Tag Archives: cfa-charter-holders

SAT Investing

Can investors learn something from the SATs? It may be only a few more days to Christmas, but it’s also college application season. A lot of high-school seniors are filling out the Common App, writing and re-writing essays, and anxiously awaiting their latest test scores. And there’s a test-taking technique that kids use to improve how they do on standardized tests that can help investors. It’s elimination. When they come to a question to which they don’t know the answer, they can improve their scores by eliminating what is most clearly wrong. In a multiple-choice test, someone just filling in the circles gets 20 or 25% correct by random chance. But by eliminating the obviously wrong answers, students can better their odds. They won’t guess right every time, but they’ll do better than if they had left the answer blank. In the same way, investors can do better by eliminating what’s wrong. If a company’s business model makes no sense – if you can’t figure out how they earn their money – then don’t own that business. If management seems to be focused more on politics and celebrity than capital investment and HR, don’t buy the stock. This is a variant of The Loser’s Game by Charlie Ellis. We can be smart by avoiding dumb ideas. For example, in December of 2000, Enron employed 20,000 people and claimed revenues of over $100 billion. But some analysts started looking in depth at their derivative books and couldn’t figure out how the company was earning all their money. There was a gap between what was reported and what they could confirm. We know how this story ends: Enron filed for bankruptcy in December 2001. The executives used a willful, systematic, and intricately planned accounting fraud to inflate their earnings. (click to enlarge) Enron stock. Source: Bloomberg Investors would have improved their relative performance by avoiding Enron. That was difficult to do: the company was a media darling, considered a high-flying harbinger of the new economy. It had tremendous price momentum. But it was hard to see how they could turn 2% growth in utility revenues into consistent double-digit earnings growth for themselves. By looking under the hood – understanding the business, reading the financials – investors can sometimes avoid the big flops. And just like when kids take the SATs, if you can improve your odds – in a low-return world – that just might be enough.

We Eat Dollar Weighted Returns – VII

Photo Credit: Fated Snowfox I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch. As he said in his blog post at The Wall Street Journal’s The Experts blog: WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance. “No problem,” you might think-buy and hold and ignore the short-term noise. Easier said than done. Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009 . The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period. What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.” The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially. In other words, fund managers can deliver a great long-term strategy, but investors can still lose. That’s why I wanted to write this post. Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions. As such, his investors buy high and sell low with his funds. The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database. The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data. The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports. This is all public data, but somewhat difficult to aggregate. I do it by hand. I use annual cash flows for most of the calculation. For the buy and hold return, I got the data from Yahoo Finance, which got it from Morningstar. Note the pattern of cash flows is positive until the financial crisis, and negative thereafter. Also note that more has gone into the fund than has come out, and thus the average investor has lost money. The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance. This would be an ideal fund to rebalance. Talented manager, will do well over time. Add money when he does badly, take money out when he does well. Would make a ton of sense. Why doesn’t it happen? Why doesn’t at least buy-and-hold happen? It doesn’t happen because there is an Asset-Liability mismatch. It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short. If you underperform for less than a few years, they yank funds. The poetic justice is that they yank the funds just as the performance is about to turn. Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in. It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out. The more volatile the fund, the more rapidly that happens. And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months. Pretty astounding I think. This highlights two main facts about retail investing that can’t be denied. Asset prices move a lot more than fundamentals, and Most investors chase performance These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees. Remember as well that passive investing does not protect retail investors from themselves. I have done the same analyses with passive portfolios – the results are the same, proportionate to volatility. I know buy-and-hold gets a bad rap, and it is not deserved. Take a few of my pieces from the past: If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets. If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets. Rebalance to those percentages yearly. If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon. (Why 120? End of the mortality table. Take it from an investment actuary. We’re the best-kept secret in the financial markets.) Okay, gotta close this off. This is not the last of this series. I will do more dollar-weighted returns. As far as retail investing goes, it is the most important issue. Period. Disclosure: None

Time To Bring Active Back Into A Portfolio?

The U.S. stock market has advanced steadily over the past six years, a rally fueled partly by unusually accommodative monetary policy and notable for its near absence of volatility. But while stocks in general have rallied since the economic recovery began to take hold in 2009, many active portfolio managers have struggled to deliver investor returns in excess of the broader market, according to a BlackRock analysis of data accessible via Bloomberg. Many factors have been cited for this persistent underperformance , including higher fees and risk aversion in the aftermath of the financial crisis. However, another contributing factor has arguably been the Fed’s extraordinarily easy monetary policy suppressing volatility and hindering active managers’ ability to generate excess returns via security selection and portfolio tilts. Regardless of the cause, the value proposition of active management simply hasn’t materialized in recent years. However, with the Federal Reserve (Fed) poised to begin raising rates as early as next month , investors will have to adjust to more modest returns from U.S. stocks as well as brace for heightened volatility. This could create an opportunity for an active management approach. As Kurt Reiman and I write in our new Market Perspectives paper, ” A Quantum of Solace: Can the return of volatility revive active management “, we may be entering a more favorable environment for active manager performance. Based on our analysis using Bloomberg performance data for the S&P 500 Index back to the mid-1990s, there’s some evidence that managers’ ability to beat benchmarks comes in cycles. In fact, two somewhat interrelated variables do a reasonably good job of explaining the performance of active managers relative to their benchmarks: the annual change in volatility and the annual change in cross-sectional dispersion. (Cross-sectional dispersion measures the spread of asset returns or, in the case of the S&P 500 Index, the tendency of individual company returns to diverge from the average index return.) As the chart below shows, we found that periods of rising volatility and heightened cross-sectional dispersion coincided with manager outperformance in large-cap U.S. stocks. (click to enlarge) Looking forward, both volatility and cross-sectional dispersion are likely to eclipse the levels experienced in the past few years for large-cap U.S. stocks. This means that, in an environment where returns are harder to come by, investors may want to consider an active manager to source some returns and take idiosyncratic risk. That said, we’re not advocating that investors abandon the benchmark-replicating approach. With bull market and economic expansion more mature, blending active management exposures – whether through actively-managed exchange-traded funds (ETFs), multi-asset managers, traditional active equity managers or other sources – with benchmark-replicating vehicles will become increasingly important for meeting return objectives and controlling risk. The bottom line: The more muted return prospects for traditional assets from here and rocky road ahead warrant a more thoughtful approach to blending active and passive investing in a portfolio . Kurt Reiman, a Global Investment Strategist at BlackRock working with Chief Investment Strategist Russ Koesterich, contributed to this post. This post originally appeared on the BlackRock Blog.