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Crisis? Tempted To Flee To Shelter Of Big Funds? Bad Idea

A new report out of the Cass Business School, City University, London, indicates that investors, especially in times of crisis (that is, when the use of the adjective “hedge” in front of “fund” is most apropos), are better off investing with a small fund rather than a large one. This is counter-intuitive, in that it is precisely in times of crisis that the temptation to flee to the larger institutions is most powerful for many investors. Yet the negative statistical correlation between size and performance was largest in three periods within the database of this study, times of crisis: 1999 to 2000, 2003 to 2004, and 2008 to 2010. Why? Largely because of the restrictions that the larger funds place on redemptions. More obviously, diseconomies of scale play a role, and can themselves vary with the business cycle. Size and Time The authors (Andrew Clare, Dirk Nitzsche, Nick Motson) describe their study as based on a more comprehensive database that that of earlier studies along the same lines. Specifically, their database consisted of 7,261 funds and their performance over a twenty year period (1994 to 2014). One important side issue for their study involves the evolution of average industry size over time. Bigger Than It Used to Be (click to enlarge) As the above table shows, the average size of funds has grown, consistently over every decile, through the 20 year period included in the TASS data the authors reviewed. This is what one would expect even before looking at such data, having only a headline-inhabitant’s view of the industry, but it does highlight the issue of whether and to what extent the size/performance relationship itself has varied over the years. Another counter-intuitive finding to emerge from their study: age is also negatively correlated with performance. This seems odd because common sense might indicate that a small fund that has been around for several years (and has remained small) is a fund that has failed to attract investors, likely in turn because it has failed to perform. A large fund may well be a fund that became large because of performance and thus new investment. So … why the negative correlation here? The authors don’t offer a hypothesis. Time and Context They do say, though, that the age/performance relationship is considerably less impressive than the size/performance relationship. Here, again, one has to look at the development of the industry over the 20 years discussed in order to develop a sense of the context for the relationships found in the data. The age/performance relationship was statistically significant in the earlier years of the study’s sample, but by the period since 2003, especially since 2009, this relationship has become “not significantly different from zero.” So the authors focus on the stronger relation of the two they have identified, that between size and performance, and they look at it strategy by strategy, for L/S Equity, Emerging Markets, Event Driven Funds, and Managed Futures. They find considerable variation by strategy. In particular, Managed Futures don’t follow the general rule at all, the relationship between size and performance is positive in that context. It is positive in a way that doesn’t appear “statistically different from zero,” but still … it is not negative. That indicates “that this strategy is less constrained than others by size.” On the other side, the strategy that makes the greatest case for the proposition that petite is sweet is: L/S Equity.

