What Fund Characteristics Should Investors Seek?

In 1990, Morningstar's Don Phillips remarked about the "deification" of fund managers. For the rest of that decade, the almost cult-like worship of investment managers with a hot hand only grew worse. After the bursting of the tech bubble, mutual funds lost some of their appeal. At the same time, star managers found that they could make obscene amounts of money by taking their skills over to the hedge fund arena.

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Not only did the hedge fund fee structure allow for billion-dollar payouts for successful schemes that attracted institutional investor dollars, but the unregulated field of hedge fund investing allowed for casino-like bets on various economic events using an ever-increasing array of derivatives and synthetic investments that amounted to little more than bets against another trader at an insurance company or bank backed by customer deposits and, ultimately, U.S. taxpayers.

The “heads I win, tails you lose” payout structure encouraged a level of risk-taking not seen since the late 1990’s tech bubble. The cult of invincibility led investors to invest first and ask questions later. The natural result was a man named Bernie Madoff and a ponzi scheme blustered past the “due diligence” net cast by his FINRA regulators, and numerous “fund of fund” front men, and hundreds of seemingly sophisticated wealthy investors. Even after whistleblowers alerted regulators and the media, Madoff’s commanding persona and sterling reputation sucked investors in.

How does an investor get past the media hype to make an objective analysis of a particular fund, fund manager, or portfolio management team?

First, learn a lesson from Ken Gregory, one of the nation's most experienced fund pickers. Start with the performance record, but then go beyond the track record to get the best results.

Investigate a fund's general investment philosophy to determine whether it makes sense, and whether it is appropriate to your individual investment objectives. And look at the fund's implementation history; has the fund manager invested assets consistently according to this philosophy?

Once this information is researched, dig a little deeper. Look at the fund's current portfolio characteristics. Are these securities that you would want to own today? Most investors give money to a money manager just as his strategy is peaking. He is probably sitting on a bunch of highly appreciated securities and he's starting to wonder what he'll do with the money next. A better approach is to find a great money manager whose portfolio is full of investments which are still attractively priced. Invest with these money managers before their stocks peak. To do this, the fund analyst has to look at the fund's current holdings and evaluate them relative to what is going on in the market.

Look into fund expense ratios, management stability, turnover, and various other factors. You will never find a perfect fund. No fund will score well in every area that you research. Your goal is to know the fund as well as you can, understand its strengths and weaknesses, and make an informed opinion on which risks are reasonable in light of the current market environment.

• Factor 1: Previous Performance Record (in context)

An old expression, "don't confuse genius with a bull market," might summarize this portion of the fund evaluation process. A bull market occurs when prices, generally, rise. A bear market occurs when prices, generally, fall. Just because your portfolio manager makes you a ton of money is not really proof that he's doing a great job for you.

To do this, mutual fund analysts look for good long-term risk-adjusted track records versus an appropriate benchmark. Looking at a long-term period is essential. Even the small, Arkansas trust department where I once worked could string together a couple of months of solid outperformance. Fortunately, for that trust department, sometimes those random periods of outperformance happened to occur at the beginning of the year, meaning that the firm could report outstanding year-to-date performance versus the Standard & Poors 500 Index. But four consecutive months of investment outperformance isn’t noteworthy. Good short-term records can reverse themselves just as quickly. Unless the outperformance can be sustained, at least through one entire market cycle and preferably through a number of different market cycles, it doesn't mean much.

Soon after I arrived at that Arkansas bank-owned trust company, I was surprised by the perception that most employees had that the company's investment record was fairly solid, except for one gut-wrenching debacle involving a mutual fund that invested in mortgage-backed securities. In fact, the equity funds had lagged the S&P 500 Indexes by about 5% a year on an annualized basis. How did the previous investment management team manage to leave this erroneous impression? They got away with it because whenever short-term performance was good, they paraded those results for all that they were worth, even to the point of issuing news releases announcing that they had been listed as one of the nation's top money management firms, and cited their short-term record as an example.

But the rest of the time, when investment performance was in the tank, they kept quiet. Occasionally they would issue a formal excuse. "We didn't really underperform," they would tell clients, "we just took a lot less risk than the rest of the market took and - since everyone knows that risk and return go hand in hand - as a result we had slightly lower returns than everyone else. Using these two techniques, trumpeting short-term outperformance whenever it occurred and quietly excusing away the more typical period of lousy performance, this company managed to avoid criticism for a long-term track record which, at one point, put them absolutely at the bottom of the list of money managers. Yet most of the company's employees, and bank management, seemed surprised when I would mention that we had a "performance" problem.

It helped, of course, that this was in the late 1990’s, when the market itself was offering even poor investors handsome profits.

Look for good performance, not necessarily the "best" performance. The best track records will often be demonstrated by investment managers who currently have the "hot hand." They will sport fantastic short-term records, above average medium-term performance, and at least decent longer-term performance records. The fund with a "hot hand" may make an excellent investment so long as the current market environment is sustained. On the other hand, near a transition point these same managers may be loaded up with overheated (and overpriced) stocks which are ready to fall down to a more reasonable level. A good long-term record is mandatory. A “fantastic” record is not.

I remember being asked about which funds to buy, in early 2000. It was the height of the technology bubble, but the familiar challenge remained about how to pick a good fund. My advice was to avoid any stock that did well during 1999. Should an investor buy a Janus fund? Forget it. Just about the only way to outperform the market in 1999 was to own stocks that were overpriced and ripe for disaster. Flat out – a fantastic track record in that year was a sure sign of impending disaster. Off the top of my head, I can think of no funds that successfully navigated the top of the bubble and were able to protect investors after the market turned down.

