The Profit Motive is Not the Problem

February 3, 2012

Justin Fox has an article in the Harvard Business Review assailing the profit motive in financial services.  I don’t deny that some banks and brokerage firms have behaved badly—but the logic of the critics is (I think) all wrong.  There is a behavior problem that needs fixing perhaps, but I think it can be approached more elegantly.  Mr. Fox’s thesis is this:

If you let the financial services industry do exactly what it wants, the financial services industry will eventually get itself — and by extension the economy — into staggering amounts of trouble. If you force it to behave, it might just thrive.

I don’t think you can ever force anyone to behave.  I was never successful forcing my kids to behave when they were four years old, and I have no more success now that they are teenagers.  This thesis leads to some bad logic.  Mr. Fox continues:

I thought about this while listening Tuesday to David Swensen, the legendary manager of Yale University’s endowment, arguing that acting as a fiduciary for other people’s money and maximizing profits are incompatible activities. “A fiduciary would offer low-volatility funds and encourage investors to stay the course,” he said. “But the for-profit mutual fund industry benefits by offering high-volatility funds.”

Swensen said this at a Bloomberg Link conference held in honor of that great fiduciary, Vanguard founder Jack Bogle.

I have a few issues with this.  First, the data argues that low-volatility funds are not the answer.  If low volatility were the answer, customers would hold their low-volatility bond funds longer than they hold their high-volatility stock funds—but they don’t.  Holding periods, according to DALBAR data, are only marginally different, around three years in each case, so that argument goes up in flames.  Second, investment firms always encourage investors to stay the course, sometimes to a fault.  (And they usually end up getting criticized for it later by some Congressional panel with 20/20 hindsight.)  Seriously, did you ever read material produced by any reputable investment firm suggesting day-trading or short-term speculation?

Mr. Fox extols Jack Bogle and Vanguard for being great guardians of the investor, yet Vanguard is one of the biggest players in exchange-traded funds, something Mr. Bogle has decried as a terrible product that encourages speculation!  Does that make Vanguard evil?  (I don’t agree with that either.  ETFs don’t kill people; investors shoot themselves.)  Reality is a lot messier than an idealogical paradigm.

It all boils down to incentives.  Human beings are not all that tractable.  It’s certainly not easy to get investors to behave rationally either, and it’s not for lack of pleading by the investment companies.  Believe me, every firm would rather you keep your account there permanently!  But rather than “forcing” someone to behave, why not give them incentives to behave?

An anecdote might illustrate my point.  I worked many years ago at Smith Barney, Harris Upham when it was still private.  Share ownership was widely distributed and many people—partners and aspiring partners—felt like they had a stake in how things worked.  It was viewed in the industry as a stodgy firm that was not willing to take big risks, which was pretty much true.  The partners didn’t want to take big risks with the firm’s money because the firm’s money was their money!  Eventually the partners sold out to a public company.  The first convertible bond underwriting client that was engaged after the firm became public went bankrupt before it made its first semi-annual interest payment.  I can’t prove it, but I suspect that the partners weren’t as concerned about the underlying credit quality of the issuer when it wasn’t their money at stake anymore.  (In an interview, John Gutfreund of the old Salomon Brothers said using other people’s money was the beginning of the end.)  How many toxic mortgages would have been securitized if the partners’ personal money were at stake, or if even public firms had been required to retain substantial amounts of each pool?  Surely much less monkey business would have gone on.  (Stupidity you can’t regulate.  But if someone knows they have a grenade, they’re not happy about playing catch with it.)  Intelligent structuring of incentives will solve many of the problems that Mr. Fox rightly points out.

And, one could argue that incentives are already having an effect.  Mr. Fox mentions in passing some good actors in the industry (and I’m sure there are others):

Some of these for-profit advisers (Capital Group and T. Rowe Price spring to mind) have built a reputation for looking out for investors’s interests.

And guess what?  These firms are now huge because they realized they would have the best chance at sustainable, long-term growth by looking out for investors.  Enlightened consideration of their incentives led them to behave in ways that maximized their long-term growth.  There are other firms in the industry that have marketed celebrity portfolio managers, or have pushed performance when they were hot, or have launched all manner of ill-conceived products, but they have generally come to grief in the longer run.  (Short-termism, by the way, is not limited to for-profit enterprises.)

Could the industry incentivize even better behavior?  Possibly, and that is certainly a goal worth pursuing.  But to lay the blame for industry problems on the profit motive is just lazy thinking, in my opinion.

HT to Abnormal Returns

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Posted by Mike Moody

Why Capitalism Works

January 25, 2012

Incentives!  I first saw this story on Carpe Diem, the blog of economist Mark Perry at the University of Michigan.  He excerpts a story from NPR‘s Planet Money that details a secret contract that Chinese farmers made in 1978, during a period of communist rule.  Everyone in a small village essentially agreed to become capitalists!  And the results were remarkable.  From NPR:

In 1978, the farmers in a small Chinese village called Xiaogang gathered in a mud hut to sign a secret contract. They thought it might get them executed. Instead, it wound up transforming China’s economy in ways that are still reverberating today.

The contract was so risky — and such a big deal — because it was created at the height of communism in China. Everyone worked on the village’s collective farm; there was no personal property.

“Back then, even one straw belonged to the group,” says Yen Jingchang, who was a farmer in Xiaogang in 1978. “No one owned anything.”

At one meeting with communist party officials, a farmer asked: “What about the teeth in my head? Do I own those?” Answer:  No. Your teeth belong to the collective.

In theory, the government would take what the collective grew, and would also distribute food to each family. There was no incentive to work hard — to go out to the fields early, to put in extra effort, Yen Jingchang says.

“Work hard, don’t work hard — everyone gets the same,” he says. “So people don’t want to work.” In Xiaogang there was never enough food, and the farmers often had to go to other villages to beg. Their children were going hungry. They were desperate.

So, in the winter of 1978, after another terrible harvest, they came up with an idea: Rather than farm as a collective, each family would get to farm its own plot of land. If a family grew a  lot of food, that family could keep some of the harvest.

This is an old idea, of course. But in communist China of 1978, it was so dangerous that the farmers had to gather in secret to discuss it.

One evening, they snuck in one by one to a farmer’s home. Like all of the houses in the village, it had dirt floors, mud walls and a straw roof. No plumbing, no electricity.

“Most people said ‘Yes, we want do it,’ ” says Yen Hongchang, another farmer who was there.   “But there were others who said ‘I don’t think this will work — this is like high voltage  wire.’  Back then, farmers had never seen electricity, but they’d heard about it. They knew if you touched it, you would die.”

Despite the risks, they decided they had to try this experiment — and to write it down as a formal contract, so everyone would be bound to it.  By the light of an oil lamp, Yen Hongchang wrote out the contract. The farmers agreed to divide up the land among the families. Each family agreed to turn over some of what they grew to the government, and to the collective. And, crucially, the farmers agreed that families that grew enough food would get to keep some for themselves.

The contract also recognized the risks the farmers were taking. If any of the farmers were sent to prison or executed, it said, the others in the group would care for their children until age 18.

The farmers tried to keep the contract secret — Yen Hongchang hid it inside a piece of bamboo in the roof of his house — but when they returned to the fields, everything was different.

Before the contract, the farmers would drag themselves out into the field only when the village whistle blew, marking the start of the work day. After the contract, the families went out before dawn. “We all  secretly competed,” says Yen Jingchang. “Everyone wanted  to produce more than the next person.”

It was the same land, the same tools and the same people. Yet just by changing the economic rules — by saying, you get to keep some of what you grow — everything changed. At the end of the season, they had an enormous harvest: more, Yen Hongchang says, than in the previous five years combined.

Listening to this story makes me much more optimistic about the possibility for eventual intelligent economic reform.  The power of incentives to transform behavior is truly remarkable!  Thoughtful incentives make the economy better for everyone.  I hope it is not lost on policymakers that a 15% tax on the huge harvest generates more revenue than a 70% tax on the lousy harvest.  (Even bad incentives, I suppose, make the economy better for certain groups while making it worse for others.  Relative strength is a good way to detect who is benefiting and who is being held back.)

