In Times Like These

“My Mama told me there’d be days like this.” – Van Morrison

Stock markets are in turmoil all over the globe. Monday was especially violent and what passes for financial television was awash in bluster, doom and gloom. Markets were gapping down in China, in London, in Japan and elsewhere. Emerging markets were getting crushed. Here in the States, the S&P 500 dropped about 4 percent, with the other major benchmarks performing similarly. The next day, on what appeared to be “Turnaround Tuesday,” a day-long rally was overcome by a major sell-off just before the close, pushing all the major indexes underwater for yet another day. Today has opened well, but (obviously) we don’t know what’s coming.

Over the previous six trading days, the benchmark S&P index has lost well over 200 points, or roughly 11 percent, putting it on track for its worst August in 17 years. But since the markets haven’t seen a significant correction (a loss of at least 10 percent) since 2011, we have been due for one. When financial markets are free-falling, and all correlations seem to converge on 1.0, analytically we move into the realm of the physics of landslides, where things are inherently complicated and unpredictable (which is not to say that more “normal” times are somehow simple and predictable).

Advertisement

Yale Model Heat Check

With 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.

When Gorgeous Isn’t Enough

My March 2014 column in Research magazine is now available digitally. It opens like this.

Michelle Pfeiffer was and is a major movie star. People magazine put her on the cover for its first “50 Most Beautiful People” issue. The New York Times, no less, called her “devastatingly gorgeous.” So when Esquire magazine’s December 1990 cover asked “What Michelle Pfeiffer Needs …,” the answer printed on the inside front cover—“Is Absolutely Nothing”—seemed superfluous at best. However, as it turned out, she needed a lot of help to look like she did on that cover, which was perfect.

I hope you enjoy it.

The Perfectly Dangerous Thing Your Clients Want

Not every big talent becomes a big star

Putting all your eggs in one basket has enormous upside if you pick the right basket.  But a bad solo choice is devastating.  That’s why diversification makes so much sense. 

Enron has often been used as a primary example of why such diversification is important. Many Enron employees had 100 percent allocations to company stock in their defined contribution plans (at the end of 2000, 62 percent of the value of employee 401(k) plans were held in Enron stock) and were financially crushed when the company’s fraudulent practices and dreadful leadership were brought to light as the company went belly up in 2001.

But the potential for fraud and bad management are not the only reasons to diversify.  Sometimes good ideas – even great ideas – end up not working out desite the best of intentions and diligent effort. An investment that seems to have all the necessary elements of success can fail and fail miserably. I’ll try to make my case in this regard by using some terrific rock and roll from my high school days.      

GMs, the NFL Draft and Investing

Bill Barnwell’s excellent article in Grantland today examining whether NFL teams have any idea what they’re doing at the annual NFL draft is both interesting and instructive with respect to how we make investment decisions. Beforehand, a choice between Peyton Manning and Ryan Leaf will seem daunting and easy to screw up while, obviously, the consequences of choices like that are enormous. 

Doubling Down on Disaster

In early 2000 I was at a big pitch extravaganza for the soon to launch Merrill Lynch Focus Twenty fund.  Mother had snapped up star manager Jim McCall from PBHG to start and run the fund which was designed to hold McCall’s 20 best ideas.  These were, ubiquitous for the times, all very aggressive growth (and mostly tech) firms, even though the terms of the fund allowed him to invest virtually anywhere.  The “focus” idea was to avoid diversification so investors could really make money when the “best ideas” popped, since the fund was to be aggressively traded too. At PBHG, McCall managed its Large Cap 20 fund. In the two and a half years Mr. McCall ran it, that fund raked in average annual returns in excess of 50 percent.

McCall had to wait more than a year to start at Merrill due to a contentious departure from PBHG and the resulting litigation.  He had been a successful stock picker and Mother paid a fortune (undisclosed) to win his services. At the time, Merrill was known primarily was a value shop, but McCall was upfront about his lack of interest in valuations or profitability.  His focus (so to speak) was the “new economy” — a good story with earnings and growth momentum, albeit from a tiny base.  ”Valuation is not one of the factors that enters into our methodology,” McCall said repeatedly.