It Is Not Possible That Valuations Matter Only At The Margins

By Rob Bennett You will often hear people say that valuations matter only at the margins. That is, valuations matter when prices are very high and when they are very low. Outside of that, it is okay to ignore the effect of valuations. I see this as dangerous thinking. My view is that either valuations matter or they do not. If they matter, they always matter. If they don’t matter, they never do. I am not able to make sense of the idea that valuations matter in some circumstances, but not in others. The first point that needs to be made is that there is a practical sense in which the claim that valuations only matter at the margins is true. Stocks generally offer a significantly better long-term value proposition than other asset classes. So, when stocks are priced at only a bit more than their fair value price, they remain a good investing choice. In a practical sense, then, a high stock allocation makes sense until the overvaluation reaches such a point that the mispricing is extreme. The problem is that there is no one valuation level at which stocks are transformed from a good choice to a bad one. Stocks are a little less appealing when the P/E10 level is 18 than they are when the P/E10 level is 15. And they are, of course, even less appealing when the P/E10 level is 21. And then even less appealing when the P/E10 level is 24. And even less appealing when the P/E10 level is 27. What is the investor to do? When does he lower his stock allocation, and by how much? It’s tricky. Stocks became a bit less appealing when the P/E10 level rose from 15 to 18, and then again when it moved from 18 to 21, and from 21 to 24, and from 24 to 27. But as the PE10 level moved from 15 to 27, the feedback being received by the investor was all positive. The risk of owning stocks was becoming greater. The investor should have been lowering his stock allocation in an effort to keep his risk profile constant. But at the moment when the P/E10 value reached the insane level of 27, the investor who failed to lower his stock allocation as the P/E10 value moved to 18, and then to 21, and then to 24, and then to 27 was feeling good about those decisions. So he was left disinclined to changing it much, even when prices had gone to “the margins” of 27 and above. What Jack Bogle says about this is that investors should not change their stock allocations in response to price increases. But if they feel that they absolutely must change their allocation at the margins, they should not lower them by more than 15 percent. Bogle has never explained how he came up with the 15 percent figure. I use the historical return data as my guide. The data shows that stocks are likely to offer an amazing long-term return when prices are at low levels or at fair value levels, and then the long-term return drops and drops as prices continue to rise. The data shows that most investors should have been going with a stock allocation of about 80 percent in the early 1990s and about 20 percent in the late 1990s and early 2000s. That’s a change not of 15 percentage points, but of 60 percentage points. Bogle’s recommendation is off by 400 percent, according to the 145 years of historical data available to us today. How many people know that? People don’t know how dangerous it is to own stocks when they are selling at high valuation levels, because most advisors buy into the idea that valuations matter only at the margins. If you only consider valuations at the margins, you are missing out on most of the story of how the mispricing of stocks derails investor retirement plans. Stocks don’t suddenly become dangerous when the P/E10 value hits 27. They are virtually risk-free when the P/E10 value is 15. Then, they become more risky at 18. And more risky at 21. And more risky at 24. And more risky at 27. Unfortunately, the growing risk is a silent one. Stocks are far more risky when the P/E10 value is 21 than they are when it is 15. But years can go by before that risk evidences itself in portfolio destruction. Valuation risk plays out the way that cancer risk plays out for people who smoke three packs of cigarettes each day. Heavy smokers often “get away” with their behavior for decades before they contract a disease that kills them. However, the deep reality is different from the surface one. Someone who smokes three packs of cigarettes each day from age 16 to age 66 and then dies at age 67 from lung cancer was not avoiding the risk of smoking for 50 years; he was avoiding only the practical consequences of taking on a risk that would one day cause him to pay a terrible price. Disclosure: None.

