The Bill Gross Effect and the Need for Other Negative Indicators

Introduction

The huge amount of press covering Bill Gross’s changes of investment house was a wonderful occasion of misdirection. The day of the announcement I reviewed the average performance of ninety-six fund investment objectives for the week. Of the long-term taxable fund investment objective categories, only two were positive. The two that had plus signs in front of their weekly performance were Dedicated Short Bias Funds and Alternative Managed Future Funds. I believe the unanimous performance declines in every single domestic and international equity and bond fund is symptomatic of deep fundamental concerns.

Lessons from NY tracks

One of the personal learning institutions that has impacted my investment analysis career was the New York based horse racing tracks. The percentage of winning favorites was typically about 33%. One should look at the dollar returns from winning favorites after expenses paid in taxes and fees to the track. The winnings would not cover the losses in other races, let alone cover the expenses of getting to and into the track and an occasional hot dog.  From the track math I learned that there is a tendency for those who make mistakes to continue to make mistakes. In other words they could be negative indicators. How could this be?

At that time the New York racing crowd was the savviest in the country, perhaps like those following stocks listed on the New York Stock Exchange. Clearly these bright people were being swayed into making uneconomic bets. They were following the results of past performance races. A horse that had recently won three or four races, regardless of conditions, was expected to repeat. The crowd could have included some member of the SEC staff who then required the phrase “past performance is no guaranty of future performance,” or similar language to be appended to all performance communications with the public. Unlike many politicians that worship at the foot of “Big Mo” or momentum, some regulators were appropriately concerned about momentum investing.

What are the historical odds of winning?

From my experience in looking at investing for more than fifty years, there are two matrixes that answer the question. The much more common one is to measure whether the price of the investment went up or down. For long-term investors, the odds are that 50% of the choices finish at higher prices. Why? The discouraged ones drop out of the class and, at least in the US, the long-term secular trend has been up. You have to live longer to win. Good managers probably win about 60% of the time. The truly great managers win over time probably about 66%. Just as the critical measure of a day at the track should be measured in terms of net dollars won after all expenses, so should performance results be assessed. Even better, if one was foolish enough to think going to the track as a business, one should look at the ratio of winnings to amounts wagered. On this basis I have seen people actually make money only being right some 40% of the time because they handled their money wisely and benefitted from the knowledge that winning positions grow in relative size compared to losing positions.

Lessons from Bill Gross’s departure

First, it is important to acknowledge that he had a very good long-term record that the institutional and individual communities translated into favorable momentum. Second, Bill was the pied piper for fixed-income investing which had some impact on equity investing. Third, none of our managed accounts owned funds that he managed and there was very little owned in some of the over $4 Billion in institutional portfolios of tax-exempt groups that have me on their investment committees.

What should have been included in the press coverage? First, in all likelihood we have seen the end of a thirty year bull market in bonds which began when the late and great Arnold Ganz told me that there was a generational need for bond managers; there were not enough to go around to all the openings he perceived would be coming. Considering that individual investors around the world were rushing into bond funds, the end of the bond bull market could be very destructive to the investment public and could cause interest rates to rise on government debt as there would be fewer buyers. By the way, many institutions with professionals on their investment committees own very little in the way of bonds.

Second, in later years Bill’s success was based in part on a very strong trading facility that he helped build. His great strength was in the timely use of derivatives. Banks are far and away the biggest dealers in derivatives, with PIMCO probably getting their first call and possible price concessions. Due to rapidly changing bank regulations, banks are cutting back on their inventories of derivatives. Thus, in his new home Bill may be offered less support than what he has been used to receiving.

Third, many news articles have been speculating on how much money will leave PIMCO. While this may be harmful to the fund management company’s bottom line, I suspect that it will be good for those investors that remain within a shrunken fund. There is no portfolio that I have observed that couldn’t be improved by judicious selling. A manager may love all of his/her holdings; however redemptions will force a ranking of those holdings that are least loved.

Fourth, Bill’s quick decision to join Janus, apparently his second choice, defies historical analysis. The board at Janus has a long history of making the wrong decisions in terms of senior executives. This could change.

