Ten quick takeaways from our time in Chicago.
Value investing works. Value investors, routinely, don’t.
Charles, Chip and I had a long conversation with Mike Hunstad, head of quantitative strategies; Jim McDonald, chief investment strategist and co-PM for Northern Global Tactical Asset Allocation Fund (BBALX). They weren’t in attendance at the conference, so we met at a restaurant nearby.
Mr. Hunstad’s argument, for which he provided substantial evidence, is that the vast majority of alpha is provided by a handful of “factors,” variables that show very consistent and persistent outperformance. One of the most well-known factors is value: value outperforms growth across time, across asset classes and across markets. Makes sense: if you buy something with the intent of reselling it (as you do with stocks), you’ll make more money if you bought it at a low price than at a high one. And yet, value investors have not established a consistent record of outperforming growth investors even over very long periods. By way of illustration, we used the MFO Premium screener to examine the record of the past quarter century, during which time Vanguard’s value index fund (VIVAX) has underperformed its growth index fund (VIGRX). The raw return difference is small (9.5% annually versus 9.6%) but shouldn’t exist at all. The picture is a tiny bit better if you look at 10-year rolling averages (if you look at all 187 rolling 10-year periods since the funds’ inception, Value leads6.5% to 6.3), but not nearly so much as the theory says. If you look just at the past 10 years, value lags substantially.
Here’s Hunstad’s argument: there are six factors that drive investing performance, but value investors act as if there’s only one. As a result, they contaminate their value portfolios by including stocks that have positive value characteristics but negative attributes on some or all of the other five controlling factors. An admirably deep-value portfolio might well inadvertently contain low quality, high volatility, low dividend, oversized stocks, all of which dilute or perhaps eliminate the value premium.
He argues that this is especially problematic for investors in “multi-factor” ETFs, where the adviser promises “quality value” but actually constructs a “quality sleeve” (which might be overvalued) and a “value sleeve” (which might contain low quality stocks), neither of which controlled for, say, volatility factor. He notes that once you eliminate those contaminants, value has decisively outperformed growth even in the current environment.
Northern attempts to control for such contamination in their FlexShare ETFs, their very fine Global Tactical Asset Allocation Fund (BBALX) which invests through those ETFs and in their actively-managed funds, such as Northern Income Equity (NOIEX) and LC Core Fund (NOLCX). We’ll look more closely at the performance the latter two funds in the next couple months.
Value investing might, finally, work in Asia.
The traditional concern about value investing in Asia is that the system is rigged against the interests of outside investors. Corporations and inter-corporate ties were controlled by relationships and the sense of personal or societal obligation. Corporations made and sustained objectively horrible investments in one another because of the relationships between their control parties, often the founding family rather than the ostensible shareholder-owners. Corporations might have vast potential value which would never be unlocked because the control parties placed their interests ahead of their corporations.
That’s changing, at least if Beini Zhou is right. Mr. Zhou manages Matthews Asia Value Fund (MAVRX/MAVAX) and he believes corporate Asia is undergoing slow but irreversible changes that force economic efficiency and corporate responsibility. Many of those changes are generated by stakeholders, such as the home country’s government, who are too important to be disregarded. Sovereign wealth funds and retirement funds need their investments in corporate stocks to post steady, substantial returns if they’re to meet their own obligations. They are willing to undertake activist campaigns to pressure corporations into unlocking value and becoming more attractive to outside investors. As a younger generation of leaders – perhaps the grandchildren of the founders – ascend to leadership, they bring attitudes more aligned with modern corporate finance.
Mr. Zhou’s approach to investment research involves huge amounts of reading (his colleagues post pictures of his four-foot stacks of 10Ks) and a distinctive approach to management: he asks them to tell him the stories of their corporations, rather than to share the numbers (which he already knows). Those narratives, he believes, gives him vital clues to the corporation’s culture and its path forward.
Mr. Zhou came across as incredibly bright (Matthews has a knack for hiring such folks), curious and independent. I enjoyed our talk and was impressed by his intellect. (That’s regrettably rare.) It’s hard to question his fund’s success: he’s outperformed his Asia-Pacific peers by 330 bps a year with 20% less volatility and far smaller drawdowns. We’ll assay a profile of Matthews Asia Value in either September or October.