Some funds, and many hedge fund managers, add risk by using financial leverage (borrowing money) to buy more securities than there is capital invested in the fund. Leverage magnifies both the losses and the gains. Still other funds may use illiquid (hard to market) issues to achieve outsized returns. When looking at fund performance, try to use "risk-adjusted" performance to enable what Ken Gregory calls an "apples to apples" comparison.

This is extremely important. If two cars look the same, feel the same, and cost the same, yet one of the cars has a tendency to roll over under certain conditions, which would you rather drive? Similarly, if two funds have demonstrated similar levels of outperformance, accomplish the same objective, and have similar expense ratios, yet one of the funds tends to fall twice as far in a bear market, isn't that something you'd want to incorporate into your fund analysis?

There are several ways to spot "riskiness" in a fund. Some people look at portfolio Beta (the fund's sensitivity to market moves up and down). Portfolio concentration is another key risk factor. A high Price/Earnings ratio on the underlying stocks in the portfolio may constitute portfolio risk, as well as concentrations in certain industries which are particularly vulnerable to the economic cycle. Financial leverage (borrowing against fund assets) boosts risk. Low cash levels may enhance fund risk, particularly if the management company does not have available lines of credit which could be drawn down in the event of a sudden surge in withdrawals from the fund.

Analysts look for good, long-term risk-adjusted performance records versus an appropriate benchmark. This benchmarking can be crucial. Another tactic that the small trust department with the dismal track record used to hide its underperformance was to play a game with rotating benchmarks. When I first arrived, they were using the NASDAQ small company Index as the benchmark for one of the portfolios. Intel and Microsoft make up a good portion of that Index, however, and when those two companies started doing well, the trust company switched to the Standard & Poors mid-cap Index. This index had been lagging, and made for better performance comparisons.

It is always easier to look good when in the company of "losers." The key to outperformance, then, is in finding the right universe with which to be compared. For the press release, the company managed to find a published universe of about 100 bank-managed pooled funds. This small, specialized group of generally mediocre funds, used during one of those rare instances of great short-term performance, made for a lovely comparison.

Know what index is most appropriate for the fund you are evaluating. If the fund manager keeps changing indexes, it might mean the manager is gaming the indexes, or that the fund's strategy or philosophy is changing.  An ever changing strategy is often a bad sign, however. Moreover, don't let the fund's marketing department select the comparison period. Ask for several periods representing both short-term and long-term performance, based on calendar periods that you give them. It makes sense to request quarterly, year-to-date, 12-month, 3-year, 5-year and (if possible) 10-year trailing performance as of the most recent quarter-end. Be skeptical of other performance comparisons. They are almost certain to be biased.

If you are looking for an investment company to manage your portfolio for you, ask for composite returns presented in compliance with the standards set by the CFA Institute. These standards require the disclosure of actual net of fee performance for similar accounts. The CFA standards are designed to facilitate a full and fair presentation of the money manager's track record.

Select a benchmark appropriate for the fund being evaluated. It may be a representative index, such as the S&P 500 Index or the much broader Wilshire 5000 Index, or it may be a peer group of similar funds with the same stated objective. Track the performance regularly versus that index.

Professional analysts also look for consistent outperformance, rather than long-term outperformance which results from a few periods of incredible performance. In reviewing Martin Zweig's The Zweig Forecast newsletter, for instance, Mark Hulbert has noted that much of this newsletter's outperformance resulted from Zweig's adept handling of the market during the 1987 crash. Zweig had sold stocks prior to Black Monday and purchased an S&P 500 put option going into the crash, which soared in value when the market sold off. But if investors ignored that single incredible month's performance, and looked only at the rest of Zweig's record, the newsletter was no longer ahead of the market. Zweig's outperformance was all "bunched together" during that history making month in 1987.

Make no mistake about it, Martin Zweig still deserved credit for anticipating that crash. He is an excellent student of the market, and I would listen to his market timing advice long before most other advisors (market timing is really his strength). But when compared to another equally well performing advisor, Zweig's newsletter would be much less consistent in its ability to deliver above-average returns.

Another way to measure performance is whether the fund manager is adding to performance, or subtracting from performance, in the portfolio activity he initiates. For example, a sector fund may outperform the market because it is invested in a "hot" niche in the market, yet the fund manager may actually be making portfolio moves which have detracted from overall portfolio performance.

If computers are "hot," then a technology sector fund's outperformance ought to be expected. But if you look more closely, you will see whether the stocks sold from the portfolio really began to underperform the portfolio after being removed from the portfolio. If not, then the act of selling them created a drag on portfolio performance. Similarly, did the stocks purchased into the portfolio actually outperform the portfolio? If not, once again the activity subtracted from total returns. When the unmanaged portfolio does better than the managed portfolio, it simply means that the stocks in the portfolio at the beginning of the period, left untouched, performed better than the portfolio actually performed. The high priced portfolio manager actually reduced returns through management of his day-to-day trading activities.

At the end of 1995, that small trust department I had joined sponsored a pooled fund with one of the worst 5-year performance histories in the nation. That year had been particularly embarrassing. During a year in which the market soared 35%, that fund managed only a 21% gain. The stocks in it were so out of favor that when the new year began, and investors stopped selling them to generate tax losses, they automatically popped up when the selling pressure stopped.

At the beginning of 1996,  just before these stocks started to bounce back, the fund manager sold them. Tired of their performance the previous year, he sold them in favor of buying some other stocks which were not so depressed. In spite of these sales, the fund still managed to appreciate about 6% during the month of January. For the quarter, the fund appreciated 8.4%, putting it well within the top 20% of all funds.

What would have happened had the portfolio changes not been initiated? The unmanaged portfolio would have appreciated 11.9%, instead. The portfolio moves actually cost the fund over $700,000! The unmanaged portfolio would have placed in the top 2% of all funds during that quarter. While the portfolio manager trumpeted the "abrupt about-face" he'd engineered after the previous year's "essentially abysmal" performance, his characterization of this turnaround as "not coincidentally" the result of "quality improvements made to the fund" during the quarter was completely erroneous. But only by examining the "managed" versus "unmanaged" portfolio performance could this error be known.

