Tuesday, November 18, 2014

Valuation from All Angles: S&P 500, Russell 2000, and the 10 GICS Sectors

Click link for full charts:

The Lollapalooza Effect in Active Management

Active management is having another dreadful year in 2014. Here are the results for U.S. stock funds through October, courtesy of Bank of America:
Index fund proponents have clearly laid out the arguments against active funds over the years:
  • Higher fees.
  • Higher turnover and trading activity.
  • Tax inefficient.
  • Cash drag.
  • Stock picking is hard.
  • Market timing is nearly impossible.
  • Increased competition in the industry.
  • Low persistence in winners over time.
  • Beating the market is a zero-sum game.
The usual conclusion is that a dart-throwing monkey could do a better job of picking stocks than active portfolio managers. This is a gross oversimplification, but beating the market is difficult nonetheless.
There is another factor at play here that doesn’t get nearly as much attention as it should. Paul Sullivan discussed this issue in an excellent piece on the investment industry that he wrote for the New York Times:
Fifty-four percent of institutional investors said they feared they could lose their job if they underperformed for only 18 months; 45 percent of people managing money at asset management firms said they felt the same.
“Career risk is much more profound than we anticipated,” Ms. Duncan said. “It’s difficult to change because it’s very much embedded in everything. It’s the culture, the fee structure, it’s based on assets under management, and they’re rewarded for this.”
It’s hard enough to beat the market under normal circumstances. When you add in career risk to the equation, things can get out of hand in a hurry. Unrealistic expectations placed on these large allocators of capital flow straight through to the active portfolio managers they invest in, which makes for a near impossible situation for investors and fund managers alike. In the end, no one wins using that kind of time horizon or level of patience.
There’s a tendency to get extreme consequences when you combine a number of human misjudgments all at the same time when aiming for a particular outcome. Charlie Munger calls this the lollapalooza effect:
When several models combine, you get lollapalooza effects; this is when two, three, fours forces are all operating in the same direction. [...] 
More commonly, the forces coming out of these one hundred models are conflicting to some extent. And you get huge, miserable trade-offs. But if you can’t think in terms of tradeoffs and recognize tradeoffs in what you’re dealing with, you’re a horse’s patoot. You clearly are a danger to the rest of the people when serious thinking is being done. You have to recognize how these things combine.
It also doesn’t help that the narrative for active management is constantly changing over time depending on where we are in the investment cycle. At different times investors would like correlated returns when markets are rising, uncorrelated returns when they’re falling, absolute returns during a correction, downside protection against a crash, the ability to go both long and short in a sideways market, the ability to be tactical and time the market at the inflection points and, of course, you have to consistently beat the market.
Even the greatest investors of all-time have bad quarters, years or even entire market cycles. No investor can be all things at all times. And if they could they certainly wouldn’t open up their fund to the investing public.
Think about being a portfolio manager for a minute. When you’re performing poorly, investors rush to the exits to redeem and you are forced to sell shares when you should be looking for opportunities to buy. When you are performing well, investors shower you with contributions and force you to buy more shares at higher prices. The best performers are rewarded with much larger funds, which makes it that much harder for them to outperform going forward.
When a portfolio manager is outperforming the market and overconfidence seeps in, it’s like they’re doing you a favor to allow them to invest money on your behalf. When the script flips and they’re underperforming, it’s the investor’s turn to have the upper hand.
It’s rare to have good behavior at the same time from both investors and portfolio managers. It’s not impossible, but it’s rare. The due diligence process required to choose active managers is not easy, especially for the average investor. But even if you have a legitimate process in place to find superior funds, you still have to manage your own emotions and place realistic expectations on the strategies you choose to be able to see them through a full cycle.
This is why the best actively managed strategies will be the ones that are easy to explain and understand. If you don’t understand it or the fund manager can’t easily explain it, the odds are that you will make hasty decisions and perpetuate the cycle of underperformance.
It’s very difficult to beat the market over longer time frames. This doesn’t mean it doesn’t happen; it’s just not that easy. But investors, both individual and professional, often make it even harder for active managers to outperform.
The institutional imperative and the lollapalooza effect are a big reason for this.

