Tag Archives: economy

Why Does Indexing Shrink Alpha?

Jesse, over at Philosophical Economics, has written a couple of really fantastic posts (see here and here ) on indexing and market efficiency. His basic conclusions: The trend in passive investing is sustainable. The rise of passive indexing improves market efficiency. I’ve made the same points in a series of posts in recent months, including: Although I’ve written a good deal on this, I didn’t explain why indexing has made life so much harder for traditional active managers (aside from the obvious one, which is huge hedge fund fees). And although I totally agree with Jesse’s conclusions, I think we disagree slightly on the why. So, Jesse basically says that indexing removes unskilled players from the overall pool by relegating them to the game of owning specific index funds as opposed to engaging in the pursuit of real security analysis. The result is fewer and fewer highly skilled investors pursuing alpha via security analysis. I am going to disagree there. I think indexing is raising the aggregate skill level by giving everyone access to sophisticated strategies that better reflect “the market” portfolio. You likely know from reading this site that true passive indexing doesn’t exist. We’re all active because we all deviate from global cap-weighting. In addition, we know that an “index” is an extremely vague thing in the modern financial world. Dr. Andrew Lo even wrote an entire paper on this topic, because the concept has become so opaque in a world where there’s an “index” for everything from volatility, to futures contracts, to hedge funds and even Millennials. So, we’re knee deep in word games before we can even finish the term “passive indexing”… That doesn’t matter, though. What I want to emphasize is that the rise of indexing (regardless of how “active” that index is) has created products that give even the most novice investor access to more sophisticated strategies. Indexing doesn’t remove unskilled players from the game. It actually brings them into the game in a more even playing field. In today’s world, everyone can own Risk Parity, Global Macro, Long/Short, Private Equity, etc. As a result of this product development, the overall pool of secondary market investors has become a better reflection of the aggregate financial markets. The result of this is that the swimmers in this pool are all starting to look increasingly similar. For instance, let’s say we had just two investors in the world. Person A buys all 500 S&P 500 stocks individually, while Person B just finished reading some Gene Fama paper and decides to buy just 200 momentum stocks in a product wrapper like an index fund. When the momentum buyer enters the market, she will likely change the composition of the S&P 500, because her entrance to the market changes the allocation that Person A owns. As a result of this, Person A’s portfolio actually starts to look more like Person B’s portfolio, because now her momentum stocks look more momentumy (I just made that word up). Person A’s portfolio won’t be a perfect reflection of Person B’s for obvious reasons, but layer on 10,000 various index funds all trying to capture some form of alpha that doesn’t exist in the aggregate, and you get a bunch of portfolios that increasingly look similar. 1 A better (or worse, depending on your view) visual here might be Person B peeing in Person A’s pool. Person A’s pool will absorb the change in color, but it won’t be exactly the same color as before, and in the aggregate, the pool will morph into some other color reflecting all of the liquids that comprise that pool. This shift in the financial markets can best be seen in the hedge fund space, where the growth in the industry has coincided with rising correlations to the S&P 500 and shrinking alpha: So, the reason that indexing makes alpha more unachievable is to the fact that indexing makes the participants in the aggregate financial pool appear increasingly similar because they’re all utilizing a more sophisticated approach to asset allocation, leading to a more homogeneous reflection of “the market” portfolio. As a result, the margin for outperformance inside of the pool becomes increasingly thin, leading to alpha shrinkage. 2 1 – See ” Understanding Modern Portfolio Construction ” . 2 – I have significant knowledge in the area of shrinkage in pools, so trust my opinion here. NB – Notice I don’t argue that indexing makes the market more “efficient” as in, it reflects all available information. I don’t know what that term even means in a world where the idea of market efficiency must necessarily be a gray area. I personally don’t find the concept of an efficient market to be all that useful, since it is impossible to prove or disprove the idea that “the market” always reflects “the market” accurately.

