The Style Box Paradox

Zeno’s dichotomy paradox refers to a philosophical conundrum where someone wishing to get from point A to point B must first move halfway before completing the journey. However, since they always have to complete half the journey first, and the half-journeys can go on ad infinitum, the Greek philosopher was forced to conclude that they would never arrive at the destination but would forever be stuck at various halfway points. It’s a great theory, but it just doesn’t make sense in the real world. People get to their intended destination all the time.

In investing, the theoreticians often study portfolios in the context of investment style boxes. Some portfolios are characterized as small cap value while others are classified as large cap growth. Classifying portfolios in this way is helpful in understanding fund performance looking backward over a discreet time period. However, classifying portfolios by style box classification is not particularly helpful while building portfolios. In the real world, bottom up investors shouldn’t care that much what style box the stock falls in. A more helpful way to classify stocks when constructing the portfolio is by industry and sector. At May-Investments, our portfolio building process has always emphasized sector rather than style box classification. We might look for a consumer stock with good earnings growth prospects that sells for a reasonable valuation, but we really don’t care how the stock is classified by the style box methodology.

A recent Fidelity Investments study explains that, “beyond company-specific factors, sector exposure has been the most influential driver of equity market returns.” While passive indexers mimic their marketing masters who repeat ad nauseam the myth that stock selection doesn’t matter and that a static asset allocation makes up 85% of investor return, in reality the studies showed that asset allocation is so important that it shouldn’t be held static, and that stock picking and sector selection actually matter a lot. While these facts inconvenience the passive indexing crowd, that doesn’t change them.

Style box investing, while great for performance attribution, helps little during the portfolio construction process. It’s a great theory, but it just doesn’t make sense in the real world. The Fidelity study notes that managing sector exposure is key because, “of the distinct risk and performance characteristics of the 10 major sectors.” While a specific stock’s style box attributes fluctuate constantly as ever-changing financial characteristics evolve, companies’ sector and industry attributes remain fairly constant. Moreover, these consistent performance drivers have a wider dispersion between the best and worst performing categories. “Equity sectors tend to have significant performance dispersion relative to each other, which is a key attribute for any alpha-seeking equity allocation strategy,” Fidelity observes. In other words, for investors trying to focus their portfolio on the best performing investments, more can be gained by focusing on sectors where the difference between the best and the worst is significantly wider than is the case with styles.

Another key difference is that different sectors have lower correlations to one another. This makes it easier to diversify risk than can be done using a style box orientation. “During the 2000s, the average correlation of sectors versus one another was 0.52, while the same average correlation among style box benchmarks over the same period was 0.76.” The higher the correlation, the higher the risk that all types of styles will rise and (more importantly) fall at the same time. Fidelity goes on to note that portfolios created with equity sectors “are more efficient – providing higher return and lower risk – than those created using style box components.”

Vanguard Fund founder, John Bogle, has made quite a stir lately criticizing the exchange traded fund industry for creating industry specific ETFs and branding the investors who use them as some form of wild speculator. Bogle, of course, made his fame and living off of passive investing. To his credit, he developed a firm based on low-cost investing strategies. To maintain that his approach is the only legitimate strategy is a bit arrogant, however. The lowest price car in the U.S. is the Nissan Versa S Sedan, priced at $12,780. The car comes with a manual transmission, a less fuel efficient engine, 2 wheel drive, bad ground clearance, a hardtop and very few bells and whistles. Are we all fools for not buying the lowest priced car, as Bogleheads suggest? Or are there other reasons to prefer a different way of viewing the world?

Anyone interested in getting a copy of the Fidelity Investment Insights white paper (Equity Sectors: Essential Building Blocks for Portfolio Construction) can e-mail us and we will be glad to forward a copy of the study.

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

2013 Colorado Capital Conference

I just returned from the Colorado Capital Conference, hosted by Colorado Mesa University, the University of Colorado, and Senator Mark Udall’s office.  Hopefully the conference organizers will post Congressman Tipton’s opening remarks, or even the session where Treasury Secretary Jack Lew dropped in for a quick visit.

There were several points where the legislators emphasized how well both parties work together to help Colorado, and how we need to work together to begin making progress on unemployment, the deficit, and other problems.  Senator Udall reiterated his support for a Simpson-Bowles type of compromise, as well as his support for a balanced budget amendment.  The Budget Hero exercise we discussed demonstrated just how hard it will be find a solution.  While meeting within our diverse groups, the face-to-face time led to a more civilized conversation, but it is also much more difficult to slash and burn programs when personally faced with an advocate for that issue in the group.

