Sunday, August 27, 2017

Accurate and Misleading Measures Will Hurt Investors - Weekly Blog # 486


A cynic is described as knowing the price of everything and the value of nothing. In a society supposedly led by the intelligent there is a great tendency for the top-down thinkers to be a source of guidelines that a cynic would produce. Experts pandering the supposed short attention span of the populace produce mathematically accurate measures for comparisons to aid or direct decision making. These “experts” are found in government, media, universities, and private practices.

Three examples of this approach and their results illustrate this cynical attitude are as follows:

  • Car buying by gas mileage delivered
  • College selection by test scores and future income
  • Investment choices vs. securities indices

Car Buying

The US government in its desire to foster climate management requires auto manufacturers to place on the price stickers the estimated average gas mileage of each car being considered with the intention to lead the buyer to purchase the most fuel efficient vehicle. Early after these requirements were promulgated some of the manufacturers advertised their high number of miles per gallon. While initially there were some market share shifts in that direction, but recently the relatively low gas mileage SUV and light truck models market shares have risen dramatically.

Why didn’t the guidance work? There are two main reasons. The first is that in buying a new car the buyer is interested in other values. Many buyers either consciously or not want their purchases to say something about them either to themselves or others. This is the basis of most successful advertising. The second reason is that the number set of just city and highway driving consumption is inadequate on two levels. First, in the early years of car ownership the cost of fuel is among the smallest amount spent on the car, where normal repairs and servicing (plus in certain locations garage and insurance) are higher than gas. Second, none  of us are average in many things that we do or consume. If the data showed the range of consumption, it may become very clear that our own driving habits have a great deal to do with the results.

College Selection

For many people the single or the next most important purchase is their school education. As with any purchase it is useful to examine the transaction from both sides of the trade. From the student and/or the student’s family viewpoint early on in the decision process there is a series of statistical arrays to sort through. These include test scores, acceptance ratios, and average income expectations. Again these pinpoint numbers do not show the ranges of outcomes or even in most cases the difference between averages and medians.

I have had the privilege of sitting on two Boards of Trustees of universities that I didn’t attend. I have watched in each case the admissions staff create a model of the desired incoming class. The importance of test scores is only in the absence of other indicators. For some universities class ranking is more important combined with an overall grade point average and trend. The incoming class should augment the other students in terms of academic, sports, and social skills to produce the best universe for the school over the next few years. From their point of view, the yield of the accepted applicants to those who attend is an important measure. The odds are that an application without a visit particularly from a distant home raises the probability of attendance question. I suspect, but have no confirmation, an eye should be placed on the odds of future financial or public success of the student. In these lights, awards and work progress either for pay or organized charities is important.

In my opinion, one of the tragedies of the American college scene is the level of student debt being assumed. Too many students and their families believe just graduating from college is the ticket to a successful career. They don’t try to determine the percent of the starting class that graduates on time, the range of income earned immediately after graduation and over the working lifetime, and an all-in estimate of the costs to attend a college including a reasonable estimate of spending. A non-statistical measure that can be probed through interviews is whether the prospective college student is ready for this level of commitment and responsibility. As with many things in life, the selection of schools should not be solely or perhaps even importantly, a “by the numbers” exercise.

Investment Choices

Making investment choices can be intellectually and emotionally difficult. No wonder many people including professional investors seek quick, simple decision tools. Often they are serviced by media or salespeople that have been trained under the mantra of “keep it simple, stupid.” While the summation of a planned course of action can, and often should be, transmitted simply, most simple thinking is simply wrong. Any one sided decision that does not consider both the rewards and the risks of each decision is unwise.

The most grievous mistake is to make a comparison of two unequal subjects.  Securities indices were developed as a sales method to describe the movement of a market as if it was a single force, not a collection of many. Pooled investment vehicles, including mutual funds, are more than a collection of individual securities. Mutual funds are a legal entity that are required to follow specific federal and state regulations. Funds have expenses involved with gathering and redeeming assets, expenses of managing assets, including transaction costs. In may cases, through some marketing activity the ability is provided to discuss immediate concerns of an investor that is troubled due to personal or market concerns. Historically, a wise steadying hand has prevented many investors from selling out at the bottom. None of these functions and constraints are on the publisher of indices. (I was one a number of years ago.)

