Archive for May, 2011

Comfort is Rarely Rewarded; Maverick Risk & False Benchmarks

Posted on: 2011/05/30, In: Investment Philosophy, Risk Management, Secular Cycles

“The loser is the trend chasing, comfort seeking investor. The market doesn’t reward comfort. It rewards discomfort.”

- Rob Arnott

In Rob Arnott’s November 2010 piece, “The Glad Game” he asks investors to consider “Maverick Risk” as an important driver of investment outcomes:

There’s conventional volatility in returns, which introduces a risk of poor investment returns. There’s the asset/liability mismatch, which leads to a risk that we cannot cover our future obligations. And, there’s maverick risk, in which investors choose a different path than their peers, exposing them to criticism, especially when performance suffers. All three risks are hugely important. Yet, we typically focus our analytics on the first of these, simple volatility, and our behavior on the last of these, maverick risk.

The idea of “Maverick Risk” is an interesting one. We know that from a human behavioral standpoint, we are conditioned to think of being outside of the herd as “risky.” There is plenty of evolutionary logic behind this idea considering that humans have spent much of their existence as both predator and prey; there is safety in numbers. So as much as we modern humans know the value of “thinking outside the box” or “being contrarian” and as much as we value and revere those in society who are capable of going it alone or using creative or original thought– when it comes down to financial decisions, our lizard brains take over and we seek the safety of crowds. This is true for amateurs and professionals alike. This is well documented in the rapidly growing popular and academic literature on behavioral finance.

GMO takes the idea of “Career Risk” and relates it to idea that it can drive periods of over and undervaluation. As Ben Inker, the head of asset allocation at GMO was quoted as saying in a recent Advisor Perspectives article:

“The market tends to be priced in a way that if you want to try to outperform, you have to take a risk of looking like an idiot,” Inker said.  To outperform, you have to deviate from your benchmark, and that increases the risk of underperformance and, in the extreme, looking like an idiot and getting fired. As a result, markets exhibit herd-like behavior, which in turn encourages momentum and other self-reinforcing behaviors, such as money flowing into whatever strategy has been doing well, Inker said.  That merely ratchets up valuations within better-performing asset classes and sectors, he said, creating a self-fulfilling prophecy.

Of course this can not continue indefinitely. Eventually prices move far enough away from fair value and the risk/return trade off becomes so one-sided, that prices get pushed back towards fair value. Consider this chart from GMO.

The Way the Investment World Goes Around: They Were Managing Their Careers, Not Their Clients’ Risk

Rob Arnott suggests that by embracing Maverick Risk and deviating from the traditional 60/40 stock bond portfolio, one can add several percentage points a year to expected returns above and beyond the expected returns that are available from the valuation of traditional asset classes themselves. This is good to hear as broad equity and bond market indexes are priced to deliver very low single digit returns over the next 5-10 years, with a high likelihood of meaningful periods of negative returns. Consider my post, Expensive Markets Mean Low or Negative Prospective Returns.

The basic approaches that Arnott advocates for range from adding non-core asset classes such as emerging markets, high yield bonds, and ”alternative” strategies to choosing fundamentally-weighted indexes (Research Affiliates Fundamental Index or RAFI is what they sell after all). Importantly, he advocates employing an active, dynamic, and contrarian approach to asset allocation, which presumably does not require investment in each of these asset classes or strategies at all times. It does however require that each of these asset classes and strategies are at a minimum, part of investors’ tool box, our universe of potential investments.

Research Affiliates' Expected Returns for Various Allocations

 

GMO’s Inker agrees when it comes to power of truly active asset allocation to drive investment returns:

“The good news is that in the investment business there are very few people who do real asset allocation and actually move money around in an aggressive way,” Inker said.  “It’s a tough thing to do and survive. The nice thing about it, and the reason why we do it, is because this means it’s an inefficiency that is not going to get arbitraged away anytime soon.”

