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

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.)

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!

[click to read full size]

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.

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.

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.

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.