Shifts In Leadership: Rules 3 And 4 For Investing

The stock market has moved towards new highs on the backs of the new leaders—the economically sensitive stocks. It’s not that the global economy has improved that much but it is that these companies have retooled to do better in a weaker environment. Expectations have been brought so far down and the stocks got so cheap that it has been easy to beat expectations with first quarter results. The market likes it when companies exceed expectations. Commodity prices, the bell weather for cyclicals, are increasing too, benefiting from a weaker dollar, which has now hit a multi-month low for reasons discussed in prior blogs and a somewhat stronger China. There has clearly been a mindset shift away from the old leaders towards the new and unless you recognize this shift, your performance will continue to lag behind the averages. Fortunately for our investors, we made these changes months ago beginning with covering our energy shorts, increasing our exposure to economically sensitive (especially commodity) stocks that are financially strong. We also are over-weighted banks and financials as discussed previously as a win/win proposition regardless of the economy. The best part about this change in leadership is that future earnings comparisons get easier for them as the year progresses as their results turned down dramatically beginning with the second quarter of 2015. Secondly, a weaker than expected dollar for 2016 has caused management to lift forecasts for this year. We made the shift in investment emphasis months ago aided in good part by utilizing our Rules #3 and #4 for investing. After looking at managements and strategies, we look for companies with rising incremental rates of returns and margins. In addition we are always searching for companies nearing their inflection point for earnings. Companies increasing their returns and margins are potential long investments as it tends to boost valuation and stock prices over time and it’s the reverse for the shorts. In addition, companies nearing an inflection point in earnings from negative to positive or visa versa as additional tools for investing. Anticipating with accuracy the inflection point as well as changes in incremental rates of returns are two of my time-tested rules for investing. These stocks tend to rise on a wall of worry or decline on a wall of exuberance… all the way to the bank. Patience is needed to let them unfold. None of these rules work in a vacuum. A successful investor needs a systematic approach combining a global macro-view for the proper asset allocation and risk controls with a bottom-up selection of each investment, which requires first hand research and and in-depth testing. While I agree with Warren Buffett that hedge funds have unperformed as a group over the last few years. It would be unwise to paint all managers with the same brush. A handful, who really understand what it takes to be a global investor today and abide by their time-tested methodologies, have done quite well and are worth every penny that they earn. Paix et Prospérité is one of them. Let’s take a quick look at the data points from last week and see if there were any changes in our core beliefs, asset allocation, risk controls and stock selection: The United States reported first quarter GNP increasing at an annual rate at 0.5% as we predicted down from a gain of 1.4% in the fourth quarter. Consumer spending led the way with a gain of 1.9% in the quarter down from 2.4% in the prior quarter; service spending rose by a healthier 2.7%; the trade gap widened reducing GNP by 0.34%; housing rose at a 14.8% rate; nonresidential fixed investment fell 5.9% and the GDP price index increased by only 0.7%. It was important to note that disposable income accelerated to a 2.9% gain in the quarter from 2.3% in the fourth quarter and the savings rate rose to 5.2% from 5.0% in the prior quarter. Growth in employment and wages combined with low inflation will result in more consumer discretionary income, which will support continued growth in consumer spending and the economy in 2016. The Fed also met last week and there was no surprise that the Fed policy was left unchanged. It is obvious why the Fed remains on hold: the U.S. economy weakened in the most recent quarter; inflation remains well below the 2% Fed target; problems abound abroad and finally fear of the ramifications of Britain potentially leaving as a member of the Eurozone. Economic activity and employment accelerated in the Eurozone in the first quarter with a gain of 0.6% from the fourth quarter and up 1.6% from a year ago. It was important to note that consumer prices reported for April were 0.2% below the prior despite all the actions of the ECB. Expect no changes in monetary and fiscal policies until after the Brexit vote at the end of June. China’s official manufacturers index was reported yesterday at 50.1 down from 50.2 the prior month. A number above 50 signals that the economy continued to expand after seven months of contraction. New factory orders and the production sub-index both fell slightly but also remain over 50 indicating continued expansion too. I remain confident that China will expand by at least 6-6.5% this year bolstering world growth. Japan remains the trouble spot amongst all major industrialized countries. The BOJ met and maintained its policies; the yen strengthened as investors sold risk assets and the stock market fell dramatically. Etsuro Honda, an advisor to Prime Minister Abe, raised concerns that monetary policy alone cannot lift the economy however the country’s debt situation precludes much stimulus. I remain cautious on Japan. Let’s wrap up. Events of the last week reinforced many of our core beliefs. One of my key beliefs, “This is a market of stocks, not a stock market”, was bolstered this week by a combination of disparate earnings reports and commentary by companies across a wide spectrum of industries but also by the clear shift in mindset from old leadership to new. This doesn’t mean that an Amazon, Facebook, Alibaba or a LinkedIn cannot still stand out, but I am suggesting that you need to recognize the changes occurring and invest stock-specific rather than by groups, regions or industries. In closing, review the facts, and then pause to reflect on proper asset allocation, risk tools, mindset changes by investors and managements. Lastly, do in-depth research on each investment… and invest accordingly!