At the end of the conference, it was hard to understand how our legislators are having as much difficulty as they are.  The people I met were hard working, smart, open to other ideas – even from the other party.  Still, we asked them tough questions about the irrational formulaic budget cutting method we’ve adopted (sequestration), trillion dollar deficits, cumbersome and nonsensical education regulations and tax rules, and an arrogant bureaucracy that wants to dictate how many days a week the local school cafeteria can serve potatoes. (More than one day?  It literally took an act of Congress to get them to change.)

Should we blame Congressional leadership?  The Administration?  Is it the fault of Congressional gerrymandering?  Would redistricting or more open primaries help?

It was a fascinating opportunity to meet some of the problem solvers and public servants who are working together to solve some of these problems.  I came away with more of an appreciation for our representatives in Washington.  However, I am even more convinced that government has over-reached and is crazy out of control.  When even good people can’t make the bureaucracy listen, what hope to mere citizens have?  Because even the lawyers acknowledge that the laws are strangling the teachers and businesses and doctors trying to help people, there is hope that something might be done to change the status quo.  I do hope they’ll try more, smaller solutions and fewer 2,000-page legislative opuses (like Dodd-Frank).

Personally, meeting the lawmakers helped me come to terms with our blue state status.  While I may not have personally supported a number of the folks whom I met at the conference, these are sharp, experienced people, with Colorado-moderate tendencies, and worthy of support for the hard work that is ahead of them.  I wish them luck, but at election time we should hold them accountable, too.  While the problems are dire, I think that we’ve put capable people in charge.  I wish them the best and am far more optimistic about the future than I was before making the trek to the Capital.

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

When Does It Pay To Delay Social Security?

Retirees can start taking Social Security benefits at any time between the ages of 62 and 70.  Many people start taking benefits as soon as possible, but today’ low interest rate environment has changed the calculus enough that for many folks, that’s the wrong decision.  It almost takes a Ph.D. in Economics to calculate when to file for benefits.  Fortunately, a Stanford Ph.D. recently studied how low interest rates and increasing life expectancies impact this decision.

Retirees who file too soon receive lower benefits that, over a long lifespan, result in significantly lower monthly income late in life.  Because interest rates are low, many retirees should use savings during the early years of retirement and let benefit levels increase (risk free) so that less savings is required during later years.  Marriage, divorce, part-time work in retirement, and other retirement income benefits all complicate the calculation making it impossible to generalize.  The recent National Bureau of Economic Research study did make some general findings that readers will find interesting.

Professors Shoven and Slavov concluded that delaying benefits “is actuarially advantageous for a large subset of people, particularly for primary earners in married couples.”  While many people start taking benefits right away, afraid that something will happen to them before they can get their money back out of the system, the study actually found that, “most households – even those with mortality rates that are twice the average,” need to think about delaying benefits. 

Determining when to start taking benefits is the cornerstone of most retirees’ retirement income plan.  Moreover, without an income plan, people have a difficult time knowing how to allocate between “safe money” and “long-term investments.”  Finally, with the calculus so overwhelming that it takes an econometrician to run the numbers, many retirees give up at the outset, abandoning their planning effort and just accepting the anxiety that comes with not having a detailed plan for how to best tap resources during the retirement years.

May-Investments solution is to tap into sophisticated planning resources that allow us to evaluate the results from various options.  We can adjust when spouses file to claim their resources, adjust whether they claim their own retirement benefits, or tap into “spousal benefits” instead.  For more complicated scenarios, we have a Social Study Analyzer program that helps evaluate more complex situations, including 81 different filing options like “file and immediately suspend benefits.”  Planning software doesn’t make decisions for you, but it does make it easier to analyze alternatives.

We know that having a plan for the retirement years is a key strategy to help people enjoy a successful retirement.  Although having a “plan” is not required, it is one of the key traits that separate successful retirees from those who fail to fully enjoy the retirement season of life.  Looking at the numbers won’t necessarily change them, of course.  Folks who fail to plan for retirement and go into it with inadequate resources won’t suddenly discover new streams of income that weren’t there before.  However, for those who have saved but remain anxious about whether they’ve saved enough, a thorough planning effort brings peace of mind and enjoyment that others, who have failed to plan, rarely enjoy.

If you want to read the full study, “The Impact of Mortality, Interest Rates, and Program Rules,” e-mail me and we'll be glad to forward a copy to you.  Happy Thanksgiving from all of us at May-Investments.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Is The "New Normal" Normal?

