximum proceeds possible. Did this work?

After a late decision to cut the number of shares offered from 25.7 million to 19.6 million, Google set a price range of $85–95 (below the range previously indicated). The Dutch auction allocated the shares at $85 – the base of the indicated range, but once the shares started trading their price rose above $100 and after three months they were trading above $169. This was not entirely surprising since the Dutch auction appears to have been flawed: at $85 there was unmet demand for Google’s issue of shares, with one quarter of the bids for shares being unsuccessful. Despite the fact that equity markets were on the upturn in autumn 2004, it appears that Google underpriced its IPO. The complexity of the Dutch auction may have deterred investors from bidding for shares at the launch, thereby constraining the issue price.

The conventional process of marketing and book building would almost certainly have yielded the company more from its IPO, but Google is anything but a ‘conventional’ company. In addition to providing an interesting case study of an IPO, the subsequent sharp rise in Google’s share price prompted – not for the first time – interesting questions about the valuation of a technology company. Indeed, valuing young technology-based companies with a short financial history that operate in a rapidly changing business environment is always a challenge.

Shortly after the issue, Allan Sloan of the Washington Post wrote:

Sloan’s prediction was proved correct: Google made $3.1 billion in net income on revenues of $10.6 billion in 2006. Despite this, Google has continued to be a high profile corporate success story. In July 2011, it announced net income of $4.3 billion on revenue of $17.6 billion for just the first six months of 2011. The surge in its share price had resulted in Google becoming the world’s largest media company.

At the time of writing (2020) the success story of Google is truly staggering. On 9 December 2020 its share price was $1778, having more than doubled since mid-2017 – and remember global stock markets were struggling in 2020 due to the COVID-19 pandemic! Note that the parent company of Google is now Alphabet following a company restructuring in 2015 – so search for Alphabet (on the Nasdaq exchange) rather than Google when tracking the company’s share price.

So, by 2020 the concerns being expressed about Google were about its global power rather than whether the company was a bubble.

4.3.4 Privatisations and demutualisations – easy money?

Figure 10 These institutions were either privatised of demutualised.

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The image shows the logos of the Abbey National and the Alliance & Leicester – two building societies that demutualised. It also shows the logos of British Gas and Severn Trent (Water Authority) – two state bodies that were privatised.

Figure 10 These institutions were either privatised of demutualised.

The 1980s and 1990s saw what came to be believed as sure-fire ways to make easy money from shares – privatisations and demutualisations.

Privatisations – the conversion of state-run utilities to private listed companies via a sale of shares to the public got underway in the UK in 1984 with the privatisation of British Telecom. This was followed by a succession of further privatisations in the following years including British Gas, British Airways, the regional water utilities (for example, Severn Trent) and the British Airports Authority. Additionally, the UK Government sold off its holdings in companies like BP and British Aerospace.

The rationale for the privatisations was a mixture of politics and economics. Getting more members of the public to become shareholders and to become actively engaged in a shareholding democracy fitted with the ethos of the Conservative Governments of the late 1970s and 1980s. Getting government out of business by selling off state utilities, which were simply businesses owned or part-owned by the state, also resonated with their economic philosophy.

The economics were compelling too. Privatisations raised huge amounts of money – some £50 billion between 1984 and 1996 – and hence reduced the need of the government to borrow.

For those who successfully received allocations of the new shares in the privatised utilities, the economics usually looked good too. In most cases, the share prices rose sharply immediately after flotation, with the result that instant profits could be made by a sale immediately after the launch date (a practice known as ‘stagging’). The reasons for this phenomenon are much debated. Suggestions include:

• the underestimation of demand from personal investors for the shares, with this demand being whipped up by extensive advertising campaigns
• the fact that institutional investors had to buy up large amounts of shares for funds that tracked the FTSE 100 – since in most cases the size of the privatised utilities meant that they joined the list of the 100 largest companies on the London Stock Exchange
• the desire of the investment banks (who arranged the privatisations) to see successful share issues. This meant that no risks were going to be taken by pitching the offer price of the shares at a level which left even a proportion unsold on the launch date.

The privatisation period came to an end with the arrival of the new Labour Government in 1997. In truth though, there was not much left at that point for the government to sell off!

4.3.5 Precipice bonds

Figure 11 Investments in precipice bonds came with big risks.

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The image is a drawing of a climber on a rope on the side of a mountain.

Figure 11 Investments in precipice bonds came with big risks.