Wednesday, November 12, 2014

Audience with Rob Arnott

Our discussion begins where it must – on the extreme relative underperformance of all other asset classes versus the S&P 500 over the last few years. Rob says the only question is about when market participants will remember how important it is to be diversified into other asset classes. Diversification always feels bad in a bull market and in a raging bull market (like now), it can become painful – especially when you’re advising other people. In his PIMCO All Asset Fund, Rob’s been overweight emerging markets – both stocks and bonds – primarily because of their relative cheapness versus their US counterparts. It’s a trade that hasn’t “worked” yet, but it’s a position that he feels will shield investors from the dark side of the current reality.
We get into the wisdom (or lack thereof) in cherry-picking out some of the worst EM countries like Russia or the largest of the State-Operated Entities (SOEs) that dominate the EM indices. Rob’s counterpoint is that by eliminating Russia, you’re also eliminating one of the cheapest markets and, by default, overweighting the more expensive ones. This cherry-picking activity kind of messes with the idea of expected returns in the long run if you keep trying to do it.
I mention to Rob how fascinated I was with his piece from the Journal of Portfolio Management last summer* where he took every popular fundamentally-weighted index strategy and showed how it beats the traditional cap-weighted index over the long-term. The best part about his paper was when he then inverted these strategies and showed that – shockingly – their exact opposites also beat the index! I’m still amazed by that but Rob is not. He frames it as a simple matter of removing the market cap weighting from your equation and being able to de-emphasize the biggest, most popular (read: expensive) stocks as a result. If you can do this systematically, you pull ahead of the index through a full cycle (boom and bust) almost every time. The difficulty is that cap-weight is what really gives you rock n’ roll in a bull market – and advisors who are relentlessly judged by the clients against the S&P 500 will struggle to convince them why it’s going to work eventually.
I ask Rob the same question I’ve asked of my friends at O’Shaughnessy Asset Management and WisdomTree and BlackRock etc: What is the difference between factor investing and smart beta? I always get an interesting response to this and Rob’s reply didn’t disappoint. To Research Affiliates, factor investing – which is forty some-odd years old as a practice – is a step in the right direction – but it doesn’t go far enough. While he likes the idea of tilting toward factors, he explains that you’re still starting with a market cap-weighting posture. Whereas smart beta completely breaks the link. In essence, he views fundamentally-weighted indices as an ideal and factor investing as a lighter version – with less efficacy in his view.
He thinks the problem most people have with the concept of “smart beta” has more to do with the marketing itself than with the actual process of owning cheaper or high quality stocks. In that he and I agree. I point out that there is roughly $390 billion currently invested in so-called smart beta index products at the moment but he thinks that’s taking a very liberal definition of the term. To Rob, it’s a much lower number and, more importantly, relative to the total investable asset base of the world ($60 trillion, perhaps), it’s a pebble in the ocean.
One solution for being worried about the current state of elevated valuation in US stocks would be to own RAFI’s fundamental index version – although it’s certainly not a bargain on an absolute basis. While the S&P 500 sells at a CAPE of 27, historically very high, Rob’s index sells for 23. It’s not going to help much but it could cushion the blow on the downside because you’re starting off with lower weightings to bubblier stocks. The fundamentally-weighted versions of EM indices and the like are much cheaper. More on the Research Affiliates fundamental index products at Invesco Powershares here.
Why, I ask, if fundamental indexing is so superior, is there so little money run based on it? He points to the four decades it took for Vanguard to gain mass acceptance despite the fact that their products had been creaming active managers forever. I agree with him here as well. Just because people understand something, that doesn’t mean they will be compelled (or incentivized) to act on it. In many cases, pros have been de-incentivized to act in the interests of their clients. Rob calls it inertia – a resistance to change. I am not afraid to call it cynicism. In either event, he thinks it is inevitable that fundamental indexing will gain more adherents, regardless of the polarization caused by the smart beta label.
In any event, it’s such a thrill and a pleasure to be able to sit down with an investor like Rob Arnott, who’s had such a huge impact on my own thinking over the years. To read the Research Affiliate’s latest paper on smart beta, hit the link below:
* For the above-referenced JPM piece about inverting the fundamentally-driven indices, click here:

Friday, November 07, 2014

CTA nightmare turns into a dream

Do computers that trade financial markets ever have nightmares about losing money? It is a question investors have asked in recent years of the hedge funds that use automated algorithms and models to buy and sell billions of dollars of assets.

