The universe of investments is much richer for investors who do not limit themselves to perfect dots, lines and circles.
When I turned 10, my grandparents gave me a pair of compasses. I was thrilled. I could finally draw perfect circles! The next day at school, I immediately started drawing people and animals with perfect curves. Before puberty, that meant round heads. I was very proud of my work, and I was convinced that the teacher could only give me A’s for such perfection. But instead, I got a reprimand. Real heads are not circles, he said. My fascination with technical beauty had blinded me to reality. And that wasn’t the last time this would happen to me. Human weaknesses are hard to overcome.
For investors active in financial and commodity markets, the only responsible and sustainable source of return is risk premium. We — and our clients — must therefore be prepared to take risks. Most of these risks are financial risks, which means there is a direct risk of losing money. The most common one is market price risk. Other examples are liquidity risk and counterparty risk.
However, there are also risks that are not primarily financial in nature. But that doesn’t mean that investors do not pay a premium for off-loading them — they often do. Which in turn offers an opportunity for other investors to earn a risk premium for taking these ‘risks’. In this article we’ll discuss three examples:
Benchmark risk — the ‘risk’ of performance deviating from a chosen benchmark
Reputation risk — the ‘risk’ of being criticized by society
Beauty risk — the ‘risk’ of missing out on attractive features other than returns
These risks have one thing in common: investments that entail one or more of these risks are less appealing to many (end-)investors. And, consequently, less appealing to investment managers. But since there is no direct financial risk, earning the associated risk premium is essentially a free lunch for investors willing to take these ‘risks’. The universe of investments is simply much richer for investors who do not limit themselves to perfect dots, lines and circles. And I’m probably not the only one who sometimes forgets that.
Many investors want their investments to stay close to benchmarks. They have different reasons for this. For example, some investors believe that no one can consistently beat an index. For them, any difference from the index is an unnecessary risk. Other investors use a top-down asset allocation approach that begins by dividing their portfolio across different asset classes. To determine the asset class weightings, they use the historical performance of benchmarks for these asset classes as input. They then choose specific investment products within each asset class. If these products perform differently from their benchmarks, the asset allocation model becomes less reliable.
Since many investors want their investments to stay close to benchmarks, it’s obvious why investment managers try to do the same. It makes them more appealing to these investors. A low ‘tracking error’ is a great selling point.
But why would this mean missing out on risk premium? Well, if the investment doesn’t require any trading activity, there’s not much to worry about. However, most investments do require trading activity. This can be due to adding or withdrawing funds from the investment strategy, adjusting the weights of the components within the strategy, or rebalancing the allocation to the components after their prices have changed over time. Active investment strategies — which also include long-commodity products that are often labelled passive — require even more trading activity.
And trading has market impact, as we all know. In fact, trading activity is the only force that makes markets move. This market impact is prone to negatively affect performance, especially when the trades are executed in a way that aims to minimize the tracking error against a benchmark. The underlying economics essentially involve an exchange between market participants who want to buy or sell at a fixed time, regardless of the price at that time, and those who only wish to buy low or sell high. The former group, because they lack flexibility, typically pays a liquidity premium to the latter group. This happens all the time — it’s for instance very visible towards the markets’ close, as the settlement price is a popular benchmark.
Market participants who want to buy or sell at a fixed time, regardless of the price at that time, typically pay a liquidity premium to those who only wish to buy low or sell high.
We’ve given examples of this in our December 2019 article The market is not a shop. And in our June 2018 article Beat the index, don’t beat the market, we showed how ‘successfully’ outperforming a benchmark this way hurts the benchmark more than it hurts the performance of the outperforming investment manager. But it still hurts their performance. So, the manager’s ‘outperformance’ actually comes at the cost of the end-investor.
