Monday, December 26, 2016

Will ETFs (Factor Investing) Lose Popularity: Scientific Revolutions and Humility


Contrarians should always be looking for what is not present or expected. Exchange Traded Products or Funds are modern applications of traditional analytical screens. The established, top-down approach to selecting what to research in order to achieve investment success is a five step process:

1.   Economic/Political Overlay to Market Belief
2.   Segment Identification
3.   Security Selection
4.   Trading Requirements
5.   Timing of Purchase and Probable Sale

ETFs invest entirely in a segment. This can be a narrow segment such as an industry or a broad segment such as the components of a stock or bond index. Importantly, there is little to no additional cash to meet withdrawals or to provide flexibility. Components are selected by rigid prescribed rules.

The big advantage to this type of investing is that for many investment advisors, traders, and individual investors who believe them to be sophisticated, the choice is simple and takes far less time than what we do in a multi-step selection process. The brevity and decision speed makes these products attractive to individuals and organizations that can instead spend their time raising money or other worthwhile activities. In a number of global markets (largely stock markets), the gross inflows into these products is in the same range as the traditional long-only mutual funds. (Not all the purchases of ETFs are intended as a single, long-term investment. I believe a good bit of the reported net flow volume comes from trading elements as part of a complex strategy of being long or short other instruments, using ETFs as a hedging device.) 

With rare exception the use of ETFs has proven worthwhile as long as the various brokers and investment advisors’ selection, weighting of portfolios and timing has been reasonably good. I suspect that this has not universally been the case.

Real World Selection Processes

Many of us are happy with our marriage and other partners. Most of us are choosing to live in homes that were not selected solely by statistics. In many cases throughout our business careers we did not always pick the highest compensation offered. In each of these critically important choices either consciously or subconsciously we used a multi-step decision tree not too different to the five steps outlined above. I prefer to think that a multiple step process would lead to a more comfortable result than just buying the S&P500 Index fund, Financial Services fund, or a Single Country Developing Market fund.

Natural Law and Scientific Revolution

Over the Christmas holiday I had a deep discussion with our long-term family friend Mark Massa, SJ. This Jesuit Priest is working on a new book that is focused on the development of natural law relative to the evolution of scientific revolutions. Because I am a non-alumni trustee of Caltech, he asked me to read a section of the book which discusses Thomas Kuhn, an historian of science in a best seller, "The Structure of Scientific Revolutions."  Remembering discussions in my ancient school as well as Caltech about how “The Scientific Method” really worked, with most of the gains coming from "mistakes," I became sympathetic to Professor Kuhn's work. Normal science appears to rest on an agreement reached by a majority of scientists of a particular discipline, while the majority agrees there were always some contrarians. Instead of nice neat solutions, there were always some parts of the physical universe that were out of place in the picture painted by the accepted scientific law. These laws were meant to be universally predictive. Exceptions inevitably appeared so that the once the unthinkable  suddenly became thinkable.

Past Performance is Not Predictive 

While I made a reasonable living being the guardian of mutual fund performance records, I totally believed that past performance was not totally predictive of future results. Yet those advocating the use of constrained exchange traded portfolios are relying almost exclusively on their past records. To me the construction of market indices, (I created many) is a backward looking device. Most of these vehicles were created by publishers not active portfolio managers. Further, based on technological and legal/accounting evolution, narrow industry definitions change. I remember when analyzing steel companies, the steel company in Chicago was worth more than those in Pennsylvania, as Chicago was in a steel deficit region. Due to the cost of transportation, the Chicago steel producer could get premium prices and margins. Over time that advantage disappeared. Often just looking at financial statements one would miss a critical change such as at one point the profitability of color television tubes was the key to the profitability of TV set manufacturers.

Possible changes to the deductibility of expenses and different levels of tariffs, bring into question the predictability based on the past. In some cases, changes of reported earnings could be substantial because of changes in accounting and court settlements. An investment advisor who does not consider these and other changes is not only putting his client in a potentially risky situation, but also possibly his or his/her company's practice.

