Hi Guys,
A few famous forecasters and fund managers shared a collective forgettable 2011.
Fairholme Fund (FAIRX) manager Bruce Berkowitz, Morningstar’s domestic stock 10-year champion manager of the decade award recipient, wants to forget his financial Bank of America and real estate company St. Joes selections. Fifteen year benchmark beater Bill Miller of Legg Mason fame, lost his job after several dismal stock picking years. Money manager wizard Jon Corzine of MF Global is so forgetful that he can’t remember where over one billion dollars of client funds went. PIMCO’s bond guru Bill Gross wants to forget and be forgiven for his outsized US Treasury bond commitment. Financial analyst Meredith Whitney regrets her erroneous projection of a 2011 municipal bond market meltdown.
If such renown investment professionals fell so far, so rapidly, what chance does a time constrained and resource limited private investor have? A historically complex marketplace has become ever more challenging because of instantaneous institutional trading, highly volatile markets, and uncertain economic conditions.
Forecasting market returns and winning sectors is a fool’s task. The Midas Touch is not a constant human attribute, even among the elite professionals. Especially for the second tier of market mavens, outperforming a basic benchmark is a stumbling hurdle for most professionals.
Year after year, Standard & Poor's Indices Versus Active (SPIVA) and Persistence scorecards demonstrate that typically two-thirds of these experts fail to clear their benchmark tests. Here is a generic Link to the array of S&P summary studies that document these recurrent findings:
http://www.standardandpoors.com/indices/spiva/en/usJust look at the checkerboard pattern that Periodic Tables of Returns charts show over 10 and 20 year periods for major categories of investment options.. Attached are several illustrations generated by Callan Associates and by Allianz Global. These Links get you to a web page that can provide access to the actual reports themselves by scanning the page. The Callan report button is self-evident. The Allianz button is located at the page’s bottom-right side and is titled “The Importance of Diversification”.
The extra button pushing is worth the minor inconvenience.
These two samples currently only show performance data through 2010. Typically they are updated by late January or early February every year. I’ll Link to them again when the updates become accessible.
http://www.callan.com/research/periodic/http://www.allianzinvestors.com/EducationAndPlanning/InvestorEducation/Pages/AssetAllocation.aspx#The Allianz chart presents a more comprehensive summary of discrete investment categories. I like it better than Callan for that expanded choice format.
If there is a recognizable pattern in this jumble of data, it totally escapes me. It is chaotic in character. To paraphrase Rudyard Kipling “If you see a pattern, you’re a better man than I., Gunga Din. Behavioral researchers have identified false pattern recognition when none actually exists as a common fallacy in our attempt to know the unknowable.
Of course, one piece of market wisdom that has survived the fires of time, and even today offers at least a partial answer to the portfolio construction dilemma, is category diversification. The portfolio construction approaches recommended by Paul Merriman remain dedicated to such diversification. Please examine his tabular summary of various equity/bond mixes at the following website and hit the “Fine tuning your asset allocation” button:
http://www.merriman.com/learn/bestofmerriman/In particular, note the table at the end of the presentation.
The Merriman table is illuminating in several dimensions. Observe the measurable benefits of long term diversification; the bottom-line averages show that a 50/50 portfolio mix of equity and bond holdings can produce almost full equity market-like returns at roughly one-half its volatility (standard deviation). Other statistical values at the bottom of the table show more risk mitigation measures.
Notice that the various mixes that Merriman constructs are not just a two component equity and bond mutual fund. Merriman’s portfolios are assembled from a more diverse universe of funds that include small caps and international components. Also, he has honestly subtracted a 1 % management fee from his tabular listings.
Some market commentators argue that category performance correlation coefficients have coalesced such that diversification is no longer a viable option to mitigate risk. While correlation coefficients have migrated towards perfect correlation (a value equal to One), they remain sufficiently below the limiting “One” value to make diversification a worthwhile risk control strategy.
For example, the latest issue of Money Magazine reports that the 3-year Morningstar correlations between the US equity market is 0.9 against emerging markets, is 0.2 against US bond, is 0.8 against REITs, and is 0.6 against commodities. Correlation coefficients among investment classes are dynamic and do change over time.
One takeaway from the correlation matrix is that a simple 50/50 equity/bond mix is still an excellent risk mitigation strategy.
