From the Archives
The incredible primary source that I used for my recent Factor Archives paper on Value investing. The section on railroads is particularly worth reading. Enjoy!
Rather than focusing on a single theme for today’s Sunday Reads, this edition provides historical context on a range of different themes, debates, and hot topics that are prevalent in modern markets. Specifically, we will dive into:
- Active / Passive
- The Value Factor
- ESG & Impact Investing
- Private Markets
- Low Yields & Negative Rates
If you find these free weekly posts helpful for how you think about markets, or you just find them interesting, I’d greatly appreciate you spreading the word on Twitter or forwarding to others you think would enjoy. As always, thanks for reading!
The Active / Passive Debate
Yes, I know. Most of us are tired of hearing about ‘Active vs. Passive’, but rest assured we will not be repeating the usual discussion points you’ve heard debated ad nauseam. Instead, these two articles offer some interesting historical context, and caused me to think about the modern active/passive discussion from a different perspective. I hope you find these articles insightful as well!
In 1836, Société Générale launched the world’s first closed-end equity fund with the intent to provide a cheap source of diversification for small investors. Article 2 of the fund’s prospectus stated:
‘The company’s purpose is to present to the investors “a placement of the social capital in a large number of establishments” to have protection against reverses that one of the establishments might experience momentarily.’
This article by Gertjan Verdickt and Jan Annaert analyze whether these small retail investors were better off managing their own portfolios (Active Management), or buying into an investment trust like the one offered by Société Générale (Passive Management). It is important to remember that these trusts were designed specifically for small investors.
The paper’s conclusions are quite fascinating, and provoke broader thoughts on the markets accessible to small and wealthy investors. For the results in this paper demonstrate that the more expensive shares (in nominal price, not valuation) outperformed the market. However, these shares were not available to smaller investors, who could not afford the steeper prices. For example, not many people can afford to buy a whole share of Amazon stock costing ($1,700). The chart below shows the difference in returns between Cheap and Expensive shares.
This notion of higher alpha in markets only accessible to wealthy investors is comparable to the classification of ‘Accredited Investors’ today, who can access Private Equity, Venture Capital, Hedge Funds, etc.
‘We choose this metric since it is easily observable, comparable and important for less-wealthy investors. Arguably, less-wealthy investors were only able to choose from stocks with low nominal prices. If these investment trusts were truly targeted towards smaller investors, they would be able to outperform lower-priced stocks.’
The investment trusts offered to small investors offered better performance than individual stock picking of Cheap shares, but wealthy investors with access to Expensive shares were better off staying ‘Active’.
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:
The Value Factor
It is no secret that Value investing is going through a difficult period, to say the least. However, it is not the first time that Value investing has underperformed for this long.
Price is one of the most predictive determinants of future alpha and investors have recognized this since the first value fund was founded in 1779. While market environments and the methods of equity valuation have changed, the concept of purchasing stocks at discounted prices has persisted for centuries. In the latest installment of my Factor Archives series, I take a deep dive on the history of value investing.
ESG & Impact Investing
If it feels like you see articles about ESG and impact investing everywhere you look, it’s because you are…
One of the debates surrounding ESG and sustainable investing is how the approach might affect performance. Generally, advocates argue that these companies are poised to do well in the future as issues like climate change become an increasing risk, while skeptics are more likely to point out that stocks like Altria, which would not score favorably on ESG metrics, are some of the best performing stocks in history. This article helps provide historical context on this very question. I’ve been saving it for awhile, and am writing about this topic soon in a future edition of The Factor Archives.
‘The article demonstrates that MDCs were far more important than all local government agencies in providing low-cost working-class housing in London before 1914, and that patrons were offered rates of return broadly comparable with those they could obtain from alternative domestic investment opportunities…We must now return to the question of whether investors were sacrificing personal profit for collective good by investing in MDCs.’
The dividends were comparable as well:
‘Dividends were comparable with those paid by other property companies and for most of the period the annual average realized returns offered were not markedly different from those paid to holders of other domestic assets.’
Lastly, we have private markets. There are an increasingly large number of articles voicing concerns over private market valuations, and the rise of private credit strategies. Just check out this video from last year’s Capital Camp, where Dan Rasmussen went to town. The two articles below look at each of these issues, and some broader insights on the bond market:
Too much money chasing too few deals. We’ve seen this before.
Low yields sparking a hunt for income. Sound familiar?
“The empirical study of the effect of banking panics on the economy has traditionally been difficult due to the lack of adequate data on output during the major part of the 19th and early 20th centuries. This paper proposes an alternative approach by looking at the business activity of the banking sector. Using a newly digitized data-set on National Banks resources and liabilities, I argue that distortions to the normal activity of the banking sector are a good proxy for the impact of panics on the economy. Additionally, I propose a novel instrumental Variables approach for identifying the effects of banking panics through the exogenous drops in deposits induced by bank runs. The results show a temporary but large effect of panics on lending activity of approximately 10 p.p. (on impact) and an average duration of one year.”
Low Yields & Negative Interest Rates
This ones for you, Joe Weisenthal. Whether you enjoy obsessing over the Fed, or hold opinions on negative interest rates, you will find these articles interesting.
“Given the renewed interest in negative interest rates as a means for overcoming the zero bound on nominal interest rates, this article reviews the history of negative nominal interest rates and gives a brief survey over the current proposals that received popular attention in the wake of the financial crisis of 2007/08. It is demonstrated that ‘taxing money’ proposals have a long intellectual history and that instead of being the conjecture of a monetary crank, they are a serious policy proposal. In a second step the article points out that, besides the more popular debate on a Gesell tax as a means to remove the zero bound on nominal interest rates, there is a class of neoclassical search-models that advocates a negative tax on money as efficiency enhancing. This strand of the literature has so far been largely ignored by the policy debate on negative interest rates.”
“This paper examines the economic environments in which past U.S. stock market booms occurred as a first step toward understanding how asset price booms come about and whether monetary policy should be used to defuse booms. We identify several episodes of sustained rapid rise in equity prices in the 19th and 20th Centuries, and then assess the growth of real output, productivity, the price level, money and credit stocks during each episode. Two booms stand out in terms of their length and rate of increase in market prices n the booms of 1923-29 and 1994-2000. In general, we find that booms occurred in periods of rapid real growth and productivity advance, suggesting that booms are driven at least partly by fundamentals. We find no consistent relationship between inflation and stock market booms, though booms have typically occurred when money and credit growth were above average.”
MISS LAST WEEK’S SUNDAY READS? CATCH UP HERE