HT to FT Alphaville.

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Posted by Mike Moody

Your Inner Beardstown Lady

January 19, 2012

Most of the whippersnappers in the business don’t even remember the Beardstown Ladies.  They were grandmotherly-looking members of an investment club in Beardstown, Illinois who had generated 23% returns on the investment pool for many years.  According to an 1998 story in the Wall Street Journal:

The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald’s and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published best selling books on the subject of personal finance and investing. The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies’ actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.

Unfortunately it’s not just the Beardstown Ladies who can’t do math.  No one questioned the returns initially because they wanted to believe it was true.  The exact same error is repeated by most 401k investors who often count their contributions as part of their performance.  Even in the absence of contributions, the rest of us favorably mis-remember our results anyway.  Psychology Today explains:

What was your portfolio return last calendar year? How did you perform relative to market indexes and other investors? Most investors don’t know the answers to these questions. But their belief in their performance is quite flattering to themselves!

Two interesting studies illustrate this point. In the first study, William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. The AAII investors are presumably very knowledgeable about investing from their participation in the association. When asked about their return the previous year, they overestimated their performance by 3.4% (= estimate – actual). Architects are very intelligent with a high degree of education, though they may not be knowledgeable investors. They overestimated their return by 8.6%. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1% and 4.2%, respectively.

Markus Glaser and Marin Weber also conclude that investors have biased views of their portfolio performance in the past. They surveyed individual investors from a German online brokerage firm and compared their self-assessments to their actual returns over four years. They reported a belief of an annual return mean of 14.9% over the period. Their actual return was more like 3.3%. Now that is overconfidence! In fact, there was no correlation between the actual return and the beliefs about the returns in the sample.

Cognitive dissonance strikes again.  According to Goetzmann and Peles in the Psychology Today article:

The authors attribute this to a psychological phenomenon called cognitive dissonance. The investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor choices. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively re-enforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones.

Self-image wins every time.  A keen observer will note that investors never vastly underestimate their aggregate returns!

What can we learn from this, other than Germans are the most confident investors on the planet?  I’ve bolded the return estimates, just so you can see clearly how large the gap in perception created by cognitive dissonance really is.  The bottom line is that we all want to imagine we are getting or can get fantastic returns.

Right now we are smack in the middle of crazy season, where investors are examining their prior year returns and determining whether to stay with their current mutual fund or investment manager.  As an investment professional, one of the things you quickly realize is that you are being compared with imaginary numbers–what the client believes you should have done, or what they imagine they would have done!  Of course, as discussed above, the imaginary numbers are always terrific.

Cognitive dissonance, I believe, accounts for a lot of the manager turnover in the industry, not just volatility and style rotation.  As evidence, consider that according to DALBAR, the average holding period for mutual fund investors is about three years–whether they own a stock fund or a bond fund.  The volatility of the average bond fund is probably not enough to shake investors out, but when comparing the bond manager’s actual returns with imaginary returns, investors can only handle three consecutive years of disappointment!  Ok, I’m being a little sarcastic here, but this corresponds perfectly with studies of black-box trading systems, which indicate that investors who purchase even a profitable system abandon it after three consecutive losses.  (For fans of Markov probability chains, an average of only fourteen coin flips is required to get three heads in a row.)

When it comes to returns, we are all Beardstown Ladies at heart.  Our imagined returns are always going to be significantly higher than what we actually get.  Keep in mind that, according to the Psychology Today article, there was no correlation between the actual return and the beliefs about the returns.  Instead of being bamboozled by your inner Beardstown Lady, step back and really think about your investments.  Do they meet your needs?  Is the underlying return factor still sound?  Keep in mind that the only investment acumen required to actually earn the mutual fund NAV returns is to hold the fund!  You don’t have to condemn yourself to DALBAR-type returns.  Sure, if something has gone really wrong, you might need to make a gradual change in course–but more often than not, if the return over a multi-year period is in the ballpark, you’re quite possibly better off leaving it alone.  If you want to be a successful investor, you need to learn to deal with the real world and not imaginary returns.

Reject your inner Beardstown Lady!

 

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Posted by Mike Moody

Manager Insights: Fourth Quarter Review

January 6, 2012

[click to read full size]

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Posted by Andy Hyer

What Still Works on Wall Street?

November 29, 2011

The early editions of James O’Shaughnessy’s bible What Works on Wall Street identified two combination strategies that were so good that mutual funds were formed to implement the strategies.  Cornerstone Value was a large cap dividend strategy, while Cornerstone Growth combined value with relative strength.  The funds have been around since 1996 or so.  CXO Advisory poses the question:

Has 14 years of out-of-sample performance of these two mutual funds confirmed the motivating backtests?

HFCVX [Hennessy Cornerstone Value] underperforms both its benchmark Russell 1000 Value Index and the S&P 500 Index. The fund underperforms the S&P 500 Index by about 0.5% per year, compared to the backtested average annual outperformance of about 7%. Also, its standard deviation of annual returns (20.1%) is higher than that for the benchmark Russell 1000 Value Index (18.7%). Backtested outperformance has not persisted over a 14-year out-of-sample implementation.

HFCGX [Hennessy Cornerstone Growth] outperforms both its benchmark Russell 2000 Index and the S&P 500 Index. The fund outperforms the S&P 500 Index by about 2.5% per year, compared to the backtested average annual outperformance of about 10%. Its standard deviation of annual returns (21.2%) is about the same as that for the benchmark Russell 2000 Index (21.1%). Backtested outperformance has persisted at a subdued level over a 14-year out-of-sample implementation.

Relative Strength still works on Wall Street

Source: CXO Advisory

In other words, the dividend strategy has not been able to beat the market over the last 14 years, while the relative strength strategy has outperformed in real life.  This mirrors CXO’s findings earlier.  I might note that the outperformance of the Cornerstone Growth strategy comes despite the Q3-Q4 2008 – Q1-Q2 2009 performance of relative strength, which was a big historical outlier.  The underperformance of relative strength was epic during that brief period—and Cornerstone Growth outperformed anyway.  I would further note that the 2.5% annual outperformance is after fees.

Evidence suggests that relative strength is a strategy worth implementing.

1 Comment | From the MM, Markets, Relative Strength and Value, Relative Strength Research | Permalink
Posted by Mike Moody

The #1 Investment Return Factor No One Wants to Talk About–Still

November 22, 2011

I noticed another article on alternative beta indexes in Advisor Perspectives the other day.  In it, Jason Hsu of Research Affiliates extols the virtues of a variety of alternatively constructed indexes.  He concludes:

While the Fundamental  Index strategy remains very close to our heart, we are very encouraged by the  increasing innovation in the field of alternative betas. Despite often very  different approaches, their respective results validate the entire idea of deviating  from the binary active–passive world of the past. Some of the most compelling  attributes of both are embedded in alternative betas. Like active managers,  these methods can produce excess returns and produce different market exposures  than mainstream indices, resulting in lower volatility and increased Sharpe  ratios. Like traditional indices, most will have lower management costs, many  will have similarly skinny implementation costs, and all will have lower  governance/monitoring costs than active strategies. Furthermore, some of the  most scalable approaches efficiently capture the value and small-cap effects  without the long/short requirement, monthly maintenance, and illiquidity of a  true Fama–French implementation.

Most investors make  their biggest bets on equities, comprising more than 50% of their asset  allocation. Accordingly, they have sought to diversify risk within equities by  style, size, and geography. We assert that investors should go to greater  lengths to diversify their equity portfolio. The past 10 years have brought  considerable pain to both sides of the equity active–passive aisle. The third  choice of alternative betas—even the simplest such as Equal-Weighting—would  have resulted in a far better outcome. Will history repeat? Nobody knows.  However, we think the evidence is far too compelling to ignore. We suggest  moving alternative betas up your to-do list.