Having almost consistently made money in the decade leading up to the financial crisis, these so-called trend following hedge funds appeared to have been scrambled by the high correlation across markets caused by ultra-low interest rates and central bank intervention.
While the money being lost was just another data entry for the computers buying and selling assets ranging from pork belly futures to Japanese government bonds, their creators faced the very human stress of investors losing faith in their investment strategy.
As the funds came under huge pressure to remodel their apparently malfunctioning computer programs, some investors even began to argue that trend following systems were permanently broken – that the mathematicians and scientists should close down their spread sheets for good.
“No matter how much we have a statistical, disciplined and scientific approach to investing, that doesn’t mean that as a human you don’t watch your returns going down in periods of poorer performance and experience all the negative emotions that losses entail,” says Ewan Kirk, chief investment officer of UK-based hedge fund manager Cantab.
But the managers, who go as far as sending researchers to the British National Archives to extract grain prices from the Domesday Book to construct trend following models, remained convinced the strategy would recover. 
“When people doubted trend following, it reminded me of people giving up on value investing before the technology bubble burst, at exactly the wrong time,” says Sandy Rattray, chief executive of Man Group’s AHL, one of the largest and oldest of this type of hedge fund. “Studies have shown that momentum has worked well over long periods. It was a brave person who said that momentum was permanently broken, but many did at the beginning of 2014.”
AHL correlation
Having begun the year as the most hated hedge fund strategy, many of these trend following funds have emerged as the best performing funds of 2014, outpacing their stock picking rivals who rely on mere human intuition to make money. 
Helped by large moves in commodities, energy prices and interest rates, as well as the ongoing devaluation of the Japanese yen, funds like AHL, as well as rivals such as Cantab, and Isam, have all reported double digit returns for their investors this year. In contrast, many well known funds following other strategies, most notably global macro traders, have lost money this year.
Their managers argue it was their ability to withstand the short-term pressure of radically overhauling their core principles that meant they were ready to profit when the right market conditions returned.
“Have we changed things on the basis of what happened? The answer is no. We did not lose the faith. We are always grounded in research, and coming up with new ideas,” says Mr Kirk of Cantab, which has $3.2bn under management. “If a model is losing money, but is within the statistical expectation, you can’t just chop and change everything because you have a period of poorer performance.”
AHL diversified
Investors in these funds, who were beginning to lose patience, now appear to be back on side. “They really needed this,” says an executive from a multibillion-dollar hedge fund investor. “If they had suffered another year of bad performance it was possible some of the smaller ones could have gone out of business entirely.”
Part of the problem for trend following funds has been their perceived complexity, with terms such as “black box” frequently used to describe an investment strategy that many hedge fund investors find difficult to analyse compared with more traditional stock picking techniques.
Mr Rattray argues that in fact the machines, which are constantly monitored by humans to check for abnormal market moves, are far more transparent than traditional fund managers.
“If you tell me what Japanese government bonds will do tomorrow I can tell you exactly what we will do in response,” he says. 
He believes people will gradually get more comfortable with computers making decisions about investing their money.
“Sometimes people can be suspicious of the idea of using models or computers to make decisions. It reminds me of Nissan at first finding people didn’t want to buy the cars they built using robots in factories. It took time for consumers to trust cars that were not put together by humans on an assembly line”.

Tuesday, October 28, 2014

Soc Gen ‘Hedge Funds Left Naked By Market Correction’

Increasing volatility caused pain on short volatility plays in equity markets, hedge fund stops were hit as margin calls gave hedge funds a tougher ride down than going back up

It might seem odd that Societe Generale’s latest Hedge Fund report decries the lack of performance in hedge funds when a category it should be intimately familiar with, managed futures, continues to perform during crisis.  The report titled ‘Hedge Funds Left Naked By Market Correction’ nonetheless provides significant insight into the current state of hedge fund positioning, if tilting slightly towards those equity-based hedge funds that have historically dominated Wall Street thought processes.
Hedge Funds net positions
The report of hedge fund trade positions is always considered interesting as Newedge, Soc Gen’s derivatives brokerage holding, has access to many of the top algorithmic traders. It is odd, then, that at a time when the Newedge CTA Index is up by 0.10 percent month to date (as of October 23), the report indicates hedge funds are generally suffering during October.