At the pitch, we were told to get in while the getting was good.  Tech was hot and there was lots of money to be made.  Risk?  What risk?  We were pitched hard.

The fund launch was a huge success, with initial assets in excess of $1 billion and an initial share price of nearly $9.  And, back then, $1 billion was real money.  Assets later exceeded $1.5 billion and the price peaked above $10. 

I didn’t buy the fund for myself and I didn’t sell any of it either.  At lot of people thought I was nuts but things turned out all right for me if not for McCall.

The Focus Twenty launch came at the height of the tech bubble and of the hubris that characterized that time.  But barely a year later, Focus Twenty had the ignominious distinction of ranking in the bottom 1 percent among funds of its kind for the previous day, week, month, quarter and year and was down roughly 80 percent.  McCall refused to capitulate and kept doubling down on his strategy, all the way to the bottom.  Before 2001 ended, McCall was gone and has barely been heard from since.

As Morningstar said at the time, “McCall’s short tenure at Merrill has been an unqualified disaster.”

The easy lesson to draw from the Focus Twenty debacle is the importance of diversification. But what sort of diversification?  Market diversification protects against idiosyncratic risk.  But without idiosyncratic risk, you might as well hold index funds.   

By definition, active managers have clear points of view with respect to what is rich and what is cheap.  Concentration (pardon the pun) on selling what is richest and buying what is cheapest is how active managers go about trying to beat “the market” (and it is usually an index that benchmarks whether they have done so).  Diversification in that sense means that an active manager is in reality a “closet indexer” and, on account of lower fees, they will find it essentially impossible to beat the market long-term. Active managers want concentration rather than diversification.

However, even the best and most successful active investors make mistakes and have down periods – which can last significant periods of time.  This problem is particularly acute during secular bear markets which last, on average, about 17 years. The current one began in 2000, just after the launch of Focus Twenty. During these secular bear markets, equity markets are prone to strong cyclical swings in both directions.  In 1977, during a previous secular bear market, Time magazine called this phenomenon a “roller-coaster to nowhere.”

So if you are committed to active management, which favors concentration, how do you avoid disasters like McCall’s?  The best way for most individual investors is probably to maintain concentration within investment vehicles while owning such vehicles in at least several market sectors.  That said, for individuals and professionals alike, the active management investment process needs to be a very good one to succeed.  What’s hot can remain so for an agonizingly long time even though the strategy is anything but a long-term winner.  Growth investing worked for a long time during the tech bubble, but valuations matter longer-term.  Some approaches and factors have stood the test of time for making investment decisions — such as value, size and momentum.  Make sure your activist approach can be supported by the data.

Finally, it is crucial to remember that what’s true in investing today may not be true tomorrow.  We must not be capricious and must insist on a careful and data-driven orientation.  But we also need to be open to new and better evidence. 

As Tadas Viskanta so often says, investing is hard.  There are no guarantees.  Just ask Jim McCall.

Goldilocks Diversification

Any children’s laxative commercial with the tag line “Better Than Prunes” and featuring “Little Miss Irregular” has to be memorable and this classic Fletcher’s Castoria ad from my childhood is all of that and more.

 

The question about prunes – “three enough, six too many?” – is a crucial one indeed for parents everywhere.  Yet it also portends profound investment implications too:  How much diversification is enough and how much is too much?  We all want Goldilocks (“just right”) diversification even though it can be very difficult to achieve.  But before we tackle the question of how much is enough but not too much, let’s briefly review why diversification is so important.

The concept undergirding diversification is simple: Don’t put all of your eggs (or prunes) in one basket. A single holding has huge potential for gains if the right instrument is selected.  We all wish we had bought a big slice of Apple early on.  But for every Apple there is at least one Enron.  Moreover, success of that magnitude has as much (or more) to do with luck as it does with skill.  As Dick Morley carefully points out, generally speaking, an angel investor or venture capitalist with a 20 percent “hit” ratio is doing very well even though s/he thought that each of the failures (eight out of ten!) was a good – perhaps great – idea.  Good ideas fail all the time.  Add factors like incompetent management, fraud and the business cycle to the mix and the risks are both obvious and enormous.