Another factor to consider when evaluating performance is whether or not it makes sense to invest into an "out of favor" investment philosophy or style. What has happened for years, decades in fact (and probably for centuries) is that money flows to the hot hand, just at the time when it should probably be going the other direction. Pension consultants know that the best time to fire a money manager is when they have outperformed for a significant period of time. But clients never want to fire money managers at that point. Clients are in love with the money manager that has helped them beat the market.

Clients do want to fire all of the money managers which are underperforming the market, even the good ones. Instead, experienced pension consultants know that hiring a good manager when his performance is less than stellar is often the wise move. Investment cycles change. Favored investment styles change. These changes most often hurt the manager with the hot hand, and help boost the good money manager who is currently in a slump.

Picking a fund manager requires the same larger vision. Even great money managers experience slumps, during which time their long-term records falls toward the mediocre category. All managers who are at the top of their form eventually rotate out of the favored seat and into a less advantageous position. I am less likely now to be "reflexively contrarian" than I would have been fifteen years ago. With mutual fund money flows heavily favoring whoever has the best short-term record, sometimes the hot hand can stay hot for an extended period of time. Marty Zweig often reminds us that "you can't fight the tape." Getting in the way of a trend is usually about as satisfying as getting in the way of a freight train.

Finally, when evaluating a fund's previous track record, the reasons for the performance need to make sense. Did the fund outperform for reasons which could reasonably be repeated in the future? Did a fund underperform for reasons that are temporary in nature and likely to reverse direction in the near future?

It is difficult to evaluate where the performance came from, and what it means to you, without having a broad understanding of what's going on in the market, and a well defined objective for each fund incorporated into your asset allocation model.

Examining the basis for the fund's performance makes sense for many different reasons. The portfolio manager who sold his underperforming stocks at just the wrong time did not outperform for the reasons he cited. This calls into question not only the manager's ability to understand his own fund performance, but also his credibility in communicating fund philosophy and future progress updates. There is a difference between putting a good face on a bad situation, and misrepresenting the situation. When that line is crossed, investors should look elsewhere for their money management expertise.

Examining previous performance, in context, is just the first step. Investors should also look at a fund's general investment philosophy, which helps investors know whether the fund is suitable for their own unique investment objective. Even great funds are not great for everyone. A finely crafted Mercedes Benz may be the perfect (albeit expensive) car for many people, but it may be a lousy choice for the weekend boater looking for a vehicle to pull his boat through scrub oak with a camper on top. Similarly, funds must be matched to investor objectives. Without knowing an investor's objective, no professional should be recommending particular funds. Finding good funds is only half the battle. Matching them to the appropriate investor need is the other half.

Next post: Factor 2: General Investments Philosophy  (Not yet posted.)

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

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What Might Be Different Now?

After reviewing a fund's performance track record, within the context of the current portfolio, the No Load Fund Analyst analysts next ask themselves the important question, "what might be different now?" Focusing primarily on funds whose fund managers have provided excellent performance in the past, the issue becomes whether or not the investment process remains capable of providing above average returns in the future.

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As is typical in the investment world, the list of important factors to consider is probably endless! Analysts are never done asking questions, but at some point a decision is required to overcome analysis paralysis, which results in opportunity costs as well.

Some examples of changes which might raise a red flag for a fund analyst include the size of assets under management and the changing responsibilities of team members. Managing $25 million is a much different task than managing $25 billion! In the fixed income sector, I would argue that managing a billion dollars is easier than $25 million. In the equity markets, that is not necessarily the case. There is also a big difference between managing a $1 billion large cap portfolio and managing the same amount of money invested in small cap companies. Finally, managing a billion dollars at Fidelity is more challenging than at a stand alone company where you don't have to share analysts with fifty other equity fund managers who may also be interested in buying the same stocks that you want to buy.

Ken Gregory and others generally prefer to invest with portfolio managers whose primary responsibility is money management. The best portfolio managers that I've seen love stock picking, and little desire for the administrative side of the business. Most good shops split these duties as much as possible. A senior person may handle most administrative and marketing details, while the Chief Investment Officer focuses primarily on investment tasks.

But responsibilities always change, and usually the most successful managers find themselves becoming more involved in marketing and management. Investors need to ask themselves whether analysts are still analyzing, or have they moved on to other duties. A key analyst may move up to become the portfolio manager of another fund. Has the portfolio manager graduated to levels of greater responsibility and, consequently, been forced to delegate investment decision making responsibility? Even past success, and particularly the rewards which accompany this success, can become a distraction, taking fuel away from the "fire in the belly" which drove the manager to his or her past success.

Garrett Von Wagoner was a case in point. Von Wagoner compiled a stellar record while at the helm of Govett Small Companies, and then left to start his own fund company. Ken Gregory noted that Von Wagoner always had a reputation for doing his own research work, so leaving behind the research infrastructure of Govett was never really an issue. Von Wagoner was used to operating on his own, and had proven himself to be a bright, instinctual investor. However, when he decided to open his own company, he added an enormous amount of work to his daily workload. Instead of just being responsible for selecting stocks, Von Wagoner was now busy managing press releases, hiring analysts and traders, moving the office and attending to the details of opening a business, as well as picking stocks.

As Gregory and the No Load Fund Analyst team considered investing money with Von Wagoner, Gregory felt that Von Wagoner was probably a better investment manager than he was before he started his own firm, however the No Load Fund Analyst wasn't likely to recommend investment in any of his funds until they were convinced that Von Wagoner was capable of repeating his past success in his new environment.

