Tag Archives: events

The Future Of Beta – Slip Sliding Away…

Value, momentum, size, quality, volatility, etc., as factors in investing are quite popular. They’ve produced significant outsized returns relative to benchmarks. Now, we even have Smart Beta funds and ETFs popping up all over to make taking advantage of factors super easy. That brings up the critical question every investor interested in taking advantage of factors in their portfolio should ask – will the outperformance of factor investing continue in the future? Here I’ll take a look at a recent post from Alpha Architect that addresses this question. In short, investors should expect past outperformance to decrease in the future. Basically, there are two reasons why outperformance could go away; data mining (the factor is not real and just an artifact of the data) and arbitrage (basically investors becoming aware of the anomaly, investing in it in a big way, and thus it disappears). The Alpha Architect post references a study that looked at out of sample performance of factors. Below are the results. Basically, out of sample returns are lower than what the historical results had shown. The returns were about 40-70% of what they were in the past. Sobering. But as I’ve discussed on the blog in the past, some factors are better than others. In another post , a bunch of factors are analyzed and the only two sustainable ones are value and momentum. This is the reason all the strategies I use are primarily focused around these two factors. But one of the reasons that value and momentum work is that they come with periods of awful performance, absolute and relative, and drawdowns. All of which make them very difficult to stick with over the long term. And if history is a guide, investors should expect their relative outperformance to decrease going forward as more investors become aware of them. In a way, these factor strategies are even harder to stick with than just simple buying and holding of traditional index products. When you’re indexing at least you’re doing no worse than the index! There is no FOMO (Fear of Missing Out). If you’re not willing or able to tolerate underperformance, potentially for long periods of time, then you won’t be successful with factors. But I think the are a several things investors can do to increase their chances of success going forward. Reduce expectations: I always reduce potential outperformance by at least half when I look at implementing a strategy. Diversify: Use multiple strategies – buy and hold indexing, TAA, smart beta, individual stocks. There’s a very strong chance at least one of the strategies will be outperforming, thus increasing your chances of sticking with your program. It doesn’t and shouldn’t be all or nothing. Stick with what works – Value and momentum strategies have stood the test of time… at least so far. Dampen portfolio volatility with bonds. Reduce noise – There is a lot of noise in markets today. Investors need to work hard to tune it out. Try and go 1 month without looking at the market. Most investors I know can’t go a week. Have an investing process – Investing your money shouldn’t be haphazard and random. As with many things in life, having a system and process will help you achieve success. What are your goals? How does your portfolio match those goals? When do you rebalance? What strategies are you implementing and why? Do the same things at the same times on a regular schedule, etc… In summary, factor outperformance could very possibly decrease in the future. But they are still likely to be very powerful wealth building strategies if investors can stick with them and not expect the future to be exactly like the past.

Infrastructure, Dividends And Path Dependence

A new paper from EDHEC Infrastructure Institute-Singapore argues that infrastructure firms represent a unique business model, one with lower revenue volatility, higher payouts, and substantially lower correlation with the business cycle than other firms. An “infrastructure firm” for purposes of this discussion is either a special purpose vehicle created in the context of a specific infrastructure project; a firm that conducts specific infrastructure-related activities, such as a port or an airport; or a regulated utility. Along the way to making its points, the paper also speaks, if only briefly, to an idea at the core of behavioral economics and finance: path dependence. But more of that in time. Investors and Regulators EDHEC infra prepared this paper in partnership with the Long-Term Infrastructure Investors Association, an organization of investors with a sum of $5 trillion in assets under management. In a press release that accompanied the paper, LTIIA chairman and CEO Thierry Déau said: “Not only can this research benefit investors in their profile decisions; it can also help build a deeper alignment between infrastructure investors and regulators.” The publication, “Revenue and dividend payouts in privately-held infrastructure investments,” by Frédéric Blanc-Brude, Majid Hasam, and Tim Whittaker, focuses on firms situated in the United Kingdom, because the UK offers “the largest, longest and most coherent set of infrastructure cash flow data available at this time.” Also, by confining the study to a single currency and regulatory environment, the authors avoid the need to control for those dimensions in their analysis. Six Conclusions Each infrastructure firm in the EDHEC infra database was, for purpose of this study, matched with a “nearest neighbor” non-infrastructure firm for control purposes. The matching was based on total asset size, leverage, and profitability. As a consequence of their statistical analyses, the authors came to six conclusions: Infrastructure firms have lower revenues and profits per dollar invested than the paired firm; They have significantly lower volatility of revenues and profits, in the aggregate and “at each point in investment and calendar time”; Infrastructure firms have a dynamic lifecycle, that is, the unit revenues and profits evolve by an order of magnitude over the investment cycle; Their revenues and profits are not tied, or at worst not closely tied, to the business cycle; The probability of positive equity payouts is high; finally; Equity payout ratios and considerably higher than in the relevant control groups. Trading one Cycle for Another The third and fourth of those points are closely related. One might roughly say that because infrastructure firms tie their fate to their own lifecycle, they gain some independence of the business cycle. Statistically speaking, four proxies of the business cycle highly correlated to one another [calendar year dummies, GDP, retail prices, and the Fama-French market factors] “have limited or no explanatory value with respect to the variance of revenues in infrastructure assets….” Thus, infrastructure can serve a portfolio manager as a powerful diversifier. It is in considering the equity payout process, referenced in the fifth and sixth of the bullet points above, that we come to the issue of path dependence. Path dependence is a concept developed within the subculture of behavioral economics. It refers to the sometimes nonrational and generally unanticipated ways in which later choices are affected by earlier choices. One classic example is the continued use of the QWERTY keyboard in all sorts of devices and virtual displays today, though its creation in the early days of the typewriter is shrouded in mystery. Joan Robinson anticipated the development of the idea of path dependency in the 1970s, when she wrote, “Once we admit that an economy exists in time, that history goes one way, from the irrevocable past into the unknown future, the concept of equilibrium … become untenable.” Robinson believed that path dependence was so important that it required a rethinking of the foundations of economics as a science. Blanc-Brude et al have no need to go that far. They do observe, though, that there is strong evidence of path dependency in this respect: “those [infrastructure] firms that begin to pay dividends early their life are more likely to be paying dividends later on.” This is odd, because infrastructure firms are “private firms with concentrated ownership.” The usual explanation for path dependence, that is for “stickiness,” in the level of dividend payouts, is premised upon publicly listed firms and/or distributed ownership. Stickiness is said to mitigate the agency costs inherent in the relationship between a small management group and a large ownership group. So: why do infrastructure firms, for whom the agency cost explanation doesn’t fit, nonetheless show this path dependency? The study gives no definitive answer to that question, beyond the suggestion that such a constant payout path in a standalone infrastructure product “could be interpreted” as a measure of the project’s success. It seems a fitting topic for further research.

