Facts Trap Us into Choices - Weekly Blog # 526

Introduction

Why do very bright people make wrong choices? In our highly professional world of investments why do so many financially sophisticated investors choose the wrong investments at the wrong time and in the wrong amount?

I believe that I should always be learning. Because of my investment performance background I study smart investors who regularly make mistakes. Hopefully, I will learn to my clients and my own benefit. With the above mission in mind I was struck by an article entitled “In Defense of Ignorance” which was published in the Marathon Global Investment Review. Marathon Asset Management is a very thoughtful and successful investment manager based in London. Apparently its skillset is to focus on the supply side of economic equations and limit its input largely to facts about supply. As this focused approach has worked for Marathon and its clients, I considered this thinking in terms of my own intellectual process of transitioning from security analyst through various stages to becoming an entrepreneur and registered investment advisor.

Career Transition

As I was finishing my active duty in the US Marine Corps, my plan of action to feed my young family of three (and more planned) was to become a security analyst, study all there was to know about a leading company in an important industry and be hired by a company’s investor relations area as a person serving financial analysts. My career goal then was to be a junior officer of a large, stable, and hopefully growing company by retirement. Luckily for me it didn’t work out that way.

As an analyst my goal was to gather more facts than anyone else on a targeted company. Interestingly enough, the help of employers and analyst societies did not prepare me for the real commercial world. I had to learn, usually by observing, how to sell investment research, make sensible investment decisions, understand internal politics, seek clients, and learn how to run a business. Thus, I had to move away from the simple task of just gathering facts, as comfortable as that was, to a broader set of skills.

Analyst vs. Entrepreneur

Recently I have become convinced that much of the thinking processes of investment, business, and political leaders has evolved in a similar fashion. For a long time leadership was assigned to those who gathered the most facts. Many of them were like a good litigating attorney that gathers all the known facts about a case. He or she does not want to be surprised by something said by a favorable or opposition witness. After gathering the facts, attorneys are selective as to how they build their persuasive pitches. These types of leaders, often rising through highly structured organizations, are replaced or out-maneuvered by an executive decision-maker.

The rise of the executive decision-maker is changing our world as we know it. The old practice of following a case study of known procedures is giving away to more free-form decision-making. Increasingly, successful nations and business operators have less in common with their perceived competitors. 

It is not this blog’s mission to solve world and macro problems, but rather to focus on investments largely through investment managers and mutual funds. With that thought in mind I am wondering whether our practice of building diversified portfolios based on asset classes, size of companies, locations, and market capitalizations, which worked well in the past, is becoming outmoded. Should we assemble our managers and their funds as a good theatrical producer does with people of different talents? A good producer brings these multi-talented people together in a way that produces good results as a unit. As we move in that direction we will need a different classification system, which may be different for each client portfolio.

The only time I had some limited experience with this was when I was fencing in college. In a very short time I had to make a guess whether my opponent favored offense or defense, how to change the expected flow of events, how to lure an opponent into changing styles, etc. We know that most managers are reactive to prices or announcements, only some attempt to position prematurely. Others march to their own drummer and stay fixed in their actions regardless of other stimulants. As we have very intelligent readership of these blogs, I am wondering whether any have some guidance for me as I struggle to adapt to my perceived view of the new world of investing. Please contact me at AML@Lipperadvising.com.

For the Fact Gatherers

Demand for money is gradually rising. In the daily Wall Street Journal there is a statistical box of ten “Consumer Rates and Returns to Investors.” These indicators go from short-term to 30 year mortgages. Each are shown at their current level and their range for the year. Four of the ten are near their annual highs and none are more than 51 basis points away from their annual high.

Two items:

•  Merrill Lynch’s technical people view cyclicals as being more attractive than defensive stocks. They do not see a recession near term.

• PIMCO’s latest view is that the next economic recession is 3-5 years way.

When these two major market movers (along with most others) express their views, as a contrarian I get worried about a surprise that blindsides the majority of the thinking. I would be particularly worried if the stock market goes to another new high this year.

There is likely going to be more excitement about the opening up of the Chinese “A” share market to foreigners. WisdomTree* is warning that many stocks do not have good characteristics as investments, so be careful.

*Personally owned.

