(August 27, 2013) — John Maynard Keynes, one of the fathers of modern economic theory, experienced a tough lesson in his early days as an institutional investor and it changed his investment strategy entirely.
An updated version of a study from academics David Chambers and Elroy Dimson has cast light on the 25-year period Keynes spent managing one of the largest endowments in England—the Kings College fund at the University of Cambridge.
They found that the prominent economist’s actively managed portfolio outperformed the British common stock index by an average of eight percentage points per year from 1921 to 1946.
He only underperformed this benchmark in six years out of the 25, and these were in the first eight years he spent at the helm. This underperformance could have continued but for an important lesson, the authors claimed.
“By August 1929, he was lagging the UK equity market by a cumulative 17.2% since inception. In addition, he failed to foresee the sharp fall in the market the following month. We discuss the significance of this period of underperformance [in the paper], arguing that it was the catalyst for the fundamental change in his investment approach sometime in the early 1930s.”
Keynes abruptly switched his decision-making from taking a top-down view to becoming a bottom-up investor, “picking stocks trading at a discount to their ‘intrinsic value’—terminology he himself employed. Subsequently, his equity investment began to outperform the market on a consistent basis.”
This stance marked a severe turn-around for the Kings College endowment, which had been run since 1441 and had predominantly been invested in real estate and collected rents from its agricultural portfolio.
The bursar who had traditionally been in charge of investments had spent several centuries loading up on high quality fixed income, including UK and colonial government securities, UK railway and water company securities, and local authority housing bonds and mortgages.
Keynes instead divided the endowment up into two main portfolios and injected more flair into his investments. Chambers and Dimson’s study focuses on the “Discretionary Portfolio, since it offers the purest expression of his views”.
“Keynes was an investment innovator,” the authors said, citing previous papers showing that he traded currencies at the very inception of modern forward markets, commodity futures and stocks.
“Most importantly, Keynes was among the first institutional managers to allocate the majority of his portfolio to the then-alternative asset class of equities. In contrast, most British (and American) long-term institutional investors of a century ago regarded ordinary shares or common stocks as unacceptably risky and shunned this asset class in favour of fixed income and real estate.”
The paper found Keynes began championing value investing in the UK around the same time as Columbia economist Benjamin Graham was recommending the view in the US.
“Both Keynes’ public statements and his economic theorizing strongly suggest that he did not believe that ‘prices of securities must be good indicators of value’.”
The paper investigates whether Keynes’ close relationship with many of the companies in which he invested would constitute “insider trading” in today’s markets, and finds that some of the contact may have broken the rules—which only came into effect in 1980.
However, the authors maintained that Keynes did very little “stock-flipping” and rarely got involved in IPOs. Upon the occasions he did, there were few times he sold out immediately after a float.
“The most significant of Keynes’ contributions to professional investment management was his path-breaking and strategic allocation to equities together with his early adoption of value-based investment strategies. By the 1940s, the weight of common stocks had increased to represent over half of the whole King’s College endowment’s security portfolio as a result of his equity-focused strategy. Institutional managers in general did not mimic this strategy until the second half of the 20th century.”
To read the entire updated paper, click here.
Related content: Interview with Elroy Dimson & The Equity Risk Premium (and How We’ve Been Getting It Wrong)