The 1929 Crash & Indexing, Wine for the Long Run, Imperial Debt

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Visualizing History

We’ll discuss this further in the deep dive below, but according to the paper in today’s Sunday Reads’, Wine has outperformed government bonds, stamps, and art from 1900-2012.

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From the Archives

 

Common Stocks As Long Term Investments

A standout book in the history of financial literature, Common Stocks As Long Term Investments was an incredibly popular book when it was published. The book reads similarly to The Intelligent Investor , and is heavily focused on the benefits of diversification. The author, Edgar Lawrence Smith, argues:

‘Sound investment management, while always subject to error, cannot fail to improve average investment results if the principle of diversification is strictly adhered to.’

The book also provides readers with The Principal Functions of Investment Management:

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Sunday Reads

Learning from One Another’s Mistakes: Investment Trusts in The UK and The US

This article sent me down a rabbit hole that culminated in one of my most interesting historical finds to date: A 1931 issue of The Economist that almost perfectly mirrors the arguments today that passive investing and indexing is a bubble, or will exacerbate the next market crash. But more on that later…

That research was prompted by this fascinating article on early UK and US investment trusts between the 1880s and 1930s. The first notable British trust was the Foreign & Colonial Government Trust, which I wrote about here. You should definitely take the time to read the entire article, but I’ll provide a few high level takeaways. The first, is that British investment trusts largely learned their lessons after the Barings Crisis in the 1890s wiped many of them out, and exhibited the flaws in their structure. Consequently, more conservative measures were put in place to avoid experiencing such a crisis again. The funds were much more heavily weighted in fixed interest securities, and had smaller allocations to equities. Capital gains were also set aside so that if a crisis should occur again, there would be ‘rainy day’ funds to pay out dividends.

In contrast, American investment trusts took a more ‘grip it and rip it’ approach, which utilized higher amounts of leverage, almost 100% allocations to equities, and more.

“The different management styles of British and American investment trust managers reflected a different attitude to investment. By the 1920s, Americans were happy to invest in equities and expected fund managers to seek to achieve capital gain through leverage, market timing and ‘expert’ stock selection. In the UK, retail investors preferred the security of fixed-interest securities and were content with a relatively low return in the form of income yield in return for safety through a conservative approach to reserves and an emphasis on a relatively passive investment strategy.”

However, interestingly, shareholders in some of these funds had more power than their British counterparts. For example, shareholders could force the Portfolio Manager of the fund they were invested in to sell a security that the PM had purchased:

“In the Alexander Fund, if ‘dissatisfied with a security purchased may go to a Board of Overseers elected by the shareholders from among themselves and, if they agree with him, can force the manager to sell the security.”

As we all know, the American investment trust companies were decimated by the 1929 Crash, as their leveraged structures gave way to the plummeting market.

“By the end of the boom, more than $7 billion was invested in 675 investment companies of all types, of which 193 were investment ‘management’ companies, with assets of $2.7 billion, including 19 open-ended funds, accounting for a mere $140 million. This meteoric rise was followed by a crash which was nothing if not spectacular. The Economist reported that the Standard Statistics index of the common stocks of 30 leading American investment trusts showed a fall of no less than 75 per cent from their peak, whereas the Institute of Actuaries index of the common stocks of the 15 leading British investment trusts showed a fall between their peak (March 1928) and March 1931 of only 17 per cent… By the end of 1937, an average dollar invested in July 1929 in an index of leveraged investment trust common stocks was worth 5 cents, compared with 48 cents for the common stock of an index of non-leveraged investment trusts.”

The most interesting aspect of this article, however, is its relevance to the modern Active / Passive debate. Like today, there were serious questions raised about the merits of active management following a substantial market crash (1929 and 2008). Articles in 1931 from outlets like The Economist reported the calls of many investors for a security that would “remove the human factor” from investing by offering “a security based on the best available selection of American shares… [that] should be known to every subscriber, and should be subsequently unalterable.” This sounds an awful lot like the modern index fund.  However, there were also many that felt there was merit in paying for active management:

“American investment trust managers were credited both with stock selection and with market timing skills. The British concept of just buying a large number of stocks as they were issued and then holding them to maturity was considered ‘plodding’. The Americans argued that ‘superior management was a desirable substitute for diversification’, with Leibson recommending ‘a field staff of experts throughout the world’. American investment managers were expected to buy and sell rather than just buy and hold: ‘the investment trust manager who devotes his time to whether oils or motors are the more attractive group…is certainly performing one of the essential functions of management’.”

