Views from the 2004 AIMR Conference

William Hester, CFA
March 2004
All rights reserved and actively enforced.

In February some of the most respected academics and practitioners in the investment management business met in New York City to discuss the industry's future. The message of the conference: times have changed.

As an attendee, it felt like an emergency meeting on the deck of a ship that was thrown off course by nasty weather. The storm began to brew last summer when investment consultant and historian Peter Bernstein wrote an article detailing the changes that can be expected in the field of money management 1 . There are few people in the business as respected as Mr. Bernstein, who is the founding editor of the Journal of Portfolio Management and the author of several books including Against the Gods: The Remarkable Story of Risk . His words were a jolt to an industry that had become comfortable with its own dogma.

Things are different this time, says Mr. Bernstein. The mental models and industry standards that were created during the great bull market are outdated and will be ineffective for the type of asset returns of the next decade or so. "What we have been doing has begun to outlive its usefulness; the world in which we invest today bears too little resemblance to the world of yesterday."

In the original article Mr. Bernstein focused on four areas where he expects to see substantial change: indexing, benchmarking, long only equity management, and soft dollar research. At the conference in February he expanded and defended these ideas. He also discussed how the demands of mutual fund shareholders could be creating inefficiencies in the market. Here are some of his thoughts both from the original article and his discussion at the conference.

Indexing

Indexing will lose its luster, says Mr. Bernstein. The power of equity indexing is broad diversification at a low cost. But the dynamic US economy undermines both attributes.

In 2000 there were 57 additions to the S&P 500 index, the most heavily indexed benchmark. Harley Davidson replaced Fleetwood Enterprises, Starbucks stepped in for Shared Medical Systems, and JDS Uniphase took the place of Rite Aid. Even since the market's peak, 23 changes a year have been made, according to Bloomberg data.

"New companies come along all the time to threaten and then overthrow the dominance of older companies. Creative destruction is our trademark," says Mr. Bernstein. Since the pace of technological advancement continues unabated, he thinks turnover will likely remain high.

He also points out that many of the most popular benchmarks are weighted by market value. This makes them top-heavy and strains the benefits of diversification. For example, the 10 largest companies in the S&P 500 index - only 2 percent of the total number - account for about 20 percent of its market value. The top 25 companies account for 35 percent of its value. This concentration can increase the volatility of the index, as was seen at the peak of the bubble.

Even though the larger indexes, such as the Wilshire 5000 Index and the Russell indexes, are spread out over more stocks, the largest companies affect the behavior of those benchmarks as well. These indexes have their own problems, too. "Strictly speaking, they are not investable pools of securities; they are floating crap games because their membership is much more fluid than even the membership of the S&P 500". So funds that attempt to index these benchmarks are saddled with the costs of frequent rebalancing.

Mr. Bernstein also pointed out that in the world of double-digit returns, beating the market was nice, but not mandatory to meet investment objectives. When investors begin to compare their expected future liabilities with the returns they can realistically earn on their assets, active investing may become "more attractive, even essential."

Benchmarking and Absolute Returns

Few ideas in this business have been so widely accepted as placing managers into size and style boxes. Divvying up professional investors into camps makes life easier for consultants. Choosing a manager for each combination of style and size is a simple way to create a diversified portfolio. Unfortunately, you may also create an underperforming one. When good managers are forced to adhere to only certain categories of stocks, their investors can be deprived of potential returns.

That's why managers with the greatest level of skill should be free of constraints, says Mr. Bernstein. He quotes the work of Richard Grinold and Ron Kahn, authors of the well-respected Active Portfolio Management: A Quantitative Approach for Providing Superior Returns and Controlling Risk 2 . In their book they show that the more highly skilled a money manager is, the more opportunities the manager should be given to provide extra return.

Bernstein argues that one way to measure this skill is to examine risk-adjusted returns: "The critical ingredient of performance measurement, therefore, is a manager's contribution to the fund's required rate of return relative to the risk the manager takes and the allocation assigned to the manager in the fund's risk budget. The results from these sorts of calculations do not attract a crowd around you on the cocktail party circuit, but they do lead to more effective manager selection and to greater efficiency in optimizing the mix of managers for low covariance and higher expected returns."

In addition to giving skillful managers a longer leash, Mr. Bernstein thinks that more attention will be placed on absolute returns, rather then a manager's return relative to a benchmark or a peer group.

Judging performance by peer comparison alone misses the point that assets are managed to meet future liabilities. The true benchmark for any particular investor is the return required in order to meet those expected liabilities at the date they are expected. The herding of investors into popular stocks and industries during the bubble, and their subsequent price volatility, should cause investors to question whether the popular indexes and style groups are the optimal benchmarks.

"In this sense, the notion of uncorrelated returns - especially, absolute returns, has a compelling attraction," says Mr. Bernstein.