Someone asked me the other day if I’m still in the “double-dip” (recession) camp, which led to an embarrassing confession that though I once believed that higher rates would choke off the nascent recovery, the current recovery has lasted long enough, and been strong enough, that I think those of us who were double-dippers ought to confess to being wrong. Do I think that the current recovery will eventually turn down? Of course. But if it turns down next year, or even next month, I think it would be disingenuous for the double-dip campers to claim that they accurately forecast this cycle.

In fact, thus far the “new normal” feels pretty normal, when you look at the strength of the current recovery and if you study how the market has responded to these statistics.

Our May-Investments Leading Economic Indicator remains strong, with 8 of 10 indicators showing improving conditions. Even bank lending has turned up, if only barely, indicating that since banks have stopped buying Treasury securities, they now have enough funding available to pay both their exorbitant CEO bonuses and make the odd loan here or there to small businesses who desperately need it. While overly tight bank regulators remain focused on denying capital to just about anyone who might need it to do business, forestalling job growth and pushing former pillars of the community into the hands of better-financed Fortune 500 competitors, at least (statistically speaking) the problem has finally stopped getting worse!

The two current areas of concern are export growth, which seems to be stalling, and a bit of a slowdown in the technology sector, probably related to the economic trauma suffered by Japan which may be impacting the greater Asia region. In any case, with 80% of the indicators improving, it’s hard to see why it makes sense to run for the hills. Economic growth appears to be real, significant, and ongoing.

Fidelity's Market Analysis Research & Education group published an analysis that shows that from the perspective of the stock market, the post-Recession recovery has followed a very normal path. Early in the recovery, financials and consumer cyclical stocks led the way. Now in the mid-cycle of this expansion, energy and industrials are leading the rally. The sector rotation we’ve experienced has thus far behaved exactly as a textbook on the investment cycle would have forecast.

Strictly observing sector performance, the failure of the banking sector to either write-off or in any way digest its bad loans is not apparent. The de-leveraging of the consumer sector, and the degree to which many small business owners and consumers have been cut off from access to credit, doesn’t really show up. Nor has stubbornly high unemployment seemed to matter. As far as the market is concerned, the economy put in a typical V-shaped rally and robust expansion by businesses is leading to a resurgence in inflationary pressures, which would typically result in a modest mid-cycle rally in stocks, especially by the business sector.

I think “the market” is wrong. I think the banks put in a “dead cat bounce” where those banks that didn’t go belly up, beneficiaries of an enormous wealth transfer from savers and taxpayers to incompetent financiers, rallied strongly on a faked recovery in banking sector earnings. It restored consumer confidence, but the systemic cancer remains. I think that corporate America has taken important steps to cut costs, especially in the area of interest expense, but historically high profit margins seems out of step with the economic realities facing the country. Finally, I think that to the degree that the market recovery was stoked by an end to distressed selling, mostly because bonds and cash no longer pay a competitive return (there’s no place else to go), today’s zero interest rate environment seems like an ingenious deception rather than solid long-term rationale for investing in stocks.

But sometimes it’s best to keep the alternative scenarios in mind, especially if you are writing only seven paragraphs after confessing to have blown it with my “double-dip” forecast. The investment business is, if nothing else, a humbling enterprise. I still expect inflationary pressures to get worse, interest rates to move high enough to shut down expansion, and at that point I believe that today’s deferred problems will resurface so that the next cycle down will be severe – hopefully not as severe as 2008, but nonetheless a severe recession, when put in historical context.
 
Let’s hope I’m wrong again.  

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

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Fidelity Report Says Strong Sales Growth Reflects Possible Economic Shift

A recent report by MARE (Market Analysis, Research and Education), a unit of Fidelity Management and Research Co., concluded that strong corporate sales growth in the fourth quarter of 2010 reflected a possible shift in the economic climate.

Many companies’ earnings exceeded expectations in the fourth quarter, possibly foreshadowing an increase in corporate spending. Companies that experience strong sales typically are more willing to spend capital on business growth, and such spending is a vote of confidence in future prospects. However, higher spending raises costs and can reduce growth in profit margins. Although the U.S. economy remains strong, MARE expects earnings growth among large U.S. companies to moderate this year, compared to last year’s strong, broad-based earnings performance.
 
For those who want to take a closer look at this interesting analysis, you can find it at http://www.Fund-Scout.com/Papers/Q42010.

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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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