The Float

Words of Wisdom

Two useful items from two of our favorite participant-observers: Mohamed El-Erian and John Hussman. Frist, from El-Erian's interview with Advisor Perspectives (bold text in original):

Another principle you advocate is the separation of alpha and beta in portfolio construction (something we have written about in our publication). Why has this principle gained in importance and how can advisors best implement it?

The dispersion of returns among actively managed strategies has become very large. In the old days, the dispersion resembled a "fan chart." It started with relatively small dispersion in fixed income classes, to larger ones in public equities and very large ones in illiquid asset classes. Today, we are seeing much more dispersion across all asset classes. The result is, unless you are absolutely confident of your active management choices, it is better to go passive.

The cause of this greater dispersion is that markets are more volatile. We came from a period (until the middle of 2007) that was very good to investors. Risk premia across all asset classes were compressing, delivering high returns and declining volatility. As long as investors were exposed and levered they did well. Now investors can get easily caught with the wrong position in a highly volatile environment. The hurdle for active management has gone up. You have to be sure you are actually getting something. You are paying higher fees and being exposed to more risk.

And here's Hussman, on the intertwined roles of government and Wall Street in the unwinding of the credit bubble:

As with the stock market bubble of the late 1990's, it is generally true that bad investments tend to go bad. There is little to prevent that from occurring. The only question is who bears the cost. Essentially, the Federal government issued hundreds of billions in debt, much of the proceeds which tax cut beneficiaries invested in mortgage bonds, without concern about loan quality because the debt had been tied to the good faith and credit of Uncle Sam, and now we've got to issue more government debt to bail out the losses from the bad investments.

One of the reasons that the recent credit crisis has been so wrenching is that the losses are being borne by institutions that have the explicit or implicit backing of the U.S. government, so it feels like the things that ought to be safe really aren't safe. But that is no accident -- bad credit sought out those institutions and their government backing, as the inevitable result of the swap markets (as described above). In the end, the implicit and explicit backing of the U.S. government -- which allowed all of this to occur -- is also what will be called upon to clean up the mess.

Read the whole Hussman comment, especially for his take on the making of the credit bubble. We think it's one of his best efforts.

Alpha and Beta Exposures

We've argued repeatedly that investors and advisors should be more aware of the distinction between alpha (idiosyncratic, manager-driven returns that are relatively uncorrelated to any underlying asset class or benchmark) and beta (systematic, market-driven returns that track underlying asset classes or benchmarks).

Two recent items suggest that such awareness is on the rise among institutional and individual investors. Here's an excerpt from Pensions and Investments:

Some institutional investors are betting on highly concentrated equity portfolios to gain more alpha while at the same time expanding allocations to their core passive strategies, according to consultants, managers and pension fund executives.

As global equity markets are showing signs of a lengthy slowdown and investors are more cautious about costs, a new approach to the traditional core-satellite strategy is spreading across the world. The idea is anchored on the premise that investors in active equity strategies that hug a particular benchmark might be paying for alpha but getting mostly "closet" beta, consultants and managers said.

Another contributing factor is the poor performance of enhanced indexing and quantitative risk-control strategies. Once considered as a reliable way of harvesting alpha, many of these strategies -- which tend to make a large number of small bets against an index -- have nosedived in performance, driving investors to seek different sources of return, consultants said.

According to proponents of the updated core-satellite approach, investors should use a largely passive core portfolio coupled with more concentrated bets to maximize alpha in a cost-efficient way by using one or more concentrated managers.

And here's more from Advisor Perspectives:

Distinguishing alpha from beta matters because fees for beta from well-established asset classes should be very low, while fees for alpha are very high. Furthermore, you should select alpha providers carefully so the fees are worth it! Separating alpha from beta (in a clearly defined measurement or evaluative sense, not necessarily by investing separately in them) insures[*] you will pay high fees only for positive expected alpha, not for the delivery of a beta along with random, unskillful alpha production.

The point here isn't to argue for some super-strict separation in which alpha-seeking instruments must have zero beta (which, even if theoretically possible, is vanishingly unlikely in practical terms). It's to argue that there's a lot of beta out there masquerading as alpha. Investors and advisors who know the difference, and resist paying for one while receiving the other, should do better, on balance, than those who don't.

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* Pedantic diction-related aside: The word here should be ensured, which implies making something sure, not insured, which implies the business of insurance.

