Sunday, January 3, 2016

Probable Causes of Underperformance


Most investment managers produced returns of mild single digit to mid- teens losses. Some of these managers were research-intensive managers with long histories of good results. They did not take dumb pills or drink depressing Kool-Aid on a summer eve. While they were confronted with a world where the vast majority of securities and commodities fell, they should have done better, including having some of their money in the minority of stocks that rose. What happened? I believe conditions fundamentally changed.

Lessons from the Racetrack

The first time I had to confront making bad decisions was at the racetrack when I didn’t cash winning tickets. In many ways that is when I started to learn valuable thought patterns that I applied later to investing for others and myself. In roughly the half hour between the losing race and the next one I hurriedly reviewed all of my calculations and visual inputs. I divided these into categories. In the first category were the questions did I miss changes or underestimate the importance of track or equipment changes? For example I usually noted that my horses had changes of equipment or jockeys and trainers, but I also asked, “were they being equipped with blinkers to keep them running straight and not being bothered by other horses?” Too often I did not look at these changes on all competitors which meant that I missed a poorly performing animal prior to the race that became easier to ride and guide to the finish line that was not characteristic of its past performance. (Too often investors don’t fully appreciate the changes in management of competing companies or portfolio managers.) The biggest category was the expected winning time of the race. Often if the race is slow almost any horse can win, similarly in a low performing market any investment that has a slight advantage does win. My mistake was to look at the recent track record for the race and guess which horse could run at that speed or better. In the market all too often investors look to an investment that can be spectacularly better than average. Too often one needs to look to the risks undertaken when finding such a vehicle or horse. Most of the time, a spectacular win will start with a chorus of disbelief, which could be correct. By far the biggest hurdle to handicapping or investing is to recognize that the basic conditions have changed which could be rules changes, unexpected weather, personal issues of the professionals, etc.

From an investment viewpoint, I believe 2015 experienced such cumulative changes that make many of our old approaches less useful.

What Changed?
The following are a list of important differences in 2015:

1.  The reduction of position capital at trading desks of major institutions and investment banks which are under the restraints of the Volcker Rule. Liquidity was available, but at a price and at a time of the liquidity provider’s choosing. This has led to a significant level of intraday volatility. This plays into the hands of the high frequency traders and other algorithm users picking off large scale movements. Bottom line: trading has become meaningfully more difficult and perhaps expensive in terms of full execution costs. What used to be only an equity market problem now is very much a factor in trading in US government paper and starting to be an issue for investment grade trading.

2.  The central banks’ manipulation of internal interest rates has morphed into manipulation of foreign exchange rates which are impacted by both flows into and out of the market that are not price sensitive, the values of global securities and a range of commodities.

3.  Big data comes to the Biggest Markets in a Big Way. US based managers feel comfortable having their US offices managing non-US securities. Similarly global portfolios of US securities are being effectively managed in distant offices of foreign investors. The availability of all that is known about a security instantly means that there is less opportunity to strip or dump into a market. The passage of “FD” (Full disclosure as mandated by the SEC) means the investment/trading value of published information has declined. As more institutions utilize secondary and tertiary research their value becomes discounted.

4.  “TINA” (There Is No Alternative) is not the only alternative. The investing public has globally built up their stake in money market funds and other repositories of low returns with the ability, not used yet, to rapidly reinvest. Some are using long or short positions in index ETFs or index funds. (I prefer the latter.)

5.  A growing recognition that much of government produced data needs to be questioned. In one of his first acts the new President of Argentina was to order his government to create accurate data. Another example is the former Premier of China acknowledging that its GDP was “man-made” which meant he did not trust it. 

One can take the position that one of the reasons that the Federal Reserve has had such off the mark forecasts is bad data. At a public meeting at the New Jersey Performing Arts Center (at which I am a trustee and chair of the investment committee) I asked Bill Dudley the President of the NY Federal Reserve Bank and a permanent voting member of the FOMC what additional data would he like. Bill who is a veteran numbers crunching economist at Goldman Sachs responded that he would like to know much more about the creation of the rapidly expanding student debt. He is right as student debt is the largest amount of consumer debt, greater than residential mortgages. To the extent that this debt is to be repaid colleges are going to have to produce easily employable workers who will have to postpone buying their first home and other consumer spending. An important driver of the size of student loans are the costs of food and lodging, which are often superior to their first apartment post-college, if they graduate).

6.  Many of the major economies are increasingly being driven by the service sector and not manufacturing whereas most governments and central banks have tools to spur a declining manufacturing sector. In the US it is important to focus on how US auto sales are recovering to previous heights established years ago with a smaller population. What should be noted is that in 2015 US branded cars are filling less than half of the demand. This is important because to an increasing extent a car or light truck is an electronic platform on rubber wheels. This signals that the auto (and for that matter almost all markets) have changed and our governments have not kept up. Some are conscious of this as the Bank of England has noted that there was more acquisition of service companies in 2015 than manufacturers.

7.  Target Date Funds are being questioned due to their exposure to bonds in a somewhat rising interest rate environment. This could be quite harmful to those who are about to retire when much higher interest rates and lower bond prices start to occur.

Don’t Bet on Favorites Most of the Time

I learned at the track that normal favorites win only about a third of the time, but because their betting odds have been beaten down by players pouring in the winning dollars when they do win, do not pay for the 2/3rds of the time they don’t win. That is why my bet for 2016 is for a big year up or down. My best guess is UP, for the Wall Street Journal may have taken over from Time Magazine and the former version of Businessweek with its cover pictures of success people. Saturday’s Wall Street Journal had a front page article headlined “Drab Outlook for Markets.” If the article is correct my clients don’t stand to lose a lot, but if I am correct 2016 will be anything but drab with a reasonably good chance of a better than average result. Perhaps some of the poor performing managers could produce great results in their recovery.

What Should I be addressing Next Week?

The next post of this blog will be my 400th. Are there topics I should address or would you like me to reprint any of the old posts?

As you start the New Year we wish you and your family and associates a Healthy and Happy New Year.       
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