Recently, I have noticed a number of brokerage houses and other wealth management organizations are attempting to hire qualified analysts in their fund selection efforts. I wish them well as that is part of the process of what we do. It is not easy once you no longer rely solely on “The Big Mo” or momentum as spoken by a former US President. One of the great dangers of following momentum is that it can’t go on forever in recognition that once everyone is dancing to the same tune, there will be no new followers. Momentum often ends abruptly with sharp reversals.

Fund selectors should be focusing first on comparisons with other mutual funds that are actually doing what the fund under scrutiny does, also other funds that could do those things but don’t. As someone who learned basic analysis at the racetrack, in every decision there are odds that one can be wrong. Each manager, active or passive could be wrong. The critical skill set is mixing funds with different potential risks into a portfolio that on average can sustain it itself under varying circumstances.


In each of the three decisions discussed the single most critical variable is the individual involved. How you drive will determine your gas mileage and satisfaction with your car. The student will for the most part determine his/her success at college and beyond. The owner of the securities or funds will be the biggest single determinator of the investment. In addition the people that manage the funds will drive their investment vehicle within the range of available choices and they are more important than their records.    
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Sunday, August 20, 2017

Labels Poorly Reported and Understood Could Hurt Performance - Weekly Blog # 485


Most brains require some semblance of order often to make judgments. The first thing we do when we are exposed to a set of conditions or facts is to compare it to others in our memory banks. Our memories are in effect filing systems based on some preordained classification system which are labeled internally. Because we prefer fast, if not instant, decisions, we use labels as the main filters to evaluate the new set of facts or conditions.

In most cases we pay little attention to the labeled comparator. We don’t know who and why the label was created. We don’t know the boundaries to the classification, we don’t know the sorting process used to create the universe within the classification, we don’t know the range within the label and the correlations and dispersions within the classifications that serve as labels. Perhaps most importantly we aren’t familiar with who makes the decisions in including or excluding components  and their profit motivations.

What I believe are faulty conclusions due to labeling and their comparisons are found in a number of topics which we read about as highlighted below:

Mutual Funds and Other Portfolios

Often portfolios are compared on the basis of their investment objectives no matter where their geographical focus is. Each week I look at the results published by my old firm. They break the universe of SEC registered mutual funds and their performance into close to 100 different investment objectives. In numerous cases they use the same generic investment objective names for largely domestically oriented funds, global funds and international funds. Global funds have to have some significant portion devoted to the US as well as other legal domiciles and  international funds don’t invest in the US.

Comparing Large-Cap Growth Funds average performance does appear to be similar in their results year-to-date through August 17th; Domestic +17.41%, Global +17.24% and International +18.10%. This makes sense as almost all Large-Cap companies around the world are multinationals  and are used by large financial institutions in both their home and foreign markets.  Most differences in performance can be attributed to the way the managers address the fluctuating value of the dollar as reported to dollar based investors.

Quite a different set of conclusions should be derived when reviewing Multi-Cap Core funds. These are typically equity oriented funds that can invest without constraints, often called “Go-Anywhere Funds.” The domestic version average was +7.76%, Global +12.44% and International +16.29%. When a change in geographical focus of companies’ legal domiciles leads to an international performance double the domestic average, the different opportunity set results suggest a faulty comparison under the banner of Multi-Cap Core.

Comparisons within industrial sectors can be even more skewed. While both are losing money this year through last Thursday, the domestic oriented Natural Resources funds on average were down -20.34% and the global natural resource funds only -5.90%. As global commodity prices are not that geographically sensitive and are usually priced in US Dollars, the difference appears to be in the opportunity set.

A similar but positive performance spread can be seen in the average Financial Services fund. The domestic oriented funds on average gained +3.30% whereas the Global Financial Services funds averaged +12.96%. The difference may be due to the level and direction of interest rates and possibly changing regulations. (More on this below.)

Is it any wonder that for some time when US mutual fund investors have completed their needs for domestic funding of their objectives that a portion of them have been investing beyond their borders? They got it right whereas those that lumped narrowly defined investment objectives based on where their legal domiciles are, got it wrong and are misleading themselves and some of their investors as to where the current action is.

Fixed Income Returns

I among others, but not the average mutual fund investor have had an overly cautious attitude toward fixed income funds. Using the same data source as used for equity funds, I failed to appreciate that there are seven different fixed income objectives with average gains in the 4% level, and five above 4%, with total return gains from +5.66% up to +11.70% for Emerging Market Local Currency Debt Funds. On an annualized basis alone currently these funds meet most pension funds’ payout requirements. Things are better than they seem.

