Concentrate or Diversify, 2 Questions with 3 Answers - Weekly Blog # 594

Mike Lipper’s Monday Morning Musings

Concentrate or Diversify, 2 Questions with 3 Answers

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

I have been asked to respond to two intellectual investment questions that parallel real word actions. The first question comes from a long-term subscriber of these blogs. The second comes from my preparatory work for a potential investment management client.

1. European Portfolio Manager response to Sub-Zero Interest Rates?
2. Appropriate Structure for a Long-Term Charitable Account?

In my mind both questions revolve around the same risk management question. Is it better to concentrate one’s assets and energy or spread the risk by diversifying? Too often investment people view their problems as special and quite separate from the real-world problems of others. We do this at the risk of not seeing the universality of problems.

Perpetuation of the family/species is at the core of human and animal creation. Due to potential violence, insufficient food, and medical risks, some produce multiple offspring with the hope that some will survive. Others choose to produce a limited number of descendants and protect them carefully. This is the very same quandary that investors face, particularly those with responsibly for others.

One approach to a decision process with two alternatives is to create a barbell type solution by combining the two extremes of diversification and concentration. To be prudent we should not use this barbell decision model. The third element to consider is the presence of other factors, which often determines the appropriate decision.

Reactions to Negative Interest Rates
On the surface, paying a financial institution for the privilege of letting them hold your money, which they then lend out without sharing the proceeds with you, appears to violate Newton’s laws of physics. It suggests a collapsing universe rather than an expanding one, raising the question of why an investor would contribute to such a scam?

Jim Grant, one of the best columnists on fixed income, called for the end of the 38-year bond bull market in this week’s Barron’s. In his column he quoted from a 1981 article by Parker Hall, a deceased but old friend who heralded the beginnings of the bond bull market. Today’s question is somewhat more complex than just betting on a cyclical turnaround in bond prices. It has been made more complicated by the policy dictates of various governments for political purposes. Although interest rates are expressed in their local currency, e.g. euros, they are compared to rates in other currencies and are exposed to different inflation rates. Governments, officially or unofficially, direct their central banks to induce low interest rates to create and preserve jobs, often through problematic loans which create additional market distortions.

Most large fixed income portfolios are managed through or for the political establishment, making it difficult for many managers in Europe to meaningfully exit from negative interest rate paper. However, I am seeing some increased diversification into both high-quality corporate bonds and very long-term government bonds, including century bonds. The latter is interesting in that they’re betting they can, over the long-term of possibly 100 years, reinvest the low yielding coupons at higher expected interest rates. (It is worth noting that the biggest return in long-term bond investing is through the reinvestment of payments at current rates).

If European fixed income managers can get out of the euro they generally will, often by buying US paper. Most cannot and are therefore effectively corralled into the euro and forced to extend their maturities. However, there is a limit as to how much they can lengthen their maturity structure, as many portfolios are designed to pay pension benefits. In most European countries the retirement ages are lower than in the US, thereby limiting maturity elongations.

Portfolio Structure for a Charitable Investment Account
The payout needs for any account requires current cash to make payments. There are two main ways to achieve this. The traditional way is to let the gross income earned on the entire account make the required payments, but due to market price fluctuations the available cash will fluctuate. To the extent that current income is insufficient, proceeds from sales can supplement the cash generated from dividend and interest payments.

We are advocates of another approach which divides expected payment responsibilities into specific timespan portfolio sub-accounts. The most current timespan portfolio should generate the funding necessary to make required payments. This portfolio could be structured in a way where cash or short-term investments satisfy the payment obligations before being replaced with the next timespan tranche. The advantage of this approach is that it makes certain that current bills are paid, regardless of market volatility. It also allows the rest of the portfolio to be invested for longer term horizons.

Charities, even private ones, are fiduciary accounts that are distinct from personal accounts. No one must know how well or poorly one’s personal account performs. Most fiduciary accounts make reports as to the success of their investment program from time to time and the frequency of this reporting can influence how a portfolio is managed. Financial markets are by their nature volatile. Over very long periods a fully invested portfolio of reasonably selected securities or funds should produce a higher return than a portfolio that has frequent changes.

