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Pessimistic Outlook? Maybe You Should Manage A Bond Fund

Ever notice how pessimistic bond fund managers are? They are some of the most “glass half empty” people you will ever come into contact with. Even the ones who have successfully built legacies that will endure for generations are consistently talking down on the economy, central banks, growth, and other unfavorable data points. Jeffrey Gundlach recently hypothesized that emerging markets could fall as much as 40%. He has also been an outspoken critic of the Federal Reserve’s rate hike agenda and the lack of inflation in the developed world. Gundlach is the head of DoubleLine Capital, which manages $85 billion in fixed-income assets. Similarly, renown bond investor Bill Gross railed about the problems with government debt and social service liabilities in his 2016 investment outlook . He seems very concerned about demographic trends and workforce shortages. Gross ran one of the biggest bond funds in the world at PIMCO prior to his separation from the firm he founded and transition to Janus Capital Group. These are just two of the most vocal and well-known bond managers in the world, but there are countless others that are quick to point out cracks in the global economic picture. Talking Your Book In the business we call this “talking your book” or simply slanting the facts and opinions towards a conclusion that favors your trade. Volatility, uncertainty, and fear are a bond managers dream come true. They have built empires on the back of investors fleeing the stock market in a rush to safety. Stocks usually drop in tandem with interest rates, which means that bond prices rise in kind. This favors their performance story and leads to a wave of new assets that quickly enter and are slow to leave. The returns are steady, the volatility is low, and the fees are reasonable – why would you ever want to depart that warm cocoon? These bond fund titans are simply saying ” take my hand and I’ll guide you around all the pitfalls and uncertainty “. Bless their hearts. Active managers in particular are able to shape the underlying holdings of their funds in accordance with their views. They have certain limits and mandates according to the prospectus guidelines. However, there is always some leeway to reduce exposure to areas they are concerned about, add to undervalued opportunities, or build in hedges as appropriate. This can lead to a measurable boost in performance over the benchmark if they are on the right side of the market. The best bond fund managers have risen to their status because they are right more often than they are wrong. My review of Gundlach’s predictions for 2015 were pretty spot on with the exception of his call on gold. I have been a long-time fan of his flagship strategy in the Doubleline Total Return Bond Fund (MUTF: DBLTX ) and continue to hold it in my own account as well as for my clients. The rigors of managing billions in bonds is a stress that I will likely never have to endure. As a result, I have a more even-keeled outlook for the future that balances the dangers of a bear market or recession against the opportunity for a resurgence in risk assets. This allows for a more flexible (if guarded) approach that has served me well in riding out the ups and downs of this fickle market. The Bottom Line Understanding the motivations of an investment manager can be useful in deciphering their market calls and help frame their message in the context of your personal outlook. In addition, it’s always advantageous to dig a little deeper to see how their actual portfolio is positioned versus what they are saying publicly. If there is a disconnect between these two points, it may be best to err on the side of their actions versus their words. Remember that everyone has a motivation or bias in the investment world (even me). By understanding this perspective, you can more acutely discern brains from bullshit and act accordingly.

Multialternative Funds: Best And Worst Of December

Multialternative funds averaged a 1.20% loss in December, dropping their returns for 2015 to -2.39% versus a 2015 loss of 1.79% for the Morningstar Moderate Target Risk TR USD Index (the Index). For the three years ending December 31, the category averaged annualized returns of 1.77% versus 5.60% for the Index, with a beta relative to the Index of 0.51 and a Sharpe ratio of 0.38. On a beta adjusted basis, the funds underperformed the Index with -1.01% annualized alpha over the three-year period. The top-performing multialternative funds and ETFs in December posted gains of as much as 3%, and two of the top-three performers from 2015’s final month had one-year returns of greater than 8%. But of the six funds reviewed this month – the three best and the three worst – only one from each stack launched early enough to have three-year track records, and both underperformed the category averages in terms of returns, Sharpe ratio, and volatility. Click to enlarge Top Performers in December The three best-performing multialternative mutual funds and ETFs in December were: QSPIX and EXD both generated December returns in the +3% range, with QSPIX gaining 3.01% and EXD 2.94% for the month. Both funds were similar in terms of their annual returns, too, with QSPIX gaining 8.76% in 2015 and EXD adding 8.55% for the year. But only EXD, a closed-end fund that launched in June 2010, had three-year data available: its annualized returns stood at an unappealing -1.26%, and its seemingly good-looking -0.30 beta actually resulted in losses, as is evident from the fund’s three-year alpha of +2.86%. In all EXD’s three-year Sharpe ratio was only 0.20, and its three-year standard deviation of 5.87% was the highest of all qualifying funds reviewed this month. AQR’s QSLIX rounds out December’s top three. The fund, which launched September 2014, returned +1.82% in December and +4.02% for the year. Worst Performers in December The three worst-performing multialternative mutual funds and ETFs in December were: SANAX was December’s worst-performing ’40 Act multialternative fund, returning -4.16% for the month. For the year, the fund lost 8.18%, which dropped its three-year annualized gains to just 0.74%. Through December 31, the fund had a three-year beta of 0.52, but generated alpha of -2.12% with 5.21% annualized volatility. As such, its Sharpe ratio for the period stood well below the average for its peers at 0.16. QSTAX and the Transamerica Global Multifactor Macro Fund both launched in 2015 and thus didn’t have three- or even one-year return data as of December 31 of that same year. In December they lost 4.11% and 3.96%, respectively. Past performance does not necessarily predict future results. Jason Seagraves and Meili Zeng contributed to this article.