The need for negative indicators

Since great managers in the long run are only right about 2/3 of the time, we would all like to improve our odds. From my experience those people who have been regularly wrong tend to persist in being wrong. My feeling is that these people are wrong about 75% of the time leaving them to be right 25% of the time. What we attempt to do is to take advantage of superior managers to enjoy them being right 2/3 of the time leaving 1/3 when they are wrong combined with the much smaller number of negative indicators that are only correct 1/4^th of the time. If we were absolutely successful we might potentially produce a 91% hit record. We don’t believe that we will achieve this result without your help identifying additional negative indicators.

Calling for negative indicators

I hesitantly nominate three groups to start your juices going as possible examples of negative indicators. The first is the current keepers of the Dow Jones Industrial Average (DJIA). In the last year according to Barron’s, they added three stocks. Two gained +5% and +1 % with the third declining -5%. They replaced three stocks that gained +47%, +8%, and +26%. These changes demonstrate their concerns for investors that are tied to the DJIA. Further, they have announced that in the future only those companies which are headquartered in the US would be eligible to be included into the World’s most famous stock indicator. They are following the action of the S&P 500 a few years ago. These choices will have an ironic impact. The next most popular index family, the Russell indices, are now owned by the London Stock Exchange, which might have its new owner’s proclivities in mind.

One might speculate that the keepers of the DJIA (which is now managed by a subsidiary largely owned by S&P which in turn is owned by McGraw Hill Financial^*) are defending themselves from a lawsuit by the Justice Department which it is alleged has to do with its downgrading of the credit rating of the US. Thus the announced DJIA move could be interpreted as an attempt to back the current Administration’s efforts to curtail tax inversions. Thus, we are seeing political capital topping investor capital. The history in the marketplace is that this is a short-term advantage and will actually just encourage more off-shore deals.

^*Owned personally and/or by the private financial services fund I manage.

The second negative indicator nomination is for the California Public Employees' Retirement System (CALPERS). This judgment is based on CALPERS’s decision to redeem some $4 Billion invested in hedge funds because they were too complex and too costly. I wonder what they thought they were investing into in the first place. There is a chance that their timing is exquisite. After far too many years of declining interest rates and generally rising stock prices, we have currently seen the beginnings of rising rates and falling stock prices. As stated above, the only two fund investment objectives that were up this week were Dedicated Short Biased Funds and Alternative Managed Futures Funds. In addition, a closed-end diversified currency fund had a surge in trading volume.

Caveat emptor

My private financial services fund (which is structured as a hedge fund) has not had a short position in many years. In addition I personally own shares in a non-US manager of one of the largest futures funds in the world. Further some of the non-profit investment committees that I sit on have quite successfully used hedge funds in their portfolios. Thus, I believe that CALPERS is a good nominee as a negative indicator.

The third nomination is the previously mentioned Janus Capital Management whose board of directors has consistently chosen the wrong people and the wrong diversification moves at the wrong times.

I am looking into making a fourth nomination, of a  prominent talking head or columnist who is brilliant about extrapolating yesterday’s news.

Please send me privately your nominations of negative indicators. In the meantime, invest well for the long-term and trade well in the short-term.

__________

Comment or email me a question to MikeLipper@Gmail.com  .

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 - 2014

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

The Active vs. Passive (ETF) Investment Debate

The differences between watching golf and football are similar to the differences in active vs. passive investing.  Viewing a golf tournament such as the US Open, one focuses on the shots and skills of individual players. Each player addresses each shot and each hole somewhat differently. At the end of the day it is the way the individual utilizes the combination of his/her skills with specific shots that will translate into being a winner. Equally enjoyable is watching intensely fought team sports. In league competition such as American or European football, the different teams develop certain attributes (strong defense, high scoring, deceptive plays, and extraordinary athletic abilities) which make some teams winners over others that have many of the same skills and talents.

