The Consensus Portfolio

Every year Barron’s reports on the Penta asset-allocation survey of 40 leading wealth management firms (such as Barclays, Fidelity, Goldman Sachs, JPMorgan, LPL, Morgan Stanley, Northern Trust and the like), which outlines in broad terms what those firms’ base recommended portfolios look like. The new survey is noteworthy in that overall allocations to stocks rose to an average of 51.1 percent, up from 48 percent at this time last year and 45 percent in early 2012; fixed-income holdings continued a two-year decline, now at an average 25.8 percent, down from 29 percent last year and 34 percent in 2012; and recommended hedge fund and private-equity allocations, recently “the expensive disappointments of the portfolio” and subject to widespread criticism, are up to an average of 14.1 percent from 12.5 percent last year, with all alternatives (including real estate and commodities) now weighing in at an average allocation of 20.4 percent. A more detailed breakdown is charted below.

2014 Penta Survey 2

The Tragedy of Errors

Lawn Chair LarryLarry Walters had always wanted to fly.  When he was old enough, he joined the Air Force, but his poor eyesight wouldn’t allow him to become a pilot. After he was discharged from the military, he would often sit in his backyard watching jets fly overhead, dreaming about flying and scheming about how to get into the sky. On July 2, 1982, the San Pedro, California trucker finally set out to accomplish his dream. But things didn’t turn out exactly as he planned.

Larry conceived his project while sitting outside in his “extremely comfortable” Sears lawn chair. He purchased weather balloons from an Army-Navy surplus store, tied them to his tethered Sears chair and filled the four-foot diameter balloons with helium. Then, after packing sandwiches, Miller Lite, a CB radio, a camera and a pellet gun, he strapped himself into his lawn chair (see above). His plan, such as it was, called for his floating lazily above the rooftops at about 30 feet for a while and then using the pellet gun to explode the balloons one-by-one so he could float to the ground.

But when his friends cut the cords that tethered the lawn chair to his Jeep, Walters and his lawn chair didn’t rise lazily. Larry shot up to a height of over 15,000 feet, yanked by the lift of 45 helium balloons holding 33 cubic feet of helium each.  He did not dare shoot any balloons, fearing that he might unbalance the load and cause a fall.  So he slowly drifted along, cold and frightened, with his beer and sandwiches, for more than 14 hours. He eventually crossed the primary approach corridor of LAX.  A flustered TWA pilot spotted Larry and radioed the tower that he was passing a guy in a lawn chair at 16,000 feet.

Eventually Larry conjured up the nerve to shoot several balloons before accidentally dropping his pellet gun overboard. The shooting did the trick and Larry descended toward Long Beach, until the dangling tethers got caught in a power line, causing an electrical blackout in the neighborhood below. Fortunately, Walters was able to climb to the ground safely from there.

The Long Beach Police Department and federal authorities were waiting. Regional safety inspector Neal Savoy said, “We know he broke some part of the Federal Aviation Act, and as soon as we decide which part it is, some type of charge will be filed. If he had a pilot’s license, we’d suspend that. But he doesn’t.” As he was led away in handcuffs, a reporter asked Larry why he had undertaken his mission. The answer was simple and poignant. “A man can’t just sit around.” Continue reading

Get a Good Pitch to Hit

Ted Williams was almost surely the greatest hitter of all-time. He was a two-time MVP, led the league in hitting six times and in home runs four times, and won the Triple Crown twice. A 19-time All-Star, he had a career batting average of .344 with 521 home runs, and was inducted into the Baseball Hall of Fame in 1966.

Williams was also the last player in Major League Baseball to hit over .400 in a single season (.406 in 1941). Ted’s career was twice interrupted by service as a U.S. Marine Corps fighter-bomber pilot.  Had his career not been limited by his military service – especially since it was in his prime – Williams would likely have hit over 700 career home runs and challenged Babe Ruth’s record.

During spring training of his first professional season, Williams met Rogers Hornsby, who had hit over .400 three times and who was a coach for his AA team for the spring. Hornsby emphasized that Ted should always “get a good pitch to hit.”  That concept became Williams’ “first rule of hitting” and the key to his famous and innovative hitting chart (shown below).

The concept is a straightforward one — it’s easier to hit a pitch that’s belt high and right down the middle than one at the knees and “on the black.” Investors should be mindful of this concept too and always seek a “good pitch to hit.”