Liz Bramwell provides another good example of why investors should ask the question, "what is different now?". While managing Gabelli Growth, Bramwell compiled an excellent track record. Starting in the late 1980's, her portfolio outdistanced virtually all of her peers. However, much of that excellent performance was compiled during the early years, when assets under management fell below $10 million. In later years, when assets under management mushroomed up to between $700 and $800 million, her performance record was pretty mediocre. While the tremendous early years resulted in a stellar long term performance record, Gregory's research team had to ask themselves whether or not that record would be relevant since Bramwell was managing a much larger portfolio. Does it make sense to use the long term numbers given the different composition of the portfolio?

Invesco Industrial Income Fund provided a third example. That fund also compiled an impressive track record during the 1980's. Its fund manager, John Kaweske, also happened to manage Invesco's sector fund that invested exclusively in health care companies. Perhaps as a result of this special focus on the health care industry, much of Industrial Income's success resulted from its heavy portfolio weighting in a number of very successful health care companies, at a time when the entire health care industry was achieving above average returns. One question Gregory's research team had to ask itself was whether the fund's health care emphasis was a "smart" bet, or merely a natural outgrowth of the fund manager's additional responsibilities of managing a special sector fund. In other words, should Kaweske get "credit" for making a successful sector bet on purpose, or was it happenstance? Did he have a built in bias that happened to work out well, or had he made a good call?

While uncertainties like the three mentioned here are not likely to be overriding factors, they might be a deciding factor when the No Load Fund Analyst team is trying to decide between two funds, and one of them is burdened with these uncertainties.

Successful portfolio managers stick to a discipline. Fund picking is no different. When asked to identify several characteristics that the No-Load Fund Analyst research team hopes to find in a portfolio management team, Gregory answered.that he looks for fund managers that possess traits which Gregory believes are shared by most (or all) successful fund managers.

• They look for fund managers who have the self-confidence required to be independent thinkers.
• They seek consistency between what managers say they do, and what actually happens in the portfolio.
• They want portfolio managers who are disciplined...but not inflexible. Markets change; sometimes fund managers need to re-evaluate their strategy.
• Gregory's team also looks for fund managers for a passion for the business.

 "In a business where everyone is smart and the work load is overwhelming, you have to absolutely love what you do to have an edge." They seek fund managers whose work responsibilities allow them to focus primarily on stock picking. They want a fund manager who has access to solid analytical support and research information. They evaluate the clarity of the investment approach ("if it can't be well articulated then it may not be all that well developed") and the depth of the research effort, particularly in the small company sector.

Fund picking, like stock picking, requires a well thought out plan, and a disciplined effort to stick to the plan. In other words, it's just like every other business endeavor. Can luck play a part? Absolutely. It's definitely better to be lucky than smart. But good luck is fickle. Solid planning and disciplined research is what wins, consistently, in the long run.

Can you articulate your own investment strategy? If not, is it because you don't really have one?

Next post: What Fund Characteristics Should Investors Seek? 

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

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

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Heresy #3: Successful Investing Can Be Simple (Introduction)

Most investors choose their mutual funds solely based on the fund's previous track record. Past performance is certainly a critical ingredient, but it is not the only ingredient to consider. When the nation's premier fund analysts select a fund, they do so after investigating many different factors. A good long-term performance record is often the first factor of many which the analyst will use. There are many, many different variables to consider, however. Sometimes (albeit extremely rarely), the other factors might even more than offset a somewhat disappointing track record. The key to analyzing funds is to be disciplined, thorough, objective, and well informed.

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For most investors, however, a fund's performance record is the beginning and the end of the research process. According to an April 1997 "Wise Investor" survey conducted by Montgomery Securities, 63% of all investors considered investment performance to be the single most important factor in assessing a fund. As a result, Morningstar's 4-star and 5-star funds (so-ranked exclusively because of the fund's previous performance record) took in 80% of the money invested in mutual funds during 1996. Investors looked for a hot funds in which to dump their money. That is how managers like Garrett Von Wagoner attracted a billion dollars almost overnight during the go-go 1990's.  Given the 2009 rush into bond funds after the 2008 market crash, it doesn't appear that things have changed much in the last 15 years.

Is previous performance important? Yes. Is is all-important? Absolutely not!

• The task at hand:

Identifying the successful 1 out of 5 mutual funds is not an easy task. With 4 out of every 5 mutual funds underperforming their benchmark, any fund chosen at random is likely to disappoint. Successful fund picking, even more than stock picking, is a challenging endeavor.  Furthermore, hiring an independent investment advisor raises the ante. These investment advisors must not only try to beat the market, but they must beat it by a large enough margin that their excess returns offset the 1% to 1.5% fee that they charge customers. In other words, not only must your investment advisor uncover the rare fund which outperforms the index, he must find the even less common outperformer which manages to beat the market by 100 basis points (equal to 1%) before any of that advantage is passed on to the client. The first 100 basis points of outperformance merely goes to pay his or her fee! This is quite a hurdle, indeed.

Ken Gregory has published Litman/Gregory’s research in the No-Load Fund Analyst since 1989. This newsletter is available to retail investors and incorporates some of the most in-depth fund analysis available anywhere. AdvisorIntelligence.com offers this same research to investment professionals, but also makes available the practice management advice and client communications that Litman/Gregory uses for their own clients. Stephen Savage now edits the newsletter (as well as AdvisorIntelligence.com), and for a subscription cost of $600 per year, retail investors get to piggy-back on the conclusions of 10 of the most experienced fund analysts in the country, five of whom have earned the prestigious Chartered Financial Analyst (CFA) designation!


Ken Gregory and his partner, Craig Litman, launched their investment advisory business in 1987, the year of the crash. The frightening plunge that October didn't help them as they began marketing their new business. They started the newsletter in 1989 to generate additional revenue for their struggling new enterprise. They were already performing the fund research anyway, they figured, so why not reconfigure their research for distribution via a newsletter.