Stock Comparisons

We have been barraged by stories as to the FANG (Facebook, Apple, Netflix, and Google/Alphabet as well as Amazon) stocks have been driving the S&P 500 performance with their gains. Few except Kopin Tan in Barron’s mention that a Chinese quartet labeled JBAT (, Bandung, Alibaba, and Tencent) are up more than double the leaders in the US. While there are great global companies in the US included in the FANG cluster, what is happening is a global phenomenon with some leaders outside the US growing faster. What this suggests is that if we want to invest in leaders we need to look beyond the constraints as to where a company’s corporate headquarters is, where it was incorporated, or even the stock exchange that is its main market.

Government Analysis

Part of the reason seasoned politicians around the world have been wrong on their expectations of what voters will do I suspect is the combination of inaccurate data, but more importantly wrong or meaningless classifications. Due to the short attention span of people within and beyond the political sphere, labels become short-cuts that can mislead. For example, as pointed out by the talented Randall Forsyth in Barron’s, the current US Administration is quite accomplished in getting to its goals. Each new or changed federal regulation needs to be recorded in the Federal Register. On an annualized basis the current Administration is responsible for 61,330 pages, whereas the former Administration in 2016 produced 97,000 pages. Not the 2 for 1 promised but a good start. The media has spent all its time on the legislative action, whereas both the current and former Administrations ruled primarily by executive actions. Thus the comparisons with legislative actions alone are misleading.

Question of the Week:

What other labels and classifications do you think are misleading to sound investment decisions?
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Sunday, August 13, 2017

Managing for the Next Decline - Weekly Blog # 484


In order to ease indexing, I have added the blog sequence number to my weekly posts.


All life is cyclical going from good periods to poorer periods. No one has repeatedly been able to predict the tops and bottoms on a regular basis. Unlike actuaries, those who learn the basis of analysis at the racetrack assume that they will be wrong some of the time. There are two keys to investor survival, the first is to be selective in which races to bet on. The second is to change the levels of the bet based on both the intensity of the conviction and to a lesser degree the need to preserve some wealth. At least this is how I look at the markets and manage the money for which I am responsible.

Any survey of known history identifies periods of rising and falling prices as human emotions react to changes in perceived conditions. From a portfolio management perspective, to me the odds favor a meaningful decline between now and probably the time of the next US Presidential election. The decline will be measured in terms of prices of securities and/or general economic data; e.g., Gross Domestic Product (GDP). There have been times when individual markets or economies have fallen and occasionally both at roughly the same time.

The problem is that few investors have had a good record of timing these declines. My life-long study of mutual fund performance suggests that winners in a particular phase who raise a lot of cash on the downslope are not very successful at recommitting the cash on the way up and often over long periods of time underperform those that accept the pains of declines, but in general remain largely fully invested in equities and especially in well managed equity funds. This is less true in bonds and commodities.

To attempt to answer the questions as to selectivity, weighting, timing, and turnover, I have developed the concept of Timespan investing. Thus, today I look at the future through the filters of at least four different Timespan Portfolios.

Short-Term Operational Portfolios

At the moment these are the most price sensitive portfolios because these have near-term payment responsibilities. For some non-profit institutions and active families the next several years can be particularly stressful. Not only that the odds favor some price disruptions in most securities and commodities markets, but there are the new imponderables of net federal and state tax payments. At the very same time as we may be experiencing a cyclical decline, calling for more contributions to those who are suffering, but a high likelihood that those of wealth will be paying more taxes as forgone taxable deductions will have greater impact than a decline in federal tax rates. In addition, in many states and local communities taxes will go up to fill some of the smaller grants from the federal government.

Often these short-term portfolios are made up of income-producing securities. As corporations see new opportunities to profitably invest in capital expenditures (even as they may reduce buy-backs) the rate of dividend increases may slow. Depending on the depth of the decline, markets may fear that there will be reductions in some dividends.

To balance the stock risks in these portfolios often a significant part of the money is invested in a variety of credit instruments. Historically the prices of these instruments did not move much. There is however a good chance that some of these will become much more volatile. Over the last couple of years many institutional investors with a primary background in stocks have offered to their clients new Credit funds. (In some cases to improve their yields these portfolios are leveraged with borrowed money.) One might be concerned with the impacts of a rumor on the credit worthiness of any of these instruments creating volatile prices which will surprise some holders.