In part, getting a good pitch to hit mean focusing on approaches and sectors that have the best opportunities for success.  These include momentum investing (see here and here, for example), including highly quantitative (algorithmic) investing based upon momentum (such as managed futures).  Another area for potential outperformance is low beta/low volatility stocks. This surprising finding (since greater return is generally connected with greater risk) has been deemed to be the “greatest anomaly in finance.”  Significantly, this approach works well in the large cap space, where closet indexers predominate.  Moreover, despite rational “copycat risk” fears, there is good research providing reasons to think that this anomaly may well persist. Looking at this opportunity on a risk-adjusted basis only makes it more attractive.

The mid and small cap sectors provide more opportunities despite some liquidity constraints.  International equities tend to provide the best opportunities due to the wide dispersion of returns across sectors, currencies and countries.  Indeed, the SPIVA Scorecard demonstrates that a large percentage of international small-cap funds continue to outperform benchmarks, “suggesting that active management opportunities are still present in this space.”  Moreover, managers running value strategies outperform and do so persistently, in multiple sectors, especially over longer time periods, although lengthy periods of underperformance must be expected and survived.  In the current secular bear market I also encourage the use of portfolio hedging.   

I wish to re-emphasize, however, that success in this arena is extremely hard to achieve and success achieved through good asset allocation can be given back quickly via poor active management. That is why I prefer an approach that mixes active and passive strategies and sets up a variety of quantitative and structural safeguards designed to protect against ongoing mistakes and our inherent irrationality.  I want to be most active in and focus upon those areas where I am most likely to succeed.  I also want to be careful to seek non-correlated asset classes (to the extent possible) in order to try to smooth returns over time and to mitigate drawdown risk. For advisors, surviving in this business can be a major challenge.  Succeeding by actually providing clients with real value is that much more difficult.  It demands the bravery to incur much greater risk – but career and reputation risk rather than investment risk.  For individuals, it requires the bravery to go against the crowd.  Ultimately, investing is a zero sum game.  In other words, all positive alpha is financed by negative alpha. It’s a mathematical certainty.

Value surely exists, but it can be very hard to find. In the equities markets I recommend starting by being very selective — getting a good pitch to hit. I suggest using active investment vehicles within portfolios for momentum strategies, focused (concentrated) investments, in the value and small cap sectors (domestic and international), for low volatility/low beta stocks, and for certain alternative investments.  Passive strategies can be used to fill out the portfolio to provide further diversification.  When you don’t have a good pitch to hit, don’t swing.  When you do, hack away.

The Value Project (6): Recognizing Value

Phil Smith is the principal trumpet of the New York Philharmonic.  In his first professional audition, while still a student, he won a place in the Chicago Symphony.  A few years later, while still in his 20s, Phil became the New York Philharmonic’s principal trumpet as a result of his second professional audition.  Concertgoers routinely pay a lot of money to hear Phil perform.  But he also regularly plays in front of Salvation Army kettles and in Salvation Army bands, sometimes in the vicinity of Lincoln Center’s Avery Fisher Hall, the home of the Philharmonic.  In that context, he is routinely ignored, sometimes by the very people who pay big money to see him perform in the nearby concert hall.  Those who hear him in a different context simply don’t recognize the value of what they are hearing.  The great violinist Joshua Bell has had a similar experience, the recounting of which won a Pulitzer Prize. 

In 1964, United States Supreme Court Justice Potter Stewart tried to explain what obscenity is by saying, “I shall not today attempt further to define the kinds of material I understand to be embraced . . . [b]ut I know it when I see it…” (Jacobellis v. Ohio, 378 U.S. 184, 197 (1964)).  If value exists and if we can attribute at least some of it to skill, will we be able to recognize it when we see it? Our success depends upon our being able to do so.

 

The Value Project

The Value Project (2): Commit to Diversification

The Value Project (3): The Value Proposition

The Value Project (4): Emphasize Process

The Value Project (5): Other Stuff

The Value Project (6): Recognizing Value

The Value Project (5): Other Stuff

Even the strongest advocate of active management must concede that, as a matter of simple arithmetic, the universe of active managers will underperform the universe of passive managers.  Costs matter and passive management is a much cheaper endeavor. As Morningstar discovered, in every single time period and data point tested, low-cost funds beat high-cost funds. Factor in the added tax efficiency of passive investing (much longer holding periods and far fewer transactions in general) and it is clear that active management bears a difficult burden in the race to earn the business of investors. 

Size matters too. The more assets under management, the harder it will be for a money manager to outperform.  This is what legendary investor Michael Steinhardt called “diseconomies of scale.” As the expression goes, “elephants can’t dance.”  Accordingly, all else being equal, I will generally favor smaller money managers and those who charge lower fees.  I will also favor strategies with a higher likelihood of tax efficiency (in taxable accounts), for the same general reasons.