Advantages of passive ETFs

As an analytical device the differences between watching team-focused sports vs. individual-focused competitions are useful in the selection of funds and managers in a multi-asset portfolio. Recently I was in a couple of investment meetings with advocates of using, or completely using exchange traded funds (ETFs) as contrasted with selecting individual funds or managers. In the institutional world this issue is an extension of the passive vs. active manager debate.  One reason for the growth in popularity of ETFs over the choice of good managers/funds is that the latter group can and has underperformed the “market” benchmark (a statistical index of individual securities usually selected by a financial publisher such as Dow Jones, S&P, or Russell to describe a group or an absolute numerical goal). As passive vehicles do not utilize investment management, they are able to charge considerably less total expenses. All other things being equal, the lower the fees deducted from the gross returns of an account, the better the performance.

Being the best in a poor league is not good enough

The professional football teams that meet in the Super Bowl have the best records in their leagues and/or their play offs even though at any given game any team can win, occasionally not the expected winner.  One of the reasons that I did not comment on the 2012 running of the Belmont Stakes is that I felt that this year’s crop of three year-old horses were not as good as past classes. On the same basis, some Super Bowl winners are not as good as winners in the past. Nevertheless, on a relative basis they were the best at the time.

Because most of my accounts are directed to the long-term, individual annual winners are not usually helpful to me in building portfolios of funds and managers.  When taking a long-term approach, some individual years and other data points are not very revealing; e.g., extreme performance outliers are less critically important than market cycle turning points.

Over the last couple of years, correlations between various investment classes has narrowed significantly, “bunching” fund performance results on top of each other. Unfortunately this concentration makes it much more difficult for individual managers to assemble distinctively different portfolios that are capable of producing outstanding results.  For example, if you invested in the entire technology sector, you would have significantly under-performed a portfolio investing in only three stocks, Apple (NASDAQ: AAPL), IBM (NYSE: IBM) and Microsoft (NASDAQ: MSFT).  

Active management: picking more winners

Active management, particularly my style of investing, is quite different than passive approaches, particularly those of exchange traded funds (ETFs). All ETFs are built around a single specific metric. Some use market capitalization, sector groupings based on sales, earnings, dividends/yields, book values, growth rates, or other easily determined sorting mechanisms. Some use market capitalization weighted as distinct from others that use equally weighted portfolios.

As an analyst of electronics, broadcasting, aerospace, steel, brokerage firms and financial service companies, I regularly ranked the companies I covered against each other. In order to carry out this exercise I made a good attempt to adjust all of the issuers’ data to the same standard of disclosure. For example:  paid and accrued tax rates, product and customer mixes as well as revenue and income recognition policies. In addition I attempted to array shareholder orientation, tables of organization, motivations, etc. Using these screens I could rank with some difficulty the companies from best to worst. 

That was half the job. Next I turned to stock price. Except in some periods of stress, usually the better companies were more expensive in terms of normal valuation techniques, which rarely led to the identification of bargains. To find bargains I needed to find ignored critical observations, particularly those that were likely overlooking some vital facts. The next task was to analyze the stock price. This entailed examining who owned the most sizeable amounts of shares (insiders and large institutions) and whether they had a history of being good investors. Other factors to be considered included the identity of the floor specialists, when we had them, or other market makers, and the history of transaction volume. While I was conscious of global macro trends, rarely did they fundamentally affect the attractiveness within a sector of stocks in vital companies.  I cannot remember a single time when I recommended buying the entire list or sector. This rather long winded recitation of my analytical approaches is why I have problems buying a pre-fabricated list found in ETFs or other index funds. However, I have used index funds in some portfolios when I was unable to conduct enough research, or when there was a lack of pertinent information to confidently pick winners.

Are you an active, passive or hybrid investor?

Let me know which and why.

___________________________

Did you miss Mike Lipper’s Blog last week?  Click here to read. 

I invite you to be part of this blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of MikeLipper'sBlog.Blogspot.com .

