Just Own Berkshire?

A friend asks:

Is the portfolio you own with shares of Berkshire Hathaway diversified enough to be your entire equity portfolio?

Here’s my response, with a bit of added color versus my original reply. It’s helpful to have Berkshire’s top 13F holdings (included below) for reference:

180930_BRK_13F
Source: Berkshire 13F via WhaleWisdom.com

Do I think you could buy today’s Berkshire 13F portfolio and hold it forever as a well-diversified portfolio? No. There’s no such thing as a permanent stock portfolio. Capital markets are far too dynamic for that.

What you’re really buying (and thus have to underwrite) with a share of Berkshire are Warren and Charlie’s capital allocation skills. This is an extremely concentrated portfolio. Not necessarily a bad thing for skilled investment managers like Warren and Charlie. But just a handful of stocks and their idiosyncratic characteristics are going to drive portfolio performance.

Do I believe you could plausibly own Berkshire and only Berkshire as a kind of closed-end fund/ETF managed by Warren and Charlie? Yes, I do. The obvious issue you run into here is that sooner or later Warren and Charlie are going to shuffle off this mortal coil. I suspect it’ll be much tougher for investors to maintain the same level of conviction in their successors.

Would I do it myself? No. It’s an awful lot of single manager risk to take, to just own Berkshire. Even if Warren and Charlie were immortal, it would be a lot of single manager risk to take. However, I could definitely see using Berkshire alongside just a couple other highly concentrated managers, if you’re the kind of investor who doesn’t mind high tracking error and is concerned more with the risk of permanent capital impairment than volatility.

Could you potentially just use Berkshire in place of an allocation to large cap US stocks? Yes, I definitely think you could.

The answer to this question really hinges on your definition of risk, and issues of path dependency in investment performance. In my view, the starting point for any asset allocation should be the global market capitalization weighted portfolio. Deviations from the global market capitalization weighted portfolio should be made thoughtfully, after careful deliberation. Whenever you deviate from the global market capitalization weighted portfolio, you are implicitly saying you’re smarter than the aggregated insights of every other market participant.

Sorry to say, but you’re probably not that smart. I’m probably not that smart, either.

To concentrate an investment portfolio in a single share of Berkshire implies you have a massively differentiated view of where value will accrue in the global equity markets, and that you’re extremely confident in that view. In hindsight, it seems obvious Berkshire would be a great bet. But in financial markets, literally everything seems obvious in hindsight.

Does this mean a concentrated bet on Berkshire wouldn’t work out?

Absolutely not. It just means we need to carefully consider whether a highly concentrated bet on Berkshire makes sense in light of its potential performance across a broad range of possible futures.

Personally, I’m not confident enough in my ex ante stock and manager selection abilities to bet the farm on a single pick like that.

And I think that’s true for most of us.

It’s Just Business

“Your father did business with Hyman Roth, your father respected Hyman Roth, but your father never trusted Hyman Roth.” – Frank Pentangeli, The Godfather, Part II

Frank Pentangeli is one of my favorite characters from The Godfather movies. He’s a lovable, old-fashioned gangster struggling to eke out a living in a brutal and cynical world. Frank’s fatal flaw is that he’s not smart enough to see all the angles. He never fully grasps how completely he’s at the mercy of forces much larger and more powerful than himself. He clings to a code of honor that seems increasingly outmoded as the plot evolves.

And so, it’s fitting that when Pentangeli finally goes out near the end of Part II, it’s not because someone whacks him. It’s because Tom Hagan convinces him the only way to salvage his honor and dignity is to off himself. The scene is one of the best in all three movies.

In Epsilon Theory speak, Frankie Five Angels is a lousy player of the metagame. (h/t to Epsilon Theory for inspiring this post, btw)

godfatherii_tom_frank

Despite Frank’s obvious flaws, his acute sense of personal honor was useful when it came to judging the character of his business partners and counterparties. His most famous line (quoted above) is a testament to the fact you can always choose to do business with someone at arm’s length. Trust is not a prerequisite for a mutually beneficial business relationship.