 

The Value Project

The Value Project (2): Commit to Diversification

The Value Project (3): The Value Proposition

The Value Project (4): Emphasize Process

The Value Project (5): Other Stuff

The Value Project (6): Recognizing Value

The Value Project (4): Emphasize Process

We all know that the outcomes in many activities in life combine both skill and luck. Investing is one of these.  Understanding the relative contributions of luck and skill can help us assess past results and, more importantly, anticipate future results.

In Major League Baseball, over a 162-game season the best teams win roughly 60 percent of the time.  But over shorter stretches, it’s not unusual to see significant streaks.  Since reversion to the mean establishes that the expected value of the whole season is roughly 50:50 (or slightly above or below that level), 60 percent being great means that there is a lot of randomness in baseball.  That idea makes intuitive sense – the difference between ball four and strike three can be tantalizingly small (even if/when the umpire gets the call right); so can the difference between a hit and an out. 

Luck (randomness) is a huge factor in investment returns, irrespective of manager.  “Most of the annual variation in [one’s investment] performance is due to luck, not skill,” according to California Institute of Technology professor Bradford Cornell in a view shared by all experts (Nobel Prize winner Daniel Kahneman talks about it in this video, for example).  Even more troublesome is our perfectly human tendency to attribute poor results to bad luck and good results to skill.

The efficient markets hypothesis claims that all market outperformance is attributable to luck. But (as noted earlier in this series) it has been demonstrated, by statistical tests and common sense, that there is a component of skill involved. There is a huge difference between saying investing is all luck and saying it has a lot of luck. But it is important to remember that, on the continuum, investing is closer to the luck side (which is why it is so difficult to profit all the time and to succeed when the market is tanking).

So what constitutes skill in a field where probabilities dominate and how can we recognize it so we can make investment allocations wisely? The key is to choose money managers with more than just a good track record of results.  Choose money managers with an excellent investment process too.

In all probabilistic fields, the best performers dwell on process. This is true for great value investors, great poker players, and great baseball players. A great hitter focuses upon a good approach, his mechanics, being selective and hitting the ball hard. If he does that – maintains a good process – he will make outs sometimes (even when he hits the ball hard) but the hits will take care of themselves.  Maintaining good process is really hard to do psychologically, emotionally, and organizationally.  But it is absolutely imperative for investment success.

The great investor Seth Klarman, founder of the Baupost Group, makes a terrific insight: “Value investing is at its core the marriage of a contrarian streak and a calculator.” The contrarian streak means that a good money manager must be willing and able to do something different from what the consensus is doing. However, investment success draws a crowd and dilutes future success, meaning that one can never “rest on her laurels.”

The issue is complicated further in that sometimes the consensus is right. If the movie theater is on fire, you should run out the door with everyone else, not in. So adding the calculator part is crucial.  Being a contrarian makes sense only when it leads to a mispricing between fundamentals and expectations. That is a market opportunity.  Finding active managers with that outlook as well as the ability and the psychological strength to execute it well is astonishingly hard.

But there is yet another problem:  a portfolio’s results are largely dictated by overall market performance during the applicable time period.  In other words, the more risk-averse strategies will generate better returns in a difficult market by protecting the downside and the reverse will also tend to be true, that managers with higher risk tolerances will be more likely to succeed during periods of strong market returns.  The conventional method of mitigating this dilemma is to “risk adjust” the results, comparing nominal returns with volatility, but this approach is uncertain at best in that volatility and risk are hardly the same thing. 

Accordingly, the decision as to which managers and which funds deserve assets in the current environment, as a practical matter, is often determined — surprise! — by how one does the analysis.  For example, analysis using five-year performance numbers will contain the late-2007 onset of disaster and the ravages of 2008, favoring the risk-averse managers.  On the other hand, analysis using three-year numbers  will be much more favorable to risk-tolerant managers as those numbers will be dominated by the post-March 2009 recovery period and the (in hindsight) relatively sanguine 2010 and the late 2011 recovery.

Whether the three or the five-year performance numbers are ultimately deemed more instructive will largely be determined by what happens during the next couple of years or so.  If markets are going to remain spotty for the next two years, advisors that use the five-year numbers will look like geniuses. A strong equity market recovery throughout 2012 will make them look like morons.

Everybody – advisors and clients alike – wants the same thing in the end: high relative returns with a minimum number of sleepless nights.  Human psychology being what it is, however, investors are often their own worst enemies. Risk-averse investors, for instance, should want to underperform the benchmark in a bull market.  It implies a strategy of risk management that will protect them when, inevitably, the benchmark heads lower. Of course the benchmark is going to outperform that strategy in a sustained bull market.  What tends to happen then is that investors, frustrated by trailing the index for a while, switch their money into more aggressive choices right before a downturn (see here for a helpful synopsis of the current – very risk averse – environment).  That goes a long way toward explaining why most people underperform.

