The Investment Danger in Models

I have spent a good bit of time over the last decade conversing with portfolio managers with good to great long-term records. But their current performances are far from stellar. What has happened?  I might stretch to answer with a paraphrase from Shakespeare, “Aren’t they honorable men (women)?”

Last week’s blog focused on the way most of our brains work, relying on short-term memory to make current decisions. Those who have had damage to the frontopolar cortex portion of the brain rely on longer term experiences. This dichotomy has made me wonder how we think throughout life. As a baby we find food and compassion wonderful and wish to obtain more. We learn to quickly translate the specific pleasure to an expected generalized pleasure. Our formal education continues to use the appeal of future benefits as a reward. By the time we formally learn about finance and investing we are hooked on the generalized rewards that can be programmed into our actions. Particularly in schools of so-called higher learning we are introduced to mathematical models. In effect, the models substitute for the reality that is available for inspection.

Time pressure

In college and graduate school as well as most entry level jobs in the financial community, we must immediately start plugging numbers into the models provided to be one of the first to solve the problem in the expected way. Rarely do we take the time to understand the historic development of the model and how the immediate conditions are different from those present at the foundation of the model.

Libor

Bankers, borrowers, and other lenders took the published Libor rate as the price for high-quality borrowers.  In terms of the US dollar Libor, they did not focus on the fact that this was a private collection of expectations of sixteen banks set in London. On many days during the crisis of 2007-2008 there may not have been a single loan at the expected rate. Further, the calculation excluded the four highest and the four lowest expectations. If one wanted to manipulate the rate one had to “reach” the middle eight to rig expectations and these middle eight could change every day. During this period there was practically no confidence on the parts of banks that other banks would repay the loans promptly. Thus the conditions that led to the creation of the model were very different than the conditions during this current bank crisis. A prudent person should not have looked to Libor as a reliable rate-setting mechanism. In a moral sense the criminals in this situation were those that used the mechanism without comprehending and revealing its frailty.

Euro

The establishment of “The Single Currency” was an attempt by Western (Continental) European governments to replace the US dollar as a reserve currency for intra-European trade. The single currency was meant to be followed by a series of additional political, economic, and legal moves. These provisions would provide backing for the currency. Long before the current problems with the PIIGS, (Portugal, Italy, Ireland, Greece, and Spain) there was a strong clue that the people of Europe did not truly support their intended union. The politicians wanted to stop the bloodshed in the Balkans, calling for NATO to provide the muscle to end the conflict. The only problem was that the various countries would not tax their populations enough in money and manpower to bring a military victory. In the end the US had to provide the additional muscle that was needed. There is an important lesson here. With rare exception, a permanently strong currency rests on both a sound economy and the bayonets that are willing to enforce the government’s will. (Perhaps I have had too much US Marine Corps training.)

I do not know if the recent brave statement by the ECB will temporarily turn the tide. Similar statements “of whatever it takes” have been an invitation to hedge funds and other speculators to move against the currency. Remember, speculators can leverage more en masse than central banks can. Stopping the run on the currency without permanently addressing the deficit will be insufficient to hold the euro up. (I hope our European brethren do find a way to address their deficits as we in the US will need an inspiration.) However at this point, if pressed, one would have to say the euro model is failing.

Indexed ETFs

While it is too early to call Indexed ETFs a failure, I am beginning to see some early warning signs that investors are not paying attention. Recently I was with the senior investment officer of a multi-billion dollar fund with a small but ample staff. I was concerned that he had a considerable number of investment funds in which the group was invested. My concern was even with his staff, did he have enough professional help? He felt he did, in that he did not have to devote much time to his index funds. At the moment he could be correct. However, I see two areas of concern. First the change in the weighting of individual stocks within an index. Within the S&P 500 one can see the rapid escalation of the weight of Apple and the decreasing weight of the older “Blue Chips.” Second, at some point these changes may call into question whether or not the index is an appropriate measure for various institutional needs. If that were to happen quickly, there might be some pressure on ETF liquidity considering the large hedge fund holdings in many ETFs.

Looking beyond the models

The current models in many shops today call primarily for US cyclical and recovery stocks.  As you might suspect, I will be looking for something different. In my quest for long-term investment additions to the accounts of my clients and family, I seek inputs from a variety of sources. If you have any insights to deliver to me privately, please do so.  I would also be happy to talk if you would like to join our growth adventure.

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