This May Take Longer than I Thought

In my book, Buy and Hold is Dead (AGAIN), the Case for Active Portfolio Management in Dangerous Markets, I make some intrepid forecasts about the future of the investment industry regarding active or tactical asset allocation.  One of my forecasts was that consumers would demand active management as traditional buy and hold, strategic asset allocation strategies failed to deliver expected returns in an ongoing secular bear market.  I felt that consumers would demand that the industry change, and that the obvious flaws in the theoretical rationale for buy and hold investing would compel professional advisors to consider a major change in how they approached portfolio construction.  Well…perhaps this is going to take a little longer than I thought.

 As I was reading the Washington Post Business Section last weekend I came across an article from Kiplinger Personal Finance called, “Knowing financial advisor’s motives, expertise can pay dividends.”  The writer, Bob Frick, a senior editor for Kiplinger, did a fine job of discussing the importance of knowing an advisors goals, fees, holistic approach, etc.  However, one question he wants prospective clients to ask is, “Do you time the market?”  He goes on to say, “By asking an advisor about her investment strategy and how it changes with developments in the markets, you’ll discover whether she’s a closet market timer.  Watch out for an adviser who says, for example, that she thought foreign stocks were getting pricey so she shifted client’s money from overseas shares to commodities.”

I love Bob, and anyone else married to the same old tired assumptions about market timing.  For the record, there is no more professional and risk reducing strategy that I can think of than to sell overpriced securities in favor of, presumably, more rationally valued asset classes.  In this case, holding on to “pricey” foreign stocks is virtually guaranteed to generate less than expected returns for the asset class in the future.  A better question for prospective clients to ask is, “how do you determine if an asset class is overvalued and what do you do about it terms of portfolio construction?”  Unfortunately, in order for the question to be asked, the financial media has to stop promoting this drivel about market timing.  While it’s clear to me from speaking around the country that the professional investment industry is getting very interested in how and why they should actively manage the asset classes in their client portfolios, I think the press is still stuck in the dark ages.  That’s too bad for the average consumer, and too bad for financial advisors who are waiting for their clients to revolt before they make the change from passive to active asset allocation.

A New Term to Consider: Asset Allocators

Recently I found myself under deadline to complete an article that should be published in the May edition of Financial Planning Magazine.  The article summarizes one of my favorite topics when speaking to audiences, which is to rebut what I consider to be the three main objections to active management.  For the record, they are 1) you believe in the Nobel Prize winning theory supporting buy and hold investing, 2) you don’t believe active managers can outperform passive benchmarks, and 3) you think the active management business model is impractical.  In the piece I refer to the confusion that reigns in and out of the industry regarding the roles of different kinds of investors.  I routinely refer to the two camps as portfolio managers and money managers.

I define portfolio managers as the group of investors who can invest in any asset class with the only constraint being the investment policy of the investor.  Portfolio managers are free to own any asset class.  Portfolio managers do not have an easy to identify benchmark. On the other hand, money managers are typically constrained by prospectus to invest in only one asset class and one investment style.  We know them as mutual fund managers, separate account managers, or nowadays, even hedge fund managers.  Money managers specialize in investing in only one asset class, and they typically manage portfolios that own individual securities, rather than pooled investments, in pursuit of beating their easy to identify passive benchmark. 

Rick Vollaro, my partner and co-portfolio manager helped to edit my article, and suggested that using the terms portfolio manager and money manager only adds to the confusion.  He suggested the term asset allocators instead of portfolio managers.  The more I think of it the more I think that Rick’s idea has merit.  In fact, any investor who is free to own multiple asset classes without constraint is an asset allocator.  The term easily differentiates us from money managers, who are not free to use asset allocation.  From now on I think we should compare the roles of asset allocators and money managers.  The same conclusion will be reached, which is that the public and the industry is completely confused about the roles that these investors play.  The choice of whether you hire “active” versus “passive” money managers has nothing to do with the decision to actively manage your asset allocation.  If you don’t manage a mutual fund or a separate account, in all probability you are an asset allocator.