This “time slice” issue and behavioral economics makes the selection of investments a tricky thing. You may choose not to care about any particular benchmark. You may develop and analyze future financial requirements and then tailor investment decisions to achieving those.  What happens to the S&P 500 or other benchmark over some random period of time is then of merely passing interest.  But, even so, for an advisor to maintain trust and business in periods of extremes will remain a significant challenge.

 

The Value Project

The Value Project (2): Commit to Diversification

The Value Project (3): The Value Proposition

The Value Project (4): Emphasize Process

The Value Project (5): Other Stuff

The Value Project (6): Recognizing Value

The Value Project (3): The Value Proposition

As the vast majority of you know, a passive investor most typically looks to hold every security from the market, with the most prevalent of such approaches looking to have each security represented in the same manner as in the market, in order to achieve market returns, usually via index funds. It is a buy-and-hold approach to money management. On the other hand, an active investor is one who is not passive and thus seeks to “beat the market.” It is the art of stock picking and market timing. Because active managers typically act on perceptions of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade more frequently – hence the term “active.”

Passive investing (e.g., indexing) is predicated upon the efficient markets hypothesis.  To oversimplify, that hypothesis asserts that because asset prices reflect all relevant information and that investors act rationally on that information, it is impossible to “beat the market” over time except by being extremely lucky.  The evidence supporting this idea is surprisingly strong, at least to many.

Most significantly, active managers generally fail to beat their benchmark indices.  Indeed, in 2010, only about 25% of active managers outperformed.  2011 was even worse.  Data from Morningstar shows that among 4,100 funds that invest in large-cap stocks, only 17% beat the S&P 500 for the year (strictly speaking, all index funds underperformed the market because of costs; however, for these purposes I will treat index funds as having matched the performance of “the market”). That is the smallest percentage since 1997.  Moreover, according to Bianco Research, 48% of equity mutual funds underperformed their benchmarks by more than 250 basis points. For example, the Fidelity Magellan Fund underperformed the S&P 500 by close to 14%. Even worse, those few active managers that do outperform in any given year have a very hard time (more here) keeping up the good work. 

With correlations among stocks at levels close to their 30-year highs (see below), finding winners is (obviously) exceedingly difficult even if it is theoretically possible.

 

Bianco Research has observed that from 1996–2008 there were only 12 days (2 up and 10 down.) when more than 490 of S&P 500 Index stocks moved in the same direction on a given trading day. In 2011 alone, there were 15 such days (with a nearly even up/down ratio). In such an environment, finding mispricings is very difficult.  Thus, in general, active managers believe that in order to overcome their higher fee hurdle, they need high beta equities that will beat the index in a rally and thus overcome the high fees. But that is a dangerous and flawed strategy.

Hedge funds – despite (and in part because of) enormous fees – have also badly underperformed, and they are the most active of active managers.  Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved simply by investing in Treasury bills. Hedge funds are prone to same inconsistencies as more traditional managers too. Legendary hedge fund investor John Paulson generated returns of up to 600% by betting against mortgages in 2008 as the market crashed, but got crushed by huge losses in 2011.

More broadly, the Global Market Index (GMI) —a passive, unmanaged but well diversified mix of all the major asset classes weighted by market values — has outperformed nearly everything else over the past decade (see below), providing a 6.0% annualized total return for the 10 years ending December 31, 2011. That puts GMI in the 89th percentile relative to the roughly 1,200 multi-asset class funds with at least 10 years of history (and thus makes it an even better performer overall than the 89th percentile suggests once survivorship bias is factored in). GMI’s rebalanced and equal-weighted counterparts did even better. 

As a consequence of performance numbers like that and the failings of active management, index funds took in a record $76 billion in 2011 and exchange-traded funds, which are predominantly passive, added another $121 billion. Actively managed funds, meanwhile, lost about $9.4 billion, according to Morningstar.

On the face of it, these facts seem to suggest that active management simply doesn’t make sense.  At a minimum, it means that any recommendation containing active management must be carefully considered and supported, especially when the advisor is a fiduciary. 

Even so, there is an abundance of evidence that markets are less than perfectly efficient. There is no such thing as perfect information.  Information can be and routinely is biased, erroneous, flawed and incomplete.  More significantly, as individuals and in the aggregate, the idea that we can somehow rationally interpret all that information is – frankly – ludicrous. Behavioral economics teaches us at least that much.