Why You Should Be Playing Defense In This Market

Summary Why you should always be thinking about protecting your assets. Why holding cash is always a good idea. What you can learn from history and China about playing defense for maximum wealth generation. Ouch. That’s how I felt in 2008 when my portfolio was down 28.6%. The S&P was down 37% that year but I certainly didn’t care about having beaten the market. I’m supposed to be indifferent to how the market is doing and to take a long term focus. After all, that’s what I tell people all the time. But I remember it clearly. I was in Seoul, Korea getting married while the market was crashing. Obviously, I wasn’t concerned because I was sweating bullets while waiting at the altar. Also, being on the other side of the world helps drown out the noise. Then it was straight to the honeymoon and by the time I woke up, the market was in ashes. I was excited though and I had to sneak away to the resort lobby and hurriedly put in some trades before my newlywed wife noticed that I was missing. But despite all that, when 2008 came to an end, my portfolio was hurting by 28.6%. It wasn’t hurt from losing money. The hurt was due to the wasted opportunities I couldn’t take advantage of because I was 100% invested. The Current Situation At the moment, I have 20% in cash which provides flexibility and the opportunity to act if needed. Here’s what Prem Watsa, “Canada’s Warren Buffett”, once said during a conference call about having a high cash position. As far as the 30% cash, remember, that can change. So in 2008, and we had this position in 2007, in 2006. 2008, things turned the financial markets. Stock markets dropped… about 50%… And Tom, the only people who could benefit from that were the people who had cash or government bonds. And so we are conscious of that in our history. Cash gives you options, gives you the ability to take advantage of opportunity but you have to be long-term. We have built our company with a long-term view. Our long-term results are excellent. For example, in 2007, ’08, and ’09, the 3 years, 2007, 2008, 2009, we made $2.8 billion after tax, our book value went up by 150%. Since that time, we haven’t done a lot. But we’ve said to our shareholders that we are long-term focused, our results are lumpy and we never know when it can change. But the cash gives us a huge advantage in terms of taking advantage of opportunity as and when they come. It’s not just in the stock market. People who had the cash to scoop up cheap real estate, businesses or even liquidated inventory to flip have all done well while other people were running scared. Warren Buffett says something similar. We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially. So are you 100% invested or do you have some room to take advantage of opportunities if it comes up? Are you willing to sacrifice 1-2% in potential returns by holding cash, or are you trying to squeeze out every basis point possible without considering what could happen? Cash Does Nothing and Is a Bad Investment True. If you’re talking about a long term horizon greater than 10 years, that is. Holding cash isn’t a popular choice because you feel like you are missing out on opportunities while everyone else is making money . Instead of holding cash, financial commentators prefer to recommend defensive companies, even after the stock market plummets when fear is supreme. But that’s the worst time to be buying defensive stocks anyways because everyone else is thinking the same thing. Plus, it assumes you have the cash to buy defensive stocks to begin with. If cash isn’t your thing, then the next best thing would be rebalance your portfolio from speculative growth picks to recession proof businesses and sleep well at night. Ditto. Learn from History and the Current Chinese Market In Howard Marks memo titled “Ditto”, there’s a section that outlines the cycle in attitude towards risk. 1. When economic growth is slow or negative and markets are weak, most people worry about losing money and disregard the risk of missing opportunities. Only a few stouthearted contrarians are capable of imaging that improvement is possible. 2. Then the economy shows some signs of life, and corporate earnings begin to move up rather than down. 3. Sooner or later , economic growth takes hold visibly and earnings show surprising gains. 4. This excess of reality over expectations causes security prices to start moving up. 5. Because of those gains – along with the improving economic and corporate news – the average investor realizes that improvement is actually underway. Confidence rises. Investors feel richer and smarter, forget their prior bad experience, and extrapolate the recent progress. 6. Skepticism and caution abate; optimism and aggressiveness take their place. 7. Anyone who’s been sitting out the dance experiences the pain of watching from the sidelines as assets appreciate. The bystanders feel regret and are gradually suckered in. 8. The longer this process goes on, the more enthusiasm for investments rises and resistance subsides. People worry less about losing money and more about missing opportunities. 9. Risk aversion evaporates and invests behave more aggressively. People begin to have difficulty imagining how losses could ever occur. When you look at how Howard Marks explains this cycle, it’s clear that history may not repeat, but it does rhyme. And it’s currently rhyming in China. (click to enlarge) My mother-in-law theory is that when my mother-in-law wants to get into the stock market or starts to recommend stocks as an investment, it’s time to move to cash. That’s what happening in China though. But look to history. (click to enlarge) The US market is different to the Chinese market, but it’s a lesson nonetheless and something to keep at the back of your mind. How Far Will the Market Continue Going Up? I consider myself an optimistic person and many times, it has worked against me. A lot of the times, I don’t want to think about the bad things that could happen and I end up pushing it under the bed. And this market isn’t easy to invest in. Most hedge funds aren’t even in positive territory after fees this year. But will the market continue to go up forever? Don’t think so. There has to be a crash correction. My way of playing defense is to be alert and not contempt. I don’t trust or listen to market news or forecasters because they are just as clueless as me about what the market will do next. All I can say about forecasters and market predictions is to quote the following. There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. – John Kenneth Galbraith How Do I Play Defense? Here’s how I do it. I’ve printed out Seth Klarman’s thoughts on holding cash and read it regularly or whenever I feel like I’m missing out. Read Howard Marks memos, Buffett letters and other papers and book on behavioral finance. I highly recommend What I Learned Losing a Million Dollars . It’s one of those books that make you grow. But reading books outside of investing keeps me fresh and always provides new insight on how I can improve. I don’t talk about stocks with non value investing people, which means I never talk about stocks at all in day to day life. Maintain a buy list. Remind myself to stop overpaying because valuation matters more than ever . There is a time for offense, but right now, I’m playing more defense. Offense wins games, but defense wins championships. So where are you at the moment? Offense or defense? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.