There is a Reward for doing Your Homework

Investment Heresy #2: Risk & Return are not ALWAYS positively correlated.

Ten years ago I had lunch with a prospect who was interested in getting a little better return on his investments. He was about 70 years old. He had made fortunes, and lost fortunes, and made them back again. I felt that I had a lot to learn from this man, which is typical of many of the investors who come to me for advice.

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During the mid-1970's, this man made over a million dollars running a small company which developed a medical cream used in fighting cancer cells. Never allowed to sell the product in the U.S., his company developed markets in Latin America and Europe. A small Denver brokerage house took his company public at 10-cents a share. The 400,000 shares for which he'd paid a penny each were suddenly worth $6 in the penny stock market! He sold his last block of shares for $16 a share.

My point is that this man was not unsophisticated about finances. Nevertheless, as he sat in my office, I soon found myself explaining - once again - the basic facts of investment life. Risk and return go hand in hand. Many people forget this rule, which is as fundamental to investing as gravity is to natural science.

Nobody likes risk. Everybody wants a high return. Prospects searching for high return but little risk, like the man I met for lunch in 1997 and the prospects I met last week and the couple I'll likely meet next month, are the norm. Risk and return generally go hand in hand.

But not always.

Investors want portfolio results above the line. They want returns that exceed the normal return for a given level of risk.

A portfolio could end up in position (A) for only a couple of reasons. One good example would be when short-term performance of the portfolio gets ahead of itself. Sometimes investors just get lucky! Experienced investors know that returns are typically "bunched." They are not spread evenly over time. In a given period, some portfolios will, for many reasons mostly having to do with chance, see their portfolio surge in value. When a concentrated portfolio meets a significant investment fad, such as the hype which surrounded "internet" stocks in 1995, performance can surpass all reasonable expectations. In the short run, returns can leap above the risk/reward line. In the long run, however, this position is hard to sustain.

Another reason that a portfolio could end up in position (A) is that its risk might not be properly recognized. For example portfolio (A) might be using options or warrants to take on more risk than most investors realize. Options and warrants, like other forms of financial leverage (borrowing money to purchase additional assets), can increase returns in a bull market, but will also exaggerate the declines of a bear market. Sometimes above-average returns are signals that you are using the wrong average! Properly classified, the return might still be attractive --- but, more importantly, the portfolio might be taking much greater risk than investors realized. Some hedge fund managers are addicted to leverage in the same way that extreme sports fanatics are addicted to adrenalin. But once again, over time the use of leverage can be fatal. Many hedge funds have reported several years of spectacular performance, with increasingly large sums of money, and blow themselves up in the end when the strategy fails and the bankers move in to sell what is left.

Looking for strategies that provide above-normal returns requires an ability to determine how returns are being earned in the first place, as well as a solid understanding of the investment risks inherent in the strategy.

A famous example of out-sized returns:

In 1993, Worth Bruntjen managed a Piper Jaffrey mutual fund that was winning accolades by investing in government securities. In fact, the fund was investing in "government-guaranteed" mortgage-backed securities which were highly sensitive to swings in short-term interest rate levels. As rates declined through 1992 and into 1993, these securities performed very well. The attractive returns drew hordes of investors into this "government bond" fund. Some of the most naive investors believed that the fund was paying out great rates of return but that their principal was not at risk. The fund received high rankings by both journalists and fund rating services. Nobody bothered to look too closely at the reason for these above-average returns.

The fund's real risk/return posture became readily apparent when rates reversed themselves. In late 1993 and throughout 1994, this fund's reliance on speculative mortgage-backed derivatives became quite clear. While rates declined, these securities paid increasingly higher rates of interest, leading to the fund's outperformance. When rates reversed, however, these securities started paying out lower rates of interest. Even worse, the bid side for these hard-to-value mortgage-backed securities plunged. Bids dried up. News about "derivative-related losses" splashed across the top of newspapers (and not just the business section, either).

