Gluttons For Punishment

If you’re a longtime reader, you may recall my little hypothesis about active mutual fund manager and hedge fund performance. The aggregate performance of active mutual fund managers and hedge funds will not, and cannot, improve while Market factor performance dominates everything else. You’ll certainly have individual managers perform well here and there. But in the aggregate, performance versus long-only benchmark indexes will remain unimpressive.

If you’re wondering exactly what the hell it is I’m talking about here, compare the pre-financial crisis and post-financial crisis periods on the below chart.

4Q18_3YR_Trailing_FACTORS — Data Source: Ken French’s Data Library

And just for fun, here’s another chart, focused on the last five years or so:

4Q18_Trailing_Factor_Returns — Data Source: Ken French’s Data Library

If there’s one thing you should take from this post, it’s this: the market is conditioning you to be fully invested and in particular to be long US equity market beta. We can certainly debate the “whys” and “hows” of this (for instance, how it’s the stated policy goal of our Friendly Neighborhood Central Bankers to keep us allocated to equities for the long run). But as a practical matter, if you’re overweight US stocks, particularly large cap US stocks, you’re receiving positive reinforcement. If you’re underweight US stocks, particularly large cap US stocks, you’re receiving negative reinforcement. And god help you if you’ve been significantly overweight small cap value stocks or ex-US stocks over the last couple of years. If so, you’re being subjected to corrective shock therapy.

I don’t say this to make value judgments.

I say this to explain what’s driving investment decisions all over the United States, and indeed the world. I say this to contextualize why the most common conversation I have with investors of all types lately seems to be: “why do we own foreign stocks, anyway?”

If you’re the kind of person who likes to extrapolate historical return data to make asset allocation decisions, all the data is screaming for you to be fully invested in US large cap stocks. You’d be a complete idiot to do otherwise. Perhaps you’ve told your financial advisor this. Perhaps you’ve fired your financial advisor over this.

And you know what? You might be right.

In my own humble opinion, the number one question confronting anyone allocating capital right now is whether or not this market is “for real.” If it is, and you decide to fight it, either as a private individual or as a professional investor, you’re toast. But if this market isn’t “for real”–if it’s all just an artifact of easy monetary policy, and you decide to “go with the flow”, and it all unwinds on you, then you’re also toast.

In thinking about my own portfolio, what I want is to develop a financial plan offering me a decent chance of hitting my goals while assuming as little risk as possible. Those of you well-versed in game theory, such as my friends over at Epsilon Theory, would call this a minimax regret strategy.

Notice I wrote “financial plan” and not “investment portfolio” above. From a pure portfolio perspective, you’re facing a no-win scenario. You have to handicap whether, when and how the whole QE-as-permanent-policy project comes undone. This is nigh on impossible. Investors have been trying and failing to do this for at least a decade now. When faced with a no-win scenario, your best strategy is to change the conditions of the game. In order to do that, you first have to understand the game you’re playing.

We investors and allocators like to believe we’re playing the investment performance game.

We’re not.

We’re playing the asset-liability matching game.

Investment performance only matters inasmuch as it helps us match assets and liabilities. You probably don’t need to “beat the S&P 500” to fund your future liabilities. You can probably afford to take less market risk. And investment performance is hardly the only lever we can pull here. We can increase our savings rates. We can decrease our spending. We can allocate some of our capital to the real economy, instead of remaining myopically focused on increasingly abstracted, increasingly cartoonish financial markets. We can start businesses that will throw off real cash flow, and own real assets.

We don’t have to remain fully invested at all times. We don’t have to be 100% net long and unhedged with the capital we do have invested.

We don’t have to be gluttons for punishment.

Mirror, Mirror

Captain James T. Kirk: What worries me is the easy way his counterpart fit into that other universe. I always thought Spock was a bit of a pirate at heart.

Mr. Spock: Indeed, gentlemen. May I point out that I had an opportunity to observe your counterparts here quite closely. They were brutal, savage, unprincipled, uncivilized, treacherous–in every way splendid examples of homo sapiens, the very flower of humanity. I found them quite refreshing.

Captain James T. Kirk [to McCoy]: I’m not sure, but I think we’ve been insulted.