Water Cooler Conversations

I recently engaged in some correspondence with a money manager who is a technical trader who makes “non-emotional” trend-following decisions for changing portfolio construction.  I welcome any and all techniques that managers use to manage risk, but I had to smile at the thought of “unemotional” investing.  I know that professional money managers are supposed to be completely dispassionate automatons who evaluate data with computer-like efficiency.  But in my experience, that simply isn’t the case.  In fact, while evaluating the performance of other managers we often imagine the “water cooler conversations” that must be taking place whenever a particular investment strategy isn’t working.  And believe me, at one time or another, virtually every investment strategy doesn’t work for some period of time.

For trend followers, the water cooler conversations take place when the market does not exhibit a strong trend and portfolio managers are whipsawed in and out of the market.  For regression to the mean managers the water cooler moment occurs when market prices continue to trend well above where they have historically mean-reverted back to their long-term moving averages.  For investors who rely on market sentiment, the moment occurs when the consensus gets it right for an extended period of time and being a contrarian turns out to be a disaster….in the short-term.  For value managers the moment occurs when stocks stay irrationally priced for longer than they can remain solvent.  In each case, we imagine the analysts and managers of the investment firm whose strategy is on the wrong side of the market, gathered by the water cooler, and talking in hushed tones about negative portfolio results and unhappy clients.

Let me be clear.  At such times professional money managers are anything but unemotional.  They are human and they are all subject to the biases and heuristics that make us human.  When the strategy is working I guarantee you that money managers are feeling good, and when it isn’t I guarantee you that you will find hardened professionals whispering by the water cooler about what they will do if things don’t “turn around soon.”  The best professionals know and understand these emotions and deal with them in a positive way as they make investment decisions.  If you are feeling fear, then the odds are that other investors are feeling the same way, and perhaps that represents a buying opportunity.  I don’t believe there is such a thing as unemotional investing.  The tactics may be quantitative and not qualitative, but managing emotions will always be part of the art of good money management.

The Unappreciated R-Squared

In the parade of Greek letters that are used to describe modern portfolio theory statistics, the most well known is beta.  When William Sharp published his Nobel Prize winning Capital Asset Pricing Model (CAPM) in the 1960’s, he posited that there are two kinds of risk.  One is systematic risk, or market risk which can’t be diversified away by investors.  The measure of systematic risk, or non-diversifiable risk, is beta.  Beta is used to measure the volatility of a managed portfolio versus the volatility of the stock market.  The second well know MPT stat is alpha.  Alpha measures whether risk-adjusted portfolio returns are better than you would have predicted using the CAPM model.  To earn positive portfolio alpha has been the holy grail of investment managers for 40 years.

The poor sister of this collection of Greek letters and MPT science is the notion of R-Squared.  R-Squared measures the strength of the relationship between the movement of the stock market and the movement of the portfolio.  The higher the R-squared the more the market tells us about the likely direction of portfolio performance.  Pinnacle portfolios have a high R-Squared meaning that a high percentage of the direction of our portfolio returns can be explained by the direction of the broad market returns.  Having a low R-Squared is a prized commodity in bear markets where investors want portfolio performance to have a low relationship to the stock market (i.e. they don’t want their portfolio going down when the market is going down).   Usually these low R-Squared investments are hedge funds, real estate funds, private equity, and market timing portfolios and they are invested in the “alternative investment” allocation of a managed portfolio.  These positions are meant to “hedge” the core holdings of stocks that have a high R-Squared.  At Pinnacle we call these low R-Squared strategies either hedge fund strategies or “eclectic managers.”

Pinnacle managed accounts are meant to be “core” portfolios.  Our tactical strategy is meant to be implemented for the majority of our client’s invested capital.  We are not offering the possibility that our portfolios will achieve investment gains in bear markets.  Our version of risk management is simply to minimize losses in bear markets so that we can legitimately earn back those losses in bull markets.  We do not consider our management style to be “an interesting diversification” for someone’s managed account.  We provide active management as an alternative to buy and hold investing for our client’s core portfolio holdings.  Our philosophy is to manage wealth somewhere between buy and hold and low R-Squared strategies.  As I often say, Pinnacle clients are likely to be frustrated in bull markets when returns are compared to stocks, and bear markets when they are compared to cash.  This means that clients are always likely to be frustrated with our relative returns.  But over time, we will generate enough excess returns over buying and holding that our client’s are comfortable allowing us to manage the majority of their investable assets.

