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”.

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.