Sunday, January 13, 2013

Setting a Big Performance Trap?

All US investment performance advertising is required to contain a caveat that past performance is not a guarantee of future performance. Some substitute the word ‘indicative’ for guarantee. Analysts are not as skilled as actuaries in drawing future trends out of past data, but they, as well as portfolio managers, sales people and investors take comfort in investing in securities and funds that have performed well in the past, particularly the immediate past. Increasingly I have a problem with this somewhat comforting approach.

While cheering for a continuation of a winning streak, those of us who follow various sports know that all streaks get broken. One of the many lessons I paid for at the race track was to avoid odds-on favorites to continue their streaks, and to look for horses which fit the current race conditions better than their last several win and loss records. In the current global investment environment I believe we are currently in a period where simplistic extrapolation of the past may well be counterproductive.


1.    In the first week of the year the value of the yield on long term US Treasuries was lost in price declines. The stretch for yield has led one bank to recommend 15% of clients’ fixed income to be invested in leveraged loans. As some are predicting no gain in investing in government paper after the impact of inflation this year, the relative risk in the fixed income allocation of portfolios is likely to approach or perhaps exceed the risk in conservative stock portfolios. (Outside of very low yielding cash there are no large places to hide-out.)

2.    At the end of December the short positions in the NASDAQ Capital Markets were on average 4.79 days compared to 5.47 days as of December 14th. Part of the decline could have been year-end trading influenced by taxes including the expected rise in ordinary rates for some traders and a drop in volume running up to year-end. Nevertheless a 12.5% drop is worth noting. Most NASDAQ stocks are more speculatively priced than those listed on the so-called “Big Board” (the NYSE). They tend to be more volatile. One of the reasons to pay attention to this data point is that every short position eventually needs to have an offsetting purchase. Thus a short position eventually means some buying. With shorts declining there will be less demand for some stocks, not a good sign for a long-only investor.

3.    Large, in theory conservative, banks and other wealth management organizations are recommending hedge funds or worse, funds of hedge funds. One bank has recommended that 20% of clients’ balanced allocations be in alternative investments (largely hedge funds). Even the sage Byron Wien is recommending 15% in hedge funds. Some who are looking for a dull 2013 believe that hedge funds, on average, will earn only mid-single digits. (This pains me as both the manager of a private financial services fund and an investor in some other funds. However, I can understand the warning, as financial services mutual funds on average gained 24.8% and so could give something back, even though there are other investors who believe that the financials will do well.)

4.    With the increasing loss of independence from political control, some fear that central banks will drive monetary policy to greater inflation. The fears are that the money created will flow into asset price inflation; for example in commodities and commodity currencies, emerging market debt and equities. The fear is that after some speculative surges these assets will crash, taking the rest of markets with them due to counterparty risks, which will lead to a significant recession in the 2015/16 time period (or at the end of the current US President’s political power.) What will happen after that will depend to some degree on the 2014 and 2016 elections, which will if anything be more divisive than the past election, particularly as the number of House of Representative seats that are considered safe has declined to 35 from 105 twenty years ago. A number of currency funds are taking the opposite view and are drastically reducing their size in terms of capital and number of employees. (This would not be the first time that the investment community reduced its capacity just before a major change in the nature of the market and then scrambled to rebuild their fortunes.)

5.    All of the above points are relatively short-term oriented and can be classified as cyclical trends. There are at least three more secular trends that will drive investments for the next generation and these are;

a)    Five of seven leading countries in terms of life expectancy at birth are relative hard currency countries. (Switzerland, Australia, Sweden, Canada, and Norway) These are all exporters that have small populations. The US is far down the list. However, the demographics of the US are changing rapidly. Would you believe that California is running out of babies who are needed to fill classrooms with union teachers and for more workers to contribute to the retiring state/city work forces?

b)   In the last year of record, the Chinese filed for some 400,000 patents compared to the approximate US total of 500,000. Contrary to some (and perhaps due to my exposure to Caltech), I believe that we are entering a period of rapid expansion in the use of technology, including biotech, into almost every aspect of our lives. Historically China has been a place of invention and I expect that their commercial and perhaps military interests will drive the US into responding, if not leading in kind.

c)    Two recent studies should be the basis for increased investments by individuals and families. While these surveys are based on US findings, I believe that they may apply to much of the western world.
                                                       i.            A survey of US millionaires showed that 82% believed that their heirs should make their own way financially. Perhaps driving that view, 31% believed that they will pass on to their heirs less than what they received. (The latter finding is particularly relevant to families with multiple generations of wealth that may be drying up.)

                                                    ii.            A survey of workers invested in retirement plans indicated that only about 12% are very confident in their retirement prospects. (One of my fundamental beliefs why the value of equities over time will grow is that both at the societal and individual level we will be investing more into retirement funds. Even if this new money goes only into fixed income, it will in effect leverage risk absorbing equity.)

What am I looking for?

          I long for much,
          I hope for little,
          I ask for nothing.
                -Tasso, 16th Century Italian poet

Most of the money I am directly or indirectly responsible for is long-term in nature. With appropriate levels of cash available to meet current needs and in some cases strategic reserves, my focus is on investing in good companies that can grow their earnings power over time relatively regardless of the progress of GDP. On a price/value basis most often I find these in small and midcap companies around the world. My preferred vehicle for these investments is in mutual funds and an occasional hedge fund that possess deep analytical skills with particular emphasis on the application of disruptive technology.

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