Every year, Dalbar’s Quantitative Analysis of Investor Behavior demonstrates just how irrational investors are. Over the past 20 years the S&P 500 has returned 9.14% annually while the average equity investor has earned only 3.83% per annum, showing how unsuccessful we are at controlling our emotions.  We routinely buy high and sell low.  It should thus be clear that markets are adaptive and people are plainly and predictably irrational – individually and in the aggregate.  

This data also evidences a related point.  People find that exploiting the market’s inefficiencies is, at minimum, extremely difficult (partially due to those very same emotional factors), as the failings of active managers demonstrate.  Moreover, investment success draws crowds of copycats, making ongoing success a constant challenge.  While the efficient market hypothesis is easy enough to falsify, indexing as an investment approach remains excruciatingly difficult to beat.

Active management outperformance can only be predicated upon two things – market timing and/or security selection. With respect to market timing, there is little evidence that it works  generally since nobody can foresee the future.  Market timing efforts – a forecasting strategy based upon one’s outlook for an aggregate market, rather than for a particular financial asset – simply do not provide good performance. Without reviewing all the research, suffice it to say that both institutional investors (more here, here and here) and individuals consistently fail as market timers. As John Kenneth Galbraith famously pointed out, we have two classes of forecasters: those who don’t know and those who don’t know they don’t know

The one major exception here (as it relates to performance, not foreseeing the future) is momentum investing (see here and here, for example), including highly quantitative (algorhythmic) investing based upon momentum (such as managed futures).  Accordingly, such strategies make good sense in portfolios generally, despite their recent poor performance, assuming their high risk is palatable.   Therefore, I tend not to recommend market-timing strategies that are not momentum-based and which do not employ excellent quantitative research.

That leaves us to consider strategies based upon security selection. Unfortunately, most “actively managed” funds are actually highly diversified and thus cannot be expected to outperform.  The more stocks a portfolio holds, the more closely it resembles an index.  The average number of stocks held in actively managed funds is up roughly 100% since 1980, according to data from the Center for Research in Security Prices. See Pollet & Wilson, “How Does Size Affect Mutual Fund Behavior?” Journal of Finance, Vol. LXIII, No. 6, p. 2948 (December 2008). Large numbers of positions coupled with average turnover in excess of 100% (per William Harding of Morningstar) effectively undermines the idea that such funds could be anything but a “closest index.”

Properly used, diversification is a means to smooth returns and to mitigate risk, as described above.  Excessive diversification, on the other hand, is merely (in Warren Buffett’s words), “protection against ignorance.”  I prefer taking active risk with vehicles that offer the best opportunities to outperform, including investments that are concentrated and unrestrained.  It makes no sense to incur excess costs and to suffer tax inefficiencies to purchase an investment that is, in effect, a closet index.

Numerous studies show that funds which are truly actively managed and more concentrated, outperform indices and do so with persistence.  See, e.g., Kacperczyk, Sialm & Zheng, “Unobserved Actions of Mutual Funds” (2005); Cohen, Polk & Silli, “Best Ideas” (2010); Wermers, “Is Money Really ‘Smart’? New Evidence on the Relation Between Mutual Fund Flows, Manager Behavior, and Performance Persistence” (2003); Brands, Brown & Gallagher, “Portfolio Concentration and Investment Manager Performance” (2005); and Cremers & Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” (2007).  As summarized by Cremers and Petajisto:

“Funds with the highest Active Share [most active management] outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses …. The best performers are concentrated stock pickers ….We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum. From an investor’s point of view, funds with the highest Active Share, smallest assets, and best one-year performance seem very attractive, outperforming their benchmarks by 6.5% per year net of fees and expenses.”

Accordingly, it is possible to earn higher rates of return with less risk (particularly since risk and volatility are decidedly different things – more on that below) via the judicious use of active management. As the saying goes, nobody is managing the risk of an index.  By combining a group of securities carefully selected for their limited downside (think “margin of safety”) and high potential return (think “low valuation” or, better yet, “cheap”), the skilled active manager has a real opportunity to stand out.  This approach has practical benefits too in that the resources devoted to the analysis (original and ongoing) of each specific investment varies inversely with the number of investments in the portfolio. 

One area for potential outperformance is low beta/low volatility stocks. This surprising finding (since greater return is generally connected with greater risk) has been deemed to be the “greatest anomaly in finance.”  As Geoff Considine pointed out at Advisor Perspectives recently, portfolios of either low-beta or low-volatility stocks over the 41-year period spanning 1968 through 2008 would have resulted in annualized alphas of 2.6% and 2.1%, respectively with return “swings” which were also far less extreme than those of the broader market.  If the universe of stocks under consideration is limited to the 1,000 stocks with the largest market capitalizations, the low-beta and low-volatility portfolios generated 3.49% and 2.1% in annualized alpha, respectively.  Significantly, this approach works well in the large cap space.  Moreover, despite rational “copycat risk” fears, there is good research providing reasons to think that this anomaly may well persist. Looking at this opportunity on a risk-adjusted basis only makes it more attractive.