The thing is, this can also be the case with an active systematic investment strategy like our Diversified Trend Program (DTP), which does not aim to track a specific benchmark. If such a strategy is implemented following the principle “the system determines the orders and these will be executed”, this essentially has the same effect as “the index composition determines the orders and these will be executed”. In essence, this type of system following is nothing but passive index tracking with a more frequent rebalancing of its components.
Benchmarking the required transactions against the price at a predetermined moment of execution leads to paying a benchmark premium. This could happen through service agreements with external trading desks to whom trade execution has been outsourced. Or this could happen when the investment manager’s internal trading desk gets rewarded for beating benchmark prices. The traders’ incentives won’t be aligned with the investors’ interests if they can influence their benchmark. And since an active strategy like trend following requires much more trading activity than a passive index tracking strategy, paying a benchmark premium could be even more of an issue there.
However, it doesn’t have to be an issue. Benchmark risks pose no real price risk to market participants other than those who have defined these artificial benchmarks. Therefore, the associated liquidity premium is essentially a free lunch for active investors aiming to buy low and sell high instead of just aiming to buy or sell. The only thing they need to do is to safeguard their whole investment process from benchmarks.
Probably the most famous example of reputation risk premium — at least in the academic literature — is the sin stock anomaly. It shows that stocks of companies that make money from industries such as alcohol, tobacco, gambling, and weapons have delivered outsized returns. In recent years, defense stocks like BAE Systems from Britain and Leonardo from Italy have also outperformed the broader British and Eurozone stock indices by a large margin. This was of course partly due to the Russian invasion of Ukraine, which increased the demand for weapons and probably also changed some investors’ views on the ethics of ‘investing in weapons’.
We will not explore this ethical question further; investors and investment managers should decide for themselves. That’s their right and their duty. But whenever a potential investment is avoided because of reputation risk, it’s worth asking whose reputation was at risk the most: that of the investor or the investment manager? One thing is clear: on the other side of this checkbook, the associated premium is only paid by (or missed by) the end-investor.
Whenever a potential investment is avoided because of reputation risk, it’s worth asking whose reputation was at risk the most: that of the investor or the investment manager?
A more recent form of reputation risk is non-ESG investing. Many investment managers, especially here in Europe, have been competing to offer ESG products. We acknowledge the sincere exceptions, but are all the ESG products out there really designed and offered because the managers do believe that these products will have a positive impact on the environment and other issues? We also question whether the providers of these products really believe that these products will generate a ‘good conduct premium’. For many products, the main reason for offering them appears to be to not miss out on the investment flows from investors who do expect a positive impact. Again, we also recognize the exceptions. But they typically make different choices than excluding exactly the markets or instruments that are most essential for making a positive change. People who don’t want to be seen with dirty hands usually don’t do the cleaning. At best, they hire cleaners to do it for them. They pay a premium for that. And in investment management, that premium is not paid by the managers but by the end-investors.
ESG has also become a lucrative business for data suppliers and rating agencies. They seem to have formed an influential ESG industry, and parallels may be drawn with the rating agencies that contributed to the 2007-2008 financial crisis. It’s important to realize that the revenues of these service providers do not depend on the actual impact of their services on the environment or other issues. The high demand for ESG data and ESG ratings is their golden goose. And it’s not hard to see who feeds it.
This doesn’t mean that considering environmental, social or governance factors will necessarily hurt the investor. On the contrary. ESG factors are clearly among the main factors driving markets. And for some markets they can be the most important factors. This was already the case before “ESG” was coined. Before launching DTP, when Transtrend was still a research project, we funded our business by what today would be called macro trades. The first one I personally took part in was a long trade in live hogs and pork bellies, which was entirely based on a fundamental analysis of the impact of the 1988 drought in the Corn Belt on the U.S. pig industry. Getting it right, we earned enough to continue our research for a while by trading that specific environmental factor. We never thought that “environment” would become such a loaded term in investing. We just recognized it as a relevant factor. And we don’t think this relevance has gone away since live hogs became lean and pork bellies are no longer traded. For example, climate was again a dominant factor in various significant commodity trends in 2020/21.