Sources

Thao Hua, "Finding Alpha With Few Bets," Pensions and Investments, June 23, 2008

Robert Huebscher, "Don't Pay Alpha Fees for Beta Performance," Advisor Perspectives, July 8, 2008

Caution: Reporters Trying to Help

In Sunday's Washington Post, Nancy Trejos assembled a true classic of the "what-should-investors-do-now" journalistic genre. Fortunately, Trejos quotes a couple sane observers, most notably Vanguard's Gus Sauter. But there's enough unhelpfulness in this piece to merit a few observations.

First, even the subtitle--"How to Play Your Stocks When They Keep Falling"--implies a wrong-headed approach to the financial markets. The number of Post readers who should be "playing their stocks" in any environment is vanishingly small. But let's move on to the more substantive elements here. We'll pull a few passages out and add some commentary after each item.

So if your money's tied up in the stock market, what are you to do?

First of all, if you've properly diversified your investments among various sectors and stocks, bonds and mutual funds, strategists suggest you just hold tight.

This isn't a huge deal, but as we've noted on several previous occasions (here, for example), some journalists tend to conflate investment vehicles (in this case, mutual funds) with asset classes. They're different, of course, and reporters should know--and help their readers understand--the difference.

If you decide selling is the right move, make sure you do it a little at a time. "Selling today will lock in that loss. Our recommendation would be to continue to trim but don't do a wholesale fire sale," said William Keller, senior vice president and director of investments for the Washington region at PNC.

This notion of "locking in" losses bothers us a little. A loss is a loss, whether it's realized or not, and though tax considerations might affect one's timing preferences on the margin (in some cases making selling more attractive in order to offset realized gains), selling (or reducing) a position is either a good idea or it isn't. If it is, then lock that loss right in there!* Doing so "a little at a time" is only a good idea if one is scaling out of a position as part of a serious, systematic plan.

Yared, on the other hand, thinks that if it's a real loser, you should not be afraid to dump it. "From an investors' point of view, you have to be somewhat coldhearted," he said.

Do a lot of research beforehand, a rule that applies to both buying and selling, he said. Look at balance sheets, stock prices, growth rates, the history of the company. Read its quarterly and annual reports. All that information and more is available on the Internet, he said.

Yared's plea for coldheartedness is spot-on. But that second paragraph, the Cramer-esque bit about digging into balance sheets, growth rates, and company reports strikes us as decidedly bad advice for the vast majority of the Post's readers, advice that encourages rank-and-file investors to overestimate both their own abilities and the utility of such information in the first place.

Late in her piece, Trejos names four companies: Johnson & Johnson, Wal-Mart (or is it now *Walmart?), General Electric, and Goldman Sachs. Cue the crickets! All that stock-jockeying advice and what do we get? A semi-plausible four-stock proxy for the S&P 500. Go figure.

But let's conclude on a high note:

Of course, each individual investor has to decide how much risk he or she can tolerate and go from there, the strategists said. If all this is too much for you and you just want to hold on to your cash, that might be the right move for you, but consider this: Inflation might be on the way, and if it gets here, it'll take a big bite out of your reserves.

"Cash has its own risks, and the erosion of purchasing power is one of them," Horan said.

That's not to say you shouldn't keep cash. "You need to have a fallback of immediate liquidity whether it's a line of credit or cash at hand," Keller said. "You have to have that because these are rocky times now."

Yes, yes, and yes, with one important amendment: inflation isn't "on the way." It's already here.

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* Of course, one can "lock in" losses if one sells a position (at a relatively low price) and doesn't replace that position until asset prices have risen. But selling X and buying Y more or less at the same time doesn't "lock in a loss" so much as it changes one's exposure from X to Y.

Source

Nancy Trejos, "When You're Tied Up in a Down Market," Washington Post, June 29, 2008

Stuck on the 50-Day

Toward the end of Wednesday's weak action, we posted an item on the challenge faced by the broad equity market as the S&P 500 sagged just below its 50-day moving average. We suggested that the short-term burden of proof (to say nothing of the long term!) remained with the bulls...just in time to see the market rocket higher yesterday in a mildly strange session. Oil moved up sharply, bond insurers were downgraded (good grief...was that still in question?), questions about Lehman persisted, &c. But a few decent retail prints and some good ol' fashioned animal spirits were enough to take 'em higher.

The trading action yesterday was unusually robust, with solid volume, and a classic open-at-the-low, close-at-the-high move to the upside. Looking back over the last few months, we've seen a few days with similar action, just after marking (and re-testing) the March lows, twice in April, and again yesterday. All but the mid-April case were followed by some sort of non-trivial pullback, the sort of moves that can whipsaw investors into and out of the market in all the wrong ways.

