Active Investment Management

CHARLES JACKSON holds an MA from Oxford University and an MBA from Stanford University, where he was a Harkness Fellow. He has 25 years experience in the investment management industry. For 13 years, he was the Head of the Fixed Interest and Currency Division of Mercury Asset Management, for most of the period the largest publicly quoted firm in Europe specialising exclusively in active investment management. He also served on Mercury's Asset Allocation Committee and Chairman's Committee. He was appointed a Vice Chairman of Mercury's Main Board in 1993. He is married, with two children, and lives near Oxford.

"Good introductory books on investment are hard to find – but Active Investment Management by Jackson falls into that rare category." (Professional Investor, May 2004) "…analyses investment and business strategies that he (the author) says will shape the future fund management." (Stanford Business, May 2004)

• Preface xvAcknowledgements xixPART I ASSET CLASSES AND PRODUCTS 11 Stocks and Shares 31.1 Three key preconditions 31.1.1 Property rights 31.1.2 Limited liability 41.1.3 Public financial markets 51.2 Market performance 51.2.1 Stock indices and performance measurement 61.2.2 Twentieth century performance 61.3 Active equity management 81.3.1 Dividend valuation models 91.3.2 Growth stocks 101.3.3 Small stocks 101.3.4 Sorting active approaches 101.4 Institutional investors 111.4.1 Life insurance 111.4.2 Pension funds 121.5 Conclusion 12Endnotes 132 Investment Products 152.1 Traditional products 152.1.1 Closed-end products 152.1.2 Open-ended products 172.1.3 Index products 192.2 Alternative products 212.2.1 Illiquid assets 212.2.2 Liquid assets 222.2.3 Offshore products 232.3 Active overlays 242.4 Conclusion 26Endnotes 263 Money 293.1 Three defining properties 293.1.1 Purchasing power 293.1.2 Return 293.1.3 Risk-free asset 303.2 Early forms of money 313.2.1 Gold 313.2.2 Deposits 323.3 Modern forms of money 333.3.1 Retail money funds 333.3.2 Institutional money funds 333.3.3 Eurodollars 343.4 Active cash management 353.4.1 Credit risk 353.4.2 Maturity risk 363.5 Conclusion 36Endnotes 374 Fixed Interest 394.1 History 394.1.1 UK to 1945 394.1.2 USA to 1945 414.1.3 From 1945 414.1.4 Performance experience 434.2 Active maturity management 454.2.1 Duration 454.2.2 Benchmarks 464.2.3 Attribution 464.3 Active spread management 464.3.1 Mortgages 474.3.2 Index-linked bonds 484.3.3 Junk bonds and emerging debt 484.3.4 Swaps 494.4 Market efficiency 504.4.1 UK tax arbitrage 504.4.2 The US Treasury market 514.4.3 Salomon episode 534.5 Conclusion 54Endnotes 545 Foreign Assets 575.1 History 575.1.1 To 1900 575.1.2 Foreign bonds from 1900 585.1.3 Foreign returns from 1900 595.2 Global investors 605.2.1 Modern portfolio theory 605.2.2 US overseas equity investors 605.2.3 US overseas bond investors 615.3 Government policy 615.3.1 Tax 615.3.2 UK exchange control 625.4 Active currency management 635.4.1 Theory and practice 635.4.2 Emerging high-yield strategies 645.4.3 European convergence strategies 655.4.4 Hedged overseas bonds 665.5 Conclusion 68Endnotes 69PART II BALANCING RISK AND RETURN 716 Measuring Risk 736.1 The chance of misfortune 736.1.1 Fixed odds 736.1.2 Uncertain odds 736.1.3 Historical prices 746.1.4 Measuring risk from historical prices 756.2 A simplifying proposition 756.2.1 The chance curve 766.2.2 Interval and variance 786.2.3 Random walk hypothesis 796.3 The case against active management 816.3.1 Testing the weak form 826.3.2 Testing the semi-strong form 826.3.3 Testing the strong form 826.4 Guarantees 836.5 Conclusion 84Endnotes 847 Investor Objectives 857.1 Selected investor instructions 857.1.1 UK pensions funds 857.1.2 Individual investors 867.2 Three essentials 877.2.1 Risk-free asset 877.2.2 Liabilities 877.2.3 Attitude to risk 877.3 Trade-off between risk and return 887.3.1 Utility theory 887.3.2 Varying appetite for risk 897.3.3 Constant risk aversion 907.3.4 Modelling the risk-return trade-off 907.4 Active mandate design 917.5 Conclusion 92Endnotes 928 Setting Policy 938.1 Policy uniqueness 938.1.1 Policy review 938.1.2 Policy variation 948.2 Liability matching 958.2.1 The liability