Judicial Temperament Required for Credit Ratings and Portfolio Management

In most professional military forces, important punishments are the result of judicial trials. In these cases, relatively senior officers are chosen to be the judges and when a jury is required, those seated need to have a representation of similar rank as the defendant. When I was in the US Marine Corps, one of my collateral duties when aboard ship was to serve as the legal officer. When there were military courts martial of significance, I had to participate in the selection of members of the jury. In selecting marines and sailors, I was required to be guided by choosing people with “judicial temperament.” This term describes an individual, who after reviewing all of the evidence presented, makes decisions based on the facts without any pre-conceived biases. These judgmental approaches to military jury selection are not shared with either the public or the press. If disclosed, these judicial screenings might spur a rush to judgment that could lead to an unpleasant set of reactions. This weekend after the Friday downgrade of the US Intermediate credit rating from AAA to AA+ by Standard & Poor’s, there were harsh and uninformed statements made in the press by various members of the government and their flacks, all lacking judicial temperament in my judgment.

The Recognition of the Downgrade

To put the action of S&P into perspective, I believe one should understand the function of a credit rating agency. (Important disclosure: we have a position in Moody’s in our financial services private fund.) The job of a credit rating agency is to express an opinion as to the odds on the failure of an issuer of timely payment of interest and repayment of principal. Since their establishment, the three main credit raters, S&P, Moody’s, and Fitch have done a remarkably good job adjusting their ratings to expected risks of default, with one glaring exception. The glaring exception was in the securitized packages of residential mortgages. (The mistake made was to treat these packages on the same risk rating scale as corporate and governmental issuers. Further, the short history of payment of interest and principal in a securitized form was not fully appreciated.) The credit rating process is to gather all the known facts about the issue to be evaluated, as well as the issuer itself; then a ratings setting committee of senior researchers evaluates the whole package as to the likelihood of default. The focus is on all of the evidence not just a sub-set. In assessing the risk of default, both the ability to pay and the willingness to pay should be considered.

The published thinking of S&P (which was discussed with the issuer, the Administration, since last April) was to take into consideration the political will to address the growing deficit. The raising of the debt limit was never a real issue, as the government had numerous ways, all painful, to avoid the immediate need to borrow more money. S&P’s view is that fiscal policy is married to political policy. The unwillingness to find a solution to the deficit issues, in the end led to lowering the credit rating. One should note that the AAA rating is like being number one on any ranking list. The history is that over time, most number ones lose their ranking.

As this is being written on Sunday we do not know what Moody’s and Fitch will do immediately, but both have made statements of concern recently. Their methodologies are similar, but not identical to S&P's. At the moment we have a split rating which at least temporarily gives a combination of AAA/AA+. Many in the traditional fixed income world give Moody’s a slight preference, as the older and perhaps sounder agency. Thus, it will be significant when and how it issues a new opinion. At the moment the focus is only on the intermediate debt, as the belief is that both the short term and the long term debt remains with the highest ratings.

While I believe that the AAA credit rating should have been removed years ago because of perennially unbalanced budgets stretching back to the 1930s, there is ample evidence that all of the recognized credit raters are currently exhibiting sound judicial temperaments.

The Fast Reactors

People believe that securities prices move on the latest incremental bit of information. That is why many analysts and the electronic media are very quick to report any and all incremental bits. To emphasize the importance of the increments, often they proclaim that various securities should be immediately bought or sold to move ahead of those investors whose information is not as current, or those who move more slowly. The prize goes to the first movers. Most often there is not a review of all the relevant facts and so there is a lack of judicial temperament being offered.

The Prudent Long Term Portfolio Manager

As fiduciaries entrusted with quasi-permanent funds, we need to balance the current changing environment with the long term needs as to the disposition of the assets that are our responsibility. We need to weigh carefully the likely impact of the news along with the costs of changing positions in terms of meeting our clients' long term goals. I have believed that the US Government and many other governments have been debasing not only their currency, but more importantly their societies, ever since they have undertaken “to do something” about employment. Thus the recognition of the initial downgrade does provide some comfort that the basic laws of economics do work eventually. As most currencies have been debased through years of inflation from unbalanced budgets, and there is only a limited amount of gold available, I would be surprised to see a major shift near term in the disposition of large portfolios. In the longer term I suspect we will put our faith in commercial companies producing reliable earnings to be our principal store of value.

What do you think?


____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of www.MikeLipper.Blogspot.com