Hedge funds exposed to the bond market correction

As a result of rising U.S. bond yields and long dollar trades, hedge funds were “exposed” to the correction.  “Even diversification can be of little help, as trades in many different asset classes go south simultaneously, leaving one feeling rather, err, exposed,” the report quipped.  What is one hedge fund’s exposure is another hedge fund’s opportunity.
Hedge Funds bonds
There are several factors that the Soc Gen report says could lead to a hedge fund fail in October. This can be broken down into two basic categories that are most interesting: Hedge fund expectations of rising US bond yields (and related market trends, particularly in currencies) and volatility.

Hedge funds’ expectation for rising U.S. interest rates

The expectation for rising U.S. interest rates is in some cases viewed as a market crash hedge, a debt crisis play. At some point the math of government debt, the momentum of which appears can’t be stopped, overwhelms the ability of a sovereign nation to pay its debt obligations. At one point this thinking was considered “crazy,” but it was really crazy only to those who didn’t do the math. It is for this reason that certain hedge funds have a long interest rate play (and some have a general long volatility play) in their risk management plans.
Hedge Funds Treasuries
While the interest rate hedge may have cost money in October – as the bet on higher interest rates met the gravity of stock market investors looking for safety in a falling stock market – that play continues to be a risk management concern.  The report noted that short treasuries was already a crowded play, showing the popularity of the interest rate hedge, but “then rates fell again. Ouch!” says the report.
Hedge funds also got hit by rising volatility, the report said, noting that certain hedge fund VIX positions were required to be sold during the recent volatility spike. But perhaps the more specific issue certain hedge funds faced was their short option put positions on individual stocks.  The report noted “hedge funds typically make money on short equity volatility positions.”  In some cases, this is a strategy that can materialize in a short put long stock relative value trade, also commonly known as a “Texas hedge” in certain derivatives circles. When the stock market is rising the long equity position gains value while the short put position loses value. Since the investor is long the stock and short the put option, it’s a win win. Typically this strategy is used at a point when the investor is willing to go long additional stock. (See Netflix stock acquisition strategy from Mark Cubin for an example.)
Hedge Funds equity volatility
Volatility causing traditional equity hedge funds difficulty
While Soc Gen noted volatility causing traditional equity hedge funds difficulty, it has benefited certain volatility hedge fund traders.  The Typhon Proteus Dynamic Volatility hedge fund, under the supervision of derivatives executive James Koutoulas, is doing well in October.  The volatility program, one of four programs Typhon manages, is up 2.49 percent on the month, outpacing the Newedge CTA index.  Attain Portfolio Advisors Trend Fund is up 9.89 percent this month and Walter Gallwas, president and founding partner of the firm, notes the entire managed futures space has been doing well.
Soc Gen interestingly noted that many hedge fund traders were stopped out on their trades, the old “margin call,” and may suffered more to the downside than to the upside.
Hedge Funds currencies
One of the hedge fund relative value trades that has been popular among certain algorithmic spread strategies is the short gold long platinum relative value play. Copper and gold started to break down with a volatility spike in early to mid July. Big up volume followed by even bigger down volume, that wasn’t confirmed in the high value metal category, indicated that a reversion from the mean in the price relationship could ensue.
Hedge Funds strategies

Hedge funds gains with commodities

This thesis is confirmed to an extent in the positive relative value hedge funds afforded platinum and the relatively negative view of copper.  Wheat and soybeans also saw negative weighting from hedge funds, but what didn’t make the report was the positive uptrend in cattle, which has been the focus of certain relative value trades as well.
The report was fascinating, but what would be equally interesting would be to see the proportion of traditional equity-based hedge funds in the study vs. the number of true algorithmic long / short programs.
Hedge Funds us equities

Thursday, October 23, 2014

Look Who Decided to Show Up to the Party…

We’ve done testing going back 100 years or so (so has AQR in their paper ) and I was delighted to see a new book out by the crew at ISAM (up a whopping 28% this year) that has a 800 year backtest!  Looking forward to reading it.