All too often professionals utilize a formulaic process rather than adjusting to the changing environment.  This leads in many cases to some bad choices.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Individual Investors Should Worry Professionals

Introduction

When I became a professional securities analyst in the 1960s there was a trend to have two separate research and marketing efforts of brokerage firms. A traditional effort to serve individual investors was joined by a second, and higher paid effort to serve institutional investors. Around the cyclical movements of the stock market, individuals and institutions invested differently and each fed off the other's transactions. Institutions were able to buy what they thought were cheap stocks from supposedly unsophisticated individual owners and sell into them when individuals were not well enough informed. Interesting this dichotomy did not work to the disadvantage of the individual investors as much as it may have seemed. Individual investors were not only net buyers, but for the most part long-term investors that often facilitated the more rapid turnover of the so-called professional investors.

This relationship is no longer the case. Because of the decision of the US government to introduce price competition in brokerage commissions (which led to a price war) the profitability of directly serving the individual long-term investor declined meaningfully. Today try to get a “full service” retail brokerage representative to be interested in opening an account to handle the sporadic purchase of a hundred shares of a NYSE traded securities. If the broker can’t get the customer to open a margin account, buy new issues, trade over-the -counter securities or place decision making judgment in a managed account or a packaged product or possibly an automated relationship with a call center, chances are he/she will not be interested in the relationship with the perspective customer. Only the alternatives just suggested are profitable for the firm and the individual broker. Thus relatively few individuals are directly active in today’s stock market. They are investors through their employers’ defined contribution plans, land stock purchase plans, and or mutual funds/variable annuities or in some cases stock options.

The plain truth on most days, particularly in the summer months, almost all the transactions come through various institutional channels. The market has become largely a game of professionals competing against each other for research and trades. In some respects the market has become more susceptible to sudden volatility within the trading day as the professionals in this interconnected world react to each incremental research element and price change. Thus, a different sort of market analysis is required to avoid being at a competitive disadvantage.

The Players

Exchange-Traded Funds (ETFs), and Exchange Traded Notes (ETNs), while relative small in terms of assets as compared with other institutions,  are selectively quite large in the intra-day markets. While the regulators believed that when they permitted the creation of these vehicles in the US and a number of other markets, that individual investors would benefit from their low cost and trading efficiency, they really created trading vehicles for fast trading professional investors including hedge funds, market makers, managed accounts of investment advisors, central banks (Tokyo), and other institutional players.

In many weeks the aggregate net transactions in ETFs is larger than those of conventional mutual funds, even though their assets are less than half of the assets of mutual funds. While there are thousands of ETF transactions in a given week, the vast majority of transactions are in a couple of products that professionals are using to invest or hedge with or without margin type leverage. According to my old firm, Lipper, Inc., for the week ending Wednesday there was $6.7 Billion in net purchases of equity ETFs; $4.4 Billion went into PowerShares QQQ Trust EFI, invested in the 100 largest NASDAQ stocks, and $1.2 Billion into the iShares Core MSCI EAFE Index fund or about 5.65% of that fund’s total net assets. This left approximately $100 million for net purchases of all other equity ETFs.

A similar pattern was present on the taxable fixed income side which had total net purchases in the week of $1.2 Billion, with $1.1 Billion into two funds, iShares 20+Year Treasury Bond ETF, and iShares Core Total U.S. Bond Market ETF.

All four of these funds could be used to fulfill the short-term trading needs of institutions. To get a feel as to how important the trading is in these products, one should look at the extreme volatility of the major stock and bond indices in the last ten minutes of a trading day as the Authorized Participants (APs) try to even up their trading books. On some days in the last few minutes the stock indices can move close to 1/3 of the daily price moves for the whole day up to 3:30. Sometimes some of the transactions in ETFs are on the short side. In October of 2016 the size of the short interest was at a record level on the SPDR S&P500 ETF. Currently it is at the lowest level in more than a year. Obviously some trading institutions were shorting due to their views on the US Election. They may have viewed this as a hedge against some long positions or it could have not been paired against other holdings.

Mutual Funds are Evolving

There is also something happening in conventional mutual fund transactions. Despite a current period of relatively good fund performance, funds are experiencing net redemptions. A careful analysis will reveal that this is not a signal of disappointment. Most of the redemptions are coming out of the Large Cap Growth and Growth and Income funds that were the major receivers of decades of inflows driven by commissioned sales people. The basic investment pitch to potential owners of funds was to provide retirement capital and to a lesser degree educational funding. On an actuarial basis a good bit of these redemptions are completions fulfilling their intended purposes. In prior decades we would not have seen net redemptions because the normal completions would have been offset by new sales of funds, except selling funds to individuals is far less profitable than it has been in part because the sale freezes the money in place for a number of years due to anti-churning rules and commissions on funds are no longer the highest level available to the salesperson.