Long Only

Letting skilled managers exploit opportunities means not holding them to a long-only constraint, says Mr. Bernstein. Why restrict skilled investors to only stocks that may rise? Skilled money managers should be able to profit from prices moving in either direction.

This will greatly expand the opportunities of a skilled investor. "Given the bias toward buy recommendations in most investment research and given the locked-in positions in which many taxable investors find themselves, should we not expect to find more inefficiency on the short side than on the long side?"

Short selling would likely lower a portfolio's volatility, he adds. "Why should institutions continue to tolerate the kind of volatility that conventional long-only investing inflicts upon their portfolios?"

Soft Dollar Research Deals

A 'soft dollar deal' is when money managers opt to receive research, subscriptions, or data terminals in return for paying higher brokerage fees. Like the stock market, these deals really hit their stride in the 1990's. The deals are convenient for portfolio managers because the fund's investors pay the higher transaction fees, but the expenses are not included in the more visible expense ratio.

The days of soft dollar research deals are numbered though, says Mr. Bernstein. Investors aren't going to pay higher fees for the biased research from investment banks. Money managers will have to seek out new and better opinions. "Objective research means true independence from conflicts of interest," says Mr. Bernstein.

The result will be higher quality research. But it won't come cheaply. Money management shops will need to either build internal research departments or pay third parties, says Mr. Bernstein. "Paying an investment banker for research with a few cents a share is no longer a viable strategy".

Open-Ended Mutual Funds and Investment Returns

It's obvious that investors prefer to have the option to sell their mutual fund shares at any time. Open-ended mutual funds account for 96 percent of fund assets, according to the Investment Company Institute . What investors might not realize is that they're likely paying a large cost when they use that option irresponsibly.

It's well known that on average, mutual fund investors have had surprisingly low returns compared to the performance of the average mutual fund itself. This is because mutual fund inflows are usually heaviest after fund prices have advanced significantly, while mutual fund outflows are heaviest after price declines. It's a classic example of buying high and selling low. Dalbar Inc., a consulting company, found that during the 16-year period through 2000, the average stock fund returned 14 percent. During that same period, the typical mutual fund investor had a 5.3 percent return. Other studies found similar results. Unfortunately, investors move in and out of funds, chasing performance, and end up capturing only a fraction of the available return.

But the open-ended structure of mutual funds is crimping returns in another way, says Mr. Bernstein. Because of the risk of short-term investor withdrawals, managers aren't able to exploit longer-term inefficiencies within the markets.

This discussion relied partly on new research by Jeremy C. Stein, an economics professor at Harvard University. Stein argues that the popularity of open-ended funds curtails managers' abilities to make certain types of arbitrage trades. These longer-term trades - allowing a depressed stock to become fully valued or betting against the Internet bubble - are where the strongest returns are most likely to be earned. This 'alpha' - a fund's return above its proper benchmark - is rarely found in short-term ideas.

But some shareholders sell so quickly, even for temporary underperformance, that managers don't have the capital to allocate to these longer-term ideas. Stein says, "being open-end exposes arbitrageurs to the risk of large withdrawals if they perform poorly in the short run. This risk in turn makes it dangerous for them to put on trades that are attractive in the long-run sense, but where convergence to fundamentals is unlikely to be either smooth or rapid".

This does leave opportunities for other investors. "Given this inefficient form (of open ended investment vehicles), funds will stick primarily to short-horizon strategies, and earn low excess returns. In so doing, they will leave large long-horizon mispricings... mostly untouched," says Stein.

Mr. Bernstein did offer up one idea to confront the problem: investors could agree to "lock" their investment for a certain period of time. Options would also be available to purchase, allowing for the early withdrawal of assets. This would place a value on the option to withdraw money early, a right investors currently think is costless. It would also better allocate expenses, since the cost of the withdrawal will fall predominantly on the investors that choose to exercise this right.

Where Do We Go From Here?

For the reasons outlined above, Mr. Bernstein thinks mutual funds will move toward a hedge fund model. Money managers will have freedom to select securities within an entire asset class; they will have the ability to hedge their portfolio in numerous ways (provided that the manager holds the portfolio's risk level to assigned parameters); they will do most of their own research, or pay for objective opinions; and the performance of money managers will be judged by the return of their portfolio versus its risk.

Mr. Bernstein concluded, "When returns are not as easy to come by as in the past, the constraints on manager activity imposed by benchmarking are archaic. Indexing has become more costly and more risky. And new techniques...that widen a manager's range of choices will always make sense in comparison with the old way of doing things."

1 Bernstein, Peter L. Points of Inflection: Investment Management Tomorrow . Financial Analysts Journal. July/August 2003.

2 Grinold, Richard, and Ron Kahn. 1999. Active Portfolio Management: A Quantitative Approach for Providing Superior Returns and Controlling Risk . McGraw Hill.

---

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).