A wide variety of alternative indexes are discussed in the article—with the exception of relative strength.  For some reason, no one ever wants to talk about it.  However, for your convenience, we are including a table from a prior post that compares relative strength indexing to other methods.

Source: Dorsey Wright Money Management

I understand why proponents of other indexing methods don’t like to discuss it—but it’s a good reason for investors to take a close look at it.

4 Comments | From the MM, Markets, Relative Strength Research, Thought Process | Permalink
Posted by Mike Moody

Quote of the Month

November 14, 2011

I believe the innovations of the 1970s and ’80s such as CAPM, alpha and beta–which started off being such useful intellectual tools–are now in danger of becoming obstacles to further innovation in financial mathematics. I would argue that too much current research effort, both academic and commercial, in this field has become–to paraphrase John Maynard Keynes–enslaved to some defunct, or not even defunct, economist.—-David Harding

It’s hard to exaggerate how entrenched efficient markets, MPT, and similar ideas have become in finance.  For some, acceptance of these ideas has led to a reluctance to even investigate other approaches.  When your mind is closed, things have gone too far.  For the brave few willing to actually work with the data, relative strength and tactical asset allocation have been a rich source of returns.

 

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Posted by Mike Moody

Third Quarter Review

October 4, 2011

Please click image below.

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Posted by Andy Hyer

Slouching Towards Debt-lehem…

July 29, 2011

Markets are undergoing a lot of changes in traditional relationships right now.  For example, Barron’s reports that corporates are the new Treasurys:

U.S. government debt is priced in the credit-default swap (CDS) market as having a higher-default risk than 22% of investment-grade corporate bonds. This means the CDS market, which influences the prices of corporate bonds, stocks, and the implied volatility of equity options, perceives Treasuries to be riskier than bonds issued by companies including Coca-Cola (ticker: KO), Oracle (ORCL) and Texas Instruments (TXN).

“This suggests corporates are the new sovereigns,” Thomas Lee, J.P. Morgan’s equity strategist, advised clients in a research note late last week, referring to corporate debt.

The phenomenon is also evident in Europe. J.P. Morgan’s Lee notes that 100% of corporate-debt issuers in Spain, Greece, and Portugal trade inside their government CDS spreads, while 60% of Italian corporate bonds trade inside that government’s spreads.

Historically, sovereign debt –bonds issued by governments – were considered low risk because governments can raise taxes or print money to pay their bills. During the credit crisis of 2007, governments all over the world printed money, and slashed interest rates to rescue the financial system, and are now saddled with massive debts. Now, some corporations might be financially healthier than governments.

There are also sharp changes in historical relationships going on in the commodity world, according to Reuters:

According to fund flows research company EPFR Global, commodity sector funds that invest in physical products, futures or the equities of commodity companies such as miners, attracted $1.465 billion in net inflows globally in the first two weeks of July.

The push into commodities in July reverses a trend in the second quarter, when investors pulled a net $3.9 billion out of commodities, according to Barclays Capital.

The move explains a divergence of stocks and commodities, with correlation dropping from more than 80 percent positive to around 40 percent negative over the past two weeks.

“Commodities could be seen in some ways as the least-worst option, given what is happening with other markets,” said Amrita Sen, an oil analyst at Barclays Capital who looks closely at fund allocations into commodities. “Some investors have not liquidated positions in commodities, while they have exited some other asset classes such as equities.”

All of the machinations with the debt ceiling and the associated market dislocations have posed a number of important questions for investors.

Q1) What happens to traditional asset allocations when traditional relationships break down?

Q2) How can we tell if the dislocations are a result of temporary factors or represent a permanent paradigm shift?

No one has all of the answers, least of all me, but a couple of things occur to me. 

A1) The same thing that always happens when these ephemeral relationships change—your allocation doesn’t behave anything like you thought it would.  Although the current uncertainties have highlighted the issues above, this kind of thing happens all the time.  In the current investment hierarchy, debt is seen as safer than equity because it is higher up in the capital structure—but that’s only true for a corporate balance sheet.  Sovereign debt always depends on the willingness of the sovereign to repay it.  Anyone who is old enough to be familiar with the term “Brady Bonds” knows what I am talking about.  If 100% of the corporate debt issuers in Spain trade inside the government debt spread, it’s not inconceivable for the same thing to happen in the US.  In other words, there’s no a priori reason for government debt to be safer than other debt.

What about commodities then?  Strategic asset allocation usually treats them like poor cousins, giving them a small seat at the children’s table.  What if they really are the “least worst option” and deserve a major slice of the portfolio due to their performance?  After all, commodities are at least tangible and do not rely on the willingness of a sovereign to be worth something.  What if the correct safety hierarchy is a) high-grade corporate debt, b) equity in companies with growing revenues, earnings, and dividends, c) commodities, and d) sovereign debt, especially in countries with a ton of obligations and a sketchy political process?

A2) We can’t.  That’s one of the issues with a paradigm shift—at the beginning, you can’t tell if it is temporary or permanent.  Around 1900, it looked like the US might supplant the UK as the world’s industrial power.  That turned out to be lasting.  Around 1990, it looked like Japan might supplant the US as the world’s industrial power.  That turned out to be temporary.  Around 2010, it looked like China might supplant the US as the world’s industrial power—and we have no idea right now if that is a temporary conceit or will become a permanent feature of the landscape.

Constantly changing relationships along with an inability to distinguish between a temporary and a permanent state of affairs, to me, argues strongly in favor of tactical asset allocation.  It simply makes sense to go where the returns are (or where the values exist, depending on your orientation).  Money always goes where it is treated best, and if you wish to win the battle for investment survival, you would be well-advised to do the same thing.

1 Comment | From the MM, Investor Behavior, Markets, Tactical Asset Alloc, Thought Process, Uncategorized | Permalink
Posted by Mike Moody

DWA Q2 Commentary

July 5, 2011

Click below for our review of the second quarter and our take on why this is likely a good environment to add to relative strength strategies.

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Posted by Andy Hyer

The #1 Investment Return Factor No One Wants to Talk About

June 29, 2011

Relative strength is the #1 investment return factor no one wants to talk about.  The reasons are not entirely clear to me, but perhaps it is because it is too simple.  It does not require a CFA to forecast earnings or to determine an economic moat.  It does not require a CPA to attempt to assess valuation.  It does not require an MBA to assess strategic business decisions.  In short, it does not play to the guild mentality wherein only certain masters of the universe have the elevated intellect, knowledge, and background to invest successfully.

Although relative strength is simple, I am not suggesting that relative strength is easy to implement.  Losing weight is simple too: eat less, exercise more.  That does not make it easy to do.  Relative strength, probably like most successful investment strategies, requires an inordinate amount of discipline—and tolerance of a fair amount of randomness.  Like most games that are easy to learn, but difficult to master—chess would be an apt example—proficient use of relative strength also requires deep study and experience.

Yet relative strength has been used successfully by practitioners for many generations.  George Chestnutt of the American Investors Fund began using it to run money in the 1930s and said it had been in use by others for at least a generation before that.  Relative strength has been shown to work in many asset classes, across many markets for more than 100 years.  Since the early 1990s, even academics have gotten in on the act.

And for all that, relative strength remains ignored.

I was reminded of its apparent obscurity again this week when reading an excellent article on indexing by the macrocephalic Rob Arnott.  He had a very nice piece in Advisor Perspectives about the virtues of alternative beta indexes.

In recent years, a whole new category of investments—called “alternative betas”—has emerged. Some of these alternative beta strategies, including the Fundamental Index® approach, use various structural schemes to select and/or weight securities in the index. In that sense, they fall between traditional cap-weighted approaches and active management: they pick up broadly diversified market exposure (beta) but seek to produce better results than cap-weighted indexes (what is desired from active managers).