There is another important trend that takes mutual fund dollars out of the US marketplace. While domestic funds in the week had net redemptions of $4.6 Billion, non- domestic funds had net sales of $2.6 Billion. This is understandable on two levels. The Financial Times data shows that there are eighteen national stock markets it tracks. Eight had gains of between twenty and twenty-six percent and only one of these (NASDAQ) was in the US. The IMF is forecasting only India and China will have GDP gains of more than 5%.

Chart Readers

All three of the major US stock market indices, Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite started last week with a price upward gap. Often price gaps get filled before a major move occurs. In addition the NASDAQ composite daily price chart shows a reversal pattern called a “Head & Shoulders” which might be predicting a decline. As part of the market’s function to promote humility, this index is now rising near its former peak. The technical market analysts at Merrill Lynch stated that if the index breaks out on the upside it would be a failed Head & Shoulder pattern that is quite bullish. As usual there is an “on the other side” market research team at Charles Schwab that suggests that we should be prepared for a summer pull back.

Investment Conclusions

One of the reasons I came up with the TIMESPAN Lipper Portfolios® is to address this kind of situation, The second of the two portfolios, the Replenishment Portfolio, has a function of replenishing the Operating Portfolio which is designed to meet payment needs near term, or about  two years. The Replenishment Portfolio expects that over a market cycle it will be called to replenish the operating funds. This assumes that over a cycle (which typically takes four to seven years) there will be at least one down market. With this in mind Replenishment Portfolios should be examining their liquidity positions . This will be easier if they are in open end mutual funds that are not expected to “gate” or temporarily restrict redemptions in cash. In some cases large redemptions will be met with in-kind transfers. In most cases the transferred securities will be relatively easily sold.

The other two portfolios, Endowment and Legacy should not be disturbed. However if there was a serious decline one might want to switch. My data and consulting client, the late and great Sir John Templeton instructed to switch into better bargains when available.

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Searching for Confidence

Introduction

If we were more confident, we would commit. The lack of confidence is what prevents us to committing to another person, a political view and an investment of time, effort, or money.  Animals as well as humans over-rely on our or others' memory as a guide for our next committed actions. The difference between humans and animals is that out of bitter experience we have been disappointed that in particular cases the past was not repeated exactly as believed.

To protect ourselves from disappointment we search for systematic ways to predict the future. Often not finding the magic formula, we rely on so-called "experts."

Another Lesson from "The Track"

While at the track after I concluded either I couldn't find the next winner or in my opinion the betting odds were too low to make a sound bet, I began a life-long exercise. I listened to those around me in their conversations as to why they thought a particular choice was the correct one. In an over-simplification, these views generally fell into two camps. The first very much focused on especially current information about various horses, jockeys, trainers, times of prior winners, and track conditions. The second camp used various numerical inputs such as past speed records for the race, the weight the horse was carrying, whether horses that were favorites that day were winning at the expected rate, etc, etc. This second group was slavishly following a systematic procedure or as it was known at the track, they had a system.

The post-race reactions after members of each camp that did not win was most instructive. First both blamed various "experts" for not producing winners for them. Those in the first camp restudied the information they had before the race to see what critical insight that they missed that they should apply to future races. The second camp’s followers rechecked their data for accuracy and if their math was correct they would begin the search for a new system and a new set of "experts."

The first camp were my first exposure to the arts of analysis. They searched the very present competitive conditions. The second group were in effect statisticians who believed the future could be determined from the numbers.

Years later I recognized that these two camps exist today in guessing which way various elections will go and what is the most successful way to manage money.

Statisticians

As a career securities analyst I have never seen a number from which I didn't want more information and data. However, I am not a card carrying member of the statistical clan. The reason I do not claim membership is that I do not think the numbers by themselves provide the answers that I need to generate confidence.

There are two other reasons that I don't wish to fit under the statistician label. The first is historical. In the era when the Dow Jones Industrial Average was being constructed, those hard working clerks in brokerage firms who produced recommendations for investors and whose main source of corporate information were the very thin reports published by companies. These clerks were unable to visit companies or third party sources and were called statisticians. My guess is that my Grandfather's firm had one or more. It was not until the era when Benjamin Graham was going beyond the ratio analyses of annual reports that the term securities analyst evolved.