To some degree, in dealing with fiduciaries it is more difficult to manage their expectations than manage the performance of the funds and/or securities. Using a rough rule of thumb, the potential peak to bottom declines are as follows:

     A 10% decline - Three times in a ten-year period
     A 25% decline - Some time over a ten-year period
     A 50% decline - Once in a generation of approximately 25 years

Many investors do not achieve the general returns available in the market because of timing their moves in and out of the market.

Diversification reduces specific risks of individual securities. However, it also reduces the opportunity for doing much better or worse than the market average. Over an extended time period, wise concentration in a small number of choices produces the highest returns, but the results can be volatile.

Pulling these thoughts together the following structure may be appropriate for a charitable account, assuming a ten-year horizon:

     10% in Money Market funds and short-term US Treasuries
     40% in growth funds of various sizes, most in mid/small-cap funds
     30% in international funds, with 2/3rds in Asia
     20% in value funds

The selection of individual funds will be guided by risk tolerance, size of the account, operating procedures, and special factors. The higher the risk tolerance the greater the commitment to a concentrated portfolio of funds.

If you need help in constructing or reviewing your portfolio, please contact me.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/09/excess-capital-less-equity.html

https://mikelipper.blogspot.com/2019/08/an-awkward-moment-with-frustration-not.html



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Contrarian Experiences Suggest Worries

Introduction

As we are in the early stages of an indefinite expansion, the self imposed function of a contrarian is to question the primary trend.  As a contrarian I was not surprised by the Brexit and Trump votes.  If you look carefully at the polling data and understood the customers for the data, you could have joined me in these contrarian views.

My worries can be addressed in the context of the TIMESPAN L Portfolios^® by allocating them into several time slots where they may have the most impact. All of the worries question Mae West's statement that "Too Much of Something Can Be Wonderful" as applied to investing, particularly long-term investing.

Operational Portfolio Time Frame

Using The Economist's table of national market stock price indicators for the week ending Wednesday 31 of 44 rose. More significantly 20 out of 23 economic leading country markets rose including US, China, and most of Western Europe. In this type of market environment far too many buy orders are "at the market" or are price insensitive. Thus, to some extent some current market valuations are being driven by an unusual amount of sentiment and are not particularly price sensitive. This surge could be driven more by retail buyers than institutions. On Friday the Dow Jones Industrial Average went to a new closing high of 18,847.66. The more institutionally followed S&P 500 and the NASDAQ did not. There may well be one or a few days of delay before the other two indices confirm the record high of the media's favorite indicator.

Clearly for most, the enthusiasm for stocks was due to the surprising to most sweep of the Republicans in terms of the Presidency, the Senate, the House, and a number of governors and state houses. In theory this means with a single party dominance, legislation action will be quite rapid. Large majorities tend to give some rebellious members license to be obstreperous as party discipline will be less powerful. Our history going back to when the Democrats had a roughly similar condition is that the ruling party can not deliver on all of its main elements, it will be blamed for their lack of control and the long cycle of "throw the rascals out" will begin. As I suggested today to a Democratic friend, (I do have some) if you can't win big the next best thing to do is to lose big, and that could have just happened.

From a short-term standpoint the market could be exposed to some sudden unpleasant surprises. A trading desk mentality is warranted. If you don't have exposure to a powerful trading desk be more price sensitive than normal. Limit orders are useful, the worst that happens is that one does not get an execution. (Which can be more beneficial than filling an order at too high a price.) I suspect many of the buyers are closing out short positions. When they have completed their covering operation that source of demand will have dried up.

Replenishment Portfolio Time Span

This total return portfolio is designed to fund the next edition of the spent out Operational Portfolio. At the moment I have three principal worries over the next five or so years.

1.  A generational long bond bull market is over where astute bond holders may have made more money through price appreciation than through receiving interest payments. The discredited central banks will no longer manipulate low interest rates and expanding economies will be using much more credit than previously. The increase in the demand for money will push its cost up and therefore interest rates will go up. Thus instead of getting capital appreciation for owning bonds they will get capital depreciation absolutely until maturity and real at maturity in terms of spending power.

Most replenishment type portfolios, whether they call them that or not are collections of stocks and bonds. Where bonds were meant to provide both income and capital stability if not appreciation, over the next five years bonds they are likely to be a depressing input. This concern is highlighted this week with US based TIPS funds attracting the second biggest inflow on record at the very same time as High Yield ETFs saw redemptions. The mutual fund business is global. In just about every market bond funds have attracted significant sales whereas equity funds have been in redemptions. I suspect that the intermediaries that sold the bond funds will see an opportunity for another transaction, selling the bond fund and buying the stock fund. If this happened in extraordinary volume the prices of bonds, if they can be traded will drop significantly.