It took about a year for the No Load Fund Analyst publication to really get off the ground. Perhaps coincidentally, at this same time the independent investment advisory industry also began growing rapidly. The newsletter's subsequent growth resulted from its national reputation as providing high quality, comprehensive information on mutual funds. Although the newsletter has never been aggressively marketed, Ken Gregory benefited from good press coverage. He was widely quoted in newspapers and periodicals, including Kiplinger's, Money, Worth, Mutual Funds Magazine (now defunct) and The Wall Street Journal.

There is no doubt, however, that Ken Gregory's trademark is his in-depth analysis. The Litman/Gregory team has been comparing funds based on distinct investment "styles" since the first issue of the No-Load Fund Analyst in November 1989. These styles enable an "apples to apples" performance comparison, and they've used these style categories long before it was popular to do so. Even before the first issue, Craig Litman and Ken Gregory were tracking fund performance, by investment style, and by 1989 their database extended back many years.

No-Load Fund Analyst was also ahead of the industry in monitoring rolling time periods when analyzing funds. By looking at 1 year performance, rolling through each quarter during the year, investment performance can be tracked in a more meaningful fashion.

Like most investors, the Litman/Gregory research team started by looking for funds with a solid investment track record. They looked at a fund's performance versus its peer group, and have data on these various peer groups which goes back more than 25 years.

One of the most important characteristics that they look for is dependability, which is measured by the fund's or fund manager's ability to consistently deliver above average investment performance. The No Load Fund Analyst research team also looks particularly closely at "down market" performance, to be certain that the fund is not taking extremely large risks which might result in particularly disastrous performance in the event of a market correction or the onset of a bear market.

The research team also considers how the fund fits into the total portfolio. This subjective review cannot easily be quantified. While previous correlations between different funds, or asset classes, can be measured, in reality these correlations - which existed during the past 10 years - are unlikely to persist into the next decade. Things do change. Today's economic environment is not exactly like yesterday's. Yesterday's fund correlations cannot reliably be depended upon to offer a repeat performance.

For example, the relationship between stocks and bonds during the 1980's and 1990's was very different from what investors experienced in subsequent years. At the beginning of the 1980's, bonds were experiencing an unprecedented sell off. Interest rates were historically high. During the period which followed, declining interest rates helped boost the stock market and the linkage between the two markets was remarkable.

By the turn of the century, however, interest rates were closer to 7% than 20%. Though rates continued to decline, falling from 7% to below 3%, the total returns experienced by falling from 20% to 7% would be much different than those experienced in the latter case. When rates declined from the 20% level, a large portion of bond's total return came from interest received. In the second instance, capital appreciation was a larger factor. This means that bonds would be much more sensitive to changes in interest rates, whereas in the early 1980's nominal interest rates were so high that the 20% coupon rate offset all but the most volatile swings in interest rates.

And while interest rates continued to fall, stocks failed to continue their upward momentum, instead resulting in what some have called the “lost decade” as the market has climbed little, overall, while still forcing investors to endure very steep ups and downs.

Gregory once observed that while these correlations between asset classes can be measured, the correlations typically provide a false sense of security because of how rarely history repeats itself exactly. Most experienced investors know that there's as much art to asset allocation as there is science. The black box hasn't yet been invested which can replace the experience gained by years of passionate involvement in the industry.

When considering investments in foreign market securities, the inability to extrapolate yesterday's correlations is even more true. Today's global economy means that yesterday's correlations between various foreign markets shed little light on how tomorrow's markets will react. What we call "emerging markets," today, were referred to as undeveloped markets just a couple of years ago. There is no historical precedent for today's global economy.

We also have precious little history with high yield bonds (used to the extent which we see them used today). At no time in the past have we converted so many bizarre fixed income assets (like mortgages, car loans, boat loans, credit card receivables, or commercial real estate loans) into publically traded securities. Today's institutional investors use options and derivative securities more than ever before.

Yesterday's market is not the same as today's, and tomorrow's will be even less relevant. What is needed is not only market experience (a picture in context provided by looking through a rear view mirror), but also sound investment judgment looking forward.

Performance records, too, cannot readily be extrapolated too far into the future. Too many important factors can change in the interim, not least of which are the names of the portfolio managers running the portfolio and the investment styles that they use.

Despite these difficulties, however, it is still very important to evaluate a fund within the context of the entire portfolio. Will the addition of the new fund raise the portfolio's overall level of diversification and reduce risk, or just the opposite? Are fund managers using similar investment styles, or different ones? Are foreign investment choices based on nations with economies that are all commodity based, or commodity dependent? Demographic, political, and economic changes render most of yesterday's statistics meaningless for tomorrow's world. Nevertheless, having a broad view of the entire portfolio, and how various funds and markets are likely to interact with each other, is now more critical than ever.

All of this study, review and evaluation doesn't sound simple, does it?  It's not simple for the analysts.  For newsletter subscribers, however, all it takes is a few minutes to write out a check each year, and a willingness to follow the advice of analysts who, I assure you, know more about these funds than you do.  It's the newsletter subscribers who have it easy.

Next post: What Might Be Different Now?

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

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

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Attribution Analysis: Don't Try This at Home

Risk and return aren’t correlated, so picking the least risky alternative isn’t as easy as just going with a lower return alternative. Yet sometimes the higher returning fund has a lot of embedded hidden risk that can cost investors dearly.

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Rates of return are fact-based. As such, there shouldn't be a lot of play in them. A number is fixed, not subjective, after all. But with the millions of dollars at stake in fund flows and management fees, the industry has a tremendous incentive to make their fund returns look as good as possible.

