Size Still Matters

Bigger is still better when it comes to pension funds, according to Tom Scheibelhut, managing director, Cost Effective Measurement Inc. in Toronto. Updating the results from his Fall 1997 Canadian Investment Review study he finds that:

• Larger funds continue to outperform smaller funds. The average size of winning funds was $14.5 billion versus $5.4 billion for the losing funds.

• Passive is still better. Funds with a higher proportion of their assets managed passively continue to outperform funds with more active implementation styles. Winning funds had an average, like the previous study, of 27% of their assets passively managed, compared to just 16% for losing funds.

• North American pension funds continue to underperform passive benchmarks. They have not been compensated for the additional costs and risks of active management. Over the past four years, the average net value added (NVA) for 140 large pension funds, representing $1.3 trillion in assets, was -0.4% per annum.

Winning funds were defined as pension funds with positive net value added--the return in excess of what could have been earned by implementing a fund's asset-mix policy decision passively. NVA thus becomes a measurement of a manager's skill in implementing asset-mix policies.

RE -- INVESTMENT DECISION USING EVA, WINTER 1998

I read with interest the above article. However, three points have drawn my concern.

I cannot support Mr. Paine's conclusion that the "historical fingerprints follow an oval shape." There are seven main business processes that will affect the EVA as described in the article "Wealth and Value Creation in Canada" by Vijay Jog and Werner Hofstatter (Canadian Investment Review, Fall 1998). The efficiency and effectiveness of any one of these seven main processes can vary at anytime, and they may do so, not necessarily following a business cycle and therefore, the resulting EVA may or may not follow a specific business cycle. Most companies in non-cyclical businesses have a lower correlation to business cycles. Therefore, I am not convinced that it is a given outcome that the shapes of what are defined as "fingerprints" must follow an oval shape.

I would also suggest that the points in the fingerprint chart be plotted for each quarter rather than based on annual data. Rolling average data of the most recent four quarters may require more work, but will help investors to choose companies more effectively.

I have used the expression of "fingerprinting" for mutual funds (Canadian MoneySaver, June 1998), because the shape of each unique fingerprint identifies the style and change of style of a fund, as well as its MVA in rising and falling markets. I used monthly data, in conjunction with a rolling average of six months. I have found it overall to be a very effective selection tool.

Cemil Otar, Thornhill, Ontario

My colleague Laurence Booth has provided a useful framework for evaluating aggregate stock values. In distinguishing noise traders from fundamental valuation traders, he raises the age-old question of what fuels stock price advances and how bubbles occur and ultimately burst.

Rational investors base their stock valuation and hence buy and sell decisions on fundamental factors such as financial ratios and expected changes in macroeconomic variables. Such investors attempt to independently value a stock or market index to determine whether it is under valued, over valued or properly valued. Although rational in approach, history has also shown that stocks and indices may remain under- or over valued for long periods of time. Accordingly, capturing the potential returns associated with correctly identifying mispriced securities or markets may come down strictly to timing.

There are four issues you should keep in mind in reading this paper.

• First, if you accept Professor Booth's arguments and assumptions, you might have concluded that it was time to "Pass the Old Maid" in 1993, maybe earlier. You would have missed out on some healthy returns over that period.

• Second, if you accept the overvaluation argument you have to translate this into action. Do you change your asset class allocation to eliminate Canadian equities from your portfolio or do you simply tilt your holdings?

• Third, how important, at least to the retail investor, are overvalued markets? Is it a viable strategy for a long-term investor to liquidate a portfolio and incur transaction costs, and possibly severe opportunity costs, given the uncertainty surrounding the timing of both the correction and the bottom of the correction?

• Fourth, could the forces of supply and demand be so impaired by the relentless flow of funds to institutional investors such as pension and mutual funds that (at least until the savings boom bursts) fundamental index valuation models will serve little useful purpose?

There is a more gruesome version of this idea. See Robert Louis Stevenson's "The Bottle Imp."

Eric Kirzner is a professor at the Rotman School of Management, University of Toronto.

Poor Bears

" 'Because people have come to believe in equities unconditionally without reference to cycles or valuation, they buy them heedlessly. So doing, they guarantee that, to borrow from the advertising boilerplate, past performance is no guarantee of future results. They will be much, much worse.' I did say that last year, in fact. However, to balance the record, let me also acknowledge that I said it as long ago as 1904."

James Grant, editor of Grant's Interest Rate Observer, defending his previous year's speech before the Toronto Society of Financial Analysts.

"Rising markets bring out good feelings. The steeper the market's angle of ascent, the greater the bonhomie; the stronger the lift, the deeper the faith in continued appreciation. What (we) can understand is that the very hospitality of a market toward new ventures is, by its nature, proof of a certain speculative ripeness. Nothing is more subversive to the habits of caution than a gaudy bout of prosperity. The inevitable consequence is that, at such confetti-speckled moments, the investment odds quiety tilt against long-term success."

James Grant in The Trouble With Prosperity