The Battle Continues

So far so bad for the S&P 500's test of its 50-day moving average. As we noted yesterday, the developing squeeze between the 50- and 200-day MAs was going to resolve itself one way or the other, perhaps decisively. And so far, the bulls can't take much solace in the market's action around the 50-day line. This story isn't over, and, as always, investors can reverse field in a hurry.

Stripping away all the caveats, and pending this last hour of trading, the last couple days haven't been especially bullish. After closing below the 50-day yesterday (on above-average volume), and remaining there after rolling over early in the afternoon today, the burden of proof remains squarely on the bulls.

The big question is whether this downside breach of the 50-day line will prove short-lived (as the most recent such instance did in mid-April) or whether they'll take 'em lower from here...yet again. 

Learning from Bill Miller

In yesterday's reading list, we included a recent New York Times piece on Legg Mason's Bill Miller, the renowned fund manager whose flagship fund beat the S&P 500 for 15 consecutive years, from 1991 through 2005.

The story's premise--that Miller has been chastened a bit by his fund's recent underperformance--is fascinating enough as a study in manager psychology. More interesting (to us, anyway!) is the fact Geraldine Fabrikant's piece features a few arguments that we've made repeatedly in this space.

First, there's the big picture phenomenon of reversion to the mean. In relatively efficient markets, it's just enormously difficult to sustain significant departures from the performance of a fund's underlying asset class. Many efficient-market absolutists will suggest that Miller's successful run may well have been little more than coin-flipping luck. With so many managers in the field, they might say, a small number of coin-flippers will come up heads 15 times in a row. We think there is such a thing as investment skill, often more temperamental than technical. But we fully acknowledge that luck is part of the game as well, and we suspect Miller was both good and lucky for many years. There's no reason to suspect he's any less skilled now than he was five years ago, but his randomized draws from the bag full of luck has clearly turned against him.

Second, there are the intertwined problems of asset bloat and market impact. Here's Fabrikant:

SOME longtime market experts think that fund size is the most daunting challenge he faces. Regardless of periodic ups and downs, he may simply be managing too much money to continue to produce outsized gains, they say.

"The number of investment opportunities just shrinks radically" when a fund swells, says John C. Bogle, the founder of the Vanguard Group, the mutual fund powerhouse, who describes himself as a fan of Mr. Miller. "The bigger you get, the fewer the number of stocks you can hold with a meaningful position."

Indeed, Mr. Miller holds a relatively concentrated portfolio, and the bad news has kept coming for some of his major picks. Last week, after Microsoft's proposed buyout of Yahoo fell apart, Yahoo's stock plunged 11.5 percent last week. Legg Mason holds a 6.7 percent stake in Yahoo. Countrywide Financial, another big holding, has been slammed by the mortgage crisis and errant lending. Its stock has fallen 87.9 percent over the last 12 months. And Mr. Miller amassed a sizable position in Bear Stearns, the investment bank gone to the grave.

We remember one of Miller's annual letters in which he freely acknowledged the constraints of running a portfolio that was at once enormous and highly concentrated. (He was aware of the problem then, but, in Fabrikant's telling, seems to dismiss it as a cause of his recent underperformance.) Because asset bloat is a structural problem, there's not much he can do about it, unless he diversifies his holdings. Which he and his team appear to be considering:

At Legg Mason, Mr. Miller has been stress-testing his investment theses -- the way he and his colleagues picks stocks -- and is considering a move away from concentrating his bets on dozens rather than hundreds of stocks.

"The question we are asking ourselves is: Should we think more broadly now about probability, about high-impact events and protecting against them by having broader exposure to the market?" he says.

Which leads us to the third point: Chasing "hot" managers is not a particularly wise game, at least not after they're both hot and pretty much universally recognized as such. Paying managers to pick positions and manage risk actively isn't inherently unwise, but it should be done with great care, and such services should be delivered in products and programs that have a relatively high probability of delivering what investors are paying for. There can be no guarantees, of course, but piling into enormous funds with a relatively high likelihood of mean-reversion strikes us as an approach that makes a difficult game that much harder.

Source

Geraldine Fabrikant, "Humbler, After a Streak of Magic," New York Times, May 11, 2008

Cash Levels and Active Management

In yesterday's reading list, we mentioned a Jonathan Burton story on varying levels of cash in mutual funds. Burton mentions a few funds that have maintained relatively high levels of cash in recent weeks, noting that some of these funds have performed well even as the equity markets have rebounded off their January and March lows.

Here are a couple relevant excerpts:

The volatile stock market and the weak economy have derailed many mutual-fund managers, but without the ability to bet against stocks, some are playing defense the only way they can -- by holding more cash.