2.  To fill the demand for loans there has been a sharp increase in the number of credit funds and other types of non-bank financial institutions. These are not policed the same way banks are. Years ago I sat through a course for bank examiners. One of the lessons from the course was the examiners were cautioned to look hard at banks growing their loan books too fast, outrunning some of their credit ratios and their staffs of seasoned underwriters. While I have no information as to various non-bank credit granting institutions, I am under the impression that many are growing faster than the banks and the newer ones may be competing for customers with more favorable terms. Most of the time this can be dangerous, but now or soon it could be particularly dangerous as interest rates move up, a lot of unsound loans could be unable to be rolled over during the replenishment portfolio period.

3.  A good bit of the enthusiasm for the new Administration is based on the repatriation of  US companies’ overseas earnings. Based on past experiences this money will be used for increased dividends and buybacks of voting common stock. In the near-term this is positive, but does nothing for longer or even intermediate-term holders. Worse, a management that is focused on its short-term stock price may pass up sound opportunities to invest overseas in markets that in the long run are likely grow faster than the US market.

Endowment Portfolio Time Span Input

Are we currently suffering from a cyclical or structurally slow period is the question for the investors trying to manage future payments for periods that their current investment committee or investment officer is functioning. Clearly most of the developed world including the US is going through a flat or sub-normal growth period. Some of this may be caused by central banks and various government regulations and taxation. Through the political system we can be hopeful that many of these issues will be addressed. Because policies go in cycles I believe these are cyclical factors that suggest that endowment management needs to wisely make changes periodically. However, these switches do not address the current reality of structural problems.

Throughout the developed world labor and therefore capital productivity is low by historical standards. One of the main culprits is demography. Birth rates are low and declining in many societies, but at least in the US people are working longer. Currently the growth rate in the population that is working between the ages of 16 to 55 is equal to the number of people over 55 that is working. As one of those I would say that shows that there is some value to experience and work ethics. I am very conscious of the benefits that my brother and I, depression babies, received when we entered the investment community. Very few young people entered the financial community from the 1940s-1955. When we entered we had a few senior elders in the field who were psychologically recovering from the depression and very little in the way of middle management. Our progress at a relatively young age was rapid and remarkable. Today's youths have too many of us still in the picture and because of the advances of medical science, we are likely to stay involved.

A very important part of the political upheaval caused by Brexit and the Trump victories has to do with immigration. The odds are if the developed world had more good, competent, workers we would see our national productivity numbers rise. The more difficult set of questions revolves around how to pay for their training and placement in productive locations. This is a societal issue that won't be quickly solved, but without it being successfully addressed our long-term rates of return on Endowment assets are likely to be below historic norms at the very same time we are living longer.

Legacy Portfolio Inputs

In some ways this is the easiest as well as the hardest portfolio to manage. It is easy as we won't be around to see whether it works and thus avoid whatever criticism that is directed at it. At the same time it is hardest, for by definition we must deal with the future and that is predictably unpredictable. Nevertheless, for those who take on this responsibility for grandchildren and great grandchildren and beyond, the best thing we can do is to lay out some useful principles.

At the heart of the dilemma is who do we trust to use the right instruments. In some ways it is dealing with the risk and reward questions that we already must deal. Almost all of the advise that is around today assumes an investment in a liquid portfolio which can periodically be readdressed to handle market turmoil. An incomplete study of great wealth indicated that once it is converted into portfolios, short-term and personal concerns reduce the size and power of the family's wealth perhaps over many generations.

Another study of great wealth is based on great entrepreneurs. These ladies and gentlemen typically have a keen understanding of a particular market niche and with high energy plus some inspiration develop a needed product or service. Then comes the much more difficult task of building a sustainable company, very few succeed beyond the third generation.

I believe a wise legacy portfolio should be invested in securities and operating businesses and have different managers for the portfolio investments and the operating business opportunities. Because I can not predict the future I am searching for the right mixture and right managers for some institutional and personal accounts. But times are changing and one should anticipate some of these changes, and that is really our legacy.

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A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.