Sometimes investors do experience outcomes from their investments that are both adverse and unexpected. In some cases, this arises from the mis-selling of products, in others it arises due to unrealistic expectations about the prospects for an investment’s performance or, simply, lack of attention to the detail of the risks involved. You saw aspects of these issues when you looked at the performance of endowment policies in Week 2.

A further case which demonstrates issues of both mis-selling and misinterpretation of investment risks came with the ‘precipice bonds’ in the 1990s and early 2000s.

The low rates of interest that prevailed in the UK from 1993 adversely impacted on the returns from interest-linked investments. Experiencing a fall in investment income on which they may have been reliant, perhaps made it inevitable that some investors would be tempted by investments where a high income was guaranteed by the product provider.

Such high-income bonds – latterly known as precipice bonds – became prevalent in the 1990s. Between 1997 and 2004, a total of some £7.4 billion was invested by over 250,000 people in these products.

These bonds were usually offered for specified periods – typically of 3 or 5 years. The bonds either offered higher annual interest than that available on conventional products or a high growth rate in the value of the investment made. These advertised rates were guaranteed. Additionally, the bonds were marketed as being tax-efficient because the returns were not subject to capital gains tax (CGT) – in contrast to the profits made on ordinary share dealings. However, this CGT exemption would have been irrelevant for the majority of investors because the capital gains, even on optimistic forecasts, would have fallen below the profits threshold at which CGT becomes payable.

But with these high returns came high risks – the amount of the original investment made by the customer that was returned to them on the maturity of the product was not guaranteed, and was dependent instead on the performance of specific shares or indices to which the product was structurally linked. Thus, although a high income might be achieved, the customer could easily end up getting back a much reduced amount of the original capital sum they had invested.

When the equity markets fell in value sharply in the early 2000s, the risk element of these precipice bonds was triggered, with thousands of investors losing significant amounts of their capital.

A number of regulatory issues arose from precipice bonds.

4.3.6 Precipice bonds – mis-selling or mis-buying?

In an environment of lower investment returns, the high returns offered by precipice bonds were attractive to investors.

Arguably, even the most inexperienced investors should understand that there is a relationship between risk and return. High returns are usually associated with high risks. Investors should have been alive to this very simple fact of investment life when considering whether to invest in precipice bonds. The simple risk–return relationship is not rocket science!

Figure 12 The Financial Ombudsman Service (FOS) deals with disputes between customers and financial firms.

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The image is the logo of the Financial Ombudsman Service (FOS).

Figure 12 The Financial Ombudsman Service (FOS) deals with disputes between customers and financial firms.

4.4 Supermarkets – low betas but high risk?

For those seeking to invest cautiously in UK equities, the draw of buying shares in the major supermarket companies looked like a safe bet. With secure footholds in markets where consumer demand was guaranteed, the supermarkets looked like equity investments that would deliver steady dividends and few share price shocks. Their low betas pointed to their relatively low risk as equity investments.

Then came 2014 – as Table 4.5 shows, the UK supermarket groups belied their image as ‘boring’ stock – although not in the way that pleased those investing in them.

In a year which saw the FTSE 100 treading water, these ‘low risk’ stocks lost around half their value.

So had supermarkets suddenly become high-risk stocks? Were their betas wrong?

The probable answer is that 2014 proved to be the ‘exception that proved the rule’ for supermarket stocks. They remain stocks which normally experience less volatility than the market as whole. In 2014, though, a major shift occurred to the expected profits of Sainsbury’s, Tesco and Morrisons due, primarily, to changes to the structure of the (food) supermarket industry in the UK. The growing market share of relative new entrants like Lidl and Aldi, as well as economy stores like Poundland, impacted on the market leaders.

Additionally, changes to shopping habits, which are seeing people move away from doing their entire weekly shop in one supermarket, are also hitting the market leaders.

Investors took this to be a realignment of medium to longer term profit expectations of the leading supermarkets and so priced their shares down accordingly.

So, supermarket shares are now still low volatility stocks albeit from a lower share price position. One-off quantum shifts do not make betas rise sharply. What makes a beta rise is when a share price is consistently more volatile than the market as a whole.

To understand more about what has happened to the UK supermarket industry in recent years let us look first at the financial environment within which these organisations conduct their business. To do this we will use ‘Porter’s five forces model’, a well-established model, first developed and published by Michael Porter in 1979 and developed further in 1996 and 2008 (Porter, 1979; 1996; 2008). This model, set out in Figure 13, identifies the five forces that will heavily influence an organisation’s financial strategy.