I am aware that most seasoned MFO participants are fully cognizant of the investment resources that I quoted above. This posting is mostly directed at the more neophyte investor who might not be familiar with all the informative tools and analyses that are easily accessible on the Web.
Concentrated investments generate superior rewards if they are correct. The historical record and commonsense suggest that it is impossible to be right all the time. Even Warren Buffett suffered a few years of bad decisions and sub-par performance. Bill Miller was not adaptive enough to changing market conditions after 15 contiguous years of Index beating performance, and paid the price.
Bruce Berkowitz, a pragmatic, highly focused, and fully committed manager lost, at least momentarily, his deft selection and timing touch. His skill set has not vanished in a single year. It is quite possible that he will recover with time just like the Nifty-Fifty growth stocks of the roaring 1960s and 1970s eventually did over integrated time.
For the fun of it, please checkout this re-revisit of the Nifty-Fifty stocks from an academic’s purview of this tiny piece of thorny investment history:
http://economics-files.pomona.edu/GarySmith/Nifty50/Nifty50.htmlInvestment controversy and debate are hardly ever fully resolved.
As I wrote in an earlier submittal: “It is Time in the Market, Not Market Timing” that matters most. The debate and the challenges continue.
Best Regards.
Comments
Paper by AQR (whose Risk Parity fund I own.)
http://www.advisorperspectives.com/commentaries/aqr_122210.php
http://www.aqrfunds.com/Our_Funds/Individual/FundID_13/Key_Facts/Risk_Parity_Fund.fs
As for Berkowitz, he went from claiming to stay away from financials because he didn't understand what they had become (in an article shortly after the crisis) to piling most of the fund into them and claiming that this time wasn't different. Apparently, there was also a statement during one of the conference calls that Sears was going to turnaround like Apple?
People say that they entrust decisions to their fund managers - that's why they got into them in the first place. Even the average person - if I did, anyone should have been able to - see that Sears was not turning itself around and that eventually it was going to have to go on something more than Eddie Lampert's name. People do have the ability to look at what a Berkowitz is doing and come to their own conclusion and, possibly, be right. You can't be moving everytime a fund manager makes one decision you don't like, but when the move involves the majority of the fund, that's an issue. Or, better yet, having more than half the fund in two names in the Fairholme Allocation fund, which is - even if eventually proven right - I think an incredibly troubling choice and risk.
I've noted recently, I've made a larger position out of Marketfield (MFLDX), whose views differ from mine in a few significant ways, but they make an interesting case and their current (at least) differing views make for something of a hedge. However, the fund's immense flexibility means that it can change and adapt if things change, and I really do believe that flexibility will be of greater and greater value in the decade ahead.
As for Sears, the long-discussed value of the real estate becomes increasingly irrelevant in a society where it's become increasingly obvious that malls are overbuilt and consumers are increasingly tech-savvy about shopping (I think Simon Property's "Premium Outlet" properties will be an example of what works in the coming years - an upscale outlet experience that allows consumers to feel as if they are getting higher-end merchandise for deals. That doesn't mean that I would invest in Simon Property or REITs in general, but that these "Premium Outlet" malls provide an experience I think will become increasingly popular.) The company's recent quarters have also been terrible, one after another. Lampert kept buying shares, but neglected the stores for too long which - worse than the real estate becoming less relevant - brings up the real risk of the name/brand becoming entirely irrelevant, which Sears and K-Mart have been able to stay ahead of.
The Barron's article on Fairholme was also - I think - concerning.
I don't doubt that Berkowitz will return to form, but given the extent of the positions and his desire to not move from them may mean it is a while. If that is the case, what is the opportunity cost of staying with Fairholme if it takes 1-3 years?
"A historically complex marketplace has become ever more challenging because of instantaneous institutional trading, highly volatile markets, and uncertain economic conditions."
Just as there are concerns about forces like HFT on equities, there are other concerns about forces at work in the bond market (intervention, rumors of intervention, etc.) I'm not against the idea of diversification (NOT as some sort of guarantee of success, but giving one somewhat better odds of success in this day and age), but I do tend to wonder if, with more complex markets and situations, one has to go beyond the traditional bond/stock mix (which goes into the "Risk Parity" question at the top).
Thank you for your comments/reply to my reply in the other thread.
Hi Scott,
Thanks for your reference to AQR Capital Management’s interpretation and implementation of the Risk Parity concept. Although I am generally familiar with the concept, my understanding of its details, especially its execution aspects, is extremely shallow. Your reference has somewhat deepened my knowledge base.