To understand the tricks that fund sponsors play, and why they play them, all you have to do is understand the incentive system under which they compete for customers. In today's world, funds which post peer-busting top-of-the-chart fund returns will experience inflows of millions of dollars of customer money. Because management fees are assessed as a percentage of assets under management, ballooning fund sizes mean ballooning management fees.

Now, let's pretend you are a fund family with customers to solicit. All that matters is that you get to the top of the charts. How do you do that?

The first question you ask in seeking top of the chart performance is, "which chart?" If a fund's long-term performance stinks, maybe a different period could be selected which doesn't look so bad. Fund companies start slicing and dicing time periods every which way possible to see where their funds rank. The next trick is to find the best possible index to which the fund can plausibly be compared.

If you're really, really smart (and companies like Fidelity are really, really, really smart), you create a lot of different funds so that some fund, somewhere in your long list of funds, is always at or near the top. Investors remember seeing Fidelity's name always near the top of the list, while forgetting that last year it may have been Fidelity's technology fund, but this year it might have been Fidelity's gold fund that topped the charts.

One of my college professors at Stanford sponsored an investment contest and offered to pay $100 to the winner. We were all diligent in our stock picking, selecting some of the best (and worst) picks of the day. But we all lost to the professor, as had been the case in his class for several years running. Why? Because our professor realized that he wasn't really involved in an investing contest. The game theory behind his contest was much different than is the case with investing. It wasn't real money being invested. Losses didn't really matter. Only winning mattered. Furthermore, it was a winner-take-all situation. Only truly outstanding performance would have a shot at winning that $100. The best blue chip portfolio in the world wasn't going to win that contest. But a leveraged bet on gold, or S&P futures, might have a shot. By setting up a few highly leveraged portfolios and not caring that most of them flamed out in complete failure, my professor was able to come up with a winning portfolio each year.

From the fund manager’s perspective, hedge funds are a very similar contest. Dramatic outperformance is attributed to skill and results in billion dollar investor inflows. Reasonable outperformance is attributed to luck – the markets are efficient after all, and the sales effort will be difficult. Mediocre and underperforming funds close their doors. Only dramatic upside pays off.

And, generally speaking, it’s not the managers’ money at risk so the downside doesn’t theoretically matter. Hedge fund managers get bonuses based on 20% of gains. When managing large sums, a one-year payoff results in several lifetimes worth of reward. A $10 billion portfolio, up 20% in a year, rakes in $400 million for the senior members of the management team.

Mutual funds are involved in a similar contest. They "incubate" small funds and hope to buy volatility that generates top of the chart performance. Successful funds are hatched and marketed to the investing public. If they can market this record and attract a lot of customer dollars, they achieve the financial industry equivalent of winning the lottery. In a little over a year, Fidelity's popular Contrafund grew from a colossal $10 billion fund to an almost unthinkable $20 billion fund. As a result, the management fees that Fidelity earned on this fund doubled from $70 million a year to about $140 million. Now that's a lottery worth entering! By 2007 the fund had grown to $80 billion.

The huge sums of money which flow into these fund will probably dramatically change the nature of the fund's investment process. Can anyone at Fidelity, with a straight face, really tell you that Contrafund's investment strategy has been unaffected by the ballooning of that fund from $8 billion in 1995 to $80 billion in 2007?

On the flip-side, bad records are merged out of existence. Fund managers change funds and leave good performance records behind them. Beginning in 1997, the opposite is now true. The Securities and Exchange Commission has decided to let portfolio managers claim their previous track record, on an existing fund, when starting up a new fund. The managers can take their old record along with them when they decide to change jobs! Suddenly, two different funds may be advertising the same successful track record!

The very performance contest which drives fund managers to go all out for their shareholders, also makes it extremely difficult for fund investors to sort through the competing claims made by fund companies who are all looking for your money.

• The Investment Advisor's role:

Armchair investors should sit back and relax, having delegated the task of sorting through the lies, damn lies, and statistics to an advisor. The advisor's role is to monitor the investment risks being taken by the portfolio fund manager to be certain that they are consistent with the objectives set for that portfolio. When a so-called government fund starts boosting its return figures by speculating in interest-rate sensitive mortgage-backed securities or sub-prime securities, it is the advisor's job to see that a false sense of security is being painted and advise investors to choose a more conservative fund.

Investment advisors subscribe to services which track fund performance over long periods of time. By comparing a fund with its peer group and appropriate indexes, standout fund managers begin to shine through. If the portfolio managers for these funds jump ship, the advisors can move investors into a safe haven.

Advisors should help investors allocate assets to the most appropriate asset classes, not dump clients in all asset classes. In addition, the advisor should be tracking the performance of funds against appropriate benchmarks to be certain that the funds being used are providing satisfactory returns, and advisors should know how the fund performance was derived. Did the fund make a bet on a particular industry that paid off? Is the manager a whiz at stock-picking? Did the manager let cash build up? Was the outperformance an accident? It happens. All of these are critical questions to ask regarding a fund's performance, and investor should delegate the job of asking them to their professional advisor. This is not the time for amateur hour.

Any advisor who says the attribution analysis effort is easy either doesn't know what they're talking about, or is just blowing smoke.  Mutual funds are a black box between reporting snapshots.  There are very few advisors who have the information necessary to really know what is driving a particular fund's performance.  It is hard enough for me to really know what is driving performance in my own fund.  Without direct access to the trading data, it is extremely difficult for an outsider to determine whether a fund is performing well due to stock selection, industry concentrations, trading calls, or other factors.  Staying on top of portfolio construction, however, is an important part of managing total portfolio risk.

Don't be afraid of risk. Learn more about it. Develop a process that evaluates risk and invests your portfolio in asset classes where non-normal risk/return distributions mean that you are more likely to have above average returns. Don't assume a normal bell-shaped curve.  Seek out long-tail investments where the upside scenarios and payoffs are relatively larger than the probability of experiencing a loss.