Piper Jaffrey's fund lost 25% of its value in a matter of months as sharp investors bailed out of the fund. The fund manager sold the most liquid securities first, but that left the manager and the remaining fund owners holding a bunch of hard to sell derivative securities that were falling precipitously in value. This was clearly a case where the portfolio's out-sized returns were achieved by taking some "hidden" risks. Had these additional risks been factored in, the outperformance would not have been so hard to explain, and the debacle during 1994 might not have come as such a surprise.

In 2008 an almost identical scenario unfolded in Memphis, Tennessee when Jim Kelsoe’s formerly top-ranked Regions Bank/Morgan Keegan Select Intermediate Bond fund imploaded under the weight of too many securities backed by sub-prime loans. You may have been wondering who was foolish enough to buy bonds backed by optimistic home owners who, though they may have lied about their income and probably couldn’t afford their home, somehow managed to get someone to loan them the money anyway. And who, ultimately, was lending them the money? Why, it was the investors in Kelsoe’s bond fund! For four years running, from 2003 to 2006, Kelsoe’s investors beat their bond benchmark by 2.5% to almost 3% per year. In the bond arena, that’s a bunch. But there was more risk in those loans to jughead borrowers than Kelsoe realized, and when the market for this garbage dried up, Kelsoe was left with a major part of his portfolio where there was no bid. His fund lost 50% in 2007, and then another 50% in the first part of 2008.

Kelsoe also made his "expertise" available to closed-end fund investors.  In 2009, the brainiacs at Morgan Keegan changed managers at just about the worst time imaginable. The new managers sold nearly all of the holdings into extremely illiquid markets, permanently locking in losses for fund investors, so that they could start with a clean slate.

The homework assignment is not to avoid funds with above-average track records, but rather to do the work necessary to understand how that performance has been achieved.

Next post: Can performance fall below the line?

To start at the beginning of the Investment Heresies eMag, click here

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Alpha, Beta, Recessions and You

Recent investment manager performance is telling. Research shows that managers really set themselves apart from one another during recessions. Moreover, InvestmentNews reports in its November 16 issue, market timing trumps buy-and-hold investing amid big swings in economic activity. “Given that we are currently in a recession,” the author said, “our work suggests that individuals should be looking for a different type of investment manager – one that invests based on macro information.”

Marcin Kacperczyk, Stijn Van Nieuwerburgh, and Laura Veldkamp published a study called, “Attention Allocation Over the Business Cycle” in October 2009 which found, “that the data are consistent with a world in which some investment managers have skill, but that skill is often hard to detect. Recessions are times when differences in performance are magnified and skill is easier to detect.”

During the good times, the macroeconomic environment is stable so “market timing” adds no value. Instead, fund managers tend to cluster around the benchmark index and “stock selection” drives portfolio relative performance. Although stocks, individually, are more volatile than the macroeconomic variables, across a diversified portfolio the different managers tend to see performance cluster around the benchmark returns.

In times of macroeconomic volatility such as a recession, however, the large scale risk, though less volatile than individual stock risk, drives investor performance. The study showed that skilled managers add value by deviating more from the benchmark, focusing more on adjusting the portfolio asset allocation, so portfolio differentiation is much greater, both in portfolio construction and, ultimately, in performance. For this reason, it is easier to spot skilled managers during tough times. Alternatively, it is easier to significantly outperform during a recession, with the skilled managers employing market timing skills that other managers refuse – or are not allowed – to employ.

One way that I might summarize the finding is that in a recession, Beta matters more than Alpha. The sensitivity of the portfolio to the rise or fall of the broad market (i.e. the Beta) matters more than the ability to pick stocks that outperform their benchmark (Alpha). Even more simply, market timing is more important than stock selection in an economic downturn. In the more stable upturn, buy-and-hold is the way to go and portfolio managers should focus attention on stock selection.

The May-Investments portfolio building approach has always recognized this fact, although now we have a fancy sounding study with some really impressive mathematical equations to tell us what we already knew.