We’re in the race of our lives.
Jeremy Grantham, co-founder of the institutional investor GMO, was utterly bleak in one of the four Morningstar keynote addresses (the link provides the transcript and video, divided into five parts). Grantham has been, in general, pessimistic about the shape of the markets and its implication for the next decade (GMO projects negative real returns for most asset classes over the next seven years) and over our stewardship of the planet, but it’s usually framed in terms such as “we need serious, immediate action to mitigate the worst effects of global warming.” This time, he abandoned almost all attempts to provide an optimistic gloss to the situation.
Here’s the short version: we are making absolutely phenomenal gains in zero-carbon energy sources, electricity storage and carbon withdrawal technologies. That still won’t be enough to save us from vast damage on a global scale, with catastrophic damage likely to occur in Africa. But, wait, it gets worse: environmental toxins compound the damage, with the number of pollinators down by 75% already and human sperm counts down by 50%. Increased heat robs food crops of their nutrients, increased storms increase erosion, both decrease our food security. These combined pressures are probably manageable in the richest countries, but are certainly not for the poorest. North African refugees, arriving by just the tens of thousands, caused the virtual collapse of Europe’s relatively open, relatively liberal post-war. We need to anticipate a world in which they are forced by the tens of millions from vast uninhabitable swathes of their continent.
He delivered the presentation with his signature wealth of data, but without his equally signature self-deprecating humor. It was a cri de Coeur from a man whose has committed 98% of his net wealth to two charitable foundations or to fighting climate change.
Grantham offers a variety of suggestions for actions investors might take, including divesting from fossil fuels (a move with essentially no loss to your portfolio), invest in green companies and technologies (a potential positive to the portfolio) and urge the companies you’re already invested in to be more environmentally responsible. While all are sensible and positive, it felt very much like an obligatory addendum peripheral to his core message: our children will not survive if we choose denial, equivocation and inaction. Acting now will require huge effort. Acting in a generation will require ten times greater effort. Not acting signs death warrants for hundreds of millions of human beings.
Cryptocurrencies are not investments. Period.
Sam Lee, who is incredibly smart, and three other guys were panelists for “Crypto, Blockchain, and Lamborghinis, Oh My!” The program title was a reference to newly-minted crypto-tycoons buying Lambos.
If I understand Sam’s argument correctly, it is that cryptocurrencies are ripe for profitable speculation: there’s a clear boom-bust cycle at work where you simply learn to play the peaks and valleys. So far, each peak and each subsequent valley have been higher than the one before. The fact that each bitcoin crash bottoms out at a somewhat higher level than during the preceding crash is a modestly hopeful sign.
That said, first, cryptocurrencies are intrinsically valuable only if you cannot trust the other side. If you think that the counter-party in your transaction is going to try to skip off with your money or if you believe that the government issuing the money is going to manipulate (or freeze or seize) the currency, cryptocurrencies are potentially valuable. In the absence of those conditions, they’re very expensive diversions.
Second, most cryptocurrencies are going to zero and taking their speculators with them. The value of a cryptocurrency is directly related to the number of people who use it, its network. Morningstar could certainly decide to issue a currency of their own and pay their staff in (wait for it!) StarBucks, but with only 4,500 people in the network if would be nearly valueless. That is, if someone walks into a Starbucks and offered to pay with a StarBuck, they’d be turned away, de-caffeinated. As of June 30, 2018, there are 1,597 cryptocurrencies in circulation. There might be enough demand for cryptocurrency to create viable networks for, oh, 10 of them. Holders of the other 1587 might find themselves better off with a stash of Venezuelan bolivars.
The other panelists seemed rather less willing, or able, to step back and consider fundamental questions; they focused instead on trivia questions like whether it’s possible to make more energy-efficient cryptocurrency miners, the answer to which is “yes, of course, but why bother?”
