Introduction
The huge amount of press covering Bill Gross’s changes of investment house
was a wonderful occasion of misdirection. The day of the announcement I
reviewed the average performance of ninety-six fund investment objectives for
the week. Of the long-term taxable fund investment objective categories, only
two were positive. The two that had plus signs in front of their weekly
performance were Dedicated Short Bias Funds and Alternative Managed Future
Funds. I believe the unanimous performance declines in every single domestic
and international equity and bond fund is symptomatic of deep fundamental
concerns.
Lessons from NY tracks
One of the personal learning institutions that has impacted my
investment analysis career was the New York based horse racing tracks. The
percentage of winning favorites was typically about 33%. One should look at the
dollar returns from winning favorites after expenses paid in taxes and fees to
the track. The winnings would not cover the losses in other races, let alone
cover the expenses of getting to and into the track and an occasional hot
dog. From the track math I learned that
there is a tendency for those who make mistakes to continue to make mistakes.
In other words they could be negative indicators. How could this be?
At that time the New York racing crowd was the savviest in the
country, perhaps like those following stocks listed on the New York Stock
Exchange. Clearly these bright people were being swayed into making uneconomic
bets. They were following the results of past performance races. A horse that
had recently won three or four races, regardless of conditions, was expected to
repeat. The crowd could have included some member of the SEC staff who then
required the phrase “past performance is no guaranty of future performance,” or
similar language to be appended to all performance communications with the
public. Unlike many politicians that worship at the foot of “Big Mo” or
momentum, some regulators were appropriately concerned about momentum
investing.
What are the historical odds of winning?
From my experience in looking at investing for more than fifty years,
there are two matrixes that answer the question. The much more common one is to
measure whether the price of the investment went up or down. For long-term
investors, the odds are that 50% of the choices finish at higher prices. Why?
The discouraged ones drop out of the class and, at least in the US, the long-term
secular trend has been up. You have to live longer to win. Good managers
probably win about 60% of the time. The truly great managers win over time
probably about 66%. Just as the critical measure of a day at the track should
be measured in terms of net dollars won after all expenses, so should
performance results be assessed. Even better, if one was foolish enough to
think going to the track as a business, one should look at the ratio of winnings
to amounts wagered. On this basis I have seen people actually make money only
being right some 40% of the time because they handled their money wisely and
benefitted from the knowledge that winning positions grow in relative size
compared to losing positions.
Lessons from Bill Gross’s departure
First, it is important to acknowledge that he had a very good long-term
record that the institutional and individual communities translated into
favorable momentum. Second, Bill was the pied piper for fixed-income investing
which had some impact on equity investing. Third, none of our managed accounts
owned funds that he managed and there was very little owned in some of the over
$4 Billion in institutional portfolios of tax-exempt groups that have me on
their investment committees.
What should have been included in the press coverage? First, in all
likelihood we have seen the end of a thirty year bull market in bonds which
began when the late and great Arnold Ganz told me that there was a generational
need for bond managers; there were not enough to go around to all the openings
he perceived would be coming. Considering that individual investors around the
world were rushing into bond funds, the end of the bond bull market could be
very destructive to the investment public and could cause interest rates to
rise on government debt as there would be fewer buyers. By the way, many
institutions with professionals on their investment committees own very little
in the way of bonds.
Second, in later years Bill’s success was based in part on a very
strong trading facility that he helped build. His great strength was in the
timely use of derivatives. Banks are far and away the biggest dealers in derivatives,
with PIMCO probably getting their first call and possible price concessions.
Due to rapidly changing bank regulations, banks are cutting back on their
inventories of derivatives. Thus, in his new home Bill may be offered less
support than what he has been used to receiving.
Third, many news articles have been speculating on how much money will
leave PIMCO. While this may be harmful to the fund management company’s bottom
line, I suspect that it will be good for those investors that remain within a
shrunken fund. There is no portfolio that I have observed that couldn’t be
improved by judicious selling. A manager may love all of his/her holdings; however
redemptions will force a ranking of those holdings that are least loved.
Fourth, Bill’s quick decision to join Janus, apparently his second
choice, defies historical analysis. The board at Janus has a long history of
making the wrong decisions in terms of senior executives. This could change.
The need for negative indicators
Since great managers in the long run are only right about 2/3 of the
time, we would all like to improve our odds. From my experience those people
who have been regularly wrong tend to persist in being wrong. My feeling is
that these people are wrong about 75% of the time leaving them to be right 25%
of the time. What we attempt to do is to take advantage of superior managers to
enjoy them being right 2/3 of the time leaving 1/3 when they are wrong combined
with the much smaller number of negative indicators that are only correct 1/4th
of the time. If we were absolutely successful we might potentially produce a 91%
hit record. We don’t believe that we will achieve this result without your
help identifying additional negative indicators.
Calling for negative indicators
I hesitantly nominate three groups to start your juices going as
possible examples of negative indicators. The first is the current keepers of
the Dow Jones Industrial Average (DJIA). In the last year according to Barron’s, they added three
stocks. Two gained +5% and +1 % with the third declining -5%. They replaced
three stocks that gained +47%, +8%, and +26%. These changes demonstrate their
concerns for investors that are tied to the DJIA. Further, they have announced that
in the future only those companies which are headquartered in the US would be
eligible to be included into the World’s most famous stock indicator. They are
following the action of the S&P 500 a few years ago. These choices will have an
ironic impact. The next most popular index family, the Russell indices, are now
owned by the London Stock Exchange, which might have its new owner’s
proclivities in mind.
One might speculate that the keepers of the DJIA (which is now managed
by a subsidiary largely owned by S&P which in turn is owned by McGraw Hill
Financial*) are defending
themselves from a lawsuit by the Justice Department which it is alleged has to
do with its downgrading of the credit rating of the US. Thus the announced DJIA move
could be interpreted as an attempt to back the current Administration’s efforts
to curtail tax inversions. Thus, we are seeing political capital topping
investor capital. The history in the marketplace is that this is a short-term
advantage and will actually just encourage more off-shore deals.
*Owned personally and/or by the
private financial services fund I manage.
The second negative indicator nomination is for the California Public Employees' Retirement System (CALPERS). This judgment is based on CALPERS’s decision
to redeem some $4 Billion invested in hedge funds because they were too complex
and too costly. I wonder what they thought they were investing into in the
first place. There is a chance that their timing is exquisite. After far too
many years of declining interest rates and generally rising stock prices, we
have currently seen the beginnings of rising rates and falling stock prices. As
stated above, the only two fund investment objectives that were up this week
were Dedicated Short Biased Funds and Alternative Managed Futures Funds. In
addition, a closed-end diversified currency fund had a surge in trading volume.
Caveat emptor
My private financial services fund (which is structured as a hedge
fund) has not had a short position in many years. In addition I personally own
shares in a non-US manager of one of the largest futures funds in the world.
Further some of the non-profit investment committees that I sit on have quite
successfully used hedge funds in their portfolios. Thus, I believe that CALPERS
is a good nominee as a negative indicator.
The third nomination is the previously mentioned Janus Capital
Management whose board of directors has consistently chosen the wrong people
and the wrong diversification moves at the wrong times.
I am looking into making a fourth nomination, of a prominent
talking head or columnist who is brilliant about extrapolating yesterday’s news.
Please send me privately your nominations of negative indicators. In
the meantime, invest well for the long-term and trade well in the short-term.
__________
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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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