Be flexible in the amount of risk you accept.  Attractive markets can justify above average risk. Unattractive markets should drive money to the sidelines. They should make investors risk averse. There’s nothing wrong with taking smart risks. Sometimes being overly conservative is a problem. Sometimes being conservative is the prudent thing to do.

Money is often made when perceived risk is high. Money is usually lost when actual risk is high. To make more and lose less, you have to understand what risk is, and what it isn’t.

Next post: Heresy#3:  Successful Investing Can Be Easy 

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

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

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Can Performance Fall Below the Line?

People who believe in the "efficient markets hypothesis," believe that all prices always reflect all available public and non-public information. The market, they say, is "efficient" because it automatically processes all of this information. Efficient markets advocates might argue that all returns always fall on the line. Just as it is impossible to earn out-sized returns above the line, it is also impossible to earn sub-standard returns which fall below the line.

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I am not an efficient markets advocate. I've seen plenty of investment groups deliver sub-par performance. Kelsoe wasn’t an “efficient” investor. He took a foolish risk in order to try to look good in the short term. Piper Jaffrey’s Worth Bruntjen made a similar miscalculation.

Trust departments are famous for explaining away bad performance (i.e. performance which falls short of the risk/reward line) by claiming that they achieved their returns by investing in high quality companies and by taking less risk than the market, generally. They argue, in effect, that their performance does not fall below the line, but rather that their results should be moved over to the left so that it will fall on the line, but at a point of much lower risk.

I have been involved with several boards and heard more than one investment advisor, when confronted with their sub-par investment performance, try to turn the tables by questioning, “I wonder what kind of risk they are taking? We have a very conservative portfolio.”

I think it is possible to fall consistently below the risk/return line. The best known example of this is the Steadman Funds, which had a long and dismal history of underperforming the market. Near the end of 1996, the Steadman American Industry fund had lost 40% over a five-year period, while the average domestic diversified stock fund had doubled. The Steadman Investment fund fell 32% during the same period. Is it any wonder that industry pundits have labeled these the "dead man" funds? At least part of this underperformance is due to extremely high expense ratios, which sapped investor return regardless of how well (or, in this case, poorly) the fund investments perform. Believe it or not, over a decade later, after changing its name to the Ameritor Security Trust, a Steadman fund has survived through 2009. The current gross expense ration of the fund was 2.45% (down from 12.84% as recently as 2008).

Is it possible to fall consistently below the risk/return line? Absolutely! Small trust shops which lack a coherent investment philosophy, or which don't invest in adequate research, can't effectively compete with larger banks and fund companies with their dozens of analysts and thousands of dollars in research service support. Expensive products, like fee-heavy WRAP accounts which pay several layers of expenses, are also consistent underperformers which end up south of the risk/reward line. Individual investors are famously on the wrong side of the risk/return line.

A famous 2003 study by Dalbar of Do-It-Yourself investors showed that from 1984 – 2002, while the market was appreciating 12.22% per year, the average stock fund investor in the study earned an annual total return of 2.57%. The Dalbar study showed that individuals tend to time the market very poorly. They watched the market rise from the sidelines, with few dollars invested. Then, at just the wrong moment, they dumped much more money into the market and watched it all fall. While the indexes returned double digit returns, on a dollar-weighted basis these individual investors were just barely breaking even.

In fact, it is so easy to find yourself below the line due to high product expenses and poor market timing that John Bogle has been sainted by the financial world for arguing forcefully that investors shouldn’t even try to beat the market. Index funds have become a rallying cry for academia, most in the media, and even a very large number of advisors. These advisors are charging clients 1% - 1.5% of assets under management annually in order to, get this, buy clients a bunch of index funds. These advisors admit that they bring nothing to the table on the investment side of things, and for their honesty charge clients as much as $10,000 to $15,000annually on a million dollar portfolio just to park the money in index funds. What they lack in investment smarts, they make up for in chutzpah.

What, exactly is the problem?

As a result of academia saying over and over, louder and louder that risk and return are always and everywhere absolutely correlated, we create a few problems for ourselves.

First of all, we no longer teach portfolio managers how to properly research a company. And if the “efficient markets” theory were really correct, why bother? If everything that could be known is already reflected in the stock price, why not just go back out to the golf course and work on your drive, instead?

Consumers operate under the assumption that all investment advisors are the same. If markets are efficient and all returns lie somewhere on the curve, then why hold your current advisor accountable for poor performance? He or she was just too conservative. And given the pain the clients felt due to the poor performance, they thank the advisor for not putting them any further out there on the risk spectrum.

As a corollary, investment advisors with good track records find themselves being labeled as “too aggressive” simply based on the fact that they’ve provided better than average returns.

Indeed, a friend of mine with a background in consulting observed that the incompetence of most advisors creates a barrier to entry in the industry. Investors move from advisor to advisor and each time manages to underperform the market. One advisor, anxious to sell the client what the client wants (instead of what he needs), allows the client to go in too heavy into technology stocks right at the top of the market. Another advisor uses his firm’s proprietary research and products and does well, for the firm, but not for the client. Yet another advisor charges the client 5% up front to buy a bunch of funds, then never calls the client again and years later the portfolio still hasn’t grown.

Sound familiar?

By this time, clients are convinced that it doesn’t matter whom they choose. So why bother? Switching advisors takes time. It is scary. It requires an uncomfortable call to fire the former advisor. There is paperwork to fill out. There may be taxes to pay when changing strategies. There are automatic deposits that need to be changed. There are dozens of reasons to let inertia rule the day, particularly when it appears that all advisors are equally bad.

The overall incompetence of advisors creates a barrier to entry in the industry. With so few clients willing to undergo the switching costs, absolutely convinced that one alternative is as bad as the next, it makes it difficult for new advisors to enter the industry.

