Follow the Money

Hedge funds per CarlHal Holbrook had a wonderful supporting role in the Watergate saga All the President’s Men, a 1976 Alan J. Pakula film based upon the book of that name by Pulitzer Prize winning reporters Bob Woodward and Carl Bernstein of The Washington Post. Holbrook played the conflicted, chain-smoking, trench-coated, shadowy source known only as “Deep Throat” (over 30 years later revealed to have been senior FBI-man Mark Felt). Woodward’s meeting with his source when the investigation had bogged down is a terrific scene.

Sadly, Holbrook’s iconic line – “Follow the money” – was never spoken in real life and doesn’t appear in the book or in any Watergate reporting. Still, Woodward insists that the quote captures the essence of what Felt was telling him. “It all condensed down to that,” Woodward says. More importantly, it provides a profound truth. Indeed, when asked 25 years later on ”Meet the Press” what the lasting legacy of Watergate was, legendary Post editor Ben Bradlee replied with the words of screenwriter William Goldman, if not Mark Felt: ”Follow the money.” It provides good guidance for reporters generally and really good guidance when one is looking at the financial advice business.

With this important touchstone at the forefront, it’s crucial to recall that the financial advice business generally builds products and portfolios for marketing purposes rather than investment purposes. For the industry as a whole, “results” relate to sales far more than to what investor-clients end up getting. Accordingly, the idea is to play to people’s hopes, fears and prejudices rather than speak the (less marketable) truth. Moreover, if something can be positioned as new, novel or complex — and thus offering a plausible justification for a high fee — so much the better.
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It’s the waiting part that’s hard

Hedge Funds 3CalPERS, the highly influential California public employee pension agency, announced in September that it would no longer invest its dollars via hedge funds. That decision is not altogether surprising in that the annualized rate of return of the hedge funds in the CalPERS portfolio over the past decade was only 4.8 percent. The behemoth pension plan sponsor was careful to note that not all hedge funds are bad, but that “at the end of the day, judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size,” the hedge fund investment program “is no longer warranted.”

In essence, CalPERS recognized and acted upon what should be apparent to everyone: hedge fund returns have simply not lived up to their hype. As Victor Fleischer famously put it, “hedge funds are a compensation scheme masquerading as an asset class.”  Continue reading

Yale Model Heat Check

Yale KeyWith a new report out from the Yale Endowment, now is a good time to do a heat check on how the so-called “Yale Model” of investing is doing. I have written about the Yale Model numerous times (see here, here, here and here, for example). It emphasizes broad and deep diversification and seeks to exploit the risk premiums offered by equity-oriented and illiquid investments to investors with an investment horizon that’s sufficiently long – in Yale’s case, essentially forever. It has worked exceptionally well for Yale. For others…not so much. Continue reading

Confessions of an Institutional Investor

The Reformed BrokerMy friend Josh Brown (The Reformed Broker) just published an interesting piece, Confessions of an Institutional Investor. Here’s a taste.

“I’ve seen complexity fail over multiple investment cycles in these types of portfolios, but as Keynes told us, ‘Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.’  Somehow simplicity has become the exception while complexity is now the rule.

“I believe that meeting long-term spending needs for institutional portfolios and controlling risk can be accomplished through simplicity.  That’s not to say that it’s easy, just less complex.  A complicated portfolio relies on the hope of being smarter than your investing peers and the markets while taking on added risks.  We all know hope is not an investment strategy.”

Josh concludes by asking, “What do you think?” I’m glad he asked.  What I think is linked below.

What’s Next?

What's NextHeraclitus is said to have been the first to assert that nothing endures but change.  Yet I doubt that it was original even to him.  In life and in business, a major key to success is anticipating the changes that the future holds and adapting to them. 

Aaron Sorkin gets it, whatever you think of his politics.  In The West Wing (I’m still a big fan – my lovely bride and I just watched a couple of episodes again this week), when President Jed Bartlet asks, often brusquely, “What’s next?,” it means that he has made up his mind and is ready to move on, even if and when his subordinates are not (see below, from Bartlet’s first presidential campaign, as he is getting acquainted with his young staff).

