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List of figures xv3.17 Frequency of equity outperformance of bonds,overlapping 5-year periods 623.18 Frequency of equity outperformance of bonds,overlapping 20-year periods 624.1 VIX indicator of US stockmarket volatility 664.2 Tobin’s Q: ratio of the market value of US corporateequity to replacement cost 684.3 S&P 500 “Shiller” price/earnings ratio 694.4 Spread between single A credit indices and highest-ratedgovernment bond indices 704.5 US Treasury 10-year constant maturity yields 725.1 Stylised surplus risk and opportunity for long-terminvestors, stylised approach 975.2 Comparison of municipal and US Treasury long-datedbond yields 1045.3 Long-dated municipal bond yields as a percentage of USTreasury yields 1045.4 US stocks, bonds and cash: “efficient frontier” and modelallocations for “short-term” investors 1147.1 Cumulative total return of US small cap and large capstocks 1417.2 10-year rolling average returns for US small cap and largecap stocks 1427.3 Ethical investing, cumulative returns 1447.4 Cumulative total return performance of US growth andvalue equity indices 1497.5 Volatility of US growth and value equity indices, 36-monthrolling standard deviations of return 1497.6 US value and growth equity indices, 5-year rollingperformance 1507.7 US and international equities, 5-year rolling equityperformance 1547.8 UK and international equities, 5-year rolling performance 1547.9 Volatility of domestic and global equities from alternativenational perspectives 155Guide Investment Strategy.indd 1513/11/2013 10:54

xvi Guide to investment strategy7.10 Who needs international equity diversification?Volatility of equity investments from a US, Chinese andIndian perspective 1577.11 Correlations between US equity market, internationalequities and emerging-market equities 1587.12 Correlations between UK equity market, internationalequities and emerging-market equities 1587.13 International equity volatility from the perspective ofdifferent countries, annualised standard deviationof returns 1607.14 US perspective on impact of hedging internationalequities, 36-month rolling standard deviation of returns 1607.15 UK perspective on impact of hedging internationalequities, 36-month rolling standard deviation of returns 1617.16 Volatility of world and emerging-markets equities, 5-yearrolling annualised standard deviations of returns 1637.17 Performance of emerging-market equities in best upmonths for world equities 1637.18 Performance of emerging-market equities in worst downmonths for world equities 1647.19 5-year rolling beta between emerging-market and worldequities 1657.20 10-year rolling returns from developed andemerging-market equities 1657.21 World, emerging and frontier markets, 36-month rollingcorrelations 1678.1 Default rate of Fitch-rated issuers of corporate bonds 1748.2 US corporate bond spreads 1768.3 Cumulative performance of US under 10-year Treasuryand corporate bonds 1778.4 Yields on US mortgage securities 1858.5 Cumulative performance of agency mortgage-backedsecurities and commercial mortgages 1858.6 US government bond monthly returns compared withmortgage-backed securities 1878.7 German government bond performance in euros 1908.8 German government bond performance in US , unhedged 191Guide Investment Strategy.indd 1613/11/2013 10:54

List of figures 411.511.611.712.112.212.312.412.5German government bond performance hedged to US 191Hedge fund industry assets under management 196Cumulative performance of hedge fund index and equities 200Hedge fund assets under management by type of strategy 206Monthly performance of arbitrage and multi-strategyhedge fund indices 225Volatility of public and private equity, proxied by 3i shareprice and FTSE 100 index 237Volatility of private and public equity, proxied by 60-dayvolatility of 3i relative to UK stockmarket 237Volatility of total equity as private equity increases 240Cumulative performance of global listed private equitycompanies and global equities 242The four quadrants of real estate investing 250Valuation-based and transaction-based measures of totalreturn from real estate investments in the US 253Valuation-based and transaction-linked measures ofcommercial real estate prices in the UK 253Valuation-based and transaction-linked measures ofcommercial real estate prices in the euro zone 254Cumulative performance of US equities and REITs 255Volatility of US equity REITs and US stockmarket, rolling36-month standard deviations of return 256Is it cheaper to buy real estate on Wall Street or Main Street?US REITs’ share price compared with Green Streetestimates of property net asset value 265Returns from fine art, stamps, violins, gold and financialassets 272Worldwide fine art auction house sales 275Calendar year performance of global equities and classiccars 283Monthly performance of world equities and classic cars 283British Rail Pension Fund realised rates of return for 2,505individual works of art acquired between 1974 and 1980 286Guide Investment Strategy.indd 1713/11/2013 10:54