Our CIO, Jason Hsu, and research staff have replicated the basic methodologies of many of these rules-based alternative betas, ranging from a simple equal-weighted approach to the straightforward Fundamental Index strategy to the truly exotic such as risk clustering and diversity weighting.7 The potential rewards are promising. Of the 10 non-cap-weighted U.S. equity strategies studied, all outperformed the passive cap-weighted benchmark. The range of excess returns by alternative beta strategies was between 0.4% and 3.0% per annum—matching a reasonable estimate of the top quartile of active managers—that is, the small cadre of managers who generally are successful at beating the benchmark (see Table 1). The bottom line: investors can obtain top-quartile performance with far less effort than is required to research and monitor traditional active equity managers.

Mr. Arnott has a very good point—and the numbers to prove it.  Lots of alternative beta strategies are available that can potentially offer top-quartile performance relative to other active managers and that may also outperform traditional passive cap-weighted benchmarks.  He is no doubt proselytizing on behalf of his firm’s Fundamental Index approach to some extent, but I think his underlying thesis is correct.  He offers the following table as evidence that alternative beta strategies can outperform, using data from 1964- 2009:

Source: Advisor Perspectives, Research Affiliates (click to enlarge)

I would like to offer a slight modification of this table, since it is only a listing of “select” alternative beta strategies.  Relative strength has been inexplicably excluded. Below, I present the same table of alternative beta strategies now including relative strength, the #1 investment return factor no one wants to talk about.  (I have my own theory about why other indexers don’t want to talk about relative strength, but I will let you reach your own conclusions.)  The relative strength returns presented in the table are for the exact same time period, 1964 through 2009.  They are taken from Professor Ken French’s database and show the results of a simple relative strength selection process when using the top third (as ranked by relative strength) of the large cap universe.

Source: Research Affiliates, Dorsey Wright (click to enlarge)

Are you surprised that relative strength blows away the other alternative beta strategies?

You shouldn’t be.  There are plenty of academic and practitioner studies attesting to the power of relative strength.  In short, I agree with Mr. Arnott that alternative beta indexes are worth a close look.  And I think it would be particularly prudent to consider relative strength weighted indexes.

See www.powershares.com for more information on our three DWA Technical Leaders Index ETFs (PDP, PIE, PIZ).

Click here for disclosures.  Past performance is no guarantee of future results.

5 Comments | From the MM, Markets, Relative Strength Research, Thought Process | Permalink
Posted by Mike Moody

The Real Wealth of Nations

June 21, 2011

This article is about history that is still being written, and about a simple way to create a powerful, sustainable economy.  It is about Lee Kuan Yew and the Singapore Central Provident Fund.  Never heard of it?  Neither had I, until I happened upon a story about it in the book Animal Spirits by George Akerlof and Robert Schiller.  I was fascinated and dug in to do a little further research.  The best thing about this story is that it is true—and therefore it is repeatable.  It has critical lessons for the United States, if we want to remain a world power.  And it is something we can easily do, if we make the choice to do it.

Most debates about the sluggish economy are conducted along Keynesian lines and argue that spending needs to be stimulated.  If people would just spend more, the economy would grow.  After all, the reasoning goes, consumer spending is 2/3 of the economy.  This line of thinking led to citizens actually being sent spending money—stimulus checks—in the mail!  The effect was pretty much what you would expect if you thought about it for more than fifteen minutes: minimal and temporary.  Giving someone money does not create prosperity—note the effects of sudden money on lottery winners.

What we have is not a spending problem, but a savings problem. Savings is what creates dynamic economic growth. Exhibit 1 in my case for the power of savings is Singapore.  Singapore became quasi-independent in 1955, after being a British possession since the 1820s (although it was occupied by the Japanese during World War II).  For a period of time, it was also part of Malaysia, but become fully independent in 1965.  Lee Kuan Yew had some training at the London School of Economics and took classical economists like Adam Smith seriously.  Adam Smith emphasized the capital accumulation that comes from savings.  With no natural resources whatsoever, except its people and their work ethic, Singapore resolved to save its way out of poverty.

Singapore Skyline

Source: www.commons.wikimedia.org

Lee Kuan Yew started the Singapore Central Provident Fund in 1955 as a way for citizens to save for retirement.  It has since been extended to include savings programs for housing and healthcare.  According to Akerlof and Schiller:

Initially it required employees and employers each to contribute 5% of employees wage income to the fund, but then contribution rates were rapidly increased.  They were steadily raised until 1983, when employer and employee were required to give 25% each (a total of 50%!).  The contribution rates follow a complicated schedule, but even today high-wage employees age 25-50 pay 34.5% and their employers pay 20%.  The system has not been “pay-as-you-go,” and the sums collected have really been invested. Largely because of the CPF, the gross national savings rate of Singapore has been in the vicinity of 50% for decades.

I put the important part in bold.  This is completely unlike our Social Security system, where the employee and employer payroll contributions are deducted, but then spent immediately.  As a result, in the US there is no actual surplus capital, only net debt which is an IOU on future generations.  Singapore already has essentially privatized their Social Security system.  Far from leading to fiscal disaster as some claim, the huge pool of enforced savings has not only secured the retirements of Singaporeans, it has allowed an enormous amount of capital investment. 

Disciplined savings as a nation over a 50-year period literally transformed Singapore from a poor trading outpost that was kicked out of the Malaysian union to one of the wealthiest nations in the world.  According to the Credit Suisse Global Wealth Report:

Household wealth in Singapore grew steadily and vigorously during the past decade, rising from USD 105,000 at the outset to more than USD 250,000 at the end. Most was due to domestic growth and asset price increases rather than favorable exchange rate movements. As a consequence, Singapore now ranks fourth in the world in terms of average personal wealth.

Wealth in Singapore is double the average wealth level in Taiwan and 20 times higher than in a neighbor like Indonesia—not to mention higher than in the US.  Now, I suppose it is not entirely surprising that a high savings rate leads to wealth.  What is more interesting, I think, is what it did to the Singaporean economy.  What grew out of the immense savings was a capital investment boom unlike anything ever seen.  And, the capital investment was not made with borrowed money, robbed from Peter today to pay Paul tomorrow, but was based on actual savings.  Thus, the growth was sustainable.  Coupled with the power of compounding, the results have been astonishing.

The able J.P. Lee did a little digging around for me and put together this graphic on the comparative GDP growth rates of the US and Singapore over the last 50 years.  Shocking isn’t it?

Click to enlarge.  Source: St. Louis Fed; Dept of Statistics, Government of Singapore

The graph on the top is a logarithmic scale which shows how much more rapid the economic growth in Singapore has been.  The magnitude of the compounded difference, though, isn’t really apparent until you take a look at the arithmetic chart below it!  GDP growth in the US over the last fifty years has been a robust 6.8%, but it has been dwarfed by the growth rate in Singapore, which has averaged a stunning 12.2%!  (If we could get even a fraction of this additional growth by privatizing Social Security, sign me up.)

Can you imagine what a national savings program could accomplish in the US?  We have many economic advantages already, ranging from an excellent university system, a diversified economy, and abundant natural resources to an outstanding record of technological innovation.  What we lack is savings.  Intelligent incentives to save and invest, coupled with Social Security payroll deductions that are actually invested in accounts for the participants could have a mind-boggling impact down the road.

Personal savings is something quite different from government savings or spending.  The US government seems addicted to deficit spending, but as a citizen you can’t do anything about that directly.  On the other hand, your level of personal savings in entirely under your control.  Like Singapore, most individuals have the ability to compound their savings for fifty years.  Even if the US never adopts an intelligent enforced savings plan, there is nothing to stop you from doing it yourself.

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Posted by Mike Moody

More Money Has Been Lost Avoiding Risk Than at the Point of a Gun

June 14, 2011

That’s a paraphrase from Ray DeVoe’s old maxim about money being lost reaching for yield.  For some reason—gee, I wonder if 2008 had anything to do with it?—investors are intensely allergic to equity risk right now.  So, instead, they are buying safe things like structured notes.  That hasn’t worked out too well.  According to an article in Investment News:

Structured notes and other derivatives products have been marketed by Wall Street as safe and secure investments. Of course, there’s safe and then there’s safe. Retail investors of all stripes have lost at least $113 billion by purchasing these purportedly safe instruments, according to a new study conducted by the nonpartisan policy center Demos and The Nation Institute, a media think tank.