So it is with the sell-side.

We do business with the sell-side. We respect the sell-side. But we should never, ever, under any circumstance trust the sell-side.

I was moved to reflect on this after another one of those “market outlook” meetings where a “portfolio specialist” (a salesman with his CFA designation) from a big asset manager comes and talks to you about how the next recession is at least a couple years away* and sure there some risks but nonetheless the fundamentals are sound. Oh and by the way have you looked at leveraged loan funds lately?

Sure, leveraged loan covenants suck, and the space is red hot, and investors will get burned eventually. But there’s still a couple years left in the trade.

Sure, high yield looks like a crap deal on a relative basis, but on an absolute basis there’s still a supportive bid for yield from foreign buyers.

Sure, this stock trades rich, but our analysts can see a path higher from here.

How many times have you heard this stuff? Or stuff that rhymes with this?

Our relationship with the sell-side should always and everywhere be a transactional relationship. But the goal of every great salesman is to turn a transactional relationship into a personal relationship. Personal relationships bring with them all kinds of social conventions and obligations. Unless you’re a complete sociopath, it’s nigh on impossible to behave in a transactional manner once a business relationship turns personal.

That doesn’t mean you can’t go to lunch with the sell-side.

It doesn’t mean you can’t use research from the sell-side.

It means you should never, ever under any circumstance allow yourself to believe the helpful guy or gal from the sell-side you have lunch with once a quarter is truly on your side of the table, always and everywhere with your best interests in mind.

If you do this, and you choose to trust these people instead of merely transacting business with them, you will eventually discover that they do not, in fact, sit on the same side of the table as you. They do not, in fact, suffer like you when the bill of goods they’ve sold you blows up.

And it’ll cost you.

*The next recession is always at least a couple years away.

Weapons Of Mass Destruction?

There is this meme out there that the increasing popularity of ETFs as investment vehicles is eventually going to blow up the world. This came up in a meeting I attended recently. Whenever I have these conversations what I take away from them is that a shocking number of financial market participants do not actually understand how ETFs work.

The meme goes like this: there are too many people investing through ETFs these days and when there is a nasty bear market they will all redeem from the ETFs at the same time and the ETFs will all explode. On the off chance you’re wondering how this meme got started this graphic should set you straight.

ETF_flows
Source: ICI

As you can see, if you’re an active equity mutual fund manager you’ve got several hundred billion reasons to portray the rise of the ETF as a harbinger of doom. And so here is the first and most important thing everyone needs to know about ETFs:

ETFs are not mutual funds!

From what I can tell, the ETF-As-Weapon-Of-Mass-Destruction meme is founded on the incorrect assumption an ETF is like an open-ended mutual fund or hedge fund that needs to liquidate holdings to meet redemption requests in cash.

That’s basically the opposite of how an ETF works.

An ETF is much closer in nature to a closed-end fund that can trade at a premium or discount to net asset value over time. The difference is that certain sophisticated market participants (“authorized participants”) can transact with an ETF issuer to create or retire shares. In theory, this mechanism should keep an ETF’s share price in line with its NAV (Arbitrage 101, friends).

Here is a helpful diagram, courtesy of ICI:

ETF_create_redeem_process
Source: ICI

When individual investors like you and me want to sell ETF shares, we don’t participate in the creation/redemption process. We couldn’t participate in that process if we wanted to. Instead, we have to sell our shares in the secondary market like a stock. The price we can transact at is determined by supply and demand. This can be a blessing or a curse, depending on circumstances.

Some Grains of Truth

ETF investors do face risks as they transact in the secondary market. The biggest risk is that they become forced sellers when the market for a particular ETF is thinly traded. In that case, they’ll have to take a haircut to unload their shares. This is no different from what happens when someone tries to unload shares of an individual stock in an illiquid market. That’s Trading 101.

Thus, if you’re going to invest in ETFs you need to pay attention to liquidity. This goes for your personal liquidity (under what conditions might I become a forced seller of this security?) as well as market liquidity (are bid-offer spreads for this security going to stay reasonably tight across a range of market conditions?).