Portfolio Construction In The Age Of Extraordinary Monetary Policy: Part I

Why This Series? This will be the beginning of a multi-article series that seeks to assess the Fed’s monetary policy and its effect on markets, and thus how we should invest going forward. My objective in writing this series is to make the case for why the traditional models of asset allocation will not provide the same results going forward as they have in the past, and thus a new approach is necessary. I form this conclusion by analyzing the data, and exploring the economic environment that investors find themselves in, as well as the unprecedented level of global central bank action and how this will affect the process of portfolio construction to meet the goals of the future. The series will have a particular focus on engineering the best portfolio possible by incorporating cutting edge academic research into the portfolio construction process. The series will consist of five pieces which together represent an in-depth discussion about the Fed, the economy, and how to invest in the new normal. The 2008 Financial Crisis and The Fed’s Response The 2008 financial crisis was the worst since the Great Depression of 1929, and by some measures, it was worse. In 2008, the S&P 500 fell by over 37.02% as the financial crisis took hold, figures four, five, and six below illustrate the take no prisoners effect of a violent market drop. The crisis was caused by a combination of government induced lending to unqualified borrowers, brought on by the community reinvestment act (12 U.S.C. 2901), as well as Wall Street speculation on real estate prices. Wall Street banks packaged Mortgage Backed Securities (MBS) rated AAA with subprime debt in various groups called tranches. These tranches of debt, then went bad when the subprime loans were deemed worthless. Wall Street packaged Collateralized Debt Obligations (CDO), which are pools of securities packaged together for sale to investors. The senior tranches of this debt are generally safer and have higher credit quality, while junior tranches are generally made up of riskier securities with higher yields. The challenge during the crisis was that Wall Street was packaging these CDOs with more and more risky debt and less and less of the AAA debt. On top of this, they created securities known as Synthetic CDOs, which use derivatives and other securities to obtain their investment goals without owning the assets of a CDO. The following chart depicts the creation of a Synthetic CDO in detail. Source: Financial Crisis Inquiry Commission When these junior tranches went bad, the House of Cards came down and brought trillions in consumer real estate and equity market wealth with it. Banks were most seriously hit with billions in worthless securities on the books. In response, the government took action to combine failing banks to create even larger financial institutions, and initiated new regulations under Dodd-Frank. The reality, however, is that this bill does little to increase the safety of our financial institutions, and only provides the illusion of safety with increased capital requirements. A Quantitative Analysis of Risk In conducting a quantitative analysis of the risks within financial services firms, there are multiple avenues to be considered. In terms of fair value accounting, IFRS 13 and FASB 157 are the two methodological statements for application. As we are going to focus the analysis on U.S. banks, I will limit the scope of this writing to U.S. GAAP application, and leave concerns from IFRS out of the discussion. Currently, U.S. GAAP only requires netting of derivatives exposure, providing investors with only a part of the overall exposure of any financial institution. Two additional pieces are required to more accurately understand the risks from derivative securities. First is the PFE, the potential future exposure, largely calculated through counter party risk. The second piece is the CVA (Credit Value Adjustment), this adjusts for the deterioration in credit quality of counter parties. It is important to note, however, that the CVA has no standardized method of calculation, adding another layer of uncertainty in arriving at a dependable quantifiable value of the derivatives exposure. (For additional exploration-Ernst & Young laid out this point well in this piece .) One additional layer of exposure is found in the Level 3 section of the valuation hierarchy. According to FASB 157, assets can be valued according to a hierarchy. Level 1 represents securities where readily available markets are available, and thus observable pricing exists. Level 2 are securities where inputs are observable either directly or indirectly, such as in markets that are thinly traded or where observable inputs can be estimated based on the prices of similar assets. Level 3 assets are assets where no observable market prices are available. In such a scenario, banks are allowed to use various methodologies to determine the prices of these assets. In my opinion, the challenge with these Level 3 values is that they are given a certain value simply because the banks say that is what they are worth. With no observable inputs, it is hard to put much confidence in the stated prices of these assets without a more dependable model for price discovery. It is important to note that the challenges with Level 3 assets extend beyond the world of bank balance sheets. The May 4, 2015 issue of Barron’s includes a very interesting