matching condition 958.2.2 Historical evidence 968.3 Pension fund cash 968.4 Active asset allocation 988.5 Conclusion 99Endnotes 99PART III ACTIVE PRODUCT SELECTION 1019 Finding Skill 1039.1 Evidence of skill 1049.1.1 People 1049.1.2 Past performance 1049.2 Measures of skill 1059.2.1 Confidence 1059.2.2 The information ratio 1069.2.3 Active risk 1079.3 Elusiveness of skill 1079.3.1 Manager tenure 1079.3.2 Benchmark ambiguity 1089.3.3 Experience and age 1099.4 Advisors and skill 1109.4.1 Traditional products 1109.4.2 Hedge funds 1119.5 Conclusion 112Endnotes 11310 Using Style 11510.1 Active product weights 11510.1.1 The MPT solution 11510.1.2 Accuracy 11610.1.3 The industry solution 11610.2 Style definition 11610.2.1 Asset classes 11710.2.2 Specialised categories 11710.2.3 Universe medians 11710.3 Portfolio construction 11810.3.1 Specialist portfolios 11810.3.2 Balanced portfolios 11910.4 Freestanding overlays 11910.5 Conclusion 121Endnotes 122PART IV THE NATURE OF SKILL 12311 Firms and Professionals 12511.1 Exceptional talents 12511.1.1 Benjamin Graham 12511.1.2 Phillip Fisher 12611.1.3 Warren Buffett 12611.2 Public and private information 12711.2.1 Graham and Fisher 12811.2.2 Market anomalies 12811.2.3 Size and value effects 12811.3 Intuitive and systematic approaches 12911.3.1 Keynes’s metaphor 13011.3.2 Information and strategy 13111.3.3 Demonstrating skill 13311.3.4 Portfolio manager autonomy 13311.4 Fault lines 13411.4.1 Institutional processes 13411.4.2 LTCM 13511.4.3 MAM fixed interest 13611.5 Conclusion 137Endnotes 13712 Active Overlay Risk 13912.1 LTCM 13912.2 Active return distributions 14012.2.1 Active strategies 14012.2.2 Trading rules 14112.3 Different processes 14112.3.1 Systematic 14212.3.2 Combined 14212.3.3 Intuitive 14312.4 Conclusion 143Endnotes 144PART V THE PRICE OF SKILL 14513 Fees 14713.1 Types of fee 14713.1.1 Flat fees 14713.1.2 Performance fees 14813.1.3 Transaction charges 15013.2 Demand and skill 15113.2.1 The evidence 15113.2.2 Skill-driven demand 15213.3 Fee rates and skill 15313.3.1 Revenue maximising 15313.3.2 Paying for information 15413.4 Fee-setting behaviour 15513.4.1 Traditional products 15513.4.2 Funds of hedge funds 15513.4.3 Hedge funds 15613.5 Conclusion 158Endnotes 15814 Pay 15914.1 Pay and skill 15914.1.1 Before hedge funds 16014.1.2 After hedge funds 16014.1.3 Hedge fund self-investing 16214.2 Dividing the spoils 16214.2.1 Prima donnas 16314.2.2 Threshold skill 16314.2.3 Position limits 16514.3 Valuing investment management firms 16514.3.1 Traditional firms 16514.3.2 Hedge fund firms 16714.3.3 Fund of hedge fund firms 16714.4 Conclusion 168Endnotes 168Afterword 169Technical Appendix 175A.1 Basic modelling tools 175A.1.1 Calculus 175A.1.2 Natural logarithms 176A.1.3 Normal distribution 177A.1.4 Central Limit Theorem 177A.1.5 Higher moments 177A.2 Investment algebra 178A.2.1 Time value of money 178A.2.2 Time versus money-weighted performance measurement 178A.2.3 Bond prices 179A.2.4 On and off the run 179A.2.5 Seventeenth century Dutch annuities 180A.2.6 Duration 180A.2.7 Bond attribution 181A.2.8 Constant growth model 181A.2.9 Purchasing Power Parity 182A.2.10 Covered interest arbitrage 182A.3 Time series analysis 182A.3.1 Standard approach 182A.3.2 Confidence interval 183A.4 Utility theory 184A.4.1 Certainty equivalent 184A.4.2 Expected utility 184A.4.3 Risk adjustment 184A.4.4 Abnormal distribution 185A.4.5 Constant relative risk aversion 185A.5 Mean variance analysis 186A.5.1 Correlation 186A.5.2 Matrix algebra 186A.5.3 Utility maximisation 186A.5.4 Maximising the mean variance ratio 187A.5.5 Optimal investment in risky assets 187A.5.6 Two asset optimisation 187A.5.7 Liability matching condition 188A.5.8 Portfolio eligibility 188A.5.9 Information ratio 189A.6 Industry economics 190A.6.1 Demand for freestanding overlays 190A.6.2 Demand for products with style 191A.6.3 Revenue maximising fee 192A.6.4 Combining overlays 193A.6.5 Information costs 194A.6.6 Relaxing the independence assumption 194A.6.7 Self investing 195A.6.8 Running a hedge fund 195A.6.9 Hedge fund style 196A.6.10 Trading limits 196A.6.11 Trader experience 197A.6.12 Tenure and investor confidence 197Endnotes 198Index 199