If, for example, you own the S&P 500 index in ETF form you probably don’t have much to worry about from a liquidity standpoint. This won’t protect you from behaving like an idiot as an individual, but it’s fairly unlikely you will ever have to part with your ETF shares at a 50% discount to NAV. In fact, the early S&P 500 ETFs have been battle-tested across a number of stressed market environments, including the global financial crisis. They have yet to explode.

If you own more esoteric things, however, (e.g. the EGX 30 index, high yield debt, bank loans, complicated VIX derivatives) you need to think carefully about liquidity. Shrewd traders will eat you alive if you try to unload esoteric stuff in a dislocated market. In general, it’s dangerous to assume a share of something can ever be more liquid than the stuff it owns or represents. Yes, bank loan and high yield ETF investors, I’m looking at you here.

But these risks aren’t unique to ETFs. They’re present with every exchange traded security. It’s just that mutual fund investors aren’t used to thinking about this stuff. They just buy or redeem each day at NAV.

In Conclusion

Never generalize about any security or type of security.

Securities are not inherently good or bad. Investing is not a morality play.

In fact, any time someone is presenting a security or investment philosophy as a black/white, good/bad, dualistic type of situation it’s a good sign he’s financially incentivized to sell you something.

There are smart ways to use ETFs and stupid ways to use ETFs. But that’s more a comment on investor behavior and specific implementations of ETF investment strategies than the structure itself.

You Have To Earn It

Personally, I’m relieved to see market volatility pick up again.

I’m sick of all this feel-good, bull market crap where everyone can be investing geniuses as long as they focus on the “long term” and own the lowest cost, most tax efficient index funds. It’s high time some volatility comes along and shakes some weak hands out of the market.

People want to live in a riskless world where all the market ever does is go up. You know what kind of returns you are entitled to in a riskless world where all the market ever does is go up?

T-bills.

(Arbitrage 101, friends)

Lately, we’ve gone soft. We’ve forgotten good investment returns aren’t some god-given, inalienable right. Good returns must be earned. And here are some ways you can earn them:

  • By being so far ahead of a secular shift in technology or market structure that everyone else thinks you’re insane.
  • By investing in esoteric stuff no one else can sell to an investment committee.
  • By putting money to work when the world looks to be going to hell in a hand basket.
  • By enduring short and medium-term pain in unloved assets.
  • In spite of inevitable blowups and meltdowns in individual investments.
  • More generally, by persevering when fear and loathing reign supreme in the markets.

Whenever volatility picks up and people start freaking out, I’m reminded of Nick Murray’s definition of a bear market: “a period when stocks are returned to their rightful owners.”

Portfolio Construction In A Frightening And Uncertain World

My last post on risk management was somewhat impractical. It was critical of the shortcuts we often take in analyzing risk but didn’t offer anything in the way of practical alternatives.

The theme of the last post was that in spite of the sophisticated-sounding calculations underlying most analyses, they are at best crude approximations. In general, these approximations (e.g. assumption of uncorrelated, normally distributed investment returns) make the world seem less risky than it really is.

So, what are we supposed to do about it?

In theory:

  • We should take even less risk than our statistical models indicate is acceptable, building in an extra margin of safety. For example, holding some cash reserves even if we have the risk tolerance to run fully invested.
  • We should use leverage sparingly.
  • We should not make overly concentrated bets. I’m not just talking about individual stocks here. The same goes for securitized asset classes like US large cap stocks.
  • We should not have too much conviction in any given position.

Also, in theory, the more certain you are of an investment outcome, the larger and more concentrated you should make your positions. If you knew the future with total certainty, you would go out and find the single highest return opportunity out there and lever it to the max.

Given we live in a world where a 60% hit rate is world class, most of our portfolios should be considerably more diversified with considerably less than max leverage.

I don’t think any of that’s particularly controversial.