Moreover, some incredible successes are almost entirely random.  Viagra was a heart medication with interesting side effects.   Plastic was first synthesized in a failed effort to replicate a shellac made from beetle husks.  An engineer was experimenting with military radar systems when he noticed that a candy bar in his pocket was melting and the microwave oven was born. The blood-thinner Coumadin was originally a rat poison.  Penicillin was an unexpected byproduct of moldy bread. What became Super Glue was supposed to be a clear plastic gun sight.  Potato chips were invented by a spiteful chef angered by a diner complaining that his french fries were too thick.  Diversification allows for serendipity.

You get the idea.  Diversification is a good thing because investment success is so uncertain and because it lowers risk.  Thus a well-diversified portfolio captures most of the potential investment upside available with much lower volatility.  Let’s quantify the concept quickly.

The table 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 percent 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 percent. Even so, an investor who created a more diversified (if not optimal) portfolio of 45 percent domestic large cap stocks, 10 percent domestic small cap stocks, 10 percent international stocks and 35 percent aggregate bonds would have seen average annual returns similar to those earned by the contrarian (9.66 percent) but with much lower volatility (12.61 percent versus 21.32 percent for the contrarian). 

The key advantages of diversification, then, are the capture of at least 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.  Indeed, if one is a passive investor, we’re essentially done.  For passive investors, the goal should be the broadest diversification possible: exposure to the entire market.  For them, there is no such thing as too much diversification.  In my view, that’s an appropriate investment default.  A passive investment approach using low-cost index funds via dollar cost averaging would provide significantly better investment results for the vast majority of investors. 

But investors looking to “beat the market” (difficult though that is) or who have other needs/desires (such as gaining better risk management, seeking investment or behavioral discipline, or managing complicated tax or estate issues) will need to do more and that gets us to our quest for Goldilocks diversification.  If our positions aren’t numerous enough, our risk of disaster is too high.  On the other hand, too many positions means too little room for distinction (in Warren Buffett’s words, it’s “protection against ignorance”).

Most actively managed funds are highly diversified and cannot be expected to outperform.  The average number of stocks held in actively managed funds is up roughly 100 percent 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 percent (per William Harding of Morningstar) effectively undermines the idea that such funds could be anything but “closest indexes.”  It makes no sense to incur the excess costs and to suffer the tax inefficiencies of active management 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 passive management 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.

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.  I generally favor a carefully delineated and bounded process with clear execution rules and a long-term commitment.  This process should focus on making enough “bets” within our favored approaches (such as value, momentum and low beta) and market sectors (such as global and small cap) to mitigate risk and to provide the best likelihood of success overall while limiting investment enough to avoid closet indexing.  Moreover, as Warren Buffett argues, “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.” My working hypothesis is that 20-40 positions within a given approach or sector is the right amount generally but I remain open to being shown otherwise.  I emphasize the tentative nature of this approach both because more research is needed and because constant monitoring is always necessary in that what works today will not necessarily work tomorrow.

Note, however, that diversification within investment approaches and portfolios is distinct from diversification of investment approaches and portfolios. My working hypothesis here is generally to utilize 5-6 investment approaches and portfolios with allocation amounts predicated upon market action and trends.  My starting point is Meb Faber’s Spring 2007 Journal of Wealth Management paper, “A Quantitative Approach to Tactical Asset Allocation.”  I then seek to tweak those allocations via other quantifiable probability analyses (see James O’Shaugnessy’s What Works on Wall Street) overlaid with various market valuation measures (not just one or two) to remain cognizant of the “long cycle.”  In the current secular bear market I also encourage the use of portfolio hedging.  This approach is not without difficulties and demands further testing, but it is the overall approach to asset allocation I favor now.

It’s a common maxim that diversification is the closest thing to a free lunch offered by the markets.  Having too little diversification is a common and well understood problem.  Having too much is a less well understood problem.  Finding the Goldilocks just right level of diversification of and within market sectors and approaches as well as within investment portfolios remains a constant challenge.