I downloaded the AQR document and spent an hour reviewing it. In the spirit of the Internet, here is my WikiView of the paper.
I am favorably impressed by the directness, the honesty, and the technical characteristics of the report. Its content clearly identifies the prospects and the limitations of the risk parity strategy. It helps to establish a trust in the author’s firm.
I applaud the AQR philosophy that management costs, particularly in the Hedge Fund universe, are far too high. The current cost structure seems appropriate, but the huge initial investment hurdle is an unassailable entry mountain for most private investors. I hope some group alternatives exist as is often the case.
A major AQR position is for ultra diversification across products, markets, and globally. It is ubiquitous in their document. I completely agree, but that is not a novel investment idea.
AQR talks about the complexity of risk, about its multidimensional nature. Yet when reporting their methodology, they revert to the conventional standard deviation measure of the risk parameter. This defection to the conventional representation has implications further down the road in my review. For now, the AQR document failed to walk the talk.
I was pleased with the ADQ presentation of investment category outcomes from the past 40 years, particularly with the segmentation of their discussions into decades and into different crisis periods. History does matter and informs our decision making.
I applaud ADQ for properly crediting the academic work completed by Harry Markowitz and James Tobin in the 1950s. These are the cornerstones of efficient portfolio construction and the investment separation concepts. Again, these are well established risk control concepts that are taught in every financial college course today. Nothing new here.
Let’s get back to the definition of risk once again. The ADQ team acknowledges standard deviation shortcomings, but uses it throughout the paper. That’s okay, except when displaying the potential benefits of leveraging in the Efficient Frontier curve given as Figure 6. Markowitz and Tobin used standard deviation as the full measure of risk because that was likely their simplified understanding five decades ago. By resorting to that same definition, ADQ understates the risk of Leverage when investing.
Note that the Leveraged portfolio in Figure 6 is still a linear function of Risk. ADQ knows better. See the warnings in their disclaimer section. At one point, they say: “It is also possible to lose more than the initial deposit when trading derivatives or using leverage.” That’s honest, but it is not properly reflected in the linear extrapolation relationship depicted in Figure 6. For the leverage notional depiction, the curve should bend, convex downward. As expected rewards increase, at some point, the risk price tag is likely to become exorbitant. The leveraged risk/reward tradeoff is definitely not linear.
Without leveraging, the standard Risk Parity portfolio is likely to deliver muted returns (perhaps similar to the Permanent Portfolio genre). The commonsense risk/reward investment tradeoff axiom remains intact; higher expected reward means higher risk adventures.
ADQ offers to sweeten the deal by engaging in very active Hedge Fund leveraging techniques, many of which are fairly presented in the paper. These techniques include special forecasting skills, preferential market assessments, and very active, and accurate money management tools. Hedge funds typically operate in this space. ADQ has considerable expertise and experience functioning in this specialized environment. But those operations increase risk; success can never be guaranteed, and risk is not fully represented in the Figure 6 plots.
ADQ has the experienced talent to execute this investment approach. They have been doing it for years. Just recognize, that is a risk mitigation method that degrades in risk control as leverage stretches for higher returns.
Market watchers have long recognized the realities of “fat-tailed” return distributions. About 15 years ago I did personal Monte Carlo computer simulations to inform my retirement decision. I did my own computer programming. Initially, I postulated Bell curve return’s distributions.
To enhance my simulation fidelity, I modified my code to do Bell curve returns when the randomly selected volatility was within a stipulated standard deviation factor, and then defaulted to a power-curve distribution when that standard deviation criteria was violated. The power-curve distribution better models the real world fat=tail return’s distribution.
Of course, my portfolio survival rate declined with the wilder ride that the fat-tails modeling projected. I still retired as planned, but my wife and I decided on a smaller portfolio drawdown rate as a result of those simulations.
We were never happy with the robustness of those simulations because the point of departure from the Bell curve, and the decay exponent in the postulated power-curve distribution were arbitrary. There is a paucity of data in the fat-tail regime. Inputing an exponential decay rate is pure guesswork. Assumptions must always be made in the borderline zone between orderly and unpredictable future market behavior. Luck is important.
I’m sure you made a wise decision in your ADQ investment. I know you do not expect miracles. It’s a nonlinear world.
Best Wishes.