I wish to re-emphasize, however, that success in this arena is extremely hard to achieve and success achieved through good asset allocation can be given back quickly via poor active management. That is why I prefer an approach that mixes active and passive strategies and sets up a variety of quantitative and structural safeguards designed to protect against ongoing mistakes and our inherent irrationality.  I want to be most active in and focus upon those areas where I am most likely to succeed.  As noted above, I also want to be careful to seek non-correlated asset classes (to the extent possible) in order to try to smooth returns over time and to mitigate drawdown risk. 

In the large cap space, markets are relatively efficient and thus alpha-constrained.  The mid and small cap sectors provide more opportunities despite some liquidity constraints.  International equities tend to provide the best opportunities due to the wide dispersion of returns across sectors, currencies and countries.  Indeed, the SPIVA Scorecard demonstrates that a large percentage of international small-cap funds continue to outperform benchmarks, “suggesting that active management opportunities are still present in this space.”  Moreover, managers running value strategies outperform and do so persistently, in multiple sectors, especially over longer time periods.

The Fama and French three factor model provides several very helpful pieces of information: expected returns are a function of stocks v. bonds, small cap v. large cap and value v. growth. These three factors explain ~95% of the variation of a diversified portfolio.” Further, each has an expected return premium associated with its higher volatility (if not necessarily risk) but each is unique, so one cannot be lumped in with the others. History and even just the past decade alone suggest that, per Fama and French, a small cap/value equity “tilt” works (see below).

Note that the small-cap value (Russell 2000 Value) and microcap value (Russell Microcap Value) indexes nicely outperformed over the past 10 years (through January 17, 2012). Indeed, the Russell 2000 Value Index has generated a 6.7% annualized total return for that decade, or nearly twice the 3.7% gain provided by the broad large-cap equity market (Russell 1000). It’s also notable that even within the large-cap space, value beat growth. One cannot count on the small-cap and value factors in the short term, and perhaps not even in the long run (remember, investment success draws a crowd and dilutes future success), but they are excellent sources of value (apologies for the pun) today. I focus much of my portfolio attention there.

Active management is not merely predicated upon outperformance.  It can also be predicated upon risk mitigation.  Yet defining risk can be quite difficult.  Traditional quantitative finance equates risk with volatility.  By that definition, broad diversification lowers risk because it lowers volatility.  I look at risk more practically, however.  For me, risk relates more to my chances of losing money – perhaps a great deal of money – over time than the volatility of my portfolio (as Zvi Bodie describes it, uncertainty that matters). 

For a deep value investor (and I try to be one), purchasing a stock that has been beaten up and trades at low multiples for its fundamental value may have high volatility but not be all that risky due to a significant “margin of safety.” Grouping such stocks together in a carefully concentrated fashion provides a good opportunity to outperform while mitigating risk.  As Warren Buffett put it, “a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.” 

Successful managers tend to continue to perform well, particularly in the nearer term, and losing managers tend to continue losing.  Even so, the best and most successful investors make mistakes and have down periods – which can last a significant period of time.  That’s why so many money managers are so willing simply to mimic the index.  Performance which is close to one’s benchmark allows managers to retain assets while significant underperformance will likely cause investors to head for the hills (just ask Bruce Berkowitz – his $7 billion Fairholme Fund went from being the top performing large-cap-value fund in 2010 to the worst-performing fund of 2011 and lost a great deal of assets as a consequence). Being willing to stand out as a contrarian is perhaps as hard as achieving the actual outperformance. That’s why so many money managers remain perfectly willing to act like index investors and hope for roughly index-like returns.  For them, it’s a matter of survival.

For advisors, surviving in this business can be a major challenge.  Succeeding by actually providing clients with real value is that much more difficult.  It demands the bravery to incur much greater risk – but career and reputation risk rather than investment risk.  For individuals, it requires the bravery to go against the crowd.

How brave are you willing to be? 

Value surely exists, but it can be very hard to find. I suggest using active investment vehicles within portfolios for momentum strategies, focused (concentrated) investments, in the value and small cap sectors (domestic and international), for low volatility/low beta stocks,   and for certain alternative investments.  Passive strategies can be used to fill out the portfolio to provide broad and deep diversification.

