My
two most valuable investment assets are learning and recognizing imperfections. Most of the time
when events don't work out the way we expect, we look for someone or
something to blame. The perpetrators are not trying to disappoint or hurt us,
but compared to our model of events, their model is proven to be imperfect.
Because we are humans by nature, we are imperfect. Thus it would be wise to be
prepared for imperfections in thinking about investing.
There
is an enormous lesson that will be learned by a small minority of investors
from the classic mistake of getting the recent election results wrong. They
don't have the advantage that the Caltech and other scientists have over most
economists. While almost all of us want certainty, political and investment
pundits need to predict with absolute
certainty. If they don't, they may lose the title of "expert" in the
eyes of their audience. In contrast the research scientist is in the business
of expanding knowledge. Thus, when "mistakes” occur in well constructed
experiments the boundaries of knowledge are expanded through the recognition of
the imperfections in their model. Often through recognizing the imperfection worthwhile
discoveries are made.
The
essence of the difference between the public expert and the research scientist
is the pundit is looking for certainty and the researcher is looking for
imperfections in the accepted model. Both use the power of mathematics to
summarize behavior. The pontificator uses perceptions of the masses, whereas
the scientist is searching for the limitations to perceived wisdom. Perhaps,
the big difference is the good analyst/scientist incorporates a large quantity
of doubt in his/her thinking. While every effort is made to reduce the quantity
of doubt, only the fool would believe that all doubt is removed.
The
biggest source of imperfections is that we do not completely understand what we
are measuring. Much more importantly, we do not fully understand what is not
being measured as well as the fallacies built into our measuring devices. One
of the standard series of questions on intelligence tests is which item is like
the others shown. This kind of recognition is built into our way of thinking.
Unfortunately for statistical analysis purposes no two people or groups are
exactly like another person or group. Thus in searching for good investments we
should pay more attention to the differences rather than similarities. With
that in mind when we see a long chain of results such as investment or economic
performance, we should remember from the racetrack and other sporting histories
that streaks always get broken eventually. Thus, we need to examine the
current situation and look for differences from past events (or at least
express a doubt that the current event could be different than expected through
extrapolation of the past).
I define my task in managing money for clients
and family is to be a student of the Investment Arts. Thus, among other tasks I
look to understand where the "experts" got it wrong. Recently I have
found three major current and understandable mistakes that we can learn from:
- Most economic predictions
- "By the numbers" investing
Economic
Predictions
At
this time of year a number of major investment organizations produce short to
long-term economic predictions. There are at least two problems with these
predictions. The first is that they are being made largely if not entirely by
economists. (Remember no institution has more highly credentialed economists
than the Federal Reserve and its regional banks. Look at their long- term record
of predicting even the current economic conditions!) Interesting that they could get some help from
the institutions’ portfolio managers and some of their investment strategists
who are dealing with what market prices and volumes are in effect every day. Because
all who predict the markets are wrong at least some of the time, the managers
and strategists may be wrong but they have a daily report card that often
causes them to adjust their working assumptions.
The
second drawback to most economic predictions is the source of their inputs. For
the most part they use government-gathered data. This is hardly the most
accurate or timely source. Two examples follow of what the government models are
missing (or if you prefer imperfections to the government models). The first is
income. Importantly, they use reported income from tax forms. What individual
does not report the least that they are obligated to report? I am guessing if
we add up all spending done through the economy it would be larger than the
income reported for it would include both the "informal" segments and
indirect benefits from gifts, etc. Significantly, many of those that are not
solely relying on reported wages make their economic decisions based on their
own perceptions of their wealth and changes to it. Our national data on wealth
suggests that it is roughly divided in half with variably priced assets and
so-called fixed assets (largely real estate less mortgage debt). One of my
learning experiences in working with successful families is that they view their wealth differently than what is shown on tax and other
documents. Because we are living in a particularly volatile time, attitudes to
the size of wealth can change rapidly. These changes affect both consumption
and investing that are not adequately recorded in inputs that most economists
use. I suspect those who deal with major segments of our population have at
times quite different concepts about where the economy is currently going
compared with most economists.
In
general, investors should probably pay more attention to what the people who
are managing companies and their money than institutionally employed
economists. The only time that it may be wise to pay particular attention to an
economist is when the expressed views are not coincident with what his or her organizations are currently selling. Also it may be worthwhile to be alert to
them when they express doubt as to their inputs.
The Fallacy
of "By The Numbers" Investing in Mutual Funds
Media
sound bites, sales people and regulators seem to think that fund investors have
limits to their investment intelligence. They do not know the critical
difference between ratings and rankings. When I started to develop the market
for our Lipper Mutual Fund Performance Analysis, first for my brother's firm
and then my own, the critical target markets were the mutual funds' independent
directors and their counsel. They had a specific task to decide whether to
renew the investment advisory contract for their funds. In rare cases they did
not renew. I convinced them that an independent source of fund data protected
them in case they were sued by regulators and/or shareholders. The service as
it evolved delivered rankings of their fund compared with what we felt was the
list of competitive funds in various time periods. Ranking is an ordinal
listing of past performance. As long as
I was the CEO of the publisher we resisted the use of the term "ratings."
To this day I believe the term ratings is an attempt to predict the future as
the various commercial credit ratings firm do. Their function, which they do
quite well, but not perfectly, is to predict the chances that interest and
principal will be paid as promised. Rates are predictors, ranks are ordinal
listers.
One
of the reasons I so resisted the rating term was I was an investor in mutual
funds for myself and a limited number of advisory clients. I learned quickly that
mere extrapolation of past trends led to unfortunate results in terms of future
performance. At times highly ranked funds in various short-term periods
repeated their high rankings in future periods. This is exactly why those who
are serious about investing in mutual funds and many other securities need
constant advice as to selection, weighting, and sale of investments.