We have been implementing a “Flexible Beta” approach for several years now. Our willingness to take on risk varies over the course of the economic cycle. Call it “market timing,” or “tactical asset allocation,” or “staying in the way of what’s working and getting out of the way of what isn’t working,” or whatever you want. When market volatility increases, as it tends to do during a recession, it pays to be more conservative.

On the other hand, when the investing environment becomes favorable again, as it no doubt will at some point, we move to a fully invested position and focus more on industry research to keep us invested in healthy industries that are working well in the market. Though statistically this looks like a high Beta strategy (because it’s outperforming the market, which is also rising), it is focused more on stock selection (Alpha) when constructing a bull market portfolio.
 
Merry Christmas to all!

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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God Test Ye Merry, Gentlemen

From Ben the Chairman of our Fed
A helicopter came;
And loads of money fell into
the hands of banks so lame:
Then GM bonds were trashed to buy
The Union vote to blame.
O tidings of worry and fear,
Ain't it so queer
No hurry to worry and fear

In Wall Street now, in New York streets,
The bonus pool goes on
And bankers all across the land
pull off this spineless con
A bank account pays 1 percent
But businesses get none
O bankers both greedy and mean,
CD rates lean
The old folks eat ramen and green bean.

"Fear not then," said the Angel 'cause,
"The White House has your back,
We won't raise income taxes now
Of funds we do not lack,
The trillions that you're forced to pay
The rich will pay you back."
O tidings of borrow and tax,
Those are the facts
Raise the limit on our debt to the max

Obama came to save the day
With Congress playing ball,
Soon Treasury can't borrow and
The markets hit a wall:
Then China plays the China card
Oh where'd they find the gall.
O tidings of borrow and spend,
when will it end
On good tidings of our lenders we depend

Pelosi gave healthcare to all,
While saving bankers hides,
They bought GM illegally,
then watched as business died;
With Barney Frank and Dodd in charge,
Reality denied.
Civic leaders lying, full of gall,
I'm appalled
Send the politicians home from the mall.

We're praying for a happy end,
Before this song is done,
The stimulus worked briefly
and the spending sure was fun;
We'll pay for that till our kids die
And grandkids too are gone.
O tidings of credit and debt,
Come and get
The problem is that lenders don't forget

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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A Prize For the Most Useless - Part II

William Sharpe


In 1990, William Sharpe won his prize for his contributions to what a generation of business school students have learned to call the Capital Asset Pricing Model (CAPM). In the rarified world of Chartered Financial Analysts, we pronounce it “Cap’em,” like what one gang member might say to another when he wants someone shot.

Like most of what is taught in universities, it was anti-establishment to the extreme and based on theories that sound reasonable in the abstract but don’t fare well in the real world. The CAPM, for example, taught students that all investors have rational expectations. However the parents of those students could testify to the lack of correlation between their children and any sense of rationality at all. They may not talk about it. They may even laugh about it at times. They will go to bat for their kid and threaten to sue the school if it decides to expel a student. But there is very little underlying belief in the concept of a rational college student-consumer. Parents aren’t total idiots.

The CAPM also assumes that investors are solely concerned with level and uncertainty of future wealth. The mere appearance of wealth, in the nightclubs or in later years at high school reunions, is assumed to be unimportant. Risk-free borrowing rates are assumed to be equal, which is true until that first late credit card payment, at which time borrowing rates get very unequal, very quickly. The CAPM assumes perfect information, which isn’t even true after the invention of the internet, and was even less true when Dr. Sharp was dreaming this garbage up. The model assumes no inflation, perfectly efficient markets, and a fixed quantity of assets (whereas in reality the venture capital community exists, primarily it would seem, to create business shells which can be sold into the latest hot stock market sector).

In essence, the completely unrealistic economic theory contrasted wholly and completely with financial reality, which ought to lead one to be suspicious about whatever conclusions are drawn from the high end math incorporated into the study, no matter how elegant the mathematical equations look in the appendix of the study.