—Star Trek, “Mirror, Mirror” (1967)

As any sci-fi nerd who reads this can likely attest, “Mirror, Mirror” is one of the best known Star Trek episodes. It’s an Alternate Universe story, with the all-too-common “transporter malfunction” serving as catalyst (aside: if transporter tech is invented in my lifetime I will never, ever use it). In the Mirror Universe, the Federation is instead the Terran Empire. Imagine all the worst impulses of the Roman emperors, applied on a galactic scale.

In Terran society, only the strong survive. Don’t like your boss? Kill him. You simply take what you want through violent force. Women. Resources. Power. It’s pure Social Darwinism.

A fairly horrifying way to organize social and economic activity, when you really stop and think about it. Imagine being tortured in the Agonizer Booth every month you underperform the S&P 500. Many of us would be on intimate terms with the Agonizer Booth by now.

But as Mr. Spock observes at the end of the episode, the Terrans are just an exaggerated expression of basic human nature. The kinder, gentler humans of the Federation share the same basic impulses. They have the same capacity for cruelty and violence.

They’re us. We’re them.

It’s the same in our relationships with our investment managers. Many of their failings, real and imagined, reflect our own weaknesses and failings, both as individuals and allocators.

Why are there so many overly diversified, low tracking error portfolios out there? The dominant methods allocators use to evaluate performance incentivize the construction of overly diversified, low tracking error portfolios.

Why do so many bottom-up managers dabble in macro tourism? Allocators have unrealistic expectations for how true bottom-up portfolios should perform during broad market selloffs.

Why does it feel like so little money is managed with an emphasis on “real world” cash flow generation by “real world” businesses? Because the dominant models for asset allocation are based on abstracted baskets of securities.

Why is does it feel like so much money is managed in a short-term, overfitted fashion? Clients want 200% upside capture and 0% downside capture, and they want it “consistently.”

Our flaws and biases as allocators manifest themselves in our managers’ portfolios. They’re amplified by the intense pressure that comes with managing other people’s money. We end up in a kind of nightmarish feedback loop. The more pressure a manager is under during a period of underperformance, the worse that feedback loop gets. The more exaggerated our flaws and biases become as they’re translated into security selection and portfolio construction.

I ~~sometimes~~ often laugh at the silly conversations I have with capital intro people and third party marketers. They’ll say things like: “Fund X was actually up in December 2018! You should really take a look.” As if that, on its own, is somehow a meaningful data point.

But I shouldn’t laugh.

I shouldn’t laugh because I made them this way. Me, and others in seats like mine. Ultimate responsibility for the pervasive absurdity in the investment management business lies with us. We not only tolerate it, but actively encourage it. We encourage it with our peer group rankings and tracking error parameters and quarterly performance evaluations, not to mention our fear and greed.

I’ve always loved Wes Gray’s take on this, using a poker metaphor:

On the other side of the table is an institutional poker player, hired by wealthy investors, to play poker as best as possible. This poker player is a pure genius, mathematically calculates all probabilities in her head, and knows her odds better than anyone. Now imagine that our super player, as a hired gun, has a few limits. “We need you to maintain good diversification across low numbers and high numbers. We also want to see a sector rotation between spades, aces, and clubs. Don’t take on too much risk with straights and flushes, stick to pairs like the market does…” No one would ever play poker like this. But in finance, this is how people play.

They’re us. We’re them.

Mirror, mirror.

Mortification of the Flesh

seventh-seal-the-1957-007-flagellants

Jöns: What’s that rubbish there?

Painter: People think the plague is a punishment from God. Crowds wander the land lashing each other to please the Lord.

Jöns: Lashing each other?

Painter: Yes, it’s a horrible sight. You feel like hiding when they pass.

Jöns: Give me a gin. I’ve had nothing but water. I feel as thirsty as a desert camel.

Painter: Scared after all?

—The Seventh Seal

The Seventh Seal is a film about the silence of God. It’s set in medieval Europe, during the Plague and the Crusades. The protagonist, the knight Antonius Block, spends the film looking for signs of God’s existence. He stalls Death with a now-iconic game of chess.

They just don’t make ’em like this anymore, folks. We’re too clever for movies that take religion so seriously. So literally. It’s all too earnest for The Age of Snark.

Anyway, as much as it’s about Antonious Block’s existential crisis, The Seventh Seal is about medieval European society’s response to the apocalyptic destruction wrought by the plague. And boy, it ain’t pretty. Inquisitors burn witches. Charlatan theologians prey on the weak and the naive. Flagellants wander from town to town, putting on bizarre religious displays.

