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“Ask five economists and you’ll get five different answers . . . six if one went to Harvard.” Thus quipped Edgar Fiedler, the late US government adviser (and University of Wisconsin graduate). Conservative commentator (and Yale alumnus) William F Buckley was even more scathing about the Massachusetts seat of learning’s pecuniary competence: “I’d rather entrust the government of the United States to the first 400 people in the Boston telephone directory than to the faculty of Harvard University.”
So, news that the new head of Harvard’s century-old endowment fund is concerned about “frothy” markets, and hiring a few managers to make short-term bets on falling share prices, is likely to divide opinion. It sounds like one man giving a slightly different answer to the mainly long-term approach that went before. Or someone with a telephone directory of 400 hedge fund managers.
But it matters to your portfolio, too, because so many of today’s wealth managers cite Harvard as alma mater or idea stimulator (State Street used to charge a flat fee of $100,000 to run the $38bn endowment fund because so many of its fund managers went to the college). Where Harvard’s endowment leads, top investment houses follow.
Judging by the fund’s latest report, that means some may be following chief executive Stephen Blyth out of “potentially frothy” equity markets and into cash, and joining his search for “equity managers with demonstrable investment expertise on both the long and short sides of the market” — ie a willingness to short-sell some shares and profit when they fall. This from a fund that made a 0.1 per cent return on the $6bn it gave to “long/short” and other hedge funds last year.
In fact, Blyth is overhauling the fund’s entire approach to assessing risk and return. However, while the Harvard academics expend much chalk on reinventing portfolio theory, a more real-world approach to market froth has been developed by swots down the road.
For some years now, Acadian Asset Management (whose chief investment officer is ex-Massachusetts Institute of Technology and whose portfolio director is a Boston University postgrad) has been exploiting a theoretical anomaly. Although traditional financial theory teaches that risk is rewarded with higher average returns — and the rule generally holds good at an asset class level — there is extensive empirical evidence for a “low-risk anomaly” in equity portfolios: shares that exhibit lower beta, in other words, their prices vary less than the market and perform better than high beta counterparts. Acadian calls it “the greatest anomaly in finance”, and is not alone in researching it.
In 2004, Eugene Fama and Kenneth French — the academics who developed the efficient markets theory — tracked US share prices back to 1923 and found their textbook risk/return trade-off underpredicted the returns from low beta stocks. Similarly, a study by investor Jeremy Grantham of the 600 largest US stocks between 1969 and 2005 found the lowest decile by beta outperformed by an average 1.5 per cent a year, while the highest beta holdings underperformed by 2.7 per cent.
In the UK, wealth manager Charlotte Thorne of Capital Generation Partners (and Oxford University) has just compared Acadian’s managed volatility portfolios with other managers’ efforts to capture the anomaly. She identified 20 global developed market funds with low volatility mandates, and found that over the past four years they outperformed the MSCI World Index by 150bps with 30 per cent lower volatility. Similar results were achieved in emerging markets.
“Clients value low volatility less than they should,” Thorne concludes, noting that volatility can have a big impact on wealthy families’ portfolios designed to pay an income. She calculates that over the 14 years to January, a $100m portfolio paying out 4 per cent a year would be worth $115m if it matched the MSCI World Index with no volatility, but only $98m when exposed to full market volatility.
To her, the performance of managed volatility portfolios is no mystery — it is explained in two papers: “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly” and “The Low Beta Anomaly: A Decomposition into Micro and Macro Effects”. Lead author on both? Malcolm Baker, professor of finance at Harvard Business School and senior consultant at Acadian.
It seems a simpler answer to the Harvard endowment’s challenge was under its nose — and it is not always bad when, in the words of entrepreneur Mo Ibrahim: “People suspend their common sense because they get drowned in Harvard business school teachings.”
This article has been amended since original publication to clarify that the Harvard endowment’s focus is mainly long-term.