If you want some background reading on Trendfollowing search the archives, lots and lots in there including some of the below:

Podcast interviews that are excellent
Dual Momentum Investing – Antonacci
Following the Trend – Clenow
Trendfollowing Bible – Abraham
Global Investment Returns Yearbook – Dimson, Marsh, Staunton
Trendfollowing – Michael Covel
The Capitalism Distribution – LondBoardFunds

- See more at: http://mebfaber.com/2014/10/21/look-who-decided-to-show-up-to-the-party/#sthash.qr8sG2g1.dpuf

Wednesday, October 08, 2014

Here’s The Problem With Underperformance

“A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular.” – Seth Klarman
Active mutual funds continue to lag the market this year. This chart from BMO Capital Markets, courtesy of MarketWatch, shows the percentage of active stock managers that are outperforming the market over the past six years or so:
This is nothing new, but there are some risks for investors in active funds to consider that can result from this underperformance. Brian Belski, the chief investment strategist at BMO, had this to say about the implications of these numbers:
We believe fund managers being too inactive and defensive with their portfolio positioning this year is largely responsible for this. However, given the level of underperformance, fund managers will likely have an added incentive to position portfolios more aggressively between now and year-end to play “catch-up” – something we believe will be a strong positive for market performance.
Ignoring the market implications (why would the market go up just because portfolio managers shift their stock holdings around?), this brings up a risk that few investors consider when making fund selections – career risk.
Whether right or wrong, if you underperform the market for an extended period of time, it will be much harder to attract new investors and keep current investors from selling out of the fund. Lower assets means lower fees which all compounds into more and more pressure on the manager to bring returns back up to stop the bleeding.
The risk for investors in underperforming funds is exactly what Belski outlines here – which is that portfolio managers take more risk to try to make up for their underperformance. Once a manager becomes fixated on short-term relative performance, risks can become magnified. Instead of performing rational analysis, they turn into speculators. They speculate on what other investors are going to do and try to get their first. They’re trying to forecast what the other forecasters are forecasting.
In essence, when you play the short-term relative performance game, you have to be able to guess the psychology of other people…not an easy task.
Obviously, this isn’t an optimal way to run a portfolio. This is why it’s so important for investors to understand what they are getting themselves into with any fund offering. A few points to consider when you’re involved with an underperforming fund or strategy:
Does the portfolio manager/firm have a disciplined process? A deep understanding of the fund and strategy is always important, but this is especially true when a period of poor performance hits. You must consider whether the manager will stick to their knitting or change course and go a new direction. Style drift is acceptable when it’s been sold as part of the strategy, but that’s rarely the case. More often than not style drift is a huge red flag for an underperforming fund.
Do you have the correct expectations for fund performance? Being out of favor isn’t that surprising. Nothing outperforms forever. Just as markets are cyclical, so too are strategies and investment styles. These things go in and out of style. It all depends on how willing you are to wait for things to turn around, which may or may not happen.
Do you have a plan for an underperforming fund? There’s no easy answer to the question of when to cut your losses in an underperforming fund. Investors always preach process, process, process until a bad outcome hits. At that point, process goes out the window and emotions take over. Emotions are the enemy of buy and sell decisions.
Playing catch-up to the market isn’t a great position to be in from a fund manager’s perspective. But adding risk for the sole purpose of getting even is not the solution.
Remember, trying harder doesn’t lead to better returns in the market.


“If it keeps on rainin’, levee’s goin’ to break.” – Led Zeppelin 
Crashes get all the headlines, but the reality is that a breakdown in markets is more often a process than an event. It takes time to break the back of a strong uptrends as there are many buyers on the sidelines eager to “buy the dip.” This is why you tend to see a period of back and forth, a rotation from strong hands to weak hands, before the sharper declines ensue.
If we look at the average stock in 2014 as reflected by the Russell 2000 Index, this is precisely what we have been witnessing for the entire year.
Where have we seen this before?
The First 7 months of 2011…
But It’s Different This Time
The perception today is that it’s different this time. This belief stems from the view that the Fed has repealed the business cycle and eradicated market corrections through nearly six year of 0% interest rates and multiple rounds of quantitative easing. The validation for this narrative comes in the form of price action and the longest uptrend in the history of markets. At 471 trading days above the 200-day moving average in the S&P 500, most cannot remember a time when equities did anything but go up.
Streak 10-8
Perhaps the Fed true believers are right, you say, and the uptrend will last forever. Anything is possible in markets but the more likely scenario is that it’s finally coming to an end here.  The sustained weakness in small caps, high yield credit, and cyclical sectors is becoming too much for large caps to ignore (see here for comparison to 2007).
Small caps, mid-caps, Emerging Markets, and European equity markets have all tested their 200-day in recent days/weeks. All that remains is large caps; it is the last shoe to drop. I have been arguing for much of the year that investors have been rotating into U.S. large caps and defensive areas, hiding in anticipation of the end of QE in October (see “Fed Prisoner’s Dilemma”).
Well, October is here and investors may soon come to understand that U.S. large caps are not a risk-free asset class, in spite of what Fed has done over the past six years.
The chart below of the Russell 2000 is likely to become very important in the coming months. It illustrates the back and forth action that is reminiscent of 2007.
I’ve heard a number of perma bulls call this a “beautiful consolidation,” just a pause before the next sharp move upward. Perhaps, but if they are wrong and the levee of support (YTD lows in February and May) is broken, there could be significant downside ahead.
Will it break or will it hold? On this question I’ll defer to the wisdom of Page and Plant: “If it keeps on rainin’ [negative intermarket relationships persist], levee’s goin’ to break.”