Observing a procession of flagellants, Block’s squire mutters:

Is this what we offer to modern men’s minds? Do they really believe we will take all of this seriously?

As investors, we too wrestle with God’s silence. It’s not war or plague that shakes our faith but changes in the structure and behavior of financial markets. How do we respond?

Inquisitors burn witches.

Charlatan theologians prey on the weak and the naive.

Flagellants put on bizarre religious displays.

In many circles–particularly those of the fundamental discretionary persuasion–there has emerged a kind of millenarian cult mindset. We endure this suffering to purge our sins. To mortify the flesh. When The Great Reckoning arrives, the Algos and the Indexers and the Risk Parity Heretics shall be cast into the flames. And we, The True Investors, shall emerge from the hellfire unblemished, as did Buffett after the Dot Com Bubble.

Make no mistake. This is religion. Yes, the sermon comes with charts. There will be CAPE charts. There will be Value/Growth dispersion charts. There will be Active/Passive cycle charts. But these charts aren’t science. They’re religious icons.

As we begin meeting with clients, investment managers and management teams in 2019, I’d encourage us all to look at the arguments and data we’re being presented though this lens.

How much of what’s passed off as “analysis” is, in fact, religious fanaticism clothed in the language and trappings of science?

How much of what’s passed off as “analysis” is, in fact, religious art?

How often, when we laud “conviction,” are we just promoting the mortification of the flesh?

Mental Model: How To Make Money Investing

In my line of work, I see a lot of client investment portfolios. Very few of these portfolios are constructed from any kind of first principles-based examination of how financial markets work. Most client portfolios are more a reflection of differences in advisory business models.

If you work with a younger advisor who positions her value add as financial planning, you’ll get a portfolio of index funds or DFA funds.

If you work with an old-school guy (yes, they are mostly guys) who cut his teeth in the glory days of the A-share business, you’ll get an active mutual fund portfolio covering the Morningstar style box.

No matter who you work with, he or she will cherry-pick stats and white papers to “prove” his or her approach to building a fairly vanilla 60/40 equity and fixed income portfolio is superior to the competition down the street.

My goal with this post, and hopefully a series of others, is to help clarify and more thoughtfully consider the assumptions we embed in our investment decisions.

So, how do I make money investing?

There are two and only two ways to get paid when you invest in an asset. Either you take cash distributions or you sell the asset to someone for a higher price than you paid for it.

Thus, at a high level, two factors drive asset prices: 1) the cash distributions that can reasonably be expected to be paid over time, and 2) investors’ relative preferences for different cash flow profiles.

What about gold? you might wonder. Gold has no cash flows. True enough. But in a highly inflationary environment investors might prefer a non-yielding asset with a perceived stable value to risky cash flows with massively diminished purchasing power. In other words, the price of gold is driven entirely by investors’ relative preferences for different cash flow profiles. Same with Bitcoin.

So, where does risk come from?

You lose money investing when cash distributions end up being far less than you expect; when cash distributions are pushed out much further in time than you expect; or when you badly misjudge how investors’ relative preferences for different cash flow profiles will change over time.

That’s it. That’s the ball game. You lose sight of this at your peril.

There are lots of people out there who have a vested interest in taking your eye off the ball. These are the people Rusty and Ben at Epsilon Theory call Missionaries. They include politicians, central bankers and famous investors. For ~~some of them~~ almost all of them, their ability to influence the way you see the world, and yourself, is a source of edge. It allows them to influence your preferences for different cash flow profiles.

Remember your job!

If you’re in the business of analyzing securities, your job is to compare the fundamental characteristics of risky cash flow streams to market prices, and (to the best of your ability) formulate an understanding of the assumptions and preferences embedded in those prices.

If you’re in the business of buying and selling securities, your job is to take your analysts’ assessments of cash flow streams, as well as the expectations embedded in current market prices, and place bets on how those expectations will change over time.

Ultimately, as the archetypical long-only investor, you’re looking for what the late Marty Whitman called a “cash bailout”:

From the point of view of any security holder, that holder is seeking a “cash bailout,” not a “cash flow.” One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.

A security (with the minor exception of hybrids such as convertibles) has to represent either a promise by the issuer to pay a holder cash, sooner or later; or ownership. A legally enforceable promise to pay is a credit instrument. Ownership is mostly represented by common stock.