But I’m not just talking about individual stocks here. This goes for broad asset classes and the notion of “stocks for the long run,” too. I’m not arguing we should all be capping equity exposure at 50%. But it’s prudent to stress portfolios with extreme downside scenarios (this is unpopular because it shows clients how vulnerable they are to severe, unexpected shocks).

How robust is the average retiree’s portfolio to a 30% equity drawdown that takes a decade to recover?

For that matter, how robust is the average retiree’s portfolio to 1970s-style stagflation?

Jason Zweig interviewed a couple of PMs who had to endure through that period:

“It was so painful,” says William M.B. Berger, chairman emeritus of the Berger Funds, “that I don’t even want my memory to bring it back.” Avon Products, the hot growth stock of 1972, tumbled from $140 a share to $18.50 by the end of 1974; Coca-Cola shares dropped from $149.75 to $44.50. “In that kind of scary market,” recalls Bill Grimsley of Investment Company of America, “there’s really no place to hide.” Sad but true: In 1974, 313 of the 318 growth funds then in existence lost money; fully 123 of them fell at least 30%.

“It was like a mudslide,” says Ralph Wanger of the Acorn Fund, which lost 23.7% in 1973 and 27.7% more in 1974. “Every day you came in, watched the market go down another percent, and went home.”

Chuck Royce took over Pennsylvania Mutual Fund in May 1973. That year, 48.5% of its value evaporated; in 1974 it lost another 46%. “For me, it was like the Great Depression,” recalls Royce with a shudder. “Everything we owned went down. It seemed as if the world was coming to an end.”

Are we building portfolios and investment processes taking the possibility of that kind of environment into account?

Are we equipped psychologically to deal with that kind of environment?

I conclude with this evocative little passage from George R.R. Martin:

“Oh, my sweet summer child,” Old Nan said quietly, “what do you know of fear? Fear is for the winter, my little lord, when the snows fall a hundred feet deep and the ice wind comes howling out of the north. Fear is for the long night, when the sun hides its face for years at a time, and little children are born and live and die all in darkness while the direwolves grow gaunt and hungry, and the white walkers move through the woods.”

Alignment of Interests

Recently, someone argued to me it’s not good if your personal portfolio looks too different from what you recommend to clients as a financial advisor. Generally, I disagree. However, there are certainly limits. If you are selling your ability to “pick winners” to clients and your portfolio is all index funds, for example, that is a problem.

If I am acting as a fiduciary, I am to act in clients’ best interests. Most clients will look nothing at all like me in terms of their goals, financial circumstances, risk tolerance and level of financial sophistication.

The biggest difference between me and a client would probably be our relative tolerance for tracking error. That is, our tolerance for investment performance that is very different from the broad market indices and our neighbors, who are inclined to chase momentum and do stupid things like borrow money to buy Bitcoin at the top.

Everyone wants to be +20 when the market is +10, or breaking even when the market is -10. No one likes being -5 when the market is +5.

Oddly, the pain of being -5 when the market is +5 seems more acute for clients than being -10 when the market is -10. For the client, the right thing to do is minimize tracking error and the pain of relative underperformance to make it easier for him to stick to his asset allocation and financial plan more generally.

What is more important than the optics of my portfolio is the alignment of interests in the advisor-client relationship. My financial incentives should be structured such that I am at all times incentivized to make decisions in my clients’ best interest.

Two And Twenty

Some people claim the hedge fund two and twenty (that is, a two percent management fee and twenty percent of profits) fee structure aligns the managers with their clients. This, too, is nonsense. It is a totally asymmetric payoff for the manager. The manager suffers nothing if performance is poor. The compensation structure is a free option that encourages excessive risk taking. That’s why it’s extra important for hedge fund managers to be personally invested in their funds and “eat their own cooking.” It creates symmetry in the incentive structure.

A financial advisor is not a hedge fund manager.

A hedge fund manager should be entirely focused on investment performance (here I am including risk management under the umbrella of performance). For a financial advisor, investment performance is at least two or three lines down the list, well below things like cash flow management and asset allocation. If a client is not generating free cash flow even Buffett’s returns won’t save him. Likewise, a client who is inclined to whipsaw herself to death trying to time the market will not benefit from clever security selection.