I recently had an opportunity to meet a prospect but had little time to get to know him. In the short period I had, I wanted to let him know how our investment strategies were performing. I quickly presented how we do things differently, and presented some performance examples.

A month later, after he’d chosen to use another advisor, he explained that, “everybody shows you good performance numbers in the beginning.” The bottom line for him was that it didn’t make much difference which advisor was selected. Performance was a great unknown quantity and any honest advisor would deliver roughly comparable returns.

We are taught that no one does better than anyone else. Control costs. We are taught that it makes sense to pay an advisor 1% to buy index funds. Work with someone you know, because they probably aren’t a crook. But to spend time finding out about the advisor’s investment strategy? That’s thought to be a waste of time, just as it is a waste of time for the portfolio manager to read that quarterly 10-K report that his portfolio company just released.

•  Getting Above the Line:

Mark Hulbert publishes the Hulbert Digest, which tracks the performance of many newsletter advisory services. He charted the risk using standard volatility statistics versus the return and found that at the far right side of the graph, for the newsletters that had provided subscribers with the best performance results, the risks entailed in the strategy were far below what the normal risk/return analysis would suggest. How can that be?

How can investors get "above the line?"

First, understand that the “efficient markets” and Capital Asset Pricing Model were developed by economists, not practitioners, and have some high level math embedded in their theoretical DNA. They make some assumptions about the different investments including a major assumption that returns are distributed in a normal bell shaped curve around a mean return. In other words, if the typical (mean) return to stocks is 10% per year, then there will be just as many years where it underperforms as years that it will outperform. Even in the extremes, there will be as many years where the market is up 35% (25% above the mean) as there are when it is down 15% (25% below the mean). When you plot the returns over time, the assumption is that they will form a nice looking “bell” shaped curve with the most occurrences centered around the mean, and far fewer instances in the outlying areas.

The problem is that returns are not distributed in this fashion, especially for individual stocks. In fact, the stock picker’s goal is to find stocks whose future returns are heavily skewed to the positive side of the curve. One of the reasons that “value investors” have a leg up in the race for performance is exactly this; out-of-favor and distressed security returns often have non-normal return prospects. These investors aren’t fishing in a typical pool of water with lots of normal size fish, and a few whoppers along with a few minnows. These investors are fishing in waters where most of the fish are above average size.

So one way that investors can achieve above the line returns is investing with these experienced value mavens and just being patient. Most great managers will underperform the market for a stretch. It requires commitment not to bail out on them when this happens, but patience and discipline will eventually win out.

Timing the markets adroitly (not perfectly, but with better than random results) is another way to achieve above the line returns.

Remember the university house of terror in which those academic studies were contrived? They required a host of assumptions. One of the key assumptions is that over the course of time, the portfolio bought and held different combinations of securities. The portfolio was static. It never changed. Given a static mix of assets, the results were somewhat pre-ordained. The best performing assets, usually equities, were on the right. The worst performing assets, usually cash over long periods of time, was on the left. Other asset combinations found themselves in the middle.

Over shorter time periods, these pretty risk/return charts, which the economists and financial planners love, break down completely. In some periods, bonds outperform and have less risk. In other periods, cash is king. Sometimes international stocks add return to the portfolio. In other periods, they cause a drag. Small caps usually add zest to the portfolio, but not always. There are entire decades when the risk/return charts look nothing like the traditional graph.

But why assume “buy and hold” other than to keep things simple for the computer?

In fact, go back to the typical investor’s quest for 30% returns and little or no risk. There is no asset class that you can buy and hold and achieve this investment nirvana. Stocks definitely won’t deliver on that promise. Private equity won’t. Neither will venture capital. Real estate certainly won’t. Nothing can deliver on the holy grail of 30% returns and below average risk, unless you are willing to relax the buy and hold assumption.

With perfect insight, it would be possible to deliver high returns and relatively low risk. Over time, by moving between asset classes, it would be fairly easy to deliver that outcome.

True, no one has perfect insight. However, that doesn’t change the fact that by having a flexible asset allocation discipline, instead of a static portfolio, investors can potentially improve portfolio returns rather dramatically.

Part of the proof is that we know that as a class, individual investors typically dramatically underperform the market because they do such a poor job of timing the markets. Why wouldn’t you look into “who’s on the other side of that trade?”

To get above the line, get help from investment professionals who are willing to provide advice on which asset classes to buy, and which ones to avoid. The vast majority of advisors will tell you to buy a little bit of everything. Under the guise of “diversification,” they assure that you’ll receive mediocre results at best, and probably worse (depending on the fees).

Most mutual funds and advisors cling to mediocrity like a drowning sailor to a life preserver. Here’s a secret for you. They are not trying to protect you from risk. They are protecting only themselves.

Given the barriers to entry where all advisors are considered equally inept, and switching costs are relatively high, most clients will not abandon an advisor who provides them with mediocre returns.

They won’t abandon an advisor with excellent returns, either, but few financial service firms are willing to stand apart from the herd and do what is necessary to earn above the line returns.

Above the line returns require an opinion on which markets to buy and which to avoid. If the firm gets that wrong, then some client somewhere will complain and, increasingly, bring a lawsuit. There are giant law firms whose entire business strategy is built upon suing companies as soon as some mistake causes the stock price to drop. If these firms were to start making market forecasts and actually acting upon them with client dollars, what a bonanza that would be for the American Bar Association. It is yet another example of what economist John Maynard Keynes described when he said, it is better to fail conventionally than to succeed unconventionally.”

You don’t get sued for mediocrity, nor do you lose clients. Wall Street’s overdiversified, benchmark-hugging strategies have nothing to do with trying to protect investors.

Next post: Don't Try this At Home 

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

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

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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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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.

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