Bridge over ocean
8 September 2017 Financial Analysts Journal Book Review

Asset Management: A Systematic Approach to Factor Investing (a review)

  1. William J. Bernstein
This highly engaging book will be warmly received by a wide audience. Anyone teaching entry-level finance should consider adopting it, and practitioners will be well rewarded by a close reading. It belongs on the front shelves of pension and endowment managers, who should read and reread the chapters on hedge funds, real estate, commodities, and private equity.

The phrases “finance textbook” and “page-turner” rarely occupy the same sentence or even the same paragraph, but Asset Management: A Systematic Approach to Factor Investing, by Andrew Ang, the Ann F. Kaplan Professor of Business at Columbia University, justifies that pairing of terms.

The best economic writing often stretches the fabric of theory ever so gently over a frame of successive narratives. Ang follows this venerable recipe by beginning each chapter with a compelling story—variously involving war, revolution, fraud, drug-addled mutual fund executives, or, at a minimum, monumental financial incompetence—and then concluding with a coda from the same tale. (One wishes, though, that he had not overused “redux” with such abandon.) Of course, no serious finance text can dance the “full monty” of narrative economic history, executed by such masters of popular finance as Peter Bernstein, Edward Chancellor, and Frederick Taylor.  Asset Management ’s exposition of finance is so muscular, however, that the reader does not mind as each chapter’s opening narrative disappears, behind the turned pages, into dry theory and occasional thickets of equation-laden constructs. Writers of academic finance and economics titles should take note of Ang’s deft delivery of potentially deadly material.

Ang tees off, improbably, with the story of East Timor, the modern vestige of Portugal’s first-mover advantage in 16th century Europe’s mad rush for spices in Asia. This flyspeck of a nation, the winner of a brutal war of independence against Indonesia, possesses oil reserves and thus a sovereign wealth fund. You would be hard pressed to find a better example to illustrate the critical challenges and responsibilities faced by the owners and managers of wealth, especially the agency conflict between them. Because East Timor’s oil reserves account for 95% of its GDP, it is no exaggeration to say that the fate of the nation hangs on this conflict. (Later in the book, Ang provides this pungent exposition of agency theory: “The agent is out to screw you, not because the agent dislikes you, but because the agent is human and, therefore, cares first and foremost about himself.”)

The author goes well beyond the usual treatment of investor utility and mean–variance optimization by covering the algorithm’s considerable pitfalls—which have mainly to do with the difficulty of estimating inputs—and how to deal with them. Managers should think about risk parity only if they can accurately estimate correlations and volatilities—no mean trick. Returns are even harder to estimate, and only those who can forecast all three datasets should deploy the full mean–variance engine. (The author neglects to add that if you can accurately forecast returns, you have no need for an optimizer in the first place.) You can almost hear Ang chortling when he writes that a manager is more likely to play shortstop for the Red Sox than successfully estimate most of the Markowitz inputs. He is more explicit in his opinion that nearly all money managers would be better off simply holding equal asset weights if they can rebalance or the market portfolio if they cannot.

The book’s broad middle analyzes the landscape of return factors, and it relentlessly hammers home the point made by the author’s consulting colleague Antti Ilmanen in his magnum opus, Expected Returns: An Investor’s Guide to Harvesting Market Rewards (Wiley, 2011): Risk premiums are primarily earned by shouldering bad returns in bad times (BRBT). A risk factor related to BRBT is volatility; because a long position has a negative long-term expected return, investors can reap a premium by selling it (i.e., by providing insurance to those desiring protection against market declines). The world of finance divides between those who need liquidity and must pay for it and those who can profit by selling it. The problem is that just as the overwhelming majority of drivers believe that they are above average, so too do a majority of managers believe that when crisis arrives,  they  will be the ones doing the buying. Financial history shows that many of them will be mistaken. (Or, as put by that great “financial economist” Mike Tyson, “Everybody has a plan until they get punched in the mouth.”)

Ang’s model of illiquid security trading finds that the typical endowment aimed at a 59/41 mix of liquid risky/riskless assets should adjust its mix down to 44/56 at an average one-year delay to liquidity, to 11/89 at 5 years, and to 5/95 at 10 years. Further, the investor in illiquid assets should require an additional risk premium of 0.7%, 4.3%, and 6.0% for assets at those liquidity horizons. Had Harvard University’s endowment done this sort of calculation, the banks of the Charles River would not today be dotted with so many undeveloped lots (and one giant hole in the ground in Allston, Massachusetts).