List of tables3.1 Long-run market performance and risk 523.2 Longest periods ending December 2012 of equitiesunderperforming long-dated government bonds 563.3 Does time diversify away the risk of disappointing equitymarket performance? 614.1 Indicators of global investable assets 744.2 Pattern of asset allocation by global investors 765.1 Unaggressive strategy: negative return risk varies asinterest rates move 855.2 Bond diversification in months of equity market crisis 865.3 Bond diversification in years of extreme equity marketperformance 875.4 Stylised model long-term strategies, with only stocks,bonds and cash 965.5 Model short-term investment strategies, with only stocks,bonds and cash: historical perspective 1125.6 Model short-term investment strategies, with only stocks,bonds and cash: forward-looking perspective 1135.7 US and global capital markets: volatility and excesskurtosis 1166.1 The impact of taxation on taxable investment returns andwealth accumulation 1338.1 Government bond and equity markets 1708.2 Long-term rating bands of leading credit-rating agencies 1728.3 Corporate bond average cumulative default rates 1738.4 US corporate bond yields, spreads and performance 1758.5 US investment grade credit spreads and excess returns 178Guide Investment Strategy.indd 1813/11/2013 10:54

List of tables xix8.6 Performance of selected debt markets in months ofextreme US equity performance 8.7 US corporate high-yield and emerging debt marketssummary statistics 8.8 Performance and volatility of components of Barclays USAggregate bond index 9.1 Hedge fund performance during calendar quarters ofequity market crisis 9.2 Hedge fund industry: assets under management 9.3 Hedge fund performance during calendar quarters ofequity market crisis 9.4 Selected hedge fund strategies: correlations withglobal equity market 9.5 Equity hedge fund performance during calendar quartersof equity market crisis 9.6 Emerging-market hedge fund performance duringcalendar quarters of equity market crisis 9.7 Fixed-income hedge fund performance during calendarquarters of equity market crisis 9.8 Arbitrage hedge fund performance during calendarquarters of global equity market weakness 9.9 Multi-strategy hedge fund performance during calendarquarters of equity market crisis 9.10 Managed futures fund (CTA) and commodity indexperformance during calendar quarters of equity market crisis 10.1 Geographical spread of Standard & Poor’s Listed PrivateEquity index 11.1 Direct real estate investment by type of property 11.2 US, UK and euro zone real estate market indices: volatility,and correlations with stocks and bonds 11.3 Income yield from REITs, quoted equities and bonds 11.4 Direct real estate investment by type of property Guide Investment Strategy.indd 25826113/11/2013 10:54