In recent months that's been a smart move. Cash is king when stocks head south. A sizeable allotment to short-term Treasury bills and other cash-equivalent vehicles can dodge the worst blows of a down market and absorb its unpredictable shocks. Moreover, money on the sidelines lets a cost-conscious manager scoop up bargains as they appear.

...

Yet this seemingly safe route is not without its own risk. Cash is trash when stocks rebound. Clinging to cash at those times creates a drag that can transform a leading fund into a laggard. Since no one knows when markets will turn, and given the constant pressure -- from both their shareholders and their bosses -- to outdo a benchmark index, most fund managers stay as close to fully invested as possible; the average diversified U.S. stock fund keeps only about 4% of its assets in cash, according to Morningstar.

Financial advisers in particular look askance at funds with outsized cash positions. Advisers set and adjust portfolio allocations between stocks, bonds, cash and other investments based on a client's risk profile. A cash-rich fund can upset those plans, says Dan Moisand, an investment manager at Spraker Fitzgerald Tamayo & Moisand LLC in Melbourne, Fla.

"If you're hiring managers to buy and sell stocks, that's what they should be doing," he says. "We should be making the cash decisions, because we're closer to the client."

Now, this leads to an interesting and important discussion.

In one sense, Dan Moisand is entirely right: Advisors are closer to their clients, and they should make the big asset allocation decisions. But there's another sense in which we think Moisand is on the wrong track.

When clients want active management (i.e., the explicit pursuit of alpha through some combination of outperformance in strong markets and capital preservation in weak ones), we think they should get it in a framework that's meaningfully different from the typical mash-up of active and passive exposure delivered by conventional long-only funds.

One of the key differences between tracking-error minimizers and true active managers is that the latter are less constrained than the former, in particular in the sense that their investment mandates do not require them to be (more or less) fully invested in all market conditions. After all, money management is risk management, and managing risk can be done in one of two ways: (1) strategic asset allocation and radical diversification or (2) active hedging of one sort or another (using options, short positions, cash levels, &c.). Both methods are perfectly legitimate. But they're different! And they need to be understood, pursued, and sold differently.

Burton's certainly right that large cash positions can weigh on performance during strong market episodes. But the essence of successful money management is in delivering market-beating returns for the same level of risk or market-like returns for a lower level of risk.

If advisors are frustrated with fund managers who maintain high cash levels (or whose cash levels vary somewhat unpredictably), they should look elsewhere for pure asset-class exposure, in particular to the inexpensive ETFs and index funds designed to provide exactly that.

If they want active managers, and are willing pay for same, they should know that varying levels of exposure to risky assets is part of what any self- and investor-respecting money manager should deliver.

Source

Jonathan Burton, "Kings of Cash," MarketWatch, May 11, 2008

"Prediction" Breakdowns

On Tuesday, the prolific team at CXO Advisory Group posted an interesting item on the predictive capacity of S&P 500 futures traders. The key distinctions were across type of market (1995-2000, 2000-2003, 2003-2008) and type of trader (commercial hedgers, large speculators, retail speculators).

We recommend the post in its entirety, in part for the excellent graphical presentation. But the key takeaways here are (1)retail speculators are generally wrong in all periods and (2) all types of traders have become less predictive over time. Interesting stuff.

Vaguely related: Developments in the correlation between the CBOE equity put-call ratio and the broad equity market. As we've noted in this space on several occasions (most recently here), peaks in this indicator's 21-day exponential moving average have coincided very neatly with intermediate bottoms in the stock market.*

In the chart below, you can see quite clearly that the market lows of August, November, January, and March matched up with highs in the equity put-call. What we've found interesting is that since the March lows, the 21-day EMA has moved only slightly lower as the S&P 500 has moved non-trivially higher. Our suspicion is that the residual fear reflected in CPCE could provide a firm foundation of sentiment (i.e., skepticism) for further moves higher.

Notwithstanding today's relatively impressive corporate reports--and, more importantly, investors' bullish reactions to very mediocre ones--we remain concerned about the medium-term earnings outlook. But medium-term markets are a bunch of short-term markets stacked end-to-end. And the current short-term environment, driven by a mix of re-awakened risk appetites, stubborn anxiety, and non-apocalyptic news, looks relatively buoyant from here.

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* Here's more from CXO on whether put-call ratios are leading or lagging indicators.

Watch That Tracking Error

We've never understood--or, to put it more precisely, we've never seen the value of--the money management industry's emphasis on tracking error in long-only funds. Minimizing tracking is a perfectly reasonable objective. But to do so, investors should (more or less) eliminate it by using index-based vehicles.