Michelle Pfeiffer Needs Help

She was and is a major film star.  People magazine put her on the cover for its first ever “50 Most Beautiful People” issue. The New York Times, no less, has called her “devastatingly gorgeous.” So when Esquire magazine’s cover asked “What Michelle Pfeiffer Needs…”, the answer printed on the inside front cover — “…Is Absolutely Nothing” seemed superfluous at best.

However, as it turned out, she needed a significant amount of help to appear perfect.

As academics Danielle Nicole DeVoss and Julie Platt of Michigan State have reported, Adbusters magazine obtained a copy of the Esquire editorial memo to  their photography retouching company which included detail as specific as “clean up  complexion, soften eye lines, soften smile line, add colour to lips, trim chin… soften line under ear lobe… add hair to top of head.” Harper’s magazine printed a copy of the bill for retouching services for the two images.  The charge? $1525 (back in 1990).

Many portfolio managers must publicly disclose their holdings on a quarterly basis.  When I worked institutionally, at the end of every quarter, some managers would prepare to “have their picture taken” by getting rid of a number of problematic holdings.  It’s also called “window dressing.”  In earlier days, before regulatory mandate eliminated the practice, some managers would “sell” before quarter-end with a “handshake agreement” to buy the same securities back after the reporting was done.  Either way, while a few didn’t want their competitors to see everything they were doing, these managers typically didn’t want their investors to see some of their “bets” or the mistakes they had made. 

For whatever reason, we humans tend to pick apart the pieces more than appreciate the whole.  This problem relates to the “fundamental attribution error” I have noted previously — the error we make when we overweight the role of the individual and underweight the roles of chance and context when trying to explain successes and failures.

Every retail advisor has experienced the frustration of being able to report good performance overall but having the client fixate on those things that didn’t go so well.  That frustration is difficult enough when the underperformance is real.  But often the “problem” is nothing of the sort — it’s simply a down period for a particular investment type or sector.  As I have emphasized before,  a portfolio without assets that aren’t performing well on a nominal basis is not diversified and that diversification is a very good thing indeed.  Managing those expectations is a crucial part of the job.

No diversified portfolio is full of winners all the time.  Such an expectation isn’t just unrealistic — it’s nuts.  By any reasonable measure, Michelle Pfeiffer is gorgeous without a bit of touch-up work.  Perfectly wonderful portfolios aren’t perfect either.

Do You Really Believe in Diversification?

I was talking to an advisor recently (“Joe”) who was considering the replacement of a manager for what he claimed was poor performance.  Based upon my inquiries, however, it became clear that there was no problem with relative performance or with risk-adjusted returns.  Nor was there any problem with “mission creep” either.  The manager was doing what he was supposed to be doing in the way he was supposed to be doing it.  Joe was simply dissatisfied with the returns that were being generated on a nominal basis.

Most fundamentally, what this conversation revealed was that Joe neither understood nor believed in diversification.

Few advisors argue with the idea that establishing a well-diversified asset allocation plan consistent with one’s goals, investment horizon, and risk tolerances should be the first priority of most investors. Joe surely wouldn’t.  The key advantages of broad and deep diversification are the capture of a healthy share of available returns, smoother portfolio performance and lower volatility.  Especially in a secular bear market like the one we have been suffering through since 2000, those are worthy goals.  Unfortunately, either Joe doesn’t believe what he claims or doesn’t understand what he believes — perhaps both.

As I have pointed out before, the total return of any portfolio consists of three components, each of 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 important.  The exercise of allocating funds among various investment vehicles and asset classes — providing diversification — is at the heart of investment management.

The theory supporting 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 bigger risks (because investing “home runs” are so hard to come by).  In general, the greater a portfolio’s diversification is, 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, thus providing higher risk-adjusted returns.

A diverse portfolio ensures that at least some of a portfolio’s investments will be invested 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 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, diversification is now more valuable than ever.

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 (and, sadly, most advisors – like Joe) pick investments based upon what has been “hot” — as if looking in the rearview mirror while driving.  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.

But let’s get back to Joe.  Just as a diversified portfolio ensures that at least some of a portfolio’s investments will be invested in the market’s stronger sectors at any given time, that portfolio will also – of necessity – be invested in some of the market’s weaker sectors too.