GMO knows what they are taking about when the say that it’s a tough thing to do and survive. Their refusal to chase expensive markets in the late 1990′s meant they lost half their assets under management. HALF. 50% of their assets, 50% of their revenues, gone. They were willing to embrace Maverick or Career risk and looked like idiots for doing so. That must have been a somewhat painful experience, but perhaps they were comforted by John Maynard Keynes:

…it is the long term investor…who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

Of course, the bubble burst, GMO saved/made their clients lots of money while most others were comfortably failing (read: losing money) the conventional way, and the assets came back and then some. In his piece, Arnott is quick to point out that

taking these steps is not comfortable. Comfort is rarely rewarded. Investors can move down the path toward this maverick portfolio, careful not to exceed their board’s or their client’s “comfort” threshold. This approach goes against human nature and invites second-guessing whenever it inevitably doesn’t work. Keynes’ oft-cited “reputation” quotation, in its more complete form, bears careful consideration.

This point bears further consideration. GMO clearly did exceed their client’s comfort threshold. That’s why so many left.

If we spend too much time as professional investors calibrating ourselves to our client’s comfort threshold there is significant risk that we will make sacrifices to our process, our investment discipline, and ultimately to our fiduciary duty of acting in our clients’ best interests. It’s not just a little ironic that the line between doing what is right for our clients and doing (or not doing) things that might make them fire us is a blurry one indeed.

Client-Manager Alignment

How do we deal with this paradox? For starters, there needs to be a high level of trust between clients and investment managers. This trust should be based on the obvious considerations like ethics and integrity, but also the more difficult ideal of alignment and understanding of the investment objectives and the process by which we are trying to meet those objectives. This requires open communication among other things.

Seth Klarman is unequivocal when he says “having great clients is the key to investment success.” For those unfamiliar with Klarman, his Baupost Group hedge fund gained an average of 17 percent annually from 2000-2010, a period in which the S&P 500 Index fell 1 percent annually. And while Baupost faced some criticism during the 1990s when the fund had a hard time keeping up with the raging and speculative bull market, the fund has returned 19 percent a year since it was started in 1982 (Klarman was 25 years old), even as it held more than 40 percent of its assets in cash at times.   In an interview, he goes on to describe Baupost’s ideal client as having two characteristics:

1.) If we feel we have had a good year, they agree, regardless of relative performance

2.) When we call, asking them to consider adding new capital, they a.) appreciate the call and b.) add new capital

The second characteristic is important for Baupost because they often invest in illiquid securities or non-traded assets such as real estate. When prices are down, they want to have extra liquidity from clients in order to purchase more assets. Such was the case in 2008-2009 when Baupost doubled their assets under management to $22 billion after being closed to new investors for many years.

The subtext of point #1 is that Klarman’s clients know that his number one priority is to generate positive absolute returns regardless of the market’s direction. To put it another way, Klarman’s self-identified “key to investment success” is having clients who want what he is offering: a strategy that seeks out attractive returns for the risk that he is incurring without the expectation that he will outperform in every market environment.  Indeed, he is clear that the returns they will generate are a function of the opportunity set presented by the market’s valuation and is not afraid to return capital to investors (whether they want it or not) as he did at the end of 2010 if the market is not offering abundant opportunity.

At a recent Grant’s Interest Rate Observer Conference, Klarman professed to “being surprised at how little cash we have.” 28% of the Baupost portfolio was held in cash. While 28% sounds like a large amount of cash (mutual funds currently hold 3.4% of their assets in cash) to most relative return investors– the expensive valuations present in the stock and bond markets have pushed an absolute return-oriented investor like Klarman to buy hotel properties in places like Charlotte, N.C. at a 7-9% cap rate, while keeping 28% of dry powder for an eventual return to attractive valuations in the public markets.

Bringing it all home: What’s your benchmark?

We should all strive to place less emphasis on the conventions of the day and seek to arrive at a fundamental understanding what really drives investment returns so that we can make smart decisions about where we put our money. We can not accomplish this however, without knowing what our future liabilities or objectives are and addressing as Arnott puts it, “the asset/liability mismatch, which leads to a risk that we cannot cover our future obligations.” For most individuals, these “future obligations” come in the form of a desire for lifestyle maintenance in retirement, the ability to leave a legacy, or give back to the world. These obligations tend to be absolute in nature– that is requiring a certain level of assets– independent of how much your neighbor is making on his portfolio or how much “the market” returned last year.