There are three sources from which a security holder can get a cash bailout. The first mostly involves holding performing loans. The second and third mostly involve owners as well as holders of distressed credits. They are:

Payments by the company in the form of interest or dividends, repayment of principal (or share repurchases), or payment of a premium. Insofar as TAVF seeks income exclusively, it restricts its investments to corporate AAA’s, or U.S. Treasuries and other U.S. government guaranteed debt issues.

Sale to a market. There are myriad markets, not just the New York Stock Exchange or NASDAQ. There are take-over markets, Merger and Acquisition (M&A) markets, Leveraged Buyout (LBO) markets and reorganization of distressed companies markets. Historically, most of TAVF’s exits from investments have been to these other markets, especially LBO, takeover and M&A markets.

Control. TAVF is an outside passive minority investor that does not seek control of companies, even though we try to be highly influential in the reorganization process when dealing with the credit instruments of troubled companies. It is likely that a majority of funds involved in value investing are in the hands of control investors such as Warren Buffett at Berkshire Hathaway, the various LBO firms and many venture capitalists. Unlike TAVF, many control investors do not need a market out because they obtain cash bailouts, at least in part, from home office charges, tax treaties, salaries, fees and perks.

I am continually amazed by how little appreciation there is by government authorities in both the U.S. and Japan that non-control ownership of securities which do not pay cash dividends is of little or no value to an owner unless that owner obtains opportunities to sell to a market. Indeed, I have been convinced for many years now that Japan will be unable to solve the problem of bad loans held by banks unless a substantial portion of these loans are converted to ownership, and the banks are given opportunities for cash bailouts by sales of these ownership positions to a market.

For you index fund investors snickering in the back row—guess what? You’re also looking for a cash bailout. Only your ownership of real world cash flow streams is abstracted (securitized) into a fund or ETF share. In fact, it’s a second order securitization. It’s a securitization of securitizations.

I’m not “for” or “against” index funds. I’m “for” the intentional use of index funds to access broad market returns (a.k.a “beta”) in a cheap and tax-efficient manner, particularly for small, unsophisticated investors who would rather get on with their lives than read lengthy meditations on the nature of financial markets. I’m “against” the idea that index funds are always and everywhere the superior choice for a portfolio.

Likewise, I’m not “for” or “against” traditional discretionary management. I’m “for” the intentional use of traditional discretionary (or systematic quant) strategies to access specific sources of investment return that can’t be accessed with low cost index funds. I’m “against” the idea that traditional discretionary (or systematic quant) strategies are always and everywhere the superior choice for a portfolio.

What sources of return are better accessed with discretionary or quant strategies?

That’s a subject for another post.

Investing vs. “Getting Market Exposure”

Like “financial advisor” and “hedge fund,” the word “investing” is probably one of the most abused terms in our financial lexicon. These days many people use the word “investing” when what they are really talking about is “getting market exposure.”

For fun I googled the definition of investing:

I also re-read this post from Cullen Roche where he discusses “allocating savings” (what I would call “getting market exposure”).

It’s funny how “investors” abuse the term “investing”. What we’re really doing when we buy shares on a secondary exchange is not really “investing” at all. It’s just an allocation of savings. Investing, in a very technical sense, is spending for future production. So, if you build a factory and spend money to do so then you’re investing. But when companies issue shares to raise money they’re simply issuing those shares so they can invest. And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production. You just allocate your savings by exchanging shares with other people when you buy and sell financial assets.

Now, this might all sound like a bunch of semantics, but it’s really important in my opinion. After all, when you understand the precise definitions of saving and investing you realize that our portfolios actually look more like saving accounts than investment accounts. That is, they’re not really these sexy get rich quick vehicles. Yes, the allure of becoming the next Warren Buffett by trading stocks is powerful. But the reality is that you’re much more likely to get rich by making real investments, ie, spending to improve your future production. Flipping stocks isn’t going to do that for you.

This leads you to realize your portfolio is a place where you are simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss. It’s not a place for gambling or getting rich quick. In fact, it’s much the opposite. It’s a nuanced view, but one I feel is tremendously important to financial success.

I have promised myself I will stop using “investing,” “getting market exposure” and “allocating savings” interchangeably.

For me, the semantic line between investing and “getting market exposure” is a little different from what Cullen proposes. For me it’s this: as an investor you are looking to compound capital at a rate exceeding your cost of capital (opportunity cost), while avoiding permanent impairment of capital.