Tuesday, October 07, 2014

Global Diversification: Accepting Good Enough to Avoid Terrible

The U.S. stock market is once again trouncing the broader international markets this year. Through the end of September, the total U.S. stock market, as measured by the Vanguard Total Stock Market Fund, is up nearly 7% while the Vanguard Total International Fund is basically flat on the year.
Since the beginning of 2013, the U.S. market it up almost 43% against a 15% gain for foreign markets. It’s tempting to look at these numbers and assume you’ll be fine just holding U.S. stocks and forgetting about the rest of the globe.
Investors have a short memory at times, so it’s easy to forget that everyone hated U.S. stocks in the middle part of the last decade as foreign stocks, led by emerging markets, were up almost three times as much on a total return basis:
Intl 4
Over the entire 2002 to 2014 period the total returns are fairly close, with the U.S. market up 139% against a gain of 133% for international stocks. These numbers show how mean reversion works over time.
It’s also instructive to break out the international markets by different regions to show how certain geographies have performed over time. MSCI data goes all the way back to 1970 and they have an index for both Europe and the Pacific region (made up of Japan, Australia, Hong Kong and Singapore).
Looking at the performance of these two markets along with the S&P 500 over forty plus years, we find that the annual returns are fairly similar:
Intl 3
Any long-term investor would have done great in these markets had they been invested over the entire time frame. But breaking the numbers down by different periods shows how cyclical the annual returns have been over time:
Intl 1
Until the latest period, European stocks have actually been the most consistent performers while the U.S. and Pacific markets have taken turns going from top to bottom.
These numbers are a good reminder of why it makes sense to diversify globally and avoid a home country bias. There could be long stretches of severe underperformance if you invest in a single geography at the wrong time.
No one can predict if U.S. returns on stocks will be as high as they’ve been historically or if another country or region will outperform in the coming decades. There are far too many factors that are unknown.
It’s impossible to know ahead of time if the down periods in one market will coincide with your spending needs when you need to start drawing down your portfolio. Selling in a down or underperforming market only compounds your problems when a market runs into a bad stretch.
Not only are there long stretches of underperformance for some regions, but there is Japan-style underperformance which is in a league of it’s own. Japan currently makes up about 60% of the MSCI Pacific Index so it makes for a pretty good proxy. Here are the annual returns for the Pacific Index and  S&P 500 broken out by pre- and post-Japanese bubble:
Intl 2
Anytime you bring up the benefits of being a long-term stock investor, someone will play devil’s advocate by pointing out that Japan has been a terrible long-term investment for some time now. But it really depends on your definition of long-term because the returns are so close over the entire data-set.
Sometimes it comes down to luck and what period you happen to be saving and investing your money in. You have no control over this whatsoever. Pacific shares were an amazing investment for two decades, but have been working off those excesses ever since.
It would be great if we were all guaranteed a smooth ride with no variation in performance, but markets don’t function that way. They’re extremely cyclical and can go from worst to first and back again over any month, quarter, year, decade, etc.
It’s intelligent to utilize diversification so you don’t get stuck with a portfolio that only earns the Pacific returns since 1990. You have to give up the chance for exclusively earning the returns from 1970-1989, but that’s the trade-off.
Diversification is about accepting good enough while missing out on great but avoiding terrible.