Say It Ain’t So, Gus

Occasionally an article will come across my desk and something in it will catch my attention.  This week, William Bissett, a wealth manager here at Pinnacle, dropped me an article published in the Morningstar Advisor called, “Asset Allocation Heavyweights Square Off.”  The piece, written by Ryan Leggio in the Feb/March 2010 issue, featured a conversation between John Hussman, the manager of the Hussman Strategic Growth Fund (owned by Pinnacle in our managed accounts) and Gus Sauter, the Chief Investment Officer of the Vanguard Group, the famous money management firm overseeing more than $1.4 trillion of managed assets in over 100 mutual funds.  Let me just say that John Hussman, in my opinion, has to be one of the smartest people on the planet and his weekly letter about his fund is required reading for Pinnacle analysts.  I most definitely would not want to be on the other side of the table debating just about anything with John Hussman. 

 Towards the end of an interesting interview, Leggio asked both participants how they feel about relative valuations right now.  Here is what Sauter had to say: 

 “A lot of people have asked, what is the equity risk premium looking forward?  Is it zero?  Is it negative  Is it small?  Or is it the historic norm, with the historic norm being in the 5.5% to 6% range?  I would say that, on average, the equity risk premium is at historic norms all the time.  So, I think that we’re looking at average rates of return going forward, and that’s based on the concept that we’re rewarded for investing in stocks because of the inherent risk of investing in stocks.  If we weren’t going to be rewarded for that, we’d sell stocks, and we’d sell them down to a price that made them attractive again.  In fact, that’s what happened from the end of 2007 to the beginning of 2009.”

 Mr. Sauter goes on to argue that the stock market is priced to deliver historically average returns going forward over the next decade.  I don’t know how he gets there from here.  Based on normalized P/E ratios the stock market is expensive.  Hussman says we will basically get the earnings growth rate from stocks over the next decade, which is about 6%.  Many other analysts think we will get a lot less.  What is blatantly and obviously true is that the rewards for owning stocks depends on the price at which you buy them, and the average risk premium is a useless bit of information used to confuse buy and hold investors.  Gus should forget the garbage about “average risk premiums at historic norms” and get in the game.  Investors praying for average returns should know that there is little data to support the idea that buying and holding from these prices will be a successful strategy.

Happy Anniversary

I hate when I forget an anniversary or a birthday, which is why my wife, Linda, took over the job of remembering family dates for birthdays, anniversaries and the like twenty years ago.  But I didn’t need any help remembering that this month is the Big One for investors and financial planners.  March happens to be the ten-year anniversary of the current secular bear market which has defined the entire career of young planners and investment advisors and severely altered wealth creation plans for just about everyone else.

In March of 2000 the stock market had just finished one of the best five years of annualized performance in stock market history and investors were so enthusiastic that they were paying more than 50-times 10-year normalized earnings to own broad market indexes like the S&P 500.  At the time, we left traditional measures of value based on earnings behind, instead measuring the future prospects of American companies by new metrics, like how many eyeballs might view a website.  Everyone was getting rich investing in “dot-coms” and the technology sector had grown to be more than 40% of the total stock market by market capitalization.  Value investors were in full retreat, or were going out of business, and if you didn’t own the top 50 companies in the S&P 500 you were guaranteed another losing year relative to the broad market.  Wasn’t it grand!

Ten years later the stock market is trading 30% below March 2000 prices, and adjusted for dividends stocks have lost about 1.5% per year, before adjusting for inflation.  Unfortunately there is no data that I’m aware of to suggest that the stock market will deliver historical average expected returns from current elevated valuation levels.  If you don’t care to look at values, perhaps the “new normal” of bloated debt levels, higher consumer saving, more regulation, and higher taxes will convince you that future stock market returns are certainly not guaranteed from here.  The only answer will be active management, however you define it.  Those who can scrape a few extra percent of returns above what the market will offer will truly be delivering an important service to investors who need to earn risk premiums even though the broad market is not cooperating.  Buying and holding from here is truly a high-risk strategy.