Which brings us to this article in The Economist discussing the popularity of ‘Fixed Trusts’. When reading these excerpts below, just replaced ‘Fixed Trusts’ with Index Fund, and it sounds like something written today. I don’t want to oversell it, BUT IF YOU READ NOTHING ELSE, READ THIS ARTICLE. There is so much to unpack in this original article from 1931, so you’ll just have to read it to obtain all of the gems. However, here are some highlights:

Calls for Passive Management in the form of an Index Fund (1931):

However, The Economist expresses some doubts over the efficacy of such a strategy. In doing so, they inadvertently describe what would be the first Smart Beta strategy based upon the yield factor:

And finally, just like today, there were concerns over how the increasingly popular funds would perform in a market downturn, and how passive investment affects price discovery. In particular, this author argues that the fixed trusts acted as a bullish instrument for market prices:

Independence and The Effect of Empire: The Case of “Sovereign Debts”

It would make sense that:

“‘Sovereign’ bonds issued by colonies are often supposed to benefit from an implicit imperial guarantee. This guarantee is usually presented as the main reason why yields on colonial bonds are exceptionally low.

Bearing that idea in mind:

“This paper investigates investors’ perception of this guarantee during the interwar period, a period during which some guarantors faced financial turmoil and some colonies began their journey towards independence… in general, market participants believed the guarantee would be honored. This general observation needs however to be nuanced.

In 1931 when Britain left the gold standard, investors felt the British guarantee was less valuable. Furthermore when colonies were facing extreme financial distress markets reassessed the likelihood the guarantee would be honored. This was also the case when it became clear that India would become independent.”

While the subject of this paper may seem niche, the implications go far beyond colonial bonds during the interwar period. Market participants in this example ‘believed the guarantee would be honored’, which made colonial bonds a safe investment. However, like many shifts in market paradigms today, there are often certain ‘investment truths’ in the market that increasingly cease to be so. For example, interest rates should always be positive, right?

In this paper, the authors study the specific examples of Australia and India under the British Empire. For British investors, they would have felt safe to assume that India would always remain within her majesty’s empire, and that meant a certain ‘implicit imperial guarantee’ as it related to their bonds. The Indian independence movement rattled the market dynamics that investors’ had always known and believed in. Similar to the Greek debt crisis in recent years. 

“Our analysis shows that bonds issued by colonies benefited indeed from an implicit guarantee. But the implicit nature of the guarantee led investors to expect that in case of extreme financial distress the guarantor would not be willing to honor the guarantee. Furthermore the guarantee was conditional on the colonies not becoming independent. This historical example offers a striking parallel with market perceptions of Greek debts before the Eurozone crisis. Before the crisis, investors rationally considered that the EMU countries had an interest in Greece’s continued participation in the EMU. Bonds were therefore priced as if they were guaranteed. The withdrawal of this implicit guarantee on Greek debts affected negatively the price of Greek bonds. More generally, our research suggests that implicit guarantees are only credible for minor crisis but that markets question these as soon as the amounts at stake become large.”

The Factors Driving Long Term Returns on Wine

In a previous article, I discussed investing in the beer industry, specifically the late 19th century Guinness ‘IPO’. However, this paper covers investing in beer’s more sophisticated counterpart: Wine. I will confess that I didn’t think this article would be anything too thrilling, but it turned out to be a fascinating read on an area of investing that I truly knew nothing about. Well, put simply, Christie’s held it’s first “wine only auction” in 1769, and the rest is history.

This paper analyses 36,271 wine prices from 1900 to 2012, and calculates the returns of this niche asset class. The authors find that from “1900-2012, we estimate a real financial return to wine investment of 4.1%, which exceeds government bonds, art, and investment-quality stamps.” Quite the claim. However, much of the high-net worth investment world are already well aware of this ‘asset class’ offering an attractive alternative investment, with a Barclays report claiming roughly 25% of the global High-Net Worth population own a wine collection, and it represents about 2% of their wealth. There are even a number of wine funds dedicated to investing in this area, but more on that in a minute.