Yes, “extraordinary” is a fuzzy term. To me, pretty much anything above 10%, net of expenses, is extraordinary. That will give you nearly a 7x return over 20 years. If you can do 15% (an extraordinary achievement, btw), that multiple jumps to over 16x.

Some of you are no doubt thinking you can net 10% annually forever in an S&P 500 index fund. And maybe you are right. In my view the odds are stacked against you over the next 10 years. In fact, I would gladly take the other side of that bet over next 10 years. But beyond the next decade or so it is hard to tell.

The reason is broad market returns measured over long time periods are sensitive to starting valuations. If you ask the average equity analyst he will probably tell you the market is “fairly valued” today based on the one-year forward price/earnings multiple. Which is another way of saying “meh.” By other measures, such as the Shiller CAPE, the US market is extremely expensive. But if you are allocating your savings based on one-year forward earnings multiples you’ve got bigger problems than parsing the nuances of various valuation multiples.

Also, analysts kind of suck at forecasting earnings growth. So the forward price/earnings multiple is a flawed input at best.

BI_earnings_forecasts_vs_reality — Source: *Business Insider*

Anyway, if none of this stuff interests you, you aren’t thinking like an investor. The whole point of investing is to seek out asymmetric risk/reward propositions. That’s very different from “simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss.”

Deworsification [WONKISH]

If you are not interested in the mathematics of portfolio construction you can safely skip this post. This is a (relatively) plain language summary of a research paper published in The Financial Analysts Journal. It is not investment advice and should not be used as the basis for any investment decision.

One of the issues that I have been interested in for a long time is the issue of overdiversification in investment portfolios. We are conditioned by portfolio theory to accept diversification as a universal good. However, depending on the investor’s objectives diversification can be counterproductive–particular when higher cost investment strategies are involved. This post examines the research paper, “What Free Lunch? The Costs of Over Diversification” by Shawn McKay, Robert Shapiro and Ric Thomas, which offers a rigorous treatment of the issue.

Summary

The authors use empirical and simulated data to develop a framework for assessing the optimal number of active managers in an investment allocation. They find that as one adds managers to an investment allocation, the active risk (a.k.a “tracking error”) decreases while investment management expenses remain constant or even increase. This leads to the problem of “overdiversification” or, more colloquially, “deworsification.”

The authors propose two measures to analyze the impact of overdiversification:

Fees For Active Risk (FAR) = Fees / Active Risk

Fees For Active Share (FAS) = Fees / Active Share

All else equal, one would like the FAR and FAS ratios to be as low as possible.

However, perhaps the most important conclusion the authors reach is that as active risk decreases, the security selection skill needed to deliver outperformance versus a benchmark rises exponentially:

Holding breadth [portfolio size] constant allows us to develop a framework that illustrates the trade-offs between active risk and the information coefficient for various levels of expected return. Each line in Figure 5 is an isometric line, highlighting various combinations that give a fixed level of expected return. The curve at the bottom shows all combinations of active risk and the information coefficient in which the excess return equals 1% when holding breadth constant at 100. The two other lines show the same trade-offs for breadth levels of 60 and 20, respectively.

As expected, the required information coefficient increases as tracking error declines, but it rises exponentially as we approach lower levels of active risk. Allowing for greater breadth shifts the line downward, beneficially, but in all cases, there is a similar convex relationship.

Active_Risk_vs_Skill — Source: McKay, et al.

Practical Implications

The more diversified your allocation, the more difficult the relative performance game gets due to increasing fee drag on decreasing levels of active risk.
Investors who are aiming for significant outperformance via active management should concentrate capital with a small number of managers.
Investors who desire highly diversified portfolios are thus better off allocating to a passive, factor and enhanced-index funds than dozens of highly active equity managers.
Capacity and fiduciary constraints make it extra challenging for capacity constrained investors such as large pension funds to generate substantial alpha at the portfolio level, as it is imprudent for them to run highly concentrated portfolios. For these investors in particular, a core-satellite approach likely makes sense.

The Relative Performance Game

I wrote in a previous post that much of what passes for “investing” is in fact just an exercise in “getting market exposure.” In writing that post, and in the course of many conversations, I have come to realize the investing public is generally ignorant of the game many asset managers are playing (not what they tell you they are doing but what is really going on under the hood). In this post, I want to elaborate on this.

Broadly speaking, there are two types of return objective for an investment portfolio:

Absolute return. For example: “I want to compound capital at a rate of 10% or greater, net of fees.”