As markets begin to fracture, RiverPark Long/Short Opportunity (RLSFX) is resurgent. RiverPark holds comfortable performance leads over its Lipper peer group over the past one-, three- and five-year periods, generally with more volatility but smaller drawdowns. Much of RiverPark’s success is driven by a macro-level overlay which identifies dying industries and sectors then shorts stocks in those areas. Document Storage, companies which warehouse millions of tons of old corporate records, is dying, and even the best companies in that sector are going down with the ship. Data Centers, companies which run the computers that make “the cloud” possible, are thriving and the best companies there are poised to make a mint. For a while, zero interest rates and central bank interventions made it possible for dying companies to mask their plight; lately that has ceased to be the cause and RiverPark is profiting.
We’ll update our profile of the fund in August.
361 Global Long/Short Equity (AGAQX) is worth attention. At $700 million and a five-star rating it’s getting attention, it just might warrant your attention, too. Tom Florence, 361’s president and CEO, spent some time with us, talking through the strategy’s distinctions. The core discipline resonated strongly with our discussion of factor investing with Northern’s Mike Hunstad. At base, volatility is one of the persistent drivers of performance whereby low vol stocks routinely and consistently outperform high vol ones. Nonetheless, high vol “story stocks” are continuously and irrationally popular.
Management of the 361 long/short portfolios is handled by a team for a famous sub-adviser, Analytic Advisers (now a subsidiary of Wells Fargo Asset Management). The team, led by president Harindra (“Harin”) de Silva, are quants whose discipline exploits the volatility anomaly. Controlling for other factors as a risk-management strategy, they target low vol stocks for their long book and high vol stocks for their short book.
The fund’s performance has been exemplary; it qualifies as a Great Owl for having top 20% risk-adjusted returns in the three application time periods available to us (1-year, 3-year and since inception) but it actually had a longer, strong record as a hedge fund before that. We’ll assay a profile of the fund in August.
Cognios Large Cap Market Neutral (COGMX) remains one of the very few sensible market-neutral funds in existence. Most market neutral funds offer irrelevant returns in exchange for market-free movement. The question is “why bother with a complicated, expensive market neutral strategy when I can get comparable returns in a virtually risk-free ultra-short bond fund?” Most long-short managers don’t have an answer; over the past five years, the average market neutral equity fund has returned 1.3% annually while ultra-short bond funds clocked in a 0.8%. Cognios clocked in with a five-year return of 4.6% annually, three-and-a-half times its average peer. That’s tied for the second highest total return with the $5.4 billion Gateway (GATEX) fund. Cognios is distinctive among the performance leaders because it’s really market neutral (R-squared of 5 against the S&P 500) while its top-performing peers were actually tracking the market upward (R-squared of 84 for GATEX and 82 for Eaton Vance Hedged EROIX).
The quality of tchotchkes was way down. The FlexShares folks had cool USB lights with flexible necks, so that you could plug one into a USB port on your laptap and have a reasonable light with which to read or write. Queens Road, whose Value Fund (QRVLX) is way smaller than its record and discipline warrant, offered up jars of delicious peanuts made by their church. Other than that, there was some weird and anachronistic fetish for fidget spinners (hello, 2016!) and a continuing attachment to “invest mints.” Here’s the marketing note: tchotchkes should align with some value the company espouses (Southern firm/peanuts, got it) and should be around long enough to buy mindshare. A bag of M&Ms that get trashed before you leave the exhibit hall don’t do it.
It is a distinct pleasure to meet Dick Gillons. Dick works with RHG Advisors in Tucson. He’s been in the business a long time, though he’s paring back a bit now. He reads MFO and we met with no greater agenda than to meet and chat. It’s always a delight to meet with you folks, and was most especially with Dick. Thank you, sir!
The next Morningstar Investment Conference will be May 8–10, 2019, again at McCormick Place, Chicago.
Morningstar’s Sarah Wirth reports that “total attendees registered was over 2,260. Total exhibitor booths were 171. We had more than 40 speakers, 80 registered media, and more than 740 employees attend the conference.” That compares with the April 2017 conference at 1,313 registered attendees (mostly advisors), 756 exhibitors, 175 exhibitor booths, and 45 speakers. The bump in paying customers was likely driven by the decision to move back to June and to merge the Investment Conference and the ETF Conference into a single event.
And, again presumably, attendance did not warrant prime-time space in McCormick Place so the conference is heading back to May.