exploration of the subject on page 31, as it relates to bond mutual fund financial statements. The article discusses a specific fund currently under investigation, but also deals with the issues of Level 3 securities on the books of many mutual funds. The story quotes the independent auditor of the specific fund in question in its most recent annual report as stating the following in relation to Level 3 assets: “These estimated values may differ significantly from the values that would have been used had a ready market for the investments existed, and the differences could be material.” The article also warns investors that during a crisis many assets classified as Level 2 can quickly become Level 3. I would echo this view in relation to bank balance sheets, as we learned during 2008 many of these arcane securities buried deep within bank balance sheets may carry a material variance between stated value and real market value.” Analyzing Level 3 in the Largest Banks Bank of America (NYSE: BAC ) As you can see from this analysis from page 241 of Bank of America’s annual report (2014), Level 3 assets represent 3.37% of the total assets after netting. The company is holding over 1,592,332M in total Level 1, 2, and 3 assets before netting with Level 2 making up 86.7%. I give BAC management a great deal of credit for maintaining a low value of Level 3 assets, but I believe the high value of Level 2 assets may expose investors to unquantifiable, and possibly material risks, in a financial crisis as there is no way of knowing how much of Level 2 would become Level 3 in such a scenario. Additionally, according to the OCC’s Quarterly Report on Bank Trading and Derivatives Activities for the 4th quarter of 2014 , BAC had total credit to capital exposure of 93%, and 85% as of the fourth quarter of 2015. Wells Fargo (NYSE: WFC ) Note 17 and Table 65 of the 2014 Annual Report, illustrates an exposure of 2% for investors to Level 3 securities. WFC is holding the majority of its assets at level 2, representing 94% of assets after netting. Additionally, according to the 4th quarter OCC report on Bank Trading and Derivatives Activities, WFC has total credit to capital of 22%, and 31% for the fourth quarter of 2015. JPMorgan Chase (NYSE: JPM ) Page 163 of the Annual Report indicates total Level 3 assets as a percentage of total assets measured at fair value of over 7.2%, which appears to be rather high when compared to peers. Additionally, according to the 4th quarter OCC report on Bank Trading and Derivatives Activities, JPM has total credit to capital of 177%, and 209% for the fourth quarter 2015. Note 3 of JPM’s annual report lays out the detail for fair value accounting for the firm. Citigroup (NYSE: C ) Page 262 of the 2014 Annual Report shows total Level 3 exposure of 2.42%. Additionally, Citi had a credit to capital ratio in 2014 of 172%, and 166% in the fourth quarter of 2015. Before netting exposure, Citi is holding close to a trillion dollars in derivatives at $892,760M. After netting of $824,803M occurs, this number is reduced to $67,957M, and this total includes Levels 1, 2, and 3 securities. The total Level 3 exposure after netting is $11,269M which is 16.58% of the net exposure of $67,957M, and 2.42% of total investments in Levels 1, 2, and 3 of $302,901M. What would be worrisome to me if I were a Citi shareholder is that the vast majority of the assets in the hierarchy are recorded in Level 2. The question is how much of Level 2 would become Level 3 in a crisis? It is important to note that many of these risks are mainly material to the investment thesis if we were to have another financial crisis. Level 3 assets are not a day-to-day concern for investors, generally speaking. That being said, they would be material should another crisis befall us. As nothing has been done to address the root cause of too big to fail, we now have larger financial institutions with more complex securities on the books, and another financial crisis may be inevitable. The Fed Response to the Crisis The Federal Reserve acted quickly instituting, what could be best characterized as an unprecedented experiment in monetary policy. The Fed put these extraordinary monetary policy measures in place to unfreeze markets and induce risk taking in the economy. They did this by implementing a combination of Large Scale Asset Purchases (LSAP) as well as Zero Interest Rate Policy (ZIRP). The combination of these policies were introduced to drive down the risk premium for long-term bonds (BRP), and drive up the risk premium for equities (ERP). While Ben Bernanke , the Fed Chair at the time defends his actions in monetary policy, the effects of these policies, which I will explore in the next article, are muddled at best and a down right failure at worst. The Fed’s objective in instituting this monetary policy was to drive up the prices of equity securities with the hopes of creating a real wealth effect. At the same time, the Fed hoped to induce risk taking in the real economy by driving down interest rates. The idea was that the two-fold effect of driving down interest rates to the zero lower bound, and inducing a rising equity market would allow us to avoid the negative effects of the great depression. But many question whether this was simply a mechanism to delay rather than avoid the worst of the financial crisis. In part II, we will discuss the implications of these policies on asset prices. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.