Where investors want active management of some sort, on the other hand, tracking error per se should be viewed as a decidedly positive characteristic--as long as it isn't consistently to the downside, of course. Managers who are compelled (by institutional consultants, retail advisors, in-house mandates, and/or their own insecurity) to minimize tracking error have little opportunity to deliver what they've been hired to do, which, presumably, is to deliver something other than the fully commoditized returns of some particular benchmark.

We were reminded of this important idea yesterday by Yves Smith, who passed along a recent FT story on "innovation stagnation" in the mutual fund industry. Here's a key exceprt from Kevin Burke's piece in the FT:

The US mutual fund industry’s best attempts at innovation have fallen flat in recent years due to a hairy mix of factors ranging from changes in how funds are distributed to the simple fact that many new products have failed to deliver their promised returns.

Compounding the lacklustre output is the industry’s maturity level. With all the major asset classes already chock full of choices, there is little room for more products on shelves that are stocked with 7,044 mutual funds.

...

A big factor in the innovation stagnation is the fact that so-called gatekeepers at the broker/dealers whose financial advisers sell funds have gained much greater influence over what those advisers sell. These gatekeepers are paid to sort through the thousands of funds available. And they want predictability in the funds they recommend.

Specifically, gatekeepers do not want to see more than 3 per cent tracking error, or deviation from the relevant benchmark funds are supposed to track. It is an attempt to manage risk and avoid negative surprises. Their job is on the line if the funds they recommend do not deliver as promised. Innovative products, by definition, are not going to be predictable.

...

The safe bet for portfolio managers is to stay close to their benchmark. The rub for investors is they end up paying a higher fee for active management when what they are essentially getting is an index fund.

As always, we don't stake any theological claim on behalf of active or passive styles. We use both, and we think each can play an important role in a comprehensive asset management program. What we are committed to, both in theory and in practice, is that those two styles should be pursued (and understood) very differently. Where the passive approach is strategic, highly diversified, tax-efficient, and inexpensive, the active approach should be tactical, relatively concentrated, eclectic, and a little more expensive.*

These two styles, the relative merits and demerits of which have prompted endless debate, are, if nothing else, different. Rather than pushing ugly mashups of active and passive styles in the form of big, bloated, highly diversified mutual funds, the kind of industry "creativity" Kevin Burke finds wanting should manifest itself in an honest telling of this important distinction.

Alas, we won't be holding our breath...

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*It should be a little more expensive if it's good. If it's good, it's scarce, and thus deserving of a premium price. But not, we hasten to add, a ridiculously high one.

Source

Kevin Burke, "Fads dominate as creativity fails," Financial Times, March 2, 2008

Technical Question Marks

This morning Barry Ritholtz updated one of his favorite charts, the percentage of NYSE issues trading above their 200-day moving averages. Here's Barry's point--or, more accurately, his question:

The present reading on the % of NYSE stocks above their 200 Day Moving Average indicator is at readings that--at least in the early part of the market cycle--have led to strong rallies in the short run. The first 3 readings (far left of chart) were deeply oversold conditions caused by a) the initial collapse from March 2,000; b) The 9/11 sell off; and c) the sell off following that 9/11 selloff/bounce.

So far, this reading has produced a peak rally reading of 9.6% at its recent high price. This is a far cry from the past bounces.

If you believe--and this is a big if--that history will repeat itself, then we still have a ways to run. If you expect those prior bounces were materially different than today, than this rally may run out of steam.

Not exactly determinative, but then that's market life these days (and most days, for that matter).

Which prompted us to think about a minor mystery unfolding in a sentiment indicator we've mentioned several times over the last few months: the equity-only put-call ratio. When we last checked in with this time series (in mid-January), the ratio's 21-day exponential moving average had bumped up against levels recently associated major market bottoms in March, August, November. We've added the dashed blue line to indicate that the 21-day EMA topped out again last month--just after we posted our January 17th post on this topic. (See the chart below.)

Now, however, we have the 21-day EMA lurking at the 0.75 level. Does that imply another sharp bottom is waiting in the wings?

Market action, in particular today's anemic afternoon breakdown, doesn't seem especially bullish. But when we see this kind of divergence--between (1) a contrarian (and currently bullish) indicator such as the put-call ratio and (2) the absence of fearful capitulation, which typically marks sharp v-shaped bottoms--we begin to suspect that investor risk-aversion is turning more chronic--and less acute--than it has been for the last several months.

If the fear and panic routine (which, let's be honest, could re-open at any time!) is playing itself out...the next market chapter might be characterized by malaise and indifference. The upshot: Less volatility, lower volumes, and no particular directional conviction.

What we'd expect is that a series of short-term "V's" resolve into a medium term "U" to form a broader, firmer base for future gains.