Why the Gross vs Ivascyn comparison is misleading

A lot has been made of the track records of Bill Gross and Dan Ivascyn managed funds since the sudden departure of Gross from PIMCO. Mainstream media has covered the aftermath in great detail, but explanations of the performance have gone relatively untouched. Was the performance of Bill Gross really that awful? Was it entirely attributable to a poor call on US Treasuries? Is the Ivascyn magic touch now about to change all of PIMCO’s bond funds? Let’s sort through the facts and establish some pragmatic views on the subjects.
1. Ivascyn knocked it out of the park
Make no mistake about it, the management of Dan Ivascyn’s funds the since the crisis has been nothing short of superb. The PIMCO Income Fund (PIMIX) is up an average of 12.8% over 5 years versus the category average of 7.2%, ranking it better than 99% of peers according to Morningstar. Fund assets grew from $300mil in 2008 to $6.5bil at the end of 2011, and now $38.6bil at the end of September 2014.
Ivascyn and co-PM Alfred Murata targeted beat up credit assets that would benefit from a reflating of the financial markets. As central banks moved interest rates to zero and removed government bonds from the system, investors were forced to incrementally move out the credit curve.
An example of something that PIMIX has owned and done extremely well on is Spanish Covered Bonds. This is one the larger holdings in PIMIX. As shown, in three years, the price has risen from ~50 cents on the dollar to ~120 as the Euro debt crisis calmed.
Arguably the largest source of returns for the PIMCO Income Fund has been from non-agency MBS. There’s been arguably no better place for outsized returns in fixed income than non-agency MBS since 2009. Ivascyn and team made shrewd bets that these assets would recover and they did.
All in all, Ivascyn’s bets have been credit related and have centered around risk premium compression in the junkiest areas of credit. He has not been without misses - as his PIMCO funds held large amounts of Brazilian entrepreneur Eike Batista’s bankrupt OGX, as well Mexican homebuilder Homex. The point is not that he got a few wrong, but that he bet big on a recovery in the weakest areas of the credit markets and has largely been correct. Gross himself recognized & apparently liked this opportunity set as he is the largest owner of the Ivascyn managed PIMCO Dynamic Income fund (I consider it a leveraged version of PIMIX) with over 1.6mil shares held.
2. Gross’ Total Return Fund was not comparable to Ivascyn’s Income Fund
The objective of the PIMCO Total Return Fund is to "maximize total return, consistent with preservation of capital and prudent investment management. The fund invests at least 65% of its assets in investment grade fixed income".
The objective of the PIMCO Income Fund is to "maximize current income and to seek for long-term capital appreciation…"
These objectives are not anything similar to each other. The Gross managed Total Return Fund by mandate must seek preservation capital and may only hold a maximum of 35% in non investment grade bonds. In contrast, the Income fund is seeking to maximize current income and long term capital appreciation.  Gross was forced to hold a substantially larger amount of government bonds and lower yielding IG credit.
3. Even if he wanted to, the Total Return Fund was too large to buy the bonds that Ivascyn bought
Peaking at $293billion, the Total Return Fund is an absolute behemoth. Bottom line is that the types of bonds which had the most outsized returns (such as non-agency MBS) were not able to be purchased in great enough size to move the needle.
The size of the entire non-agency universe has fallen to under $750billion. After accounting for legacy holders, hedge funds, and banks, the universe to buy is very small. As an example, the large Maiden Lane auctions where the Government sold off amounts of non-agency MBS were only around $7bil if I recall correctly.  If the Total Return Fund bought that whole thing it still would’ve been a very small allocation to the fund. 
4. The performance of the Total Return Fund was largely based on duration calls
With a fund so large as Gross managed, the relatively performance of it came down to his call on duration. It’s been well documented that he was wrong about US rates a few years ago and that lack of duration hurt his relative performance. Regardless of QE or “the new normal”, his views on how much duration to take was the big determinant. He bet that rates would rise and inflation would as well (Gross funds were heavily long TIPS).
Yes, Gross and team made some mistakes but comparison to Ivascyn’s funds are misleading. They were playing in very different areas of the bond market and the size of Gross’ Total Return Fund were a big headwind. Astute readers will note that Ivascyn isn’t on the PM team for the Total Return fund & that’s probably a smart choice. Ironically, as Gundlach mentioned yesterday, the biggest mistake that Gross made might have been letting his flagship fund get too large.

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.