Relative return. For example: “I want to outperform the S&P 500.” Or: “I want to outperform the S&P 500, with tracking error of 1-3%.”

We will look at each in turn.

How Absolute Return Investors Play The Game

The true absolute return investor is concerned only with outperforming his established return hurdle. The return hurdle is his benchmark. When he underwrites an investment, he had better damn well be underwriting it for an IRR well in excess of the hurdle rate (build in some margin of safety as some stuff will inevitably hit the fan). He will be conscious of sector exposures for risk management purposes but he is not checking himself against the sector weights of any particular index.

I emphasize “true absolute return investor” above because there are a lot of phonies out there. These people claim to be absolute return investors but still market their ~~products~~ funds to relative return oriented investors.

Guess what? The Golden Rule applies. If your investor base is relative return oriented, your fund will be relative return oriented. I don’t care what it says in your investor presentation.

How Relative Return Investors Play The Game

The relative return investor is concerned with outperforming a benchmark such as the S&P 500. Usually managers who cater to relative return investors also have to contend with being benchmarked against a peer group of their competitors. These evaluation criteria have a significant impact on how they play the game.

Say Amazon is 2.50% of the S&P 500 trading on 100x forward earnings and you’re running a long only (no shorting) fund benchmarked to the S&P 500. If you don’t like the stock because of the valuation, you can choose not to own it or you can choose to underweight it versus the benchmark (maybe you make it 2% of your portfolio).

In practice you will almost certainly own the stock. You may underweight it but you will own it at a not-insignificant weight and here’s why: it is a popular momentum stock that is going to drive a not-insignificant portion of the benchmark return in the near term. Many of your competitors will either overweight it (if they are ~~reckless~~ aggressive) or own it near the benchmark weight. Most of them will own it at or very near benchmark weight for the same reasons as you.

Sure, if you don’t own the stock and it sells off you may look like a hero. But if it rips upward you will look like a fool. And the last thing you want to be is the idiot PM defending himself to a bunch of retail channel financial advisors who “knew” Amazon was a winner all along.

The safe way to express your view is to own Amazon a little below the benchmark weight. You will do incrementally better if the name crashes and incrementally worse if the name rips upward but the effects will not be catastrophic. When you are ranked against peers you will be less likely to fall into the dreaded third or (god forbid) fourth quartile of performance.

This is the relative performance game.

Note that the underlying merits of the stock as a business or a long-term investment get little attention. The relative performance game is about maximizing incremental return per unit of career risk (“career risk” meaning “the magnitude of relative underperformance a client will tolerate before shitcanning you”).

If you are thinking, “gee, this is kind of a prisoner’s dilemma scenario” I couldn’t agree more. In the relative performance world, you are playing a game that is rigged against you. You are handcuffed to a benchmark that has no transaction costs or management expenses. And clients expect consistent outperformance. Good luck with that.

I am absolutely not arguing that anyone who manages a strategy geared to relative return investors is a charlatan. In fact I use these types of strategies to get broad market exposure in my own portfolio.

I do, however, argue that the appropriate expectation for such strategies is broad market returns +/-, that the +/- is likely to be statistically indistinguishable from random noise over the long run*, and that this has a lot to do with the popularity of market cap weighted index funds.

Corollary: Don’t Be An Idiot

If you are one of those high net worth individuals who likes to run “horse races” between investment managers based on their absolute performance, the corollary to this is that you are an idiot.

The guys at Ritholtz Wealth Management (see my Recommended Reading page) have written and spoken extensively about the problems with such an incentive system. It is nonetheless worth re-hashing the idiocy inherent in such a system to close out this discussion. It will further illustrate how economic incentives impact portfolio construction.

If you say to three guys, “I will give each of you 33% of my net worth and whoever has the best performance one year from now gets all the money to manage,” you will end up with a big winner, a big loser and one middle of the road performer. You will choose the the big winner who will go on to be a loser in a year or two. Except the losses will be extra painful because now he is managing all your money.

Here’s why. You have created an incentive system that encourages the prospective managers to bet as aggressively as possible. This is exacerbated by the fact that your selection process is biased toward aggressive managers to begin with. No self-respecting fiduciary would waste his time with you. People like you make for terrible clients and anyway a self-respecting fiduciary’s portfolio is not likely to win your ill-conceived contest. Your prospect pool will self-select for gamblers and charlatans.