“In my three decades of Wall Street experience, I have not seen any other product as absurdly destructive as retail investments linked to structured products,” securities arbitration consultant Louis Straney wrote in the report.

We’ve written about this kind of karma boomerang before: the harder you try to avoid getting nailed, the more likely it is that you’ll get nailed by exactly what you are trying to avoid.  

This happens because risk cannot be defined simply by volatility or capital loss.  Risk is much more encompassing and there is no way to avoid it.  Since you can’t avoid it, take your risk without significant leverage, in assets that have a chance to grow in value, in relatively liquid marketable instruments that you can understand—and do so in a systematic fashion.

Do you feel lucky, punk? Do ya?

Source: www.simpsonwallpapers.net

5 Comments | From the MM, Investor Behavior, Markets, Thought Process | Permalink
Posted by Mike Moody

Modern Portfolio Theory IS Harming Your Portfolio

June 7, 2011

This title is taken from a long blog post at Value Restoration Project—and no, I didn’t write it.  The author, J.J. Abodeely, is a portfolio manager at Sitka Pacific Capital, and a CFA to boot.  It’s nice to have some brothers-in-arms for a change!  Mr. Abodeely bases a lot of his commentary on a recent article by Scott Vincent, available on the Social Science Research Network.  Here’s the core of his argument:

In the paper Vincent argues that the flawed foundation of Modern Portfolio Theory (MPT) that risk=volatility has allowed MPT advocates to control the language of the debate and set the stage for the obvious conclusion that passive index-based investing is inherently superior. And don’t think for a second that this debate is simply theoretical, academic, or unimportant– the basic tenets of MPT shape the decisions of nearly every institutional money manager, wealth management firm, investment counselor/consultant, and financial planner in profound and often disturbing ways. YOUR money is almost certainly being managed with these ideas at the core. The traditional approach to asset allocation is built on false axioms.

While Vincent’s direct assault seems to be focused on highlighting the mistreatment of active, concentrated equity or fixed income asset managers vs. holding a passive equity or fixed income index, his arguments hold sway over the much larger and dangerous consequences of MPT on asset allocation. My assertion is that most damage to investors portfolios from the traditional approach to investing comes from the foundation of static, backward looking assumptions informing broad asset allocation decisions. 

I put the good parts in bold—and I think you can make a good case for both of those statements.  Instead of using static, backward-looking assumptions, I think it makes sense to examine tactical asset allocation, where asset weights can vary dynamically based on performance or valuation.   To me, it makes no sense to assume, for example, that bonds are preferable as a client gets older, regardless of the interest rate environment or poor price performance.  If an asset is performing poorly, why would any client be excited about holding it?

Strategic asset allocation is founded on the assumptions of Modern Portfolio Theory, and if the axioms are false, it is not surprising that it has not delivered in the way its apologists suggest it should.  Most distressing to me is the fact that asset allocation models are most sensitive to the inputs for return, and return is the most variable input of the three (returns, correlations, and standard deviation).  By definition, if your asset return assumptions are off, your asset allocation is wrong.  And seriously, if you could actually forecast asset returns accurately, you wouldn’t need asset allocation—you’d just buy the best-performing asset.  The greatest danger in strategic asset allocation, to me, is the assumption that past asset returns will be similar in the future. 

I think that assumption is flat-out wrong, because it flies in the face of the observed life cycles of companies and economies.  When companies are small, they are vulnerable.  Many of them simply don’t make it and go out of business.  Midsize companies that succeed often go through a very dynamic growth phase, where revenues and profits grow at a pace far beyond the growth rate of the underlying economy.  Once companies become very large, it is almost impossible for them to grow at a rapid pace, simply because they are working off such a large base.  It is pretty easy for a 20-store retailer to open ten new locations in a year and have 50% growth.  To get 50% growth at Wal-Mart would require them to open 4,485 new locations in a year, more than 12 per day—and then 18 per day the following year to keep that growth rate up.  That’s substantially more difficult.

Economies are no different.  Developing economies can growth at a fast clip, but not forever.  Once an economy is developed, the growth rate is going to slow down.  Growth can be boosted by productivity enhancements and good incentives, but eventually broad market returns will be connected with revenues and profits in the underlying economy.  In 1800, the US was an emerging market economy and the European economies were the developed markets.  The US has gone through a long period of powerful growth and is now the largest economy in the world.  As the Wal-Mart of world economies, we are not going to have the highest growth rate.  That doesn’t mean we can’t have good stock market returns—and, clearly, plenty of dynamic individual companies will do fantastically well—but emerging markets are likely to have higher growth rates.

As a result, I think it is naive to assume that US returns will necessarily resemble what we’ve seen before.  They will be lower than before if we pass the torch to more rapidly growing emerging economies, and they could be higher if emerging economies sabotage themselves with poor incentives or a lack of political stability.  Money goes where it is treated best and that is always an open question in the future.  Whatever the returns end up to be is a function of how we handle the future, not what has happened in the past.  Asset allocation needs to be forward-looking to be relevant for investors’ performance in the future.

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Posted by Mike Moody

ETF Usage Continues to Grow

May 27, 2011

This Advisor Perspectives article is worth reading.  Here is their summary:

More institutional investors are making ETFs part of their portfolio strategy, and that’s good news for retail investors. With many innovations, institutional investors are often the first in. Later the retail investors follow. ETFs, however, have shown a slightly different pattern. After 1993, when the first ETF was introduced in this country, ETFs were primarily of interest to institutional investors. At first, their main use was as a place to hold cash before investing in a new asset class, but institutions soon began using them for other purposes, such as tactical allocations and hedges.
We have seen tremendous interest and growth in our ETF-based separate account and mutual funds, particularly the go-anywhere Global Macro strategy.  There is definitely strong interest among retail investors in a flexible product that uses tactical asset allocation.  From a standing start in 2006 with Arrow Funds, we now manage about $800 million in ETFs!

See www.powershares.com for more information on our three DWA Technical Leaders Index ETFs (PDP, PIE, PIZ).

To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.

Click here for disclosures.  Past performance is no guarantee of future results.

Leave a Comment » | From the MM, Tactical Asset Alloc | Permalink
Posted by Mike Moody

Modern Portfolio Theory Is All Wrong

May 20, 2011

…according to a speaker at the recent IMCA conference.  The speaker was Arun Muralidhar, an economist trained at the Sloan School of Management at the Massachusetts Institute of Technology.  He is the former head of investment research for the World Bank, a former managing director at J.P. Morgan Investment Management and currently head of AlphaEngine Global Investment Solutions LLC.

What is his specific criticism?  It has to do with the static nature of traditional portfolio theory.  According to an article in Investment News:

The foundation of the CAPM investing model is to construct an optimal desired portfolio based on the investor’s objectives. As the market moves, the portfolio allocations are re-balanced to get it back to its optimal state. For example, if stock prices go up, a portfolio with 60% stocks and 40% bonds will become over-weighted in stocks. To prevent drift in the portfolio, the adviser re-balances by selling stocks and investing the proceeds in more bonds.

The benefit of this process is that it’s simple, transparent and easy to execute. However, a static re-balancing process does not work well in falling markets, Mr. Muralidhar said. The biggest risks faced by investors are large draw-downs in asset values, as it requires more substantial gains to recover the lost value. The re-balancing does nothing to prevent further losses when asset values plummet — as they did in the financial crisis.

“It’s like tieing the rudder on your ship in place and ignoring the winds and currents that you experience,” Mr. Muralidhar said.

How does he believe assets should be managed?  Well, I’m feeling quite validated today.  In fact, it sounds exactly like the systematic relative strength process we use.