How Little We Know

In addition to the normal cautions about survivability, is the less mentioned historic truism: that the only guaranteed product of investment is humility.  Marathon Global Investment Review has a useful quote from Daniel Kahneman, "We have very little idea of how little we know." One of my concerns for high reliance on the use of ETFs is that there is no built-in flexibility to be able to change the portfolio. Actually the only thing that I promise my accounts is that I will make mistakes, but hopefully recognize them quickly and begin corrective actions soon.

Too Much of a Good Thing
I worry about “too much of good thing.” The current level of market enthusiasm is too high and suggests very little can go wrong. Many professionals have been trained to view the VIX measure from the CBOE as a fear gauge. The peak reading was 80, and averages about 20, and on December 22nd it dropped to about half of the average. Just on general principle, when others are not worried, I am concerned.

To my readers, their friends and family, I wish a Merry Christmas and a Happy New Year.  This next year may prove to be quite different from what we have experienced.

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Sunday, December 18, 2016

Short and Long-Term Unseen Implications


Being solely a contrarian is insufficient to be a competitive investor. There are instances when the majority is correct. To improve the contrarian's odds the search for seeing elements that others don't is essential.

Since the presidential election there has been a dramatic blast of enthusiasm for US stocks and a disdain for high quality bonds and emerging market securities. While the positive effects of rising interest rates have been present for a number of months, the equity acceleration began almost immediately after the election. One might be accurate in believing that all those who were so wrong about the outcome of the elections at every level were attempting to play catch-up by doubling down their bets. In both cases their views were narrow and lacked fundamental knowledge.

Early Contrarian Training

In the 1960s I was a journeyman electronics analyst. The technology to produce color television had been known since the 1940s if not before, but the projected retail cost for a set was over $1000. My analyst peers focused their time on getting up to date on all the technological advances in components for the set. Unlike them I spent time with the marketing research people of the major set producers. In turn, they were very focused on how middle market consumers were spending their money. By the mid to late 1960s, the portion of consumers’ budget devoted to auto purchases had peaked as the post WWII replacement surge had peaked.  Thus they were ready to buy their first color television at prices over $600, and some up to $1000. That perception allowed me to be early in recommending color set producers and some of their component suppliers before my more technologically-oriented competitors were waiting on new breakthroughs.

There are Two Important Elements the Enthusiasts are Missing

The people that were so wrong about the Republican surge in the election are making the same mistake again. They are taking what Donald Trump has been saying as a concrete plan for his and the party's actions, just as they misread the polls for two generations wanting an outsider to have someone to listen to them. It didn't matter whether they were on the right or the left of the political spectrum. To some extent Mr. Trump's fellow elected Republicans have not fully accepted the implications of the recent elections.

The issues for the Republicans comes down to how they will vote and how will they manage their attempts to "drain the swamp." I believe (somewhat naïvely) that the investment bulls believed explicitly in the words of the candidate and President-elect in terms of both corporate and personal taxes. One needs to remember how tax proposals become laws and regulations. The House Ways & Means committee, after what will be strenuous debate, will eventually report out a bill to the full House where there will be further debate.

Any reductions in the net tax realization of revenues will increase the size of the deficit unless one accepts dynamic scoring that suggests that tax reduction will expand tax revenues through growth. The political problem facing the Administration's desires is in the House where there are a significant number of Republican deficit hawks who probably feel that they can not get re-elected if they vote in favor of an increased deficit. It is quite possible before a tax bill can pass the full house some Democrats will need to be in favor of it. Traditionally this support is purchased with some very specific policies favored by the Democrats which the Administration would have to signal approval. Subsequently the Senate will pass it's own bill setting up a joint congressional committee to work out the differences so that both Houses can approve the legislation. Both houses' majority leaderships will appoint members to the conference committee from both parties. These will likely be their most senior tax aware members. Eventually a compromise bill will be agreed to in the small hours in the morning between as few two members and a small number of their staffs. Due to their exhaustion and some lack of familiarity of the wording of tax regulations, the committee will get help from selected lobbyists from the deepest part of the swamp  will suggest the actual language to be used.