Unfortunately, however, the nation’s business schools hopped on the CAPM bandwagon like a day-trader buying into the notion that internet stocks only go up. The study introduced the concept of beta as a measure of stock volatility, but failed to deliver because later studies showed that some low beta stocks may actually offer higher returns to investors, which is exactly opposite of what the CAPM crowd believes. CAPM assumes that the “variance of returns” is an adequate measure of risk, which is a candidate for the biggest lie ever told and deserves an entire chapter or two of its own. The model assumes that given certain and equal return projections, investors will prefer the lower risk strategy but fails to take into account investor fads that drive investors to put money into sexy new products in a pathetic search for excitement. The model assumes no taxes or transactions costs, which in itself is so ludicrous that outside of an election year, not even an economic neophyte would be likely to buy into that hypothesis.

Sharpe’s work stood the investing world on its head. Now the majority of investing models try to encapsulate “risk” into one all-encompassing number, either Beta or a statistic that measures “return variance,” as if the winner of the Super Bowl can be determined by counting the number of first quarter rushing yards throughout the season.

Investors have bought into the notion that markets are “efficient” and that there is no reward for time spent researching one alternative versus another, separating out the boring and profitable from the exciting and overpriced alternatives, as if a flip of the coin has as much chance of picking a winner as does any other method. Ironically, the model which assumes no transaction costs that would limit investors’ ability to shift back and forth between stocks and bonds and other asset classes has decreased investors’ willingness to do that very thing. Investors have come to believe that shifting assets around doesn’t matter, yet it was the assumption that assets would shift around which led to the model’s conclusion that the world is efficient in the first place.

According to the efficient markets hypothesis, no one could have known that we were in a technology bubble in 1999. Outside of Alan Greenspan’s inner sanctum, there was pretty broad agreement among experienced investors that we were in a bubble. You didn’t get a lot of air time on CNBC with such pedestrian observations, but there was no way that the NASDAQ at 5000 was in any sense a “rational” equilibrium. “This time it’s different,” said the market hype, and the efficient market crowd agreed that it must be so. Indexers were among the biggest buyers of tech stocks at the top of the bubble as new names with gargantuan market values were being added to the indexes that index funds emulate. We have the CAPM crowd to thank for much of what happened at the turn of the century, when active management and rational thinking lost favor to the momentum players and the index investors who aided and abetted the thrashing that investors received.

Thanks, Professor Sharpe, for nothing.


Myron Scholes

After Sharpe developed his unrealistic and math-centric view of the world, Dr. Myron Scholes took the formula and put it on steroids. He and Fischer Black left the consulting world to develop the Black-Scholes pricing model, which is still used throughout Wall Street to assign a price to derivative assets for which no real market exists and therefore no actual prices can be found.

The formula works great, so long as it isn’t tested in the real world. For example, Scholes threw in with his Nobel Prize co-winner Robert C. Merton and John Meriwether (best known for his adroit skill at playing Liar’s Poker) to form a hedge fund called Long-Term Capital Management. LTCM’s long-term strategy was to leverage up 50 times (so, using borrowed money, a $1 investment was used to collateralize $49 in borrowing to buy $50 in assets) to invest in short-term derivatives trades. So long as money was coming in so nothing needed to be sold, pricing the assets based on the Black-Scholes model worked well for the partners, who claimed a first year annualized return of 40% which made for a big payday to the fund managers.

In 1998, however, a crisis in Asia and Russia resulted in the need to actually sell some of the portfolio assets to satisfy their bankers annoying request that some of the money be paid back. This resulted in a $4.6 billion loss and the fund failed, becoming one of the most prominent examples of a hedge fund blowing itself up. The Federal Reserve finally engineered a bailout in order to avoid a general financial panic, and the hedge fund partners were forced to look for a new gig, although by that time they’d already made so much money off their investors that they didn’t really need to work anymore if they didn’t want to.

The 2008 financial meltdown provided much more evidence that Scholes formula is to investor success what meth is to student achievement. The short-term high it gave traders at bonus time led to a financial addiction that resulted in the long-term destruction of the corporate host, and a lot of collateral social destruction as well.