The solution is for advisers to focus on using optimal investment strategies rather than maintaining optimal portfolios, he said. These strategies involve managing allocations more actively, based on market conditions. Mr. Muralidhar suggested advisers employ a “systematic management of assets using a rules-based technique” — “smart” investing.

Essentially, that involves an informed re-balancing of the portfolio toward the more-attractive assets and away from the less-attractive ones.

I added emphasis to the good parts.  I think his focus on optimal investment strategies rather than optimal portfolios is quite insightful.  We’ve long argued that the path to constructing better portfolios is to mix strategies, not just assets.  As it turns out, relative strength and value are both excellent strategies—and they work extremely well in combination because the excess returns are uncorrelated.  Unlike asset cross-correlations which can and do swing wildly up and down, strategy correlations are likely to be much more stable.  The reason is simple: trend-following and trend reversion are opposites; stocks and bonds (or pick any asset pair) are not.

It’s nice to see an economist discussing the theoretical flaws in MPT that have been evident to thoughtful practitioners for years and years.

1 Comment | From the MM, Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

David Ricardo’s Golden Rules

April 20, 2011

Most people, if they have heard of David Ricardo at all, associate him with classical economics and the law of comparative advantage.  What they don’t know is that David Ricardo was a trend follower—and made a fortune doing it.

David Ricardo was born in 1772, which ought to give you some idea just how robust trend following is and for how long it has worked.  His father was a stockbroker, so he had some familiarity with financial markets.  After an estrangement from his family from marrying outside his faith, he started his own brokerage business.  He retired in 1814 (age 42) with a fortune of $65 million (in today’s dollars; 600,000 pounds sterling then) and bought Gatcombe Park, in Gloucestershire.  (Today, Princess Anne lives at Gatcombe Park, a modest 730-acre estate, described as having  five main bedrooms, four secondary bedrooms, four reception rooms, a library, a billiard room and a conservatory, as well as staff accommodations.)

David Ricardo: Millionaire Trend Follower

source: www.econc10.bu.edu

What was David Ricardo’s secret?  According to an 1838 book, The Great Metropolis, Volume 2, by James Grant, it was what Ricardo referred to as his golden rules:

As I have mentioned the name of Mr. Ricardo, I may observe that he amassed his immense fortune by a scrupulous attention to what he called his own three golden rules, the observance of which he used to press on his private friends. These were, ” Never refuse an option* when you can get it,”—”Cut short your losses,”— ” Let your profits run on.” By cutting short one’s losses, Mr. Ricardo meant that when a member had made a purchase of stock, and prices were falling, he ought to resell immediately. And by letting one’s profits run on he meant, that when a member possessed stock, and prices were raising, he ought not to sell until prices had reached their highest, and were beginning again to fall. These are, indeed, golden rules, and may be applied with advantage to innumerable other transactions than those connected with the Stock Exchange.

The emphasis is mine, although I feel like the whole segment should be in bold!

Timeless investment wisdom: cut your losses and let your profits run!  And further, even clarification of what Ricardo meant!  If the price starts to fall, sell.  If it is rising, stay with it until it begins to fall.  Finally, the author points out that these golden rules may be applied to transactions other than those connected to the Stock Exchange.  Indeed, it turns out that relative strength investing works in stocks and across sectors and asset classes, both domestically and internationally.  And based on the story of David Ricardo, things haven’t changed much since 1800.

I think David Ricardo is now one of my favorite economists.

Hat tip to the World Beta blog and the Au.Tra.Sy blog for pointing me in the direction of this fantastic story.

1 Comment | From the MM, Markets, Relative Strength Research, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Uncertainty and the Dart-Throwing Chimpanzee

April 11, 2011

I ran across a wonderful review of Dan Gardner’s new book, Future Babble.  He discusses why pundits make predictions, why people listen to them, and why you would ultimately be better off with a dart-throwing chimpanzee.  The fact is that experts are terrible at predictions:

In Future Babble, Gardner acknowledges his debt to political scientist Phililp Tetlock, who set up a 20-year experiment in which he enrolled nearly 300 experts in politics. Tetlock then solicited thousands of predictions about the fates of scores of countries and later checked how well they did. Not so well. Tetlock concluded that most of his experts would have been beaten by “a dart-throwing chimpanzee.” Tetlock found that the experts wearing rose-tinted glasses “assigned probabilities of 65 percent to rosy scenarios that materialized only 15 percent of the time.” Doomsters did even worse: “They assigned probabilities of 70 percent to bleak scenarios that materialized only 12 percent of the time.”

Why, then, do people even listen?

Besides making fun of the failures of the prognosticating class, Gardner also explains why so many of us keep falling for false prophesy: Humans beings hate uncertainty. Gardner offers myriad insights from research in cognitive psychology and behavioral economics that explains how and why we succumb to our desires for certainty. “Whether sunny or bleak, convictions about the future satisfy the hunger for certainty,” writes Gardner. “We want to believe. And so we do.”

It’s fine, I suppose, if you listen to forecasts for entertainment.  But knowing the track record of forecasters, why in the heck would you ever base your investment policy on a forecast?  I’m not talking about just extreme forecasts like the rosy scenario or gloom-and-doom.  A pie chart that allocates assets based on a forecast of expected returns and expected correlations is no less a forecast—and no more likely to be accurate.

An Expert Pondering His Next Move in the Market

Source: www.blingcheese.com

Just because we hunger for certainty doesn’t mean it is available.  The only thing I can forecast with any certainty is that things will continue to change in unpredictable ways.  Price represents a market’s best guess about what might happen down the road, rightly or wrongly.  Price is an informed guess; people are putting real money on the line.  Research shows that prediction markets are often more accurate than experts.  Relative strength is just a handy way to measure price and gauge what market participants are doing.  There’s no guarantee that they will do the same thing tomorrow, but perceptions generally change gradually over time as new information comes to light, or new thinking about old information emerges.  Staying with strong relative strength trends and departing when they weaken is the simplest way to stay in synch with the changing flow of information in the market.

1 Comment | From the MM, Markets, Thought Process | Permalink
Posted by Mike Moody

Q1 Manager Insights

April 4, 2011

Click image below:

Leave a Comment » | From the MM | Permalink
Posted by Andy Hyer

Too Much Information Makes Elvis Leave the Building

March 15, 2011

If your teenage sends you a text with “TMI” in it, you’ve overshared.  Unfortunately for investors, the financial markets overshare all the time.  The flow of information can be so intense that your brain literally becomes overloaded.  Between earnings releases, corporate news, talking heads on CNBC with gongs, sirens, airhorns, or a dramatic opinion about everything, it’s no wonder you are overwhelmed.  No one can effectively process so much information.

Source: www.audiobooksonline.com

A Newsweek article on the science of decision making explains:

As the information load increased, she [Angelika Dimoka, director of the Center for Neural Decision Making at Temple University] found, so did activity in the dorsolateral prefrontal cortex, a region behind the forehead that is responsible for decision making and control of emotions. But as the researchers gave the bidders more and more information, activity in the dorsolateral PFC suddenly fell off, as if a circuit breaker had popped. “The bidders reach cognitive and information overload,” says Dimoka. They start making stupid mistakes and bad choices because the brain region responsible for smart decision making has essentially left the premises. For the same reason, their frustration and anxiety soar: the brain’s emotion regions—previously held in check by the dorsolateral PFC—run as wild as toddlers on a sugar high. The two effects build on one another. “With too much information, ” says Dimoka, “people’s decisions make less and less sense.”

That’s kind of scary—when you get information overload, your brain leaves the building and your emotions take over.  It’s a double whammy because the two effects reinforce one another.  It doesn’t matter how smart you are—the information overload is a neural reaction, not a decision that you make.

Source: www.tshirts.name

It’s well documented that emotional financial decisions are bad financial decisions.  While gut feelings are often useful in a social context, they are lethal in the market.