At this point hopefully the majorities in both houses will vote to pass the tax bills on to the President for enactment. For the investment bulls to believe that they can guess both the timing and the actual impact of the legislation on specific corporations and individuals is naïve. 

In many ways the easiest part of the governing process will be the passed legislation. Particularly for the incoming Republican cabinet the much more difficult process will be the actual administration of the ensuing regulations that the multi-generational government workers will write and administer. Just look at how almost every government body is actually managed by career people from "the swamp." Good luck without substantial help from "K Street" lobbyists to guess the actual implications for various taxpayers.

The chattering classes are assuming that by a swipe of the pen the President can in the long run effectively change regulations through executive action. Regulations were initially put into place because of perceived problems; some valid problems will need to be addressed for the protection of certain groups. The tradition in government is that even when totally free market people are put in place they will drift to the bureaucratic tendencies of command and control policies. In all likelihood those that will be actually administering the regulations at the local level will believe in the command and control philosophies.

The Second Misreading

The general rise in stock prices in many markets is being taken as the public' s affirmation of the results of the election. I believe that far too many people are not looking carefully at the underlying data and drawing, at the moment, the wrong conclusions. Most of those that wanted to be labeled "the smart money" were totally convinced that the US would have its first female president. Recognizing that probably meant at best a continuation of slow growth in a market that was close to being fully priced on election eve. They were short the market or  at least a number of stocks. When they woke Wednesday morning these "investors" became traders and quickly attempted to cover their shorts in a relatively thin market at higher prices. Soon thereafter to make up for their losses they went long the stock market and short the bond market.

The faulty analysis of the US stock market, at least in part, was due to the headlines that mutual funds received substantial inflows and therefore would be heavy buyers. As usual people should carefully examine the underlying data. The quoted numbers combined traditional mutual funds with Exchange Traded Funds (ETFs). Utilizing the data from my old firm, one could see that for the month of November traditional US Diversified Equity funds had net redemptions of $+38.6 Billion  up from $+22.3 Billion in October. On the other hand for the same types of equity portfolios,  ETFs had net sales of $+33.2 Billion up from $+11.2 Billion on October. Perhaps, even more significant ETFs investing in specific sectors had net inflows of $+13.4 Billion up from net outflows in October of $-1.3 Billion.  

The significance of these divergent trend is that due to the length of time many traditional mutual fund holders have owned their funds they are approaching a period of their lives that are choosing to either becoming more conceived conservative with their money and/or their need for cash has been rising. Judging by the volatility of ETFs transactions most of the transactions are from trading entities often hedge funds or professional traders. Some of their transactions are part of "pair" trades where they take a position long or short on a specific issue, but also hedge either general market or a sector against their primary choice to reduce general market risk. Thus, the main motivations of the owners of traditional mutual funds and ETFs are in terms of likely timespans of their holdings are different. Mutual fund holders own their shares for more than four years, often for twenty, where as the ETF holder is probably focused on the month's or quarter's performance.

Thus, I do not believe that there is a general affirmation of the policies of the incoming administration at this point.

Short Term Views

It is quite possible that this last week was something of a mild turning point in the market. Each week I look at the mutual fund performance of our clients' fund positions. I compare their quintile rankings versus their perceived peers. In most periods for most funds there is relatively little movement. However, among the many funds we follow, in this week, eleven of our funds (after doing among the best in the four weeks ending December 8th) did relatively poorly in the week ending on the 15th. On the other hand we had four funds that materially beat their four week average. What this pattern suggests is not that there were materially changes in the funds' portfolios, but that the market is questioning the very recent strength.

In a piece on the views of ten well-known investment strategists picking their favored industrial segments, eight picked financials which clearly have been doing well. As a portfolio manager of a private financial services fund, this near unanimity of opinion makes me nervous. Bob Farrell, one of the all time great market analysts was quoted in Barron’s saying, “When all the experts agree, something else is going to happen.”

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Sunday, December 11, 2016

Investing via Imperfections

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
  • Who owns the record 

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.

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Contact author for limited redistribution permission.