An early 2008 casualty of mis-priced derivatives was Bear Stearns. A couple of its hedge funds were the first to implode in 2007. The sub-prime issue surfaced early in the year and by Spring it was evident that there was a big problem around the corner – at least, that’s when the fund managers decided to sell down their own holdings in the fund, though publicly they were pretty certain this was just a bump on the long-term road to riches. By July their fund was upside down and the sub-prime market had locked up, which means that everyone wanted their money back; everything was for sale but the buyers were on strike and so prices were plunging even in spite of theoretical values far north of the bid side of the market.

Mark Twain credited Benjamin Disraeli for the observation that there are liars, damn liars, and statistics. What would Twain have said about the econometricians and the Wall Street firms that hired them to design what they called “structured products?” These structured products had no underlying support except for a bunch of untrustworthy math. In the past few years, Wall Street sliced and diced a bunch of disastrous loans on houses to buyers who couldn’t afford them, and watched in amazement as the AAA-ratings failed to protect investors when the underlying loans began defaulting.

These structured products represented ownership of nothing except for a speculative claim and the promise that another speculator will honor it. They represent Wall Street as a casino and the jingle and crash of financial levers and spilled drinks. Believe it or not, there really are good reasons for Wall Street to exist, but ever since Professor Scholes option pricing model came to town, the quality and tone of research and underwriting have gone downhill. He is not solely responsible for the clatter that reverberates throughout today’s capital markets. He is more like a gun manufacturer who hands out handguns on the city streets and then decries the drive-by shootings that ensue.


Joseph Stiglitz and A. Michael Spence

Joseph Stiglitz and Michael Spence have recently been recognized for doing research which pretty much takes to task everything that Arrow, North, Becker, Sharpe and Scholes represent. Whereas the old guard viewed the economy and markets as rational and efficient, Stiglitz and Spence studies show that

• information is not evenly distributed,
• wage opportunities are far from identical,
• companies have difficulty knowing who is working hard and who is hardly working,
• wage changes are sluggish,
• unemployment levels are sticky, and market failures and
• inefficiencies are the rule rather than the exception.

The traditionalists think that “Amazing Grace” just happened to evolve as a lucky combination of random notes. Stiglitz and Spence, however, could see the difference between random din and an inspired melody.

Unfortunately, the professors political prescriptions require a great deal of government intervention to “fix” these problems, but investors should still take note of the fact that these guys just won a Nobel Prize for teaching us to ignore what the first five guys have been telling us for all these years.

Stiglitz wrote about adverse selection in the insurance industry. If the insurance industry prices a risk at an average price, low risk prospects will be forced to overpay while high risk customers can buy the insurance and continue living their high risk lifestyle. Soon enough the low risk prospects (who can) withdraw from the insurance market altogether, choosing to self-insure. The insurance company is left with medium and high risk customers, and higher than average claims, and enormous financial losses. This forces the insurance companies to raise rates to an above-average level, which causes even more prospects to drop out of the pool. Because of what Stiglitz labeled the problem of adverse selection, the price for insurance is higher than it should be, and not everyone chooses to purchase coverage (though all would benefit from coverage at a fair price).

The right “big government” solution would be to require that everyone buy insurance, and perhaps a “public option” as well. But that sort of solution, as you might imagine, has its own set of drawbacks. (Perhaps you’ve heard…)

Stiglitz developed the notion of information asymmetries where one group (the insurance prospects) know more than another group (the insurance providers) about something (their own proclivity for risk taking). Information asymmetries are not efficient, nor optimal, nor rational nor congruent with traditional economic theory. They do, however, have an advantage in that they do help explain the real world better than traditional economic theory.

In the stock market, adverse selection means that new, hard to value companies where insiders know more than public shareholders are inefficiently priced. Poor quality companies have an incentive to issue shares because average share prices overvalue them, while more profitable companies are undervalued in the public markets. Gradually, as more and more poor quality companies go to the public markets, eventually the public markets become dominated by these “lemons.” When the average investor finally discovers this, the average share prices fall toward the fair value for lemons.

Can you spell “internet bubble?”