To those that are funding some non-profits and/or family spending, they may be caught in a squeeze as inflation rises. I tend not to give too much credence to government produced inflation figures. For those who have borrowed on the doubling of LIBOR levels in the last year as it moves closer to the mythical 2%, it could be driving costs up for some people. Interestingly there is a real dichotomy on savings rates offered by institutions who are paying LIBOR or higher rates, while the average money market deposit rate has dropped to 0.29%.

Limits on Upside Removed

Now that the price gaps have been filled in by the recent declines, the limitation on further price appreciation has been probably eliminated. This elimination does not guaranty gains, it is just more likely to occur than recently.

Bottom line: shorter-term portfolios will require more than custodial attention.

Intermediate or Replenishment Portfolios

These are the portfolios that are meant to replenish the operating portfolio’s payments. The duration of these portfolios should be tied to the internal policies of the account. One guide may be the period that the chair of the company or investment committee is likely to be in place. From a stock market vantage point it would be wise to consider that the period should include an expected market cycle.

As I have worked with funds advising on incentive compensation, I have favored four to seven years to set the target period of a portfolio manager’s performance pay. I am particularly concerned about the use of three-year periods, because they can be one directional and not show important elements of a full cycle. Over the last fifty years in the US 37% of the time there has been a down quarter which means 63% of the time the stock market has risen and therefore there is no institution-wide experience in down markets. This may be of real significance today as there has been only 15% of the quarters in decline since the first quarter of 2007. We could well see a major rise in down quarters to bring the current 15% closer to the historical rate of 63%.

Portfolios often own both growth and cyclical stocks. Almost all companies are affected by the cyclicality of the economy and various segments. If one could count on the bouncing ball type of behavior of a cyclical market to come back to prior levels, a buy and hold strategy would work fine. This is particularly true if the dividend is maintained through the cycle. However, in some cases former performance is not repeated. For example investments in telephone companies largely dependent on physical long lines in the age of the internet are unlikely to reach their old levels of profitability. For years there has been the substitution of aluminum and plastics for steel in cars and trucks which suggests that despite what happens on the tariff front it is unlikely that many steel companies will return to their old levels of profitability and employment.

Bond Downgrades, Reality or Rumor

Without signs of great enthusiasm for stocks, any cyclicality is likely to be limited to a decline in the twenty percent range which is a difficult arena to successfully raise cash and redeploy fast enough to beat many buy and hold quality stocks. This is not true on the bond side as there has been too much money coming into the bond markets at current prices and yields. At some point rising interest rates will drive bond prices down. It is quite possible some of those who purchased their positions with leverage will be forced to sell out into an illiquid market. A credit rating drop from investment grade BAA down two levels to B increases the expected default rates for maturities of five years from 1.67% to 22.06%, In other words the rumor or the fact of downgrade could raise the possibility of losing over one-fifth of the par value of the bond.

Long-Term Aspects of the Endowment Portfolio

Our Endowment portfolio is meant to fund the expected needs of those currently alive and thus expected to live through numerous cycles. Quite properly long-term investors should be concerned about a major market decline. In the past approximately once a generation there have been a period, usually quite short, of a 50% decline. All investors at all times should be on the lookout for the bubbles that lead to theses declines. Bubbles are created by human nature when greed relegates fear to a forgotten corner of the mind. Those of us who dwell in the world of numbers will often be very premature, that is wrong, in spotting bubbles through the use of market or economic statistics. The more useful guide is to listen to the level of enthusiasm both the professionals and the public express. Some of the attributes of past bubbles are as follows:

- A new discovery that is expected to bring wealth to many.
- Apparent liquid markets, often one-sided in reality.
- Easy and cheap credit.

At the moment in terms of stocks I don’t yet see signs of a bubble which means that long-term endowment accounts should stay reasonably well invested in stocks now.

Legacy Portfolio Items

Periodically equity market prices are focused predominately on near term results which are often troubled. At the very same time these enterprises are developing not just the products and services that will be in great demand in the future, but more importantly a cadre of managers that can bring a lot of the potential to fruition. To an important degree it is like looking at young racehorses who are expected not only to have winning records but to be successful breeders. Not easy to find, but worthwhile. Currently perhaps the best returns in these searches may be found in frontier and emerging market investing. All of these opportunities will experience some turmoil during their development. One needs very skilled analysts and portfolio managers to find these opportunities and enough patience to hold them.


What are you going to do in the next decline?
Have you been able to identify desirable Legacy investments?
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