The second reason I do not want to march under the statistician banner goes further back in history, but is equally important today. Another Benjamin, Benjamin Disraeli the Prime Minister of the United Kingdom in the 19th century is quoted (most often in the US by Mark Twain) as saying "Liars, Damn Liars, and Statisticians" were  the source of bad information and conclusions. I am afraid, particularly this remains true in the political world today. Part of this tarnished label attached to statisticians has to do with polling. Not only did the Brexit polling not capture the true intentions of those in Northern England but that it was followed in Colombia. There were three pre-referendum polls that showed that the no vote in Colombia was between 34 and 38%. The final vote was the "No" vote carried 50.2%. Again the issue has a geographic focus. Most of the No vote was largely rural, which is more difficult and expensive to gather. I am guessing many of the current US polls are similarly flawed.

One of the mistakes some British made is crediting the bookies with analytical inputs. A similar mistake, I believe, is being made on this side of the pond. The believers in the efficacy of these inputs, do not understand that both measures are similar to the pari-mutuel system at the racetracks where the odds are not judged mentally but are calculated by the amount of money bet. Further, my guess is that the northern English farmers and most Republicans in the US are not by nature gamblers, so the weight of money is not representative of the voters.

Turning to our investment world, those that believe in factor investing or other asset allocation dictates are essentially statisticians looking for their "system" as some of their brethren did at the track. Recently JP Morgan Asset Management published a 72 page   "Guide to the Markets®". An analysis of some of its data is as follows:

It has identified seven  major factors; including High Dividend Yield, Small Cap, Minimum Volatility, Cyclical Sectors, and  Momentum. The two best factor portfolios in 2015 were the last and next to last in the first nine months of this year.

Asset allocation funds may have many adherents, however since 2006 in a performance array of ten different types of Fixed Income funds on average they ranked fifth out of ten with two years in fourth place and three in sixth place.

In a similar selection of ten major asset classes from 2000, asset allocation returns were again in the middle on average, with the best in one year getting up to third place and five times in seventh place.

There is a problem with the statistical-only approach. When will the creators of the factors or asset classes recognize the changes in our dynamic markets? If those changes are perceived too late, much of the growth in value will not be achieved. For example, when the four largest global companies in terms of current market cap are recognized with appropriate weights they are all relatively young companies that are still in their first to third  generation of management.  The four are Apple, Alphabet (Google), Microsoft, and Amazon.

Analytical Approaches

A good analyst examines the past statistics to see what items are likely to be absent going forward and/or deserve a different weighting going forward because of a change of conditions. In projecting the future it is also wise to assume some level of intellectual or financial fraud as well as less than perfect executions of plans. In addition one should expect that technology will both help and hurt people's efforts. At one point, it was good analytical practice to calculate eventual scrap value from written off plant and equipment. Today it may actually cost a company to close down and get rid of plant and equipment without a tangible scrap value. In today's fast moving world useful lives may be shorter than the depreciation schedules.

Beyond the analysis of the past what can the analyst use to project the future? To an important extent demographics is destiny. However, the raw numbers have to be modified by changes in social structure and education. The answers may be quite different from work force and consumer market applications. These trends are not just national but global in implications. In turn this suggests that any US investor that does not have approximately half of his or her earnings coming from beyond our borders is not appropriately hedged. However, we already live in a global world where almost every company large or small is benefiting or suffering from multi-national influences. Thus no matter where you pay your taxes, locally based multi-nationals are diversifying the national sources of your investment income without your instruction.

Investment Implications

One of the lessons from the racetrack is that short races are more difficult to get right. The first one out of the gate has a tremendous advantage over the slightly slower. In investing I have noted a similar phenomenon. Catching up is difficult. Thus, at the track and in terms of portfolio management I prefer the longer races where there is time to recover. Therefore, at this point in our history I would like to focus a couple years after the next series of US elections which may not end until 2019. At that point demographics from today's level and mix will be playing out. There will be some major technological changes, hopefully positive.

I am more confident in the run up to my preferred investment horizon, I will rely on the past pattern of periodic and relatively painful declines followed by much longer periods of gains which in total produce a reasonable rate of return for those who are in for the long-term. This philosophy will work until it becomes dangerous because of “fellow travelers’ enthusiasm.”   

Question of the Week: Are you more a Statistician or an Analyst?

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Did you miss my blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

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