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Über dieses Buch

Institutions now dominate trading in equities around the world. Mutual funds are the most prominent, and doubly important as custodians of retirement savings. Despite this, there is no comprehensive description of fund manager behaviour, much less a matching theory. This is troubling because one of the most economically significant puzzles in finance is why experienced, well-resourced fund managers cannot outperform the market.

Applied Investment Theory: How Equity Markets Behave, and Why brings together academic research, empirical evidence and real market experience to provide new insights into equity markets and their behaviours. The book draws upon the author’s rich industry experience and academic research, plus over 40 interviews with fund managers on three continents and across different markets. The result is an innovative model that explains the puzzle of poor performance by mutual funds in terms of structural features of markets, the managed investment industry, and the conduct of fund managers.

This book provides a fully integrated depiction of what markets and investors do, and why – insights that will resonate with the needs of investors, wealth managers and industry regulators. It is fully documented, but free of jargon and arcane math, and provides a grounded theory that is relevant to anyone who wants to pierce the opacity of mutual fund operations. Applied Investment Theory sets out a new paradigm in investment that is at the forefront of what should be an industrial-scale development of new finance theory following two decades of almost back-to-back financial crises.



1. Introduction

  • Modern portfolio theory (MPT) is the dominant investment paradigm, and has proven resilient since its structure began to emerge in the early 1960s
  • In recent decades, important changes have occurred in investment that were not comprehended during MPT’s development. These include growth in scale of traditional markets and emergence of huge derivatives markets; and transformation of investors from largely risk-averse individuals to financial institutions operating in an oligopolistic, global industry
  • MPT has proven unable to explain stylised market and investor facts, most obviously biases in decisions of skilled investors, the regular cycle of significant equity price collapses, and waves of systemic corruption and weak governance in financial institutions
  • Although institutions are amongst the most sophisticated investors, they make limited use of MPT
  • Management of workers’ retirement savings by mutual funds is one of the most important principal-agent relationships in modern economies. Despite the importance of mutual funds, there is no comprehensive theory that explains their behaviour
  • In short, there is a need to significantly extend the existing investment paradigm.
Les Coleman

Investment Theory and Practice


2. Current Paradigm: Neoclassical Investment Theory

  • The framework of the current investment paradigm – neoclassical finance or modern portfolio theory, MPT – was largely developed by 1980, and remains the staple of business courses and research around the world
  • MPT is designed for individuals who own shares (i.e. investors are principals)
  • Core assumptions of the current investment paradigm are that investors:
    • Are fully informed and risk averse, and unconditionally maximise return
    • Perceive risk as the dispersion of possible outcomes around expected value, and proxy it with the historical standard deviation of returns
    • Measure investments’ utility in terms of expected return and standard deviation
  • The capital asset pricing model (CAPM) is the centrepiece of modern investment, and assumes that market return causes the return of individual equities so that a share’s return covaries with the market return in proportion to its beta, or systematic risk related to market-wide risk factors.
  • Other techniques value firms in isolation, and include multiples and discounted cash flow analysis.
Les Coleman

3. Behavioural Biases in Investor Decisions

  • Ex post examination of investor behaviour and tests of market prices against theoretical predictions reveal numerous anomalies and puzzles.
  • Despite the large catalogue, most biases can be attributed to a few factors:
    • Simplification of the decision process
    • Reliance on past values
    • Status quo bias that avoids excessive reaction
    • Personal identification with the decision
    • Social factors
  • Most biases disappear after relaxation of the assumptions that investors are fully informed and are unconditional ex post value maximisers
  • There is limited evidence that behavioural biases cause substantial mispricings.
Les Coleman

4. Uncertainty in Investor Wealth

  • There is no empirical evidence to support a stable relationship between equity return and its statistical uncertainty.
  • Investments with high expected return are usually accompanied by high possibility of loss, so that target return causes risk or uncertainty.
  • Investors are loss averse, and risk for them is uncertainty in future value of their wealth.
  • The possibility of wealth loss reflects Knightian uncertainty, which investors estimate through a variety of proxies, most of which are correlated because they represent different measures of a common underlying parameter
  • The possibility of investor loss is analogous to writing a put option whose value derives from failure to achieve expected cash flows and adverse developments in the state of the world.
Les Coleman

Structure, Conduct and Performance of Fund Manager Investment


5. Building Investment Theory Using the Structure-Conduct-Performance (SCP) Paradigm

  • Good theory sets out how and why phenomena occur, explains real-world behaviour, and is parsimonious. Its hypotheses are verifiable in natural experiments
  • While many finance theories are intuitive and mathematical, others are descriptive and based on observation
  • A comprehensive investment theory will incorporate natural and hominological components
  • The lack of investor foresight points to a qualitative, descriptive theory, albeit with some mathematically specified elements
  • The structure-conduct-performance paradigm is suitable for describing mutual fund investment
Les Coleman

6. Structure of Equity Prices

  • Equity prices have roughly lognormal price distribution, with sufficient regularity for investors to capture abnormal returns
  • Equities’ demand curve has a time-varying slope that can turn positive like a Veblen good so that prices move pro-cyclically (i.e. trend)
  • Links identified between equity return and lagged values of systematic and firm-specific factors are ex post explanations. They are unstable and noisy, and have little ex ante ability to predict returns over investors’ time horizon
  • Investors do not have predictive skill, and ex post will not be judged as unconditionally making optimum decision choices.
  • Empirical evidence is that intuitively price-sensitive public information explains relatively little of the return to equities, whose prices usually move in the absence of new information.
  • Humans control virtually all market information and have discretion in timing some of the most important data
  • Price-insensitive investment managers who dominate ownership of equities are monopsonistic buyers, which leads to a classic sawtooth price pattern
Les Coleman