The implications are obvious.  1) Shut off the ridiculous information flow. More information does not result in better decisions.  Focus on the information relevant to your return factor, like relative strength or valuation.  2) Stay calm. In fact, cutting down the information flow will help you stay calm.  The less distractions you have, the more likely you are to have a Zen-like focus on what really matters. Finally, you need to 3) systematically execute your investment process. All of your testing is worthless if you cannot execute transactions with conviction at the point of decision.

The nice thing about a systematic process (like our Systematic Relative Strength accounts) is that the process can be designed and tested without any psychological pressure.  We find there is great peace of mind designing a process that adapts—when the environment changes, we don’t worry about the model breaking.  We know it will be out of synch for a while at the turns, but then it will adapt to the new trends.  Knowing that it will adapt makes it substantially easier to execute, I think.  The whole goal is not to get emotions involved when you are interacting with the markets.

1 Comment | From the MM, Investor Behavior, Markets, Thought Process | Permalink
Posted by Mike Moody

PIMCO: Inflation Going Higher

February 25, 2011

PIMCO recently released a commentary on their inflation outlook and how to handle it in a portfolio.  The comments of Mihir Worah, the head of PIMCO’s Real Return portfolio management team, were, I thought, exceptionally clear and direct.  A glance at PIMCO’s resume as the largest global bond manager might also suggest you take their viewpoint seriously (or cause heart palpitations, depending on your portfolio allocation).  Here’s their summary:

  • We expect popular measures of inflation to show modest increases in price levels this year from last year.
  • Masked behind these seemingly benign near-term increases in inflation are a number of longer-term factors that we believe could actually result in undesirably high rates of inflation in the not-too-distant future.
  • Higher rates of increases in food, energy and other commodity prices are leading to a divergence between the core rate of inflation that the Fed focuses on and the headline rate that includes food and energy prices and actually affects consumers.

That’s a pretty calm way of saying 1) inflation is going up, especially if you eat or drive, and 2) it could get out of control.

The article discusses some of the causes, which include increased demand for commodities in emerging markets, overseas wage increases that may increase import prices, and problematic domestic monetary and fiscal policy.  Mr. Worah points out that large components in the CPI, like rents, appear to have stablized and will no longer be offsetting increases in some of the other areas.  Commodity prices especially were emphasized as a problem:

We feel that although commodity prices may show tendencies to revert to a “mean,” the mean itself is not static, but rather a moving and, in our opinion, a rising target.

The most stark conclusion comes after the discussion of domestic fiscal policy:

Our budget deficit is around 10% of GDP and given the current trajectory and in the absence of a surprise economic expansion or political compromise, we estimate our debt-to-GDP ratio will reach around 100% in a few years. There are three ways to solve our debt problem: Growth, Inflation or Default. The choice is clear to us; which one seems most likely to you?

This is an excellent rhetorical question!  Realistically, it seems that intentional inflation is a more palatable political option than default.  Growth is really a non-option in my view, since the historical track record of governments is that they have always spent all receipts, plus a little more for good measure.  Growth will help but seems unlikely to bail us out in the long run.  Ken Rogoff points out that defaults often occur when debt is owned externally, but when much of the debt is owned domestically, inflation is a more typical outcome. 

In archly understated fashion, PIMCO suggests:

All things considered, investors may wish to consider adding assets typically associated with inflation-hedging strategies to their portfolios.

While this may be bad news to the legions of retail investors snuggling up with their recently purchased bond portfolios, it may not be the end of the world for investors committed to global asset class rotation.  (The types of asset classes than PIMCO suggests may be useful for inflation-hedging—commodities, real estate, equities, foreign bonds, and TIPs—are all, not coincidentally, included in the investment universe for our Global Macro strategy.)  Tactical asset allocation makes a great deal of sense for inflation hedging, since many of the asset classes in question are quite volatile and may not be desirable to hold for the long term in the context of a strategic asset allocation. 

Leave a Comment » | From the MM, Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Relative Strength Astounds the Skeptics Again

February 16, 2011

Morningstar ran a recent skeptical look at momentum as a return factor.  The author, Shannon Zimmerman, was upfront about his bias as an analyst:

As an analyst, I’m a fundamentalist at heart, focusing primarily on fund managers whose success owes to bottom-up research and strict valuation work.

Still, he tried to give relative strength (known in academia as “momentum”) a fair look, especially since strict valuation work was notably unsuccessful.  He notes:

It’s a fascinating topic, particularly for those who favor fundamental money managers, a group that, on average, has generally lost to the relevant bogies.  Contrary to that track record, the data on price momentum seem to show remarkable long-haul success.

Then he brings up a couple of straw men to explain why relative strength may not really work.  First, he suggests that the high returns from momentum may be concentrated in a few short periods of time—more on this later— (like the famous small-cap advantage over large caps) or that it may be a function of style.

In addition to time-series static, for example, how much of momentum’s long-haul outperformance may owe to style? Has the tactic’s showing been powered by pockets of success in, say, growth stocks or mid-cap names?

Fortunately for the home team, Ibbotson completed a recent research paper on that very topic.  And what did they find?

…the conclusion is striking: Regardless of where in the style box they reside, portfolios comprising funds that provide the greatest level of exposure to high-momentum stocks significantly outperform those with the lowest levels.

While this may be surprising to a fundamentalist, this is no surprise at all to those of us that have been delving through relative strength research for many years.  Relative strength seems to be a universal return factor, present in domestic and international securities—and even global asset classes.  Clearly, Ibbotson showed that it was present in every style box.

As for the time concentration issue, not to worry.  We tracked down total return data for the S&P 500 going back to 1930 and compared it to the momentum series on the website of Ken French at Dartmouth (top half in market cap, top 1/3 in momentum).  Ironically, Ken French is one of the leading apologists for the efficient market theory.  The chart below shows 10-year rolling returns, which is why it starts in 1940.  The average ten-year returns?  405% for relative strength and 216% for the S&P 500, a near doubling!  That’s without the momentum series getting any credit for dividends.  Even more impressive, the ten-year rolling return of the relative strength series outperformed in 100% of the time periods.  Clearly, unlike the small-cap versus large-cap issue, relative strength performance is not limited to certain narrow time periods.

Click to enlarge

Source:  J.P. Lee, Dorsey, Wright Money Management

Why are value investors always so shocked by the strong performance of relative strength methods?  I think there are two major reasons: 1) the value cult has drowned out discussion of other successful return factors, and 2) the reason for strong momentum is poorly understood.

The value cult drowns out other schools of investing, but it developed its following largely by historical accident.  Ben Graham and David Dodd’s classic Securities Analysis came out early on, in 1934, and found a vocal contemporary advocate in Warren Buffett.  In other words, much of the historical prominence of value investing is due to its early start—and the fact that it developed and was propagated in academia, where it had a chance to be taught as the shining, virtuous path to wealth to generations of students.  Its tenets were never really questioned bacause value investing is also logical, pretty transparent, and it works.  However, it is a logical mistake to assume that since value investing works, it is the only thing that works.

Largely overlooked by the value cultists is the fact that Warren Buffett’s fortune has been made in growth stocks with high reinvestment rates and arbitrage, not cigar butts.  From James Altucher’s book Trade Like Warren Buffett: “…Buffett achieved much of his early success from arbitrage techniques, short-term trading, liquidations, and so on rather than using the techniques he became famous for with stocks like Coca-Cola or Capital Cities.  In the latter stages of his career he was able to successfully diversify his portfolio using fixed income arbitrage, currencies, commodities, and other techniques.”  (Note: when Buffett purchased his stake in Coca-Cola, it carried a P/E of 13, while the overall market was selling for a P/E of 10!  Not exactly a traditional value investment.)  In recent years, Buffett has become famous for a giant derivatives trade where he essentially wrote a massive amount of naked put options on the U.S. market.  In other words, the popular image of Warren Buffett as a buy-and-hold value investor is completely false.  I’m not bashing here—Warren Buffett is clearly a great investor, and while he did take Ben Graham’s course at Columbia, much of his success is due to his investment flexibility, not some imaginary ability to identify value stocks and then hold them forever.