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Is the Yale Model Past It?

Yale Key

It is axiomatic in the investment world that as an asset class becomes more popular, it suffers from both falling expected returns and rising correlations.  In other words, good trades get crowded and their advantages tend to disappear.  This crowding happens because success begets copycats as investors chase returns.  Mean reversion only tends to make matters worse.  In effect, it results in “investing while looking in the rearview mirror” or, as per the title of William Bernstein’s fine new book, Skating Where the Puck Was

The evidence suggests that this overcrowding is precisely what has been happening with respect to the Yale Model.  Continue reading

Journal of Financial Planning (9.12)

The September 2012 issue of the Journal of Financial Planning is out with a special focus on alternative investments.  My piece on hedge fund replication is one of the cover stories.  Michael Kitces writes an important piece therein about what makes an investment “alternative” that I commend to you too.  I hope you will read them both.

The Impact of Experience on Risk Management

When people calculate the risk of hurricane damage and make decisions about hurricane insurance, they consistently misread their prior experience, as reported Friday and in this week-end’s edition of The Wall Street Journal. This conclusion comes from a paper by Wharton Prof. Robert Meyer that reports on a research simulation in which participants were instructed that they were owners of properties in a hurricane-prone coastal area and were given monetary incentives to make smart choices about (a) when and whether to buy insurance against hurricane losses and (b) how much insurance to buy.

Over the course of the study (three simulated hurricane “seasons”), participants would periodically watch a map that showed whether a hurricane was building as well as its strength and course. Until virtually the last second before the storm was shown to reach landfall, the participants could purchase partial insurance ($100 per 10% of protection, up to  50%) or full coverage ($2,500) on the $50,000 home they were said to own. Participants were advised how much damage each storm was likely to cause and, afterward, the financial consequences of their choices. They had an unlimited budget to buy insurance.  Those who made the soundest financial decisions were eligible for a prize.

The focus of the research was to determine whether there are “inherent limits to our ability to learn from experience about the value of protection against low-probability, high-consequence, events.”  Sadly, we don’t deal with this type of risk management very well.  Our experience helps us somewhat, at least temporarily, but we typically misread that experience.

The bottom line is that participants seriously under-protected their homes. The first year, they sustained losses almost three times higher than if they had bought protection rationally. A small portion of these losses were the result of over-insuring.  But the key problem was a consistent failure to buy protection or enough protection even when serious and imminent risk was obvious.  Moreover, most people reduced the amount of protection they bought whenever they endured no damage in the previous round, even if that lack of damage was specifically the result of having bought insurance.

Experience helped a little.  Participants got better at the game as season one progressed, but they slipped back into old habits when season two began. By season three, these simulated homeowners were still suffering about twice as much damage as they should have.  As Meyer’s paper reports, these research results are consistent with patterns seen in actual practice. For example, the year after Hurricane Katrina there was a 53% increase in new flood-insurance policies issued nationally.  But within two years, cancellations had brough the coverage level down to pre-Katrina levels.

These findings should give us all pause.  They have significant implications for insurance of various types — whether hurricane insurance, other hazard insurance, life insurance or even portfolio insurance (either via the purchase of options or by “taking risk off the table”).  These findings may also offer some insight into the “annuity puzzle” (economists have long been baffled that people buy income annuities far less often than reason suggests they should).

We don’t do a very good job dealing with low-probability, high-impact events, whether hurricanes, early death, or market bubbles.  We are consistently overconfident and, due to the bias blind spot, think these inherent problems may exist generally, but don’t pertain to us.  At a minimum, this suggests that we might all be more cautious than we tend to be and that we all ought to consider the use of accountability partners since we all see problems and weaknesses in others far better than we see them in ourselves. Remember, risk is risky.

Listen In

I was part of a BrightTALK/Morningstar conference panel on alternative investments yesterday (July 25) as part of their Investment Summit, an online event designed for financial advisors to gain insights from industry thought leaders on investing in a volatile market and to continue conversations initiated at the 2012 Morningstar Investment Conference. You may listen to a replay here.  I hope you will listen in.