I’ve read various companies’ D&I policies over the years, but none of them stated: “Our team is not selected based on their looks”. In practice, judging by their appearance, many commercial client-facing teams indeed don’t seem to reflect the cross-section of the population. And, I confess, every time I’m filmed for a video explaining DTP’s performance, I groom my hair and beard. As if that would make a difference! It appears to be accepted that beauty is rewarded; at least commercially. A good-looking person selling the investment program can be appealing, just as for some investors a low tracking error or an ESG rating can be appealing. While for others, a bold “we don’t look at ESG factors” can be appealing. Or are we all just keeping up appearances?
A common measure of attractiveness for investment programs is their Sharpe ratio. For the managers, a high Sharpe ratio is mandatory for winning one of the many investment management awards. However, most of us are well aware that a high Sharpe ratio isn’t necessarily aligned with most investors’ ultimate goal: to achieve long-term capital growth. We all know the infamous examples of popular managers like Long-Term Capital Management that boasted extremely high Sharpe ratios before they collapsed. And there are various ways an investment manager can increase the Sharpe ratio of their strategy by paying a risk premium.¹ Again, it’s the end-investor who pays that premium, while the manager gets the award.
There are also various other cosmetic changes that a manager can make to adapt their strategy to the beauty standards of a certain audience. We’ve often been tempted to make such changes, for example excluding certain instruments or using different fund packaging. The starting point of such discussions always is: wouldn’t it be great if we could make such and such change without affecting the risk/reward profile? And indeed, if one tries enough different variations, it’s almost always possible to produce a historical simulation that seems to confirm this possibility. However, if we are honest with ourselves, we have to acknowledge that if we truly believed that such changes would also improve the future real-life performance of the investment program, we would apply these changes universally to the program, also for clients who didn’t specifically ask for it.
Beautiful formulas can be truly captivating. But pursuing that beauty can mean paying a risk premium. Or at least not earning it.
But for a systematic program like DTP, the trap of paying a beauty premium doesn’t primarily come from commercial demand. The beauty-distraction can also affect the design process. It’s a fact that a research team like ours has a high level of nerdiness. And the notion that nerds like me aren’t easily tempted by beauty is certainly incorrect. In fact, nerds are more than average susceptible to beauty. Just not the kind of beauty that will land someone on the cover of Vogue. We tend to be overly enthusiastic about technical beauty. For example, beautiful formulas can be truly captivating. But pursuing that beauty can also mean paying a risk premium. Or at least not earning it. And again, it’s the end-investors who pay that beauty premium, regardless of whether they are attracted by that same beauty.
We will not go into detail about specific examples, because they tend to be very technical. But we admit that our team, including myself, has occasionally fallen into this trap. The first paragraph of this article is from an internal management letter that we sent to our staff a few years ago to address this issue. The fact that some of the team did not like reading this letter only confirmed the problem; in this respect, nerds are as sensitive as anyone else. But like any human weakness, the healing can only begin after the problem is acknowledged.
Until 2021, one of the Community Chest cards in Monopoly said: “You have won second prize in a beauty contest. Collect $10.” In investing, winning a beauty contest doesn’t result in a reward, but a cost. Over the years, we’ve learned to be open to embracing ugliness. And we hope that investors who don’t necessarily embrace it, are willing to appreciate us anyway.
¹ For our type of strategy, the banking crisis in spring 2023 serves as a recent example. This crisis caused widespread losses in DTP’s portfolio between 9 and 17 March, making March the worst month for DTP in more than 30 years. However, DTP more than regained these losses in April. We could have taken different actions to reduce the losses in March, such as significantly cutting down the positions across the program in the heat of the crisis. But the thing is, most of the actions that we could have reasonably taken, would have hurt the performance more during the recovery. These actions would have improved DTP’s Sharpe ratio, but not our clients’ outcomes. They would have paid a risk premium, ending up with a net loss.