In addition to his work on information asymmetry, Professor Spence also furthered research in the area of signaling theory, such as when corporations take expensive actions, like paying dividends in spite of the disadvantageous tax treatment, in order to signal to shareholders with (less) asymmetrical information characteristics how high profitability is at the firm level. In the wake of the sub-prime mess, but before things got so bad that they no longer had a say in the matter, some banks were faced with the diliemma of not being able to afford to pay the dividends that shareholders were accustomed to receiving, but at the same time they couldn’t afford to cut dividends because such a move might get them completely kicked out of the capital markets, and the companies were truly capital starved and would fail if they couldn’t retain access to new funding.

Annuity products are classic examples of “signaling theory” where the insurance company selling the contract offers high first year interest rate “signals,” but in reality clients lock into product for many years and may receive substandard returns during subsequent policy years. Outside the rarified world of econometrics, we call these tactics “bait and switch.” If the stars are in alignment and every step of the fraud has been well documented, we prosecute those guilty of sending illicit signals. That doesn’t happen nearly often enough, however, so mostly we reward such expert signal providers with big profits and a high share price.

Make no mistake, the Ivy League MBA is itself a “signal” of future productivity. The companies who hire these MBA’s don’t really care if they’ve learned anything in class or not. What is most valuable is the fact that these future employees made it through the admissions office filter and the fact that they’ll spend the next two years hanging around other fast-track folks who also made the cut. If you ever wondered why a typical 2007 Harvard MBA had a starting salary and bonus of $141,250 and the local State College MBA is negotiating a foreclosure proceeding, it’s not because of what they learned in the classroom. It’s because of whom they shared the classroom with (please pardon my dangling preposition). To put it in Web2.0 terms, it’s all about the quality of the network.

The network itself has one primary mission. For better or for worse, in whatever way they can, the network is focused on separating you from your money. Some firms hire these MBA’s to go after your “wallet share.” They want to nickel and dime you for every money transaction you make. Others go for the big score – magically transforming your life’s retirement savings into a hedge fund strategy that, if it works, will add to your nestegg and make them incredibly, gloriously, fabulously wealthy. If it doesn’t work and decimates your retirement portfolio, which we might call performance asymmetry, then it’s just off to another job for them, and you’ll have to go back to work as well.

Can you say, “do you want fries with that?”


Caveat Emptor (Buyer Beware)

The strategies we use and the positions we advocate add up to one big wake-up call that your advisor and your daughter’s Professor will call heresy. We’re just asking hard questions and taking action based on the answers we’ve received.

Why is it that many of the most famous “efficient markets” random walk theorists have switched to the “active management” side? Is it just because the pay is better, or is it because they’ve realized that the “collective thinking” of the market is sometimes crazy, often foolish, and rarely profitable? Other than John Bogle, whom I love as a kindred frugal soul, why don’t we find any indexers in the money manager Hall of Fame? Indeed, why are big institutional managers moving away from indexing strategies toward active management (via hedge funds) approaches. They may combine an indexing core with a hedge fund “satellite,” but at the end of the day the total portfolio when you combine the neutral-weighted core with the long and short positions in the hedge fund is a traditional actively managed total portfolio. The only thing that has really changed is how the managers are compensated.

For all the work that has been done in the economic arena, investors are left with the sickening feeling that they’ve come full circle and paid full fare for the roller coaster ride. First, markets were efficient. Now they’re not, again. Give back the prize, guys, we’re no further ahead than we were 50 years ago.

Investors, throw away the textbook. It isn’t going to help you know how to invest your money. If nothing else, tossing the text shortens your summer reading list significantly, which might leave a spot on the list for a good murder mystery.

The good news is that with a little homework, almost anyone can design an investment management approach that takes the best of Wall Street (it’s hard to find, but it’s there) and combines it with a little technology and a pinch of professional advice to enable you to invest wisely for your future.

Before you can do that, however, there are a few myths which we need to unlearn.

Next post: There is a reward for doing your homework


To read "A Prize For the Most Useless - Part I" string, click here

To start at the beginning of the Investment Heresies eMag, click here

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

Go to Investments main page.