As  Tom Brakke of the Research Puzzle put it:

Decisions large and small are off kilter because the looming shadow of benchmark risk overwhelms almost everything else… maybe they should consider a low volatility strategy, even if some “underperformance” in a bull market comes with it, since such a shortfall versus a benchmark is not really a risk that matters relative to other considerations… Many of the benchmarks are, in fact, false ones.  I dare say that the S&P 500 is not a natural liability for many individuals or organizations to fund.  Nor is some broader market portfolio.  These are made-up constructs and should not be the prime guide for decision making.  But the business of investing is tied to them, to its detriment and that of its clients (emphasis mine).

The bull market of the 1980s and 1990s provided the fuel for the relative return performance derby embraced by so many people and organizations today. In a consistently rising market, when nearly all returns are positive, the collective focus shifts towards relative returns and places undue importance of “false benchmarks” such as meeting or exceeding the S&P 500. The last 10 years has demonstrated the importance of remaining vigilant and keeping our eye on the true “natural” benchmark of earning absolute returns without being exposed to catastrophic or permanent losses of capital.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

Book Review: The Little Book of Sideways Markets

Posted on: 2011/05/26, In: Book Reviews

[amazon_enhanced asin="0470932937" container="" container_class="" price="All" background_color="FFFFFF" link_color="000000" text_color="0000FF" /]The Little Book of Sideways Markets: How to Make Money in Markets that Go Nowhere by Vitaliy N. Katsenelson is both a concise summary and updated version of Active Value Investing: Making Money in Range-Bound Markets.

The Little Book begins with a reminder that markets do not generate consistently average returns even over time horizons as long as 10 or 20 years, but rather are marked by secular cycles.  Bull, Bear, and Sideways. Where sideways markets are defined by periods when earnings grow but valuations contract resulting in low real returns and bear markets are defined as periods when both earnings and valuations contract driving returns decidedly negative. This way of looking at secular markets is described in much greater detail by the likes of Ed Easterling in Unexpected Returns and Probable Outcomes, John Mauldin in Bull’s Eye Investing and others. However in his Little Book, Vitaliy provides good foundational groundwork for the different approach all investors must take in secular bull or sideways, range-bound markets. Importantly, the author reminds us that strategies  need to differ– “Think Long-term, Act Short-term in Sideways Market.”

[amazon_enhanced asin="0470053151" container="" container_class="" price="All" background_color="FFFFFF" link_color="000000" text_color="0000FF" /]The Little book does an excellent job describing the three characteristics of potential equity investments Quality, Value, Growth and what to look for. Again, this book is a summary appropriate for students, new investors, and the like– for details one needs to revisit Katsenelson’s original book, Active Value Investing.

The updated commentary comes in the form of a concise, lucid summary of the macro issues facing Japan and China and should be required reading for anybody who has not given full consideration to the imbalances that exist. Lastly, the biggest “AHA” idea in the book came from the foreword by John Mauldin which relates that research shows that people need to be hit with at least three negative events to be persuaded that things have changed. With two dramatic declines in the US equity markets in the last 10 years, one is advised to head the advice of Vitaliy in his Little Book to avoid needing the third negative shock to make changes to the way one invests.

Disclosure: I received a copy of the book because I asked for it.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

Currencies Are Not Like Stocks: Winners and Losers of the Currency War

Posted on: 2011/05/10, In: Risk Management

I highly recommend this audio presentation from Avinash D. Persaud at the CFA Mid East Conference. It can be found here with all of the other freely available CFA podcasts:

http://itunes.apple.com/us/podcast/cfa-institute-audio-podcasts/id200636111

The first 9 minutes or so of the presentation are a thoughtful diatribe on risk management and forecasting before he gets into currencies.