Likewise, Ben Graham made no secret of the fact that his personal fortune from the Graham-Newman Corporation was, in fact, due to the growth stocks purchased by his partner Jerry Newman.  One magazine article I read quoted the anointed father of value investing, Benjamin Graham, as saying “Thank God for Jerry Newman!  If it weren’t for him, we never would have made any money.”  Based on the real lives of Buffett and Graham, profitable investing is a little more complex than reading The Intelligent Investor a few times, and clearly not limited to any strict definition of value investing.

Once value cultists concede that successful investing can be done in several ways, we’re left with trying to understand why relative strength works.  Why do stocks that are strong tend to stay strong for a while?  Simply put, strong stocks are typically in a sweet spot, either on a fundamental or macroeconomic basis.  High RS stocks generally have tremendous current fundamentals.

Let’s look at a current example—the best performing stock in the S&P 500 last year, Netflix.  In a moribund economy, the year-over-year change in revenues at Netflix accelerated from 19% growth in Q4 2008 to 34% growth by Q4 2010.  While revenues were increasing 34%, earnings per share went up 55%, which indicates that margins were expanding.  Investors, for some reason, were attracted to a stock with rapid and accelerating revenue growth and profit margins.  Is that really so difficult to understand?

Can Netflix continue to accelerate revenues and margins?  The laws of mathematics tell us that this feat cannot be pulled off forever—but it’s already gone on for a couple of years and that’s certainly long enough to make a lot of money.  How much longer it will continue is anyone’s guess.  (Certainly it has gone on longer than Whitney Tilson expected.)  The high relative strength investor looks for stocks that are performing—but stays with them only as long as that performance continues.  At some point, Netflix will hit a speed bump, and when it does, the high relative strength investor will happily part with the shares—hopefully at a tasty profit.

Lots of practitioner and academic studies show this exact pattern: if you hold strong assets and ruthlessly replace assets that become weak, the portfolios do very well.  There’s really no mystery to it.

So, Mr. Zimmerman, if you’re reading this, don’t beat yourself up.  I’m sure you’re a great guy.  You’re not the first value investor that has had trouble understanding how relative strength operates as a return factor.  And you should take heart in this: studies show that portfolios combining relative strength and value have uncorrelated excess returns, so it works great to have a mix of both styles.  Value works, but relative strength rocks.

3 Comments | From the MM, Markets, Relative Strength Research | Permalink
Posted by Mike Moody

Is Your Index Fund Broken?

January 31, 2011

That’s the provocative title of a recent article in Smart Money.  The article makes a controversial claim:

The Journal of Indexes gives academic treatment to bland investments, and so might not seem a likely source of hot controversy. The latest issue, however, is packed with it–and has greatly annoyed mutual fund titan Vanguard. A report therein gives new support for the claim that most index investors are unknowingly missing out on a large portion of the returns that their passive approach ought to provide.

Are investors really missing out on a large part of the passive return?  The article implies that a variety of alternative weighting methods like efficiency weighting, volatility weighting, equal weighting, and fundamental weighting provide better returns than traditional capitalization weighting.  ETFs are even available for some of these alternative methods, most notably equal weighting (RSP) and fundamental weighting (PRF).  Over the eleven-year period cited in the article, all of them have better returns than capitalization weighting.

Source: Smart Money/The Journal of Indexes

Here’s what drives me crazy: when alternative weighting methodologies are discussed, there is always one method omitted.  That method is relative strength.  Perhaps it is no surprise that over the eleven-year period cited in the article, relative strength weighting outperformed all of the other methods.  (And I didn’t get to cherry pick the time period–the article made that choice.  If the blowout year of 2010 was included in the results, relative strength would have an even larger advantage over its rivals.)  It’s also nice to note that there is a relative strength weighted index available, the Technical Leaders Index (PDP).  Here’s what the same chart looks like if relative strength weighting is included.

Source: Journal of Indexes, Dorsey Wright

Why is relative strength weighting always left out?  If I were cynical, I might say that relative strength is intentionally disregarded so that alternative methodologies do not have to show their comparative performance.  But since I am in a charitable mood, I think the reason it is often ignored is because it is too simple.  Yes, too simple. 

It does not require manipulation of a massive fundamental database.  It does not require equations and a mainframe computer to calculate a covariance matrix.  It does not require a CFA, MBA, or PhD.  (Think how much money you could save on grad school!)  Instead, it requires a pocket calculator or spreadsheet and one of the many methods for measuring relative strength.  We are partial to our proprietary measurements, but lots of methods work just fine.  What does it say about your complicated alternative indexing method when it can be outperformed by something a middle-school student could learn to calculate?

There is one big advantage to capitalization weighting: it can be implemented in nearly infinite size.  Along with theoretical reasons (“owning the market portfolio” in Modern Portfolio Theory), that may well be one reason why institutions, and Vanguard, believe it is the way to go.  On the other hand, it is not really a stretch to believe that there are alternative indexing methodologies that could be designed for better performance.  We think that relative strength has been demonstrated to be the simplest and most robust way to build the better mousetrap.

6 Comments | From the MM, Markets, Relative Strength Research | Permalink
Posted by Mike Moody

Jeremy Grantham of GMO on Momentum

January 27, 2011

Art Cashin, the market guru at UBS, quoted Jeremy Grantham of GMO in his newsletter this morning.  Am I the only one that finds it ironic that Grantham was speaking at the annual Graham & Dodd breakfast?  This is Grantham discussing the economist John Maynard Keynes: 

Remember, when it comes to the workings of the market, Keynes really got it. Career risk drives the institutional world. Basically, everyone behaves as if their job description is “keep it.” Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that’s okay. For example, every single CEO of, say, the 30 largest financial companies failed to see the housing bust coming and the inevitable crisis that would follow it. Naturally enough, “Nobody saw it coming!” was their cry, although we knew 30 or so strategists, economists, letter writers, and so on who all saw it coming. But in general, those who danced off the cliff had enough company that, if they didn’t commit other large errors, they were safe; missing the pending crisis was far from a sufficient reason for getting fired, apparently. Keynes had it right: “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.”

So, what you have to do is look around and see what the other guy is doing and, if you want to be successful, just beat him to the draw. Be quicker and slicker. And if everyone is looking at everybody else to see what’s going on to minimize their career risk, then we are going to have herding. We are all going to surge in one direction, and then we are all going to surge in the other direction. We are going to generate substantial momentum, which is measurable in every financial asset class, and has been so forever. Sometimes the periodicity of the momentum shifts, but it’s always there. It’s the single largest inefficiency in the market. There are plenty of inefficiencies, probably hundreds. But the overwhelmingly biggest one is momentum…

Brilliant.  I put the really good parts in bold so you wouldn’t miss it.  This is an interesting explanation for momentum and might partially explain why it is always present in markets: it’s part of human nature.  We just try to measure it and use it.

HT to GA.

Leave a Comment » | From the MM, Markets, Thought Process | Permalink
Posted by Mike Moody

California Dreaming

January 20, 2011

Barron’s points out that CALPERS, the state pension system could have done better last year owning SPY.  CALPERS made 12.5% last year.  The state teacher retirement system, CALSTRS, did slightly better, earning 12.7%.  But SPY returned more than 14.4%.

This neglects the fact that SPY is all equity and CALPERS is a balanced fund.  The S&P balanced ETF that Barron’s mentioned, AOR, returned 11.1%.

I have a modest proposal.  Maybe CALPERS should just put their $228 billion into the Arrow DWA Balanced Fund (DWAFX).  It has bonds for stability, domestic and international equities for growth, and alternatives for diversification.  And the return last year was 16.08%, beating CALPERS, CALSTRS, SPY, and AOR.

Is anyone is Sacramento listening?  Heck, we could make do with even $5 billion.  We can dream, can’t we?

Click to enlarge.  Source: Yahoo! Finance

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

2 Comments | From the MM, Markets | Permalink
Posted by Mike Moody

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