Compounding
the utility of "ratings" is the extreme focus on expenses. While
expenses are important both as a deduction from gross performance and
as an example of the stewardship attitude of the fund's management to its shareholders, it is only a
component to proper decision making. Even a maximum expense ratio of 2% will
rarely change a bad investment into a good one by total elimination of a low
fee fund to become a good investment. Further one
should understand the continuing cost of marketing support being paid by the
fund and whether that benefits the fund holders. Many retail investors in funds
need a lot of time which translates into distribution costs before they make a
decision as to their investments. Much of this effort has to do with the time
spent on the process of changing thinking from saving to investing. As most
households in the US hold at least four or more funds, putting together the
fund portfolio takes time and effort. To the extent that the fund buyer uses an
investment advisor or a broker in that role, the cost of education is shifted
from the fund to holder directly. Perhaps the most valuable service from the
distribution channel, including investment advisors is hand holding during
periods of personal or market stress. Often timely redemptions can be more
productive than good buying in terms of investment dollars earned. From the
remaining fund holders’ point of view, any new money that comes into the fund
during periods of market stress helps them through the reduction of forced
sales at stressed prices to meet waves of redemptions.
In
their stewardship function some funds become closed to new accounts and/or new
money. While this benefits the existing holders, it is limiting the aggregate
profitability of the fund's management company. In some cases the chosen area of
investment requires a greater level of internal research than the standard
large-cap segment and this may materially cost more than standard. This element
is true for both some equity and bond funds.
Prudent
fund investing is if anything more difficult than individual securities. Good
fund investing should not be done on the basis of rankings, ratings or "by
the numbers," but by careful analysis of the data, people and market
structure. Hopefully, some day the media and regulators as well as the
distribution channels will show proper respect to the tasks of fund investors
and their supporting functions.
Who
should be credited with the record?
The
focus on press reviews shaped many otherwise smart investment professional's views as to who was responsible for the publicized record.
I was developing my skeptical nature even before I was
directly responsible for selling and managing the above mentioned Lipper Mutual
Fund Performance Analysis. At that time I was in a small institutional research
effort in a large, retail oriented brokerage firm. Because of the absence of
well trained institutional sales people, I had to sell my research to various
institutions including mutual funds. In two instances I tried to get the mutual
fund sales efforts within the firm’s large
retail branch network to change its sales efforts in terms of two well known
funds. In the first case a fund with a good record was being pushed through the
system. This happened to be a fund that I called on and knew both the portfolio
manager and some of the few analysts. The portfolio manager was good, but
actually he was a better salesman. However, he was difficult and the shop while
large was destined to be sold in pieces. One of the analysts that I knew
decided to leave and asked me about his next shop, at which many years later he
became the chief investment officer. Hopefully I was helpful to his progress.
In this case what was more important in my perceived responsibility to my firm was
that I reviewed the stocks that he was responsible for in the fund's portfolio.
I quickly realized that he was responsible for most of the successful positions
in the fund, but few if any outside the shop even knew his name. I
unsuccessfully argued with my firm that they should suspend their sales effort
on this fund. Within about a year the
fund's performance turned decidedly down. Relatively soon thereafter the
portfolio manager left and used the fund's record to sell large overseas
investors on his new firm. Too bad they did not take the time to understand as
to what created the performance.
In
a second case a well known portfolio manager left Fidelity to start his own
mutual fund organization. He did not take any of Fidelity's good analysts with
him. He picked up two journeymen analysts to join him. On the basis of a very
favorable cover story in a business magazine (whose writer eventually joined
him) he contracted with a firm to conduct underwriting of an open-end fund. My
firm was in the syndicate. I tried to explain that the manager was leaving a
well put together team like the very much respected New York Yankees. I was so
successful in my argument the firm became the second largest underwriter of the
new fund. After a very successful underwriting and follow-on sales, performance
was less than good and eventually the management company had to be merged out.
The initial fund exists today after many name changes and mergers at probably
less than 10% of its peak assets.
This
concern for understanding the record also holds true for individual companies.
In our private financial service hedge fund we rarely short stocks, but years
ago we did short one of the largest industrial companies in the world. On the
surface it had a much celebrated record. However, when one pulled apart its
financials, most of the firm's earnings progress was coming from a relatively
small revenue producing segment. The gains that were being generated came from
leveraging its fast growing loan portfolio. When I called on a number of large
but marginal companies who were growing through leveraged borrowing programs, I
found in most cases the lender at high interest rates was the same large
industrial company and no other source was readily available to make these, in
my judgment, risky loans.
However,
there is a positive side to this story. It is now relatively close to the price
we shorted the stock more than ten years ago. This is a wonderful example of
one of Wall Street's favorite investments ploys. “The Street" loves
recovery plays. Recognizing that there is not a widely consistent winner, when
the eventual disappointment sets in and pushes the price below its liquidating
value, an opportunity is created if one believes that some of the attributes
that created the good record remain. With the exception of investing for a
pension fund experiencing large benefit payments, I am not particularly
attracted to a consistent performer. I much prefer a fund where there are
logical signs of improvement in process and results. We have few potential
candidates in the recovery category that are attempting to improve their
investment process which could be good investments for our clients in the
future.
Bottom
Line
Regression
to the mean eventually overrides a "hot hand." All inputs need to
analyzed not just accepted.
Did you miss my blog last week? Click here to read.
Did someone forward you this Blog? To receive
Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed
buttons in the left column of MikeLipper.Blogspot.com
Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
Posts
