David Schofield is president of the international division of INTECH. He holds an joint honors MA in French and German from Oxford University. Formerly he was European business head of Janus Capital Group and before that he had 15 years in investment banking with Salomon Brothers, Lehman Brothers, and UBS, in New York, London, and Frankfurt.
INTECH founder Bob Fernholz, a former professor of mathematics at Princeton University, was responsible for originating stochastic portfolio theory in the early 1980s. Can you explain what it is and what it has to offer as an investment methodology?
Stochastic portfolio theory is based on Bob Fernholz’s discovery that, by analyzing only the volatility of stocks and how they move relative to one another, you can create an investment portfolio, or series of portfolios, capable of delivering results in excess of a particular stock market index while retaining index-like levels of risk. In plain words, using Fernholz’s techniques we can build portfolios with cautious, middle-of-the-road, or more aggressive return targets and outperform a particular target index by 2–3% for the cautious portfolio, 2.5–3.5% for the middle-of-the-road portfolio, and by around 4% for the higher-returns portfolio.
If we take the cautious portfolio with its return of 2–3% above the market index, that might not sound like much. However, any fund that targets a large capitalization market such as the S&P 500 and which consistently manages to beat the S&P average by just 2% every quarter, year in and year out, will rapidly rise up the performance league table. In contrast, value managers who pick stocks for their clients’ portfolios based on fundamental values will have very good years where they are way ahead of the benchmark, but they will also have very poor quarterly results when the market swings against them and will underperform significantly at such times. When you average out their underperforming years and their overperforming years, most active managers fail to even match the index, let alone outperform it.
At the same time, if you can consistently generate even 2% outperformance over the benchmark, and assuming that you are investing for the long term, the magic of compound interest means that your 2% is going to get more and more significant. Einstein famously said that he recognized no force in the universe stronger than the magic of compound interest. If you invest £1 million at 8% for 30 years, with the interest being reinvested each year, you end up with £10 million at the end of the period. If you generated 1% more return, you would end up with £13 million. Two per cent additional return would give you £17 million.
Unfortunately, by the same token, losses work very heavily against the investor. If the value of your portfolio drops by 50%, you have to generate a 100% return on that remaining 50% just to get back to where you started—a tall order if you were initially targeting an overall 8% return on your starting value each year! What this demonstrates is that avoiding the big dips in a market, the big blow-ups, is more than half the battle in successful investing. The impact of losses is what drags back active management performance over the medium to longer term.