In Closing

Incentive systems matter. Knowing what game you are playing matters. There is a name for people who play games without really understanding the nature of the games.

They’re called suckers.

*Yes, I know it is trivial to cherry pick someone ex post who has generated statistically significant levels of alpha. I can point to plenty of examples of this myself. Whether it is possible to do this reliably ex ante is what I care about and I have yet to see evidence such a thing is possible. Also defining an appropriate threshold for “statistical significance” is a dicey proposition at best. If you feel differently, please email me as I would love to compare notes.

I Would Like To Be Reincarnated As An Italian Mutual Fund Manager

I met with a UK-based portfolio manager yesterday and our conversation eventually led to a fascinating discussion of the differences in distribution and compensation structures in the US versus Europe.

In the US, for example, we have well-developed retail distribution channels for financial products (wirehouses, RIAs, broker-dealers, banks).

In continental Europe, distribution is dominated by the banks. For many reasons, there is simply not much of a retail investing culture in Europe. The end users of UCITS (European mutual funds) tend to be very wealthy families with multi-generational wealth management needs.

While here in the US we are preoccupied with what a fiduciary standard for investment advisor conduct and compensation should look like, the discussion in Europe is much different (to the extent there is any discussion at all).

Which leads me back to the title of this post, and why I want to be reincarnated as an Italian mutual fund manager…

In Italy, the standard compensation structure for an equity manager is apparently a 2% management fee with a performance fee assessed monthly, but with no high watermark or preferred return hurdle (!!!)

That is to say, if you are an Italian fund manager operating under this scheme, you get a cut of the profits every month you post a positive return. Even if your clients are underwater on their original investments. It is a hedge fund manager’s dream!

(I know, I know, #notallhedgefundmanagers…)

I will close with this chart from Deloitte:

Italian_Fund_Expenses — Source: Morningstar via Deloitte

Trolling Warren Buffett

So the annual Berkshire letter is out and Buffett could not resist taking another swipe at Wall Street over his bet with Protégé Partners. I am not going to re-hash the letter or the bet here. (Incidentally, I highly recommend giving this annotated version a read) Rather, I want to draw your attention to one particular bit no one ever seems to talk about:

Berkshire_2017_Letter_Snip — Sources: Berkshire Hathaway; Safal Niveshak (highlight)

Am I the only person on the internet who believe this was a completely insane way to build a portfolio? Obviously, in the aggregate, the best investors can hope to do is match the market return, less fees (they can of course do considerably worse). It cannot be otherwise. There is nothing especially profound about the observation that it makes no sense to try and replicate the broad market with scores of active managers.

Fama and French demonstrated long ago that the aggregate portfolio of all investment managers more or less resembles the market cap weighted portfolio (read: an index fund, but with higher fees). Behold:

The high management fees and expenses of active funds lower their returns. If we measure fund returns before fees and expenses – in other words, if we add back each fund’s expense ratio – the α estimate for the aggregate fund portfolio rises to 0.13% per year, which is only 0.40 standard errors from zero. Thus, even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns. After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.

Adding insult to injury, the aggregate portfolio of active mutual funds looks a lot like the cap-weighted stock market portfolio. When we use the three-factor model to explain the monthly percent returns of the aggregate fund portfolio for 1984-2006, we get,

RPt – Rft = -0.07 + 0.96(RMt – Rft) + 0.07SMBt – 0.03HMLt + eit,where RPt is the return (net of costs) on the aggregate mutual fund portfolio for month t, Rft is the riskfree rate of interest (the one-month T-bill return for month t), RMt is the cap-weighted NYSE-Amex-Nasdaq market return, and SMBt and HMLtare the size and value/growth returns of the three-factor model.

The regression says that the aggregate mutual fund portfolio has almost full exposure to the market portfolio (a 0.96 dose, which is close to 1.0), but almost no exposure to the size and value/growth returns (0.07 and -0.03, which are close to zero). Moreover, the market alone captures 99% of the variance of month-by-month aggregate fund returns.

In short, the combined portfolio of all active mutual funds is close to the cap-weighted market portfolio, but with a return weighed down by the high fees and expenses of actively managed funds.

Therefore, in my view, Protégé’s failure was first and foremost a failure of portfolio construction. It’s totally fair to fault Protégé for this, just as it’s fair to fault many investors for buying into a collective delusion around hedge funds as magical assets* in the mid-2000s. To the extent Warren is underscoring that point, I wholeheartedly agree with him.