 

The Value Project

The Value Project (2): Commit to Diversification

The Value Project (3): The Value Proposition

The Value Project (4): Emphasize Process

The Value Project (5): Other Stuff

The Value Project (6): Recognizing Value

The Value Project (2): Commit to Diversification

Many of you have no doubt seen some variation of the famous Stephen Covey presentation wherein Covey puts a bag of small pebbles (representing the less important, perhaps extraneous stuff of our lives) into a container and then has a volunteer try to fit a number of larger rocks in.  These larger rocks represent what each of us decides are the important things to us – but there isn’t room for them in the container.  Then Covey turns it around.  The volunteer puts the bigger rocks in first and only then adds all the smaller ones.  When done in that order, there is room for everything. Covey’s message is both simple and powerful – decide what your priorities are, do the important things first and the lesser things will fall into place.

This idea has important implications for investment management too.  It is crucial that we deal with all of the “big rocks” of investment management before moving on to the less important things.

The total return of any portfolio has three components, which may be positive or negative: (a) returns from overall market movement; (b) incremental returns due to asset allocation; and (c) returns due to timing, selection, and fees (active management). The latest research suggests that, in general, about three-quarters of a typical portfolio’s variation in returns comes from market movement (a), with the remaining portion split roughly evenly between the specific asset allocation (b) and active management (c). To the extent that research differs from that stated above, it concludes that asset allocation is more important and active management is less importantTherefore, we should spend at least as much time and care in constructing an asset allocation plan as on the investment vehicles used to execute the asset allocation decision.  Establishing an asset allocation plan consistent with one’s goals, investment horizon, and risk tolerance should be the first priority.

The exercise of allocating funds among various investment vehicles and asset classes is at the heart of investment management. Asset classes exhibit different market dynamics, and different interaction effects. Thus the allocation of money among asset classes and among investment vehicles within asset classes will have a significant effect on the performance of the investment portfolio.

Research suggests that allocation among asset classes has more predictive power than the choice of individual holdings in determining portfolio return. Arguably, the primary skill of a successful investment manager resides in constructing the asset allocation, and separately the individual holdings, so as to meet the client’s needs. Accordingly, advisors must consider the degree of diversification that makes sense for specific clients given their risk parameters and construct a list of planned holdings accordingly.

Modern Portfolio Theory asserts that all-inclusive market portfolios (those with broad and deep diversification) make the best trade-offs between risk and reward. More importantly, diversification is best based upon the sources of risk rather than returns.  That is why correlation is so crucial.

The theory behind diversification is simple: Don’t put all of your eggs in one basket. A single holding has huge potential for gains if the right instrument is selected, but even huger risks (because investing “home runs” are so hard to come by).  In general, the greater a portfolio’s diversification, the lower its risk.  Lower risk is a good thing, but only if the portfolio’s potential return is healthy enough to meet the client’s needs.  Fortunately, a well-diversified portfolio captures most of the potential upside available with much lower volatility.

A diverse portfolio – one that reaches across all market sectors – ensures that at least some of a portfolio’s investments will be in the market’s stronger sectors at any given time – regardless of what’s hot and what’s not and irrespective of the economic climate. At the same time, a diverse portfolio will never be fully invested in the year’s losers. For example, according to Morningstar Direct, about 25% of U.S. listed stocks lost at least 75% of their value in 2008 but only four of over 6,600 open-ended mutual funds lost more than 75% of their value that year. Thus a diversified approach provides much smoother returns over time (even if not as smooth as desired!).

Accordingly, portfolio diversification requires careful management of the correlations between and among the asset returns and the liability returns, issues internal to the portfolio (the volatility of specific holdings in the portfolio), and cross-correlations among these returns. With day-to-day volatility very high and correlations remarkably high too (see the chart immediately below), diversification is now more valuable than ever.

Source: Bianco Research

The table immediately above will be familiar to most of you.  It shows the annual returns of various asset classes over the past 20 years.  Most people pick investments based upon what is “hot.”  If, from 1991-2010, one had invested in the previous year’s top performer, s/he would have received 3.88% average annual returns.  But since investing tends to be mean reverting, a smart contrarian who invested in the previous year’s worst performer would have averaged returns of 10.91%. Even so, an investor who created a more diversified (if not optimal) portfolio of 45% domestic large cap stocks, 10% domestic small cap stocks, 10% international stocks and 35% aggregate bonds would have seen average annual returns similar to those earned by the contrarian (9.66%) but much lower volatility (12.61% versus 21.32% for the contrarian). 

The key advantages of broad and deep diversification, then, are the capture of a healthy share of available returns, smoother portfolio performance and thus less volatility.  Especially in a secular bear market like the one we have been suffering through since 2000, those are worthy goals.