Figure 13 Porter’s five forces

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The image is the figure of Porter’s ‘5 Forces’ business model which examines the market power of organisations. In the centre is the ‘force’ of market rivalry between organisations. Around this centre are the forces (or threats) of new entrants to the market, substitute products, buyer power and supplier (e.g. of labour) power.

Figure 13 Porter’s five forces

At the centre of the model is ’industry rivalry’. This relates to the extent of the existing competition in the markets in which the organisation conducts its business. At one extreme, markets can be very competitive – particularly when the products offered are identical (‘homogeneous’) in nature and when there are a large number of suppliers. In these circumstances, the organisation has little power to determine the market price of its products. The prices are set by the market as a whole and the organisation has to be a ‘price taker’, that is, accept the fact that it has to charge its customers the price currently prevailing in the market. Its ability to operate in this market, and to make sufficient profits to sustain it in business, will be dependent on its ability to contain business costs to a level below the income it receives from selling its products. Organisations operating in competitive markets cannot, therefore, be inefficient in managing their operations as there is no scope to pass on the cost of such inefficiencies to customers.

At the other extreme, the organisation may be a monopolist – the only supplier or one of only a very few suppliers (in that case: oligopolist) − of a particular product. Here, the organisation has considerable power in setting the market price of the product. Note, though, that in this environment the organisation’s power over the market is not total since, if it sets prices too high, some customers, at least, will forego the product as they may no longer be able to afford it.

So what has happened to the major UK supermarkets in recent years? Simply put, market entrants over the past decade have created more competition in the industry, resulting in lower profit margins for Tesco, Sainsbury’s and Morrisons.

4.4.1 Different decades, different returns

Figure 14 Icons of decades of the twentieth century

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The figure shows a number of images, one for each of the decades from the 1940s to the 1990s. For the 1940s there is a photo of a ration book and rationed goods. For the 1950s there is a drawing of a typical scene in the lounge of a family home in that decade. The 1960s image is of The Beatles. The 1970s image is of David Bowie. The 1980s image is of Duran Duran, a ‘New Romantic’ pop group and the 1990s image is of The Spice Girls wrapped in a Union Jack (hence representing the ‘Brit Pop’ era).

Figure 14 Icons of decades of the twentieth century

The past century has seen several dramatic changes in investment returns over medium- to long-term periods.

Set out in Table 4.6 are 11 periods going back over 100 years. For each of these, the average rate of price inflation for the period is provided and some details are given about the economic conditions prevailing together with other key developments affecting the financial markets.

4.5 Week 4 quiz

Check what you’ve learned this week by taking the end-of-week quiz.

Start quiz

Open the quiz in a new window or tab then come back here when you’re done.

Week 4 round-up

We have once again covered a lot of ground this week, exploring investment practices, investment performance and lessons from recent investment history.

By examining the ways that investment performance is assessed we have seen what has to be done in the fourth ‘review’ stage of the investment management model.

Certainly the content of this week and last week constitute the most complex in this course. If you have got to grips with the array of theories and concepts presented and how these can be applied to investment management, you are now well positioned to make informed decisions about your own investments.

Don't forget to continue with Activity 2.4 and check the prices for the selected companies once a week and enter their level in the Market shares tracking worksheet. Remember, you can follow these shares using the BBC Market Data tool, or by picking up a newspaper which focuses on financial markets.

Next week, we focus on the key investment issue of pension planning. This is most important investment we make in life and understanding the pensions landscape is vital.

You can now go to Week 5.

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This free course was written by Martin Upton.

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Figure 7 All logos shown are Registered Trademarks or Trademarks of their respective companies

Figure 10 All logos shown are Registered Trademarks or Trademarks of their respective companies

Figure 14 © The Open University (Food rations and ration book - IWM/Three generations watching TV - GraphicaArtis/The Beatles - Bob Thomas/David Bowie as ‘Ziggy Stardust’ - Michael Ochs Archives/Duran Duran - Fin Costello/The Spice Girls - Photoshot – all via Getty Images

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References

Porter, M.E. (1979) ‘How competitive forces shape strategy’, Harvard Business Review , vol. 57, no. 2, pp. 137–45.

Porter, M.E. (1996) ‘What is strategy?, Harvard Business Review , vol. 74, no. 6, pp. 61–78.

Porter, M.E. (2008) ‘The five competitive forces that shape strategy’, Harvard Business Review , vol. 86, no. 1, pp. 78–93.

Sloan, A. (2004) IPO’s success doesn’t justify Google’s price [Online]. Available at www.washingtonpost.com/wp-dyn/articles/A27391-2004Aug23.html (Accessed 28 February 2005).