The Problem With Accounting Book Value

In our recent article on the flaws in return on equity , we showed how it has no correlation with several different measures of valuation. However, there is one valuation metric, price-to-book (“P/B”), that, at first, appears to correlate strongly with ROE. A more rigorous look reveals the relationship between the two variables is not as strong as it first appears. Major outliers can disproportionately skew correlations, and that’s what happens with a cursory assessment of the ROE versus P/B correlations. Removing those companies (just 3 in this case) that each had at least a 5% impact on the r-squared value, along with the companies that had negative book values, reveals a weak, 27%, correlation. See Figure 1. Figure 1: Correlation Is Not Actually That Significant Click to enlarge Sources: New Constructs, LLC and company filings. When not removing any of the major outliers hat skew the correlations, ROE and P/B can have an extremely high correlation. Figure 2 shows an r-squared value of 98%. Figure 2: Seemingly High Correlation Between ROE and P/B Click to enlarge Sources: New Constructs, LLC and company filings. As Figure 1 shows, changes in ROE actually explain just 27% of the difference in P/B between different companies. Neither metric is a consistently useful valuation indicator. Both are prone to significant deviation from underlying economic reality because they both rely on the same flawed accounting rules. Book Value Can Be Misleading Accounting book value suffers from a few major flaws when it comes to measuring valuation That book value can be written down at management’s discretion at any time. Businesses can hide both assets and liabilities off the balance sheet so that they are not reflected in accounting book value. Accounting rules are designed to give the best estimate of liquidation value for debt investors, not to measure the capital used to generate returns, which is what matters to equity investors. Since shareholder’s equity and accounting book value are the same thing, both ROE and P/B rely on this same accounting construct, making them both equally unhelpful for equity investors. The Threat Of Write-Downs Mergers and acquisitions represent some of the most common sources of artificial book value. When one company buys another company at a premium to its net asset value, the excess purchase price is recorded as goodwill. Goodwill is recorded as part of accounting book value, but often ends up getting written down if the acquisition underperforms expectations. Write-downs end up being very common. 53% of all acquisitions end up destroying value, and we’ve found tens of thousands of write-downs totaling over a trillion dollars in value in the filings we’ve parsed dating back to 1998. Figure 3: Book Value Disappears During Times Of Risk Click to enlarge Sources: New Constructs, LLC and company filings. They end up happening most often during market crashes, as shown in Figure 2. That means investors who thought they were in cheap stocks due to the P/B ratio come in for a nasty surprise when billions of dollars get wiped off the balance sheet. Hidden Assets And Liabilities We make several adjustments to get from reported net assets to invested capital because companies can hide assets and liabilities off of the balance sheet in the form of reserves , operating leases , deferred compensation , and many other techniques. These off-balance sheet arrangements meant that the shareholder’s equity line ignores a significant amount of the resources that a company uses in its operations. Liquidation Value Has Limited Value For Equity Investors Accounting book value is meant to measure the potential assets available to investors in the event of liquidation, and that’s simply not a very useful measurement for most equity investors. If the company you’re investing in gets liquidated, that’s almost always a failed investment. Even the idea that a low price to book limits your potential downside is flawed. Write-downs or hidden liabilities can send the stock price below book value, as can a company earning a negative return on invested capital ( ROIC ). Accounting rules were designed to be used by debt investors. Equity investors should not expect the financial statements generated by these rules to contain the numbers that accurately reflect their concerns. Measure Economic Book Value Instead of focusing on accounting book value, investors should be looking for companies that have a low price to economic book value ( PEBV ). Rather than relying on accounting rules, economic book value comes from after tax operating profit ( NOPAT ) and weighted average cost of capital ( WACC ). Instead of measuring the liquidation value of a company, it measures its zero-growth value, which is a better baseline for equity investors. Rather than looking at the flawed metrics of ROE and P/B, we’ve found that ROIC and PEBV tend to be better indicators of future performance. Recent examples of this phenomenon include: Nvidia (NASDAQ: NVDA ), our long idea on September 24. From an ROE and P/B perspective, NVDA looked like it was middle of the pack in the semiconductor industry. Our research showed that it was actually one of the most profitable and cheapest companies in the industry, with an ROIC above 30% and a PEBV of just 1.1, implying only 10% NOPAT growth for the rest of its corporate life. In the past two and a half months, NVDA is up 37% El Pollo Loco (NASDAQ: LOCO ), our Danger Zone pick from March. Non-operating items inflated GAAP net income, and off-balance sheet debt obscured the true amount of capital used in the company’s operations. This helped LOCO earn an ROE of 20%, much higher than its actual ROIC of just 6%. And while its P/B of 4.8 didn’t look cheap, it was still better than its PEBV of 5.2. LOCO has collapsed in recent months and is now down over 50% since our call. Looking at ROIC and PEBV help you to identify winners and losers because those metrics cut through the noise and artificial accounting constructs that are at the heart of the valuation methodologies used by many investors. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.