7. The Mutual Fund Industry: Structure and Conduct

  • The mutual fund industry has developed as a global oligopoly
  • Mutual funds’ business model relies on commissions related to funds under management (FUM), so that fund managers do not have the sole, or perhaps even most important, goal of maximising return for clients.
  • Clients choose mutual funds for reputation and peace of mind as much as performance. Few investors react to subsequent performance
  • There is too much business risk for mutual funds to move far from the index or towards performance-based remuneration. Fund fees are typically unrelated to performance
  • Most observers of the industry are captives, and fund operations are opaque and characterised by information asymmetry. This leaves funds free to self-regulate
  • Funds can abuse the trust of their clients.
Les Coleman

8. Fund Managers’ Conduct: The Story of How They Invest

  • Structural factors of markets and the funds management industry determine fund manager (FM) conduct, including: market attributes, configuration of the funds management industry, prevalence of moral hazard and agency issues, and state of the economy
  • Empirical evidence shows that investors cannot meaningfully predict financial inputs to standard valuation models, and few rely solely on them.
  • FMs follow an intuitive modelling process according to macro themes within their own unique paradigm. The most important information is privately sourced, and search for it supports the industry’s extensive socialisation.
  • Fund managers assume that equity values are contingent on state of the world; and see risk as uncertainty and possible loss in value.
  • Fund managers’ utility functions incorporate historical security price, and hedonic features of the security and its market.
  • FMs look to the current cross-section of equity values rather than expected return, and rank alternatives in light of opportunity cost by combining information available at the time.
  • Fund managers are strongly influenced by colleagues, competitors, clients and others so that their investment decisions arise at least in part as a social construct.
Les Coleman

9. Performance of Mutual Funds

  • Net return of the average mutual fund in most countries and periods is below benchmark. Any fund manager skill is offset by fund expenses and fees.
  • At best, outperformance by mutual funds occurs at the margins and in specialist applications
  • Incentives for fund managers and other investment analysts are weakly directed towards maximising fund return
  • Profits by mutual funds and finance firms are high relative to their economic contribution
  • Investors’ agents contribute to emergence of financial scams, so that finance is the only sector where leading firms have received multi-billion dollar fines for defrauding their customers. The industry may face an ethical crisis.
  • The mutual fund sector can be interpreted through the structure-conduct-performance (SCP) paradigm:
    • A structural feature of markets is investors’ inability to predict returns, which leads mutual funds to base their revenue around funds under management.
    • Thus fund employees and agents are compensated for growing FUM, which diverts their efforts away from maximising client returns.
    • Fund clients are disengaged, information asymmetry obscures the quality of investment management, opacity of fund activities prevents close scrutiny, and observers and regulators provide weak oversight. This leaves mutual funds virtually free to self-regulate.
    • Moral hazard induced by fee-based commissions leads agents with a weak ethical compass to exploit the trust and indifference of their client principals.
Les Coleman

Towards an Enhanced Theory of Investment


10. Piecing Together the Jigsaw: Applied Investment Theory

  • The structure-conduct-performance (SCP) paradigm explains the behaviour and performance of fund managers as a response to structural and exogenous features of the mutual funds industry, that is also influenced by agency theory and moral hazard.
  • Markets evidence cycles and patterns in returns with time-varying auto-correlation, trending over the medium term and mean reversion over the longer term.
  • Transactions provide continuous new information of importance to valuation. Thus investors incorporate prices in utility functions.
  • Humans have significant influence over equity prices because they control the release, and often timing, of market information including some of the most important data
  • Growth of institutions to dominate ownership of equities makes their market oligopolistic. This leads to a classic sawtooth price pattern of gradual rises and sharp falls with negative skew
  • Investors accept a lack of predictive capability and the recurrence of large, systematic market swings that make it impractical to project returns of individual equities. Thus they think in terms of equity price, and rank values of candidate investments in light of their opportunity cost.
  • Investor risk incorporates uncertainty and downside loss, and is caused by target return.
  • Equities’ relative valuations are determined in light of their three economic components: the value of current operations; a long real call option whose price depends on value improvements; and a sold real put option whose value loss depends on unexpected adverse developments.
  • These relaxations of strict assumptions in the standard investment paradigm re-engineer it to be consistent with real-world evidence, and explain fund managers’ process through familiar finance theories.
Les Coleman

11. Real World Application of Applied Investment Theory

  • Applied Investment Theory (AIT) proposes a framework to explain mutual fund investing, and concludes that poor fund performance has structural causes.
  • AIT opens up as many questions as answers:
    • its innovations need to be thoroughly validated by developing a rigorous theoretical basis, testable hypotheses and empirical data for appropriate natural experiments
    • important gaps persist in our understanding of actual processes used by fund managers to compile and analyse data; and the nature and extent of expertise along the chain of investment.
  • Although expectation of investment profit is one of mankind’s oldest illusions, most investors optimise return through no-frills, low cost index funds
  • Significant changes should be made to investment industry regulation.
    • Structural causes of poor returns call for increased competition between fund managers, and improvements in their focus and reporting in the industry.
    • Chronic abuse of agents’ role calls for remuneration solely on the basis of fee for service or performance, and tougher penalties.
Les Coleman


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