The most interesting aspect of this paper is the quantitative approach it takes to measuring the predictors of wine’s returns.

“Presenting a simple and stylized model of price dynamics… the model proposes that, in general, a wine’s fundamental value is governed by the maximum of three measures:

1. 1. The value of immediate consumption.
   2. The present value of consumption at maturity plus the non-financial ownership dividends received until consumption.
   3. The present value of lifelong storage (i.e., the value as a collectible).”

In line with this ‘factor-esque’ approach to investing in wine, Quality is a significant determinant of performance, as one would imagine. “The model delivers different predictions for the price patterns of low-quality and high-quality wines (or vintages) over their respective life cycles.

“High-quality vintages appreciate strongly for a few decades, but then prices stabilize until the wines become antiquities [collectibles], after which prices start rising again. For low-quality vintages, prices are relatively flat over the first few years of the life cycle, but then rise…”

In other words, a low-quality wine initially lose money, since there is little ‘consumption value’ (a.k.a it tastes bad), but prices eventually go up over time as the wine becomes attractive for it’s value as a collectible. Conversely, high-quality wine gains money out the gate, and continues this trend for roughly 40 years while its ‘consumption value’ increases as the wine ages to a certain point of maturity, when prices then stabilize. However, like the low-quality wines, the high-quality wines then increase in price again as they become attractive for their value as a collectible.

The two chart’s below sum up this dynamic perfectly:

The article is filled with analogies for investment lessons and principles today. Consider the below excerpt:

“We should expect that trading volume at auction stays high for a longer time for a good vintage, as these bottles are best consumed at a later age. Dealers may also cater more explicitly to wine drinkers, and therefore sell a wine from a poor vintage at a younger age than a wine from a good vintage.”

To me, there is a clear analogy to investing in high-quality companies over a long time horizon, versus trading low-quality companies in the short-term. Sticking with the analogy, this would particularly apply to buying the stocks of new public companies after they IPO. The performance of different wine vintages also sounds very similar to Value investing, as the authors state: “highest returns [are] observed for maturing high-quality wines.”

While you should certainly read the whole paper, I will offer one last fascinating excerpt about the soaring returns in World War II:

“Wine prices did not increase in real terms over the first quarter of the 20th century… [but] the value of wines boomed during the Second World War; prices increased by more than 600% between 1940 and 1945. Many factors probably played a role: the war upset the trade in high-end French wines, with the port of Bordeaux and many châteaus occupied by Nazi Germany; the U.K. government prohibited sales of wines and spirits by unlicensed auction houses; Christie’s had to limit its sales activities after its main offices were bombed; and many wine bottles were sold through Red Cross charity auctions that are not included in our data but may have pushed up price levels. The boom was followed by sharp decreases in wine valuations in the years after the end of the war.”

But what about the market today? After I finished reading this paper, I was curious to find the answer to this question as well, and discovered that there is a Wine Stock Exchange of sorts, and numerous investment funds dedicated to this niche market. The exchange has multiple indices tracking different sections of the wine market, and some of the returns in recent years are staggering:

However, there is evidence that active management is even suffering in this area of the  market, as I checked out the returns of The Wine Investment Fund since its strategy’s July 2013 inception…

Financialization of the Victorian Economy and the London Stock Exchange

Perhaps because of the tax debate swirling around in the political sphere, the concept of finanicalization has been much more prominent in the news as of late. As always, this newsletter aims to provide historical context and perspective to these modern conversations. That said, this article discusses the role of financialization in Victorian England.

“The LSE was surprisingly small and by some measures also surprisingly efficient. Much of its efficiency appears to have come from its deep involvement in the “shadow banking system” of that era, a connection that appears to have been misunderstood and almost completely neglected in the past. The low levels of activity, the dominance of small investors, and low cost of the system show the very early stages of the “financialization” of the modern economy and provide interesting perspectives on modern developments.”

Alex Danco Interviews Jamie Catherwood

I recently chatted with Alex Danco about financial history, Canvas, human nature, and more… I really think you’ll enjoy our conversation.

 

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