Persaud discusses what drives currency value and changes in exchange rates over various time periods. The key take aways:

  • In the short term, risk appetite drives currency. In times of risk seeking, capital flows to higher inflation, higher yield currencies. In times of risk aversion, CAPITAL COMES HOME. It does not, according to Persaud go to the “safest” currencies, but it comes home.

I find this interesting because US Dollar strength during times of risk aversion has been a pretty consistent trade over the last few years. I venture to guess it is because there are so many damn dollars in existence and our financial system remains highly leveraged. All of those dollars that we’ve printed in the last 40 years and the leverage that has been applied to that monetary base is part of the sloshing pool of global capital.

Add to this the Dollar’s role as global trading currency and the fact that most of the world’s business needs are USD-based. In the short-term, periods of risk aversion will continue to be USD-positive and for this reason, the US Dollar remains an effective, though low volatility, hedge against risky assets.

  • Over long-time periods, the value of a currency has little to do with a country’s growth prospects as is commonly thought. Many investors, according to Persaud, mistakenly think about currencies as a country’s equity– its stock price if you will. When in fact, currencies are much more like bonds. Their value is driven by the underlying inflation rate of the country. A currency’s value is tied to its ability to maintain purchasing power.

This is why, Persaud argues, that the strongest currencies over multi-decade time frames, like the Swiss Franc or even the Japanese Yen, are in slow growth, low inflation countries.

And inflation– is deeply political. Chris Whalen’s book, Inflated, does a good job of detailing this fact. Inflation transfers wealth from creditors to debtors. Countries end up with inflation rates that they implicit want– that the voters want. And this has a lot to do with demographics.

An aging nation living off of fixed income from coupon payments, such as Japan, does not want inflation. A relatively young, highly indebted nation, such as the U.S. WANTS inflation. Now if YOU are a relatively old, relatively debt-free saver or retiree– YOU may not want inflation, but the country as a whole– and the politicians who they elect–do. Certainly they have a willing participant in Helicopter Ben Bernake. We need to be aware of this fact.

This line of thinking leads Persaud to argue that the strength of the Yen and the Euro at the expense of the USD will persist, defying those investors that think of currencies as equities– that is driven by growth.

His presentation stops here, but I won’t. He logic is very, very solid. I agree that currencies should be thought of as the credit of a country and tied to its credit quality and ability to hold value or purchasing power. It is precisely for these reasons, that going forward, the Yen will ultimately weaken– its credit position is beyond weak (see Kyle Bass’ analysis here) and ultimately the Yen will be thrown under the bus over the next several years to avoid outright default. You can’t always get what you want.

The Euro is a much more complicated political situation. The PIIGS and other periphery countries want and need inflation. Their citizens will ultimately demand it. The core of Europe and the Nordic countries want low inflation and fiscal austerity. The Monetary Union does not provide for the necessary flexibility. Something has to give. If countries like Greece leave the European Monetary Union (seems unlikely), the Euro would likely strengthen. I’ve seen estimates that a Euro ex PIIGS is worth $2 and that the PIIGS collectively, need a Euro around $0.60 to become competitive. This is the political tug of war that will play out over the next several years. I have no idea how it will be resolved, but it seems it will be ugly

I also want to address countries that having varying levels of currency pegs (whether officially or through “dirty pegs” of market intervention) to the USD. These countries have been importing US monetary and inflation policy for years, leaving their currencies’ chronically undervalued. Work by JP Morgan suggests a market cap weighted aggregate of 22 Emerging Market currencies is 32.3% undervalued on a purchasing power parity basis. Witness the Chinese Yuan (40% undervalued) and the Indian Rupee (60% under on PPP) as well as host of other Asian currencies. These countries also tend to have a very strong credit position. See this excellent piece from Research Affiliates on the fundamentals of various Sovereign debt issuers. The natural secular tendency will be for these currencies to rise, not because of their growth, but because of their fiscal position and an eventual move away from USD pegs.

Understanding currencies today, including the ultimate store of value, Gold, must be an essential component to any investment strategy.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.