We all like the idea that it’s possible to forecast what sectors will do well and allocate assets to them and away from those that won’t do well – market-timing in other words.  The idea is that we don’t need to diversify if we just learn to predict what the market will do next week, next month, and so on.  Unfortunately, there is little evidence that, as a general matter, it can be done successfully (for example, see here, here, here and here, momentum investing notwithstanding).

As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis, and along with asking them for their year-end S&P 500 price targets, Bloomberg also asks for their recommended portfolio weightings of stocks, bonds and cash.  These alleged experts are generally wrong, often spectacularly so.  The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommended weighting came just after the lows of the 2008-2009 financial crisis. Can anyone say “recency bias”? 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. 

Joe wants to fire a good manager whose sector is underperforming.  He is thus making the classic mistake of “driving” his investment analysis while looking in the rearview mirror. Don’t do that! 

The next time you are tempted to fire a manager on account of poor sector performance, remind yourself that a portfolio without assets that aren’t performing well on a nominal basis is not diversified and that diversification is a very good thing indeed.

The Diversification Debate

Abnormal Returns is one of my daily must-reads (my “Daily Dozen” must-reads is here). AR acts primarily as a trusted curator of financial information, allowing me to be much more efficient with my time. 

This morning, AR highlighted the “diversification debate.”  On the one hand, it cited Howard Lindzon for the proposition that “diversification is overrated.”   On the other hand, it cited Carl Richards and the Bucks Blog for making the pro-diversification argument. As per usual, AR remains neutral (it’s a “forecast-free investment blog,” after all):  “[B] oth pieces are worth reading in their entirety.  Allow me to split hairs here.  Carl is correct that a broadly diversified portfolio is the best solution for the vast majority of investors.  Howard’s advice is targeted more towards intrepid investors, like himself.  In that sense both bloggers can be correct.”

Allow me to elaborate.  Professionals won’t find anything new here, but individual investors may.

Richards is an advocate of index investing.  As such, diversification is the be-all-and-end-all of his strategy.  An indexer wants his or her overall portfolio diversified and the individual components of it diversified.  As his post points out, a broadly diversified 60/40 index portfolio including large, small, real estate, international and emerging markets stock indices and a broad bond market index returned far more than the 1.4% annually, including dividends, returned by S&P 500 alone from 2000-2010.  Indeed, such a portfolio — an index portfolio comprised of multiple indices — returned an average of nearly 8% annually for that same period.  As Richards emphasizes, that’s hardly the “lost decade” many have complained about.

Lindzon doesn’t elaborate on his statement, but I think his meaning is clear.  By definition, active managers have clear points of view with respect to what is rich and what is cheap.  Concentration on selling what is richest and buying what is cheapest is how active managers go about trying to beat “the market” (and it is usually an index that benchmarks whether they have done so).  Diversification means that an active manager is in reality a “closet indexer” and, on account of fees, will find it essentially impossible to beat the market long-term. Active managers want concentration rather than diversification.

That said, even the best and most successful investors make mistakes and have down periods— which can last a significant period of time.  This problem is particularly acute during secular bear markets.  The current one began in 2000.  They last, on average, about 17 years.  During these secular bear markets, equity markets are prone to strong cyclical swings in both directions.  In 1977, during a previous secular bear market, Time magazine called this phenomenon a “roller-coaster to nowhere.”  At such times, an investor’s primary job is to preserve capital. Accordingly, investment portfolios during these periods should be diversified across a range of investments that are diligently selected and carefully managed so as to control risk first. Only then should they seek to enhance return. Such portfolios should actively seek investments which are not correlated to the broader market so as to manage risk and to provide opportunities for enhanced risk-adjusted returns. 

In this setting, diversification is designed to lower risk and smooth returns.  Thus, within one’s overall portfolio, diversification is a key goal even if it is not a goal of the components of the portfolio.  Those individual components might be highly concentrated (such as, for example, a significant allocation to a concentrated value investment vehicle).

Like Billy Martin in the old Miller Lite commercials, it is possible to feel strongly both ways.