AcknowledgementsI owe a debt of gratitude to many individuals who helped mewith this book. First and foremost to my wife, Alex, for her continuedsupport and patience through this edition’s labour. Elroy Dimsonand Steve Satchell provided invaluable advice and suggestions(as for the previous editions). Stephen Collins provided importantadvice, suggestions and introductions. Colleagues at Delmore AssetManagement and the Financial Planning Corporation have beenparticularly patient as I have been preoccupied with the book. Manyformer colleagues have also been generous with their suggestions. Ialso owe a substantial debt to the trustees and principals of the fundsthat I have been privileged to work with over the years.I have been privileged to attend a number of seminars organisedby Norway’s Government Pension Fund (Global) in the past fewyears. This book has benefited considerably from the insights gainedat these world-class meetings, which debate the interface betweenacademic research and practical investment issues.Generous and insightful contributions on particular issues orchapters were provided by Victoria Barbary, Paul Barrett, Jörg Behrens,Nick Bucknell, Jeff Bryan, Ewen Cameron-Watt, Forrest Capie, NormanDeitrich, Robin Duthy, Hugh Ferry, Geoffrey Fiszel, Charlie Goldring,Howard Goldring, Dietrich Hatlapa, Arzu Huseynov, Tim Lund, YoramLustig, Cesar Murillo, Arlen Oransky, Steve Piercy, Mark Ralphs, JohnPullar-Strecker, Max Rayner, Christof Schmidhuber, Paul Stanyer andJames Wyatt. I am most grateful to each of them, but any mistakesare my own.I am also indebted to those firms whose data I have used in thenumerous tables and charts. Without their support the book could notGuide Investment Strategy.indd 2013/11/2013 10:54

Acknowledgements xxibe published in this form. I would also like to thank Stephen Broughat Profile Books for his encouragement, suggestions and support. Mythanks are also due to Penny Williams, who skilfully and patientlyedited the book.This book aims to help inform the process of seeking and givingprofessional advice, but it cannot be a substitute for that advice. Itdraws on and summarises research and investor perspectives on awide range of issues, but it is not punctuated with footnotes citingsources for facts or opinions. Although important areas of debate areflagged with references to leading researchers, in other areas ideaswhich are more commonly expressed are presented but not attributed.Sources which were particularly important for each chapter are listedin Appendix 4.Please note that the views expressed in this book are my own andmay not coincide with the views of the investment funds on whoseboards or committees I am honoured to serve.In conclusion, let me say how privileged I am that Elroy Dimson,Emeritus Professor of Finance at London Business School, has agreedto write a foreword for this third edition of the book. Although myappreciation of markets owes a great deal to the economics that Ilearnt at Cambridge University, particularly from the late MichaelPosner and from Michael Kuczynski at Pembroke College, the LondonBusiness School’s Investment Management Programme gave me aninvaluable bridge from economics to modern finance.Guide Investment Strategy.indd 2113/11/2013 10:54

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ForewordInterest rates have collapsed. Savers who put aside moneynow, to spend in the future, will earn little by way of interest. Toaccumulate a target lump sum, they need to save more than theyonce planned. Retirees, who wish to live on their savings, can nowexpect to receive a smaller income from their investments. They mustadjust to having less to spend than they expected.Of course, low interest rates and low bond yields were for sometime clear for all to see. It was less obvious that low interest ratesimply low prospective returns on all assets, including equities.Because investors require some compensation for the higher risk ofthe stockmarket, equity returns must be equal to the interest rate plusa “risk premium”. It follows that, other things being equal, a worldwith low interest rates must also be a world in which stockmarketinvestors receive lower returns.What are the implications of this dramatic change in the financialenvironment? Peter Stanyer’s response is that every saver needs acoherent investment strategy. Strategy must be underpinned by anunderstanding of how markets move, how risk should be judged,how markets reward investors and how investors behave. In this thirdedition of his outstanding book, Peter Stanyer addresses these issuesand elegantly surveys the entire field of investment.He helps us to formulate an investment strategy that is realistic.The projections made by many asset managers, retail financial productproviders, pension funds, endowments, regulators and governmentsare optimistic. Overly optimistic estimates of future returns aredangerous, not only because they mislead, but also because they canmask the need for action.Guide Investment Strategy.indd 2313/11/2013 10:54