In a related vein, Ang is a fan of rebalancing and provides new insights even to those who have thought long and hard about this process. For example, most observant practitioners realize that rebalancing provides excess returns when asset class returns are similar (as with US stocks and bonds over the past decade) and that rebalancing loses money when asset class returns vary widely (as with US and Japanese equities since 1990). Rebalancers, Ang reminds us, are providers of liquidity and, more subtly, are short volatility, earning a premium when risky asset classes behave as expected and paying out insurance when outcomes are extreme, on the upside as well as the downside.

The most arresting part of the book is Ang’s exposition of the moral wasteland that characterizes the markets in illiquid assets, especially private equity, municipal bonds, and hedge funds (to which this reviewer would add nontraded REITs and equity-indexed annuities). Ang quotes approvingly endowment expert Timothy Keating’s assessment of universities’ headlong rush into alternatives: “It’s a horror show.”

It is ironic that Asset Management appears at roughly the same time as Michael Lewis’s ballyhooed Flash Boys: A Wall Street Revolt (W.W. Norton & Company, 2014), which derides a trading apparatus that clips the odd basis point from small investors and rarely more than a dozen or two from institutional ones. Given the hundreds, even thousands, of basis points harvested by banks and brokerage firms in the vehicles documented in Asset Management, it becomes all too clear that Lewis’s righteous anger over high-frequency trading is akin to indignation over a bank robber’s unfashionable attire.

There is more—much more—in the book that will reward institutional investors and, rare in an academic finance tome, individual ones as well. The latter will find the book’s discussion of life-cycle issues, particularly health and longevity risks, especially worthwhile. The section on municipal bonds is so well written and so devoid of jargon that it should be read by anyone who has ever bought or contemplated buying an individual tax-free bond from a financial institution. It will benefit individual muni purchasers handsomely, perhaps thousands of times over, if they fall into the high-net-worth category. (When sorted by trading interval, the median municipal bond issue transacts once or twice a year.)

For Ang, there is no “annuitization puzzle”: Credit risk, actuarial unfairness, adverse selection, opaque structure, health risks, the need for emergency funds, the lack of bequests—to say nothing of the wisdom of deferring Social Security—all account for annuitization’s “puzzlelessness.” On behavioral strategies that encourage plan participants to annuitize by framing the decision so as to nudge them in that direction, Ang opines, “These efforts can only go so far if the products themselves are deficient.”

I question only a few minor omissions. Although the author accurately describes the pitfalls of using overlapping time series to estimate correlations and regressions, he fails to mention the primary tool for dealing with these pitfalls: the Newey–West covariance correction. More substantively, although Ang correctly points out the short-term detrimental effects of unexpected inflation on equities, he does not seriously consider the issue from a longer-term, consumption-based perspective, which yields a more nuanced conclusion. Yes, long-term high inflation does lower long-term returns, but equities generally provide more-than-adequate long-term inflation protection, which nominal bonds most certainly do not. The Jorion-Goetzmann and Dimson-Marsh-Staunton international databases show that in most inflationary environments, equities are a store of real value. Most famously, stocks provided a healthy real return over the course of the Weimar Republic’s hyperinflation as well as during the chronic but milder inflation in Europe and Japan following World War II and, more recently, in Chile and Israel.

But these are quibbles. Asset Management will be warmly received by a wide audience. Anyone teaching entry-level finance should consider adopting it, and practitioners will be well rewarded by a close reading. It belongs on the front shelves of pension and endowment managers, who should read and reread the chapters on hedge funds, real estate, commodities, and private equity until they realize that unless their name is David Swensen, they are the patsies at ludicrously expensive poker tables.

Finally, all participants in defined contribution plans should study the chapter on mutual funds, in which Ang breathes fire and substance into Paul Samuelson’s famous observation that “I decided that there was only one place to make money in the mutual fund business—as there is only one place for a temperate man to be in a saloon—behind the bar and not in front of the bar. And I invested in . . . [a mutual fund] management company.”1

Were the publisher to post at least some of these chapters online, it would do well by doing good. As has Professor Ang, in spades.


We’re using cookies, but you can turn them off in Privacy Settings.  Otherwise, you are agreeing to our use of cookies.  Accepting cookies does not mean that we are collecting personal data. Learn more in our Privacy Policy.