 

The Value Project

The Value Project (2): Commit to Diversification

The Value Project (3): The Value Proposition

The Value Project (4): Emphasize Process

The Value Project (5): Other Stuff

The Value Project (6): Recognizing Value

The Value Project

There is a famous story, almost surely apocryphal, that makes the rounds with some regularity in our industry.  As the story goes, a new, struggling advisor buys a mailing list of 10,000 potential prospects. He then writes two separate newsletters about the same, high beta stock. One newsletter advises a leveraged short of the stock and is sent to half of the list. The other newsletter suggests a leveraged buy of the same stock, and is sent to the other 5,000 prospects.

A month later, the prospects that got the newsletter touting the wrong side of the trade are discarded. The 5,000 that were on the right side are split into two groups and the same process is repeated with a different stock. He does the same thing again two more times.  At the end of four months, the advisor has a list of 625 prospects who can’t believe their luck in finding the next Michael Burry (or Seth Klarman or Warren Buffett).  Of course, they will also spend the next ten years wondering why, after they transferred their life savings, the magic disappeared.

Remember this story every time you consider a money manager or fund’s performance history or think about another “hot” pundit’s recommendations in print or on business television. The markets are binary.  They can only go up or down and are in this way similar to a coin toss, at least in the sense of probability. The odds of getting four calls in a row right are actually fairly low: 0.5*0.5*0.5*0.5 = 6.25% probability. Similarly, if we started with a group of 1,024 people and had them pair off and compete in coin tosses with the winners advancing, by the time we reached the ultimate winner, she would have won 10 contests in a row.  That’s a result that is nearly as unlikely in the particular as it is inevitable in the aggregate.  Good performance alone – even over significant time periods – is not enough to recommend a money manager or fund. 

None of this is to suggest that every manager with good performance is just lucky.  It is merely representative of the hurdles in the way of advisors searching for managers that are actually good at their jobs and not just rolling the dice. Past performance, as we are taught, is no indicator of future results.  Investing skill is – at a minimum – very hard to find.

This multiple-part project is designed to try to ascertain where and how value in the markets may be found. I hope you enjoy it.

The Value Project

The Value Project (2): Commit to Diversification

The Value Project (3): The Value Proposition

The Value Project (4): Emphasize Process

The Value Project (5): Other Stuff

The Value Project (6): Recognizing Value

A 50:50 Chance

The New York Times recently published an article advocating a standard portfolio of 50 percent stocks and 50 percent bonds based upon recent analysis by Vanguard.  The analysis, based upon performance data from 1926 through June 2009, suggests that this allocation seems to generate consistent returns regardless of whether the economy is in recession or expansion.  Indeed, a 50:50 portfolio generated an average annual return of 7.75 percent per year during recessions and 9.9 percent per year during expansions.  Factoring in inflation, the average real return (return – inflation) was 5.26 percent per year during recessions and 5.59 percent per year during expansions.   

The desired inference, understandable given John Bogle’s influence and Vanguard’s commitment to passive management and indexing, is that we denigrate tactical asset management.  According to an author of the analysis, quoted in the Times, “the results suggest that as investors, rather than try to time the market, most people are best off with a diversified portfolio and just sticking with it over the long run.”

Bogle, Vanguard’s now retired founder, has long advocated a 50:50 portfolio.  For example, his 2001 essay, The Twelve Pillars of Wisdom, proposes the following:

There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values. Hold your positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one.

Following a dreadful decade for stocks and a 30-year rally in bonds, it should be pretty clear that a 50:50 portfolio would have been a good idea in retrospect.  But given current bond yields and expected forward returns, will it make sense going forward?  In other words, is the analysis an exercise in hindsight bias and recency bias? 

As Geoff Considine has noted, over the past 15 years, Vanguard’s Total Bond Market Index Fund (VBMFX) has returned an average of 6.02 percent and over that same period, Vanguard’s S&P500 Index (VFINX) has returned an annualized 5.33 percent.  There is thus no combination of these two index funds that can possibly generate annualized returns greater than 6 percent, which is far from the 8 percent per year that the Vanguard analysis claims by using data back to 1926.  We can expect mean reversion at some point, but investors over the past fifteen years are likely to have been disappointed with this approach.

The Vanguard analysis wants to make the case for diversification as an antidote to difficult markets.  While I can generally agree that broad and deep diversification is a reasonable defense against difficult markets, a 50:50 portfolio is far from well diversified — just look at the correlation numbers.  As Rob Arnott points out, a portfolio that is 60 percent allocated to the S&P 500 and 40 percent allocated to a bond fund still has a 99% correlation to the S&P500

A 50:50 portfolio just isn’t very diversified.  Some other choices are necessary if diversification is the intended goal.