Beyond that, I don’t know the outcome of this best offers much insight into investment manager selection or the merits of investing actively. (See my Truth About Investing post for more on that subject) Warren Buffett did not get to be a billionaire buying index funds. Neither did Jim Simons. Or David Tepper. Or Seth Klarman.

Someone please sit down with Jim Simons or David Tepper or Seth Klarman or Howard Marks or any of the dozens of hedge fund managers who have trounced the S&P 500 over the past couple of decades and lecture them about the aggregate performance of active management. I would love to hear how it goes.

* When I write about magical asset classes I am referring to any asset class or strategy people believe is inherently superior to others. In the mid-2000s investors clearly believed they could generate outperformance just by “being in” hedge funds. There are lots of reasons why aggregate performance has declined since then. First and foremost, hedge funds became victims of their own success as the space attracted large amounts of investor capital and many hundreds of talented money managers. Now that hedge funds are out of favor, the magical asset classes of today are private equity and venture capital. Also, hedge funds are not an asset class. They are a type of fund structure, just like closed end funds and mutual funds are types of fund structures. Similarly, you can argue that private equity isn’t a unique asset class so much as a levered investment in illiquid small caps and micro caps.

The Truth About Investing, Part II

(See Part I for the background on this post. As usual, none of this should be treated as financial advice as it does not take your personal circumstances into account. If you want advice, talk to a professional advisor. Trust me, there are plenty of highly competent, ethical professionals out there who are excited to help you achieve your goals.)

After sharing the original post with some savvy friends, subsequent discussion stirred up some additional ideas for questions and answers. So here are some additions to our little Socratic dialogue.

So back to this active versus passive investing thing. It sounds like you are pro passive?

If I absolutely have to take a position, I would say most people are probably better off investing passively. Unless they happen to be really good at investing actively, of course.

Ugh. There you go again. But how can I figure out if I’m good at investing actively?

We can look at your returns 20 or better yet 30 years from now. That will give us a pretty good idea.

Double ugh. How can I know BEFORE I start making active bets? If I start down this path and it turns out I suck I may lose a lot of money.

You can’t know ahead of time. Don’t waste your time trying to “know” things that are fundamentally unknowable.

There are certain skills and psychological traits that may make you a better active investor than someone else. For example, skilled poker players typically make for good active investors. They intuitively understand expected value, probabilistic thinking and mental models for decision making under uncertainty. They understand the interplay between luck and skill in determining outcomes. Psychologically, they know how to handle a “bad beat” (or several) without blowing up. They are used to making calculated bets, and therefore also have an intuitive understanding of risk management.

If you are a good portfolio manager (you’ve got “poker skills”), you don’t have to be a great financial analyst to do well. The reason for that is that randomness plays a huge role in the markets (as it does in life). Thus it is more important in the markets to optimize decisions under uncertainty than it is to be “right” analytically. You still need to have an above average understanding of accounting, capital markets and basic principles of economic value creation to avoid making stupid, otherwise obvious mistakes. These things are easier to learn than “poker skills,” if you are willing to put in the time and effort.

Ultimately, if making decisions under uncertainty makes you queasy, I suspect you will have a difficult time investing actively.

That seems complicated and unhelpful.

Then invest passively. Or find someone you trust and respect to develop an active investing program suited to your goals (whether that is picking managers or individual stocks).

Okay. Let me try this another way. What I have really been asking this whole time is this: what is The Best Thing To Do?

There is no Best Thing To Do. There is only The Best Thing For You To Do.

So what does YOUR portfolio look like, big shot?

Approximately 70% of my investable net worth (ex-cash) is invested in actively managed strategies that should earn something like broad market returns over time. If I am lucky maybe a little extra. If I am unlucky maybe a little less. The remaining 30% is invested in a concentrated portfolio of individual securities with the goal of generating extraordinary capital appreciation over a multi-decade time horizon.

How do you know these managers will perform well over time?

I don’t. Honestly, just try to put money with folks doing sensible things who I think will be good stewards of my capital over a multi-decade time horizon, and who I believe charge reasonable fees for managing my money. That frees me up to do the work I want to do on individual securities, which will potentially compound value at a much higher rate over time.

Why this 70/30 split? Why not just go all in on the stuff that you think will go up the most?

Because if 30 years from now it turns out I really sucked at this I will not have laid waste to my net worth or my family’s financial security.

Risk management, remember?