Increasing clients’ saving rates and dissuading clients from market timing have nothing whatsoever to do with the composition of the advisor’s investment portfolio.

Shenanigans! “Index Investing Distorts Valuations” Edition

Here is an oft-repeated meme that has begun to grind my gears. Here it is again, from the FT’s Megan Greene:

Passive investments, such as exchange traded funds (ETFs) and index funds, similarly ignore fundamentals. Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher. This creates a piling-on effect as funds buy more of these increasingly expensive stocks and less of the cheaper ones in their indices — the polar opposite of the adage “buy low, sell high”. Risks of a bubble rise when there is no regard for underlying fundamentals or price. It is reasonable to assume a sustained market correction would lead to stocks that were disproportionately bought because of ETFs and index funds being disproportionately sold.

The idea that index investors cause valuation disparities within indices is a myth. It is mainly trotted out in difficult client conversations about investment performance. For the purposes of this discussion, let’s restrict the definition of “passive” to “investing in a market capitalization weighted index,” like the Russell 2000 or S&P 500. There is a simple reason everyone who makes this argument is categorically, demonstrably wrong:

INDEX FUNDS DON’T SET THE RELATIVE WEIGHTS OF THE SECURITIES INSIDE THE INDEX. 

It is correct to say things like, “S&P 500 stocks are more expensive than Russell 2000 stocks because investors are chasing performance in US large caps by piling into index funds.”

It is correct to say things like, “S&P 500 stocks are more expensive than OTC microcaps outside of the index because investors are chasing performance in US large caps by piling into index funds.”

It is demonstrably false to say, “NFLX trades at a ridiculous valuation relative to the rest of the S&P 500 because investors are chasing performance in US large caps by piling into index funds.”

Index funds buy each security in the index in proportion to everything else. Their buying doesn’t change the relative valuations within the index.

Here is how index investing works:

1. Active investors buy and sell stocks based on their view of fundamentals, supply and demand for various securities, whatever. They do this because they think they are smart enough to earn excess returns, which will make them fabulously wealthy, The Greatest Investor Of All Time, whatever. As a result, security prices move up and down. Some stuff gets more expensive than other stuff.

2. Regardless, the markets are not Lake Wobegon. All of the active investors can’t be above average. For every buyer there is a seller. If you average the performance of all the active investors, you get the average return of the market.

3. Index investors look at the active investing rat race and think, “gee, the market is pretty efficient thanks to all these folks trying to outsmart each other in securities markets. Let’s just buy everything in the weights they set. We are content to get the average return, and we will get it very cheaply.”

4. Index investors do this.

Despite what we in investment management like to tell ourselves, index investors are rather clever. They are trying to earn a free lunch. They let the active investors spend time, money and energy providing liquidity and (to a much lesser extent) allocating capital for real investment in primary market. They just try to piggyback on market efficiency as cheaply as possible.

In my experience, some index investors like to think of themselves as somehow acting in opposition to active managers. This, too, is demonstrably and categorically false. Index investors’ results are directly and inextricably tied to the activity of active investors setting the relative weights of securities within the indices. That activity is what determines the composition of the index portfolio.

It’s a symbiotic relationship. Index investing only “works” to the extent the active investors setting the relative weights within the index are “doing their jobs.” When the active managers screw up, bad companies grow in market capitalization and become larger and larger weights in the index. At extremes, the index investor ends up overexposed to overvalued, value-destroying businesses. This happened with the S&P 500 during the dot-com era.

Now, flows of passive money certainly can distort relative valuations across indices, and, by association, across asset classes. When it comes to asset allocation, almost everyone is an active investor. Even you, Bogleheads. Otherwise you would own something like ACWI for your equity exposure.

A running theme of this blog is that there are no free lunches. Someone is always paying for lunch. These days, it’s the active managers. But that doesn’t mean the passive folks will always enjoy their meal.