xxiv Guide to investment strategyInvestors vary in their need for liquidity, their tolerance forrisk, and their capacity to follow a disciplined investment strategy.They therefore need to devise a strategy that reflects their salientcharacteristics. The strategy should be founded on three pillars. Thefirst pillar is financial theory – how financial markets can be expectedto behave; the second is empirical evidence – how markets actuallydo behave; and the third is the investment environment – the currentcondition of financial markets.Peter Stanyer reviews the relevant aspects of financial theory in ahighly accessible way. He extends our knowledge without resorting tocomplicated mathematics, explaining the central concepts of modernfinance in a clear exposition of the arguments for and against differentapproaches. To better understand markets, he turns to the evidence offinancial history, often interrogating the long-term, global dataset thatmy colleagues and I have compiled. He allows the record of securitiesmarkets to enlighten us about events in the past and to underpininformed judgments about the future.To interpret the current investment environment, Peter Stanyerpresents us with a wealth of data. Drawing together theory, evidenceand information on the financial environment, he does not flinchfrom expressing a firm opinion. He presents valuable advice on howto construct a fixed-income portfolio, how to think about liquidity,what quantum of risk is acceptable for different investors, whatfactors influence investment performance, whether investments ofpassion are a store of value, and what behavioural biases investorsshould guard against.There is something for everyone in this book. It is comprehensive,but never forbidding or opaque. The surveys of each of the main assetclasses – equities and risky debt, alternative assets like hedge fundsand private equity, and tangible assets like real estate and artworks– are highly informative and the complexities of modern investingare explained with great clarity. This book will help you meet thechallenge of investing for your future.Elroy DimsonDecember 2013Guide Investment Strategy.indd 2413/11/2013 10:54

Introduction: lessons from theglobal financial crisisThe years since the credit crisis of 2007–9 have seen anumber of refreshingly simple investment messages gain tractionthat should enable investors to weather future storms in bettershape. These messages are as relevant to individuals managing theirown retirement savings as to the managers of the largest investmentfunds.One, emphasised by Antti Ilmanen, is that the timing of investmentvolatility matters as much as its magnitude. Andrew Ang stresses thisby asserting that the two most important words in investing are “badtimes”. This is a theme running through this edition and it has severalaspects. One is that past performance patterns can easily give a falselyreassuring impression of the likelihood of “bad times”. Another isthat investors should initiate discussions about how an investmentproposal might perform in bad times. If the investment will helpmitigate losses of income or capital and give flexibility in bad times, itwill be an attractive investment; if it might amplify them, and imposeinflexibility, investors will need to be rewarded amply for that and tounderstand why the reward is expected to be sufficient, given theircircumstances. This applies with particular force to the costs imposedby illiquid investments.Almost all investment products offer an alluring combination ofrisk and return. When these offer a better prospect than normallyoffered by the market, investors should always ask, how? Betterthan market performance must reflect some combination of rareskill; exploiting a market anomaly (but see Chapter 6); or a rewardfor risk-taking (see Chapter 7). The victims of the Madoff fraudsuffered because they or their advisers accepted the description ofGuide Investment Strategy.indd 2513/11/2013 10:54

xxvi Guide to investment strategypast apparent good performance with low volatility of his fraudulentfunds as descriptions of how they did, and so would, perform. Thevictims’ suffering was all the worse because their trust was betrayedby Madoff (see Chapter 1).All investors need to ask for explanations of attractive performance.Low volatility strategies in equities and credit are always popular,and Chapters 7 and 8 encourage investors to suspect that obscurerisk-taking may be the explanation. If it is, investors are forewarnedthat the attractive risk-return trade-off, which is a characteristic ofnormal times, might provide little protection in “bad times”. This wasa message of John Campbell and Tuomo Vuolteenaho’s (2004) article“Bad Beta, Good Beta” (see Chapter 7). It is also the message that hedgefunds and private equity are risk assets, and a usually reliable shortcut is to see them as types of equity investing. They will probably notprovide much help in “bad times”, but might nevertheless provideinteresting opportunities (Chapters 9 and 10).After 2008, some complained that the poor diversificatio

Guide to investment strateGy How to understand markets, risk, rewards and behaviour Third edition Peter