The Placebo Effect

I’ve had four or five true migraines in my life, mostly from getting whacked on the head with something like a baseball or a sharp elbow in basketball, and I honestly can’t imagine how horrible it must be to suffer from chronic migraines, defined by the FDA as 15 or more migraines per month with headaches lasting at least four hours. So I was happy to see a TV ad saying that the FDA had approved Botox as an effective treatment for chronic migraines, preventing up to 9 headache-days per month. That’s huge! But in the fast-talking coda for the ad, I heard something that made me do a double-take. Yes, Botox can knock out up to 9 headache-days per month. But a placebo injection is almost as good, preventing up to 7 headache-days per month. Now 9 is better than 7 … I get that … and that’s why the FDA approved the drug as efficacious. Still. Really? Most of the reports I’ve read say that the cost of a Botox migraine treatment is about $600. That’s just the cost of the drug itself. So what the FDA is telling us is that a saline solution injection (costing what? $2) is almost 80% as effective as the $600 drug, so long as it was presented to the patient as a “true” potential therapy . If I’m an Allergan (NYSE: AGN ) shareholder I’m thanking god every day for the placebo effect. And not for nothing, but I’d really like to learn more about why Botox was NOT approved for migraine sufferers with fewer than 15 headache-days per month. If I were a gambling man (and I am), I’d be prepared to wager a significant amount of money that Botox significantly reduces headache-days at pretty much any level of chronic-ness, from 1 day to 30 days per month, but that at lower migraine frequencies a placebo is just as efficacious as Botox. In other words, I’d bet that ALL migraine sufferers would benefit from a $600 Botox shot, but I’d also bet that ALL migraine sufferers would benefit from a cheap saline shot so long as the doctor told them it was a brilliant new drug, and they’d get as much or MORE benefit from the cheap saline shot than from Botox if they’re “just” enduring eight or nine migraine headaches. Per month. Geez. Of course, there’s no economic incentive to provide the cheap placebo injection nor the unapproved (and hence unreimbursed) Botox shot if you have fewer than 15 headache-days per month. Bottomline: I’d bet that millions of people who don’t meet the 15 day threshold are suffering from terrible pain that could absolutely be alleviated at a very reasonable cost if it weren’t criminally unethical and (worse) terribly unprofitable to lie about the “truth” of a placebo treatment. Of course, we have no such restrictions, ethical or otherwise, when it comes to monetary policy, and that’s the connection between investing and this little foray into the special hell that we call healthcare economics. The primary instruments of monetary policy in 2016 – words used to construct Common Knowledge and mold our behavior, words chosen for effect rather than truthfulness, words of “forward guidance” and ” communication policy ” – are placebos. Like a fake migraine therapy, the placebos of monetary policy are enormously effective because they act on the brain-regulated physiological phenomena of pain (placebos are essentially useless on non-brain-regulated phenomena like joint instability from a torn ligament or cellular chaos from cancer). Even in fundamentally-driven markets there’s a healthy balance between pain minimization and reward maximization. In a policy-driven market? The top three investing principles are pain avoidance, pain avoidance, and pain avoidance. We’re just looking to survive, not literally but in a brain-regulated emotional sense, and that leaves us wide open for the soothing power of placebos. I get lots of comments from readers who don’t understand how markets can continue to levitate higher with anemic-at-best global growth, stretched valuation multiples, and an earnings recession in vast swaths of corporate America. This week I’m reading lots of comments post the failed Doha OPEC meeting that oil prices are doomed to see a $20 handle now that there’s no supply limitation agreement forthcoming. Yep, that’s the real world. And there’s zero monetary or fiscal policy in the works that has any direct beneficial impact on any of this. But that’s not what matters. That’s not how the game is played. So long as the Fed and the ECB and the BOJ are playing nice with China by talking down the dollar regardless of what’s happening in the real world economy, then it’s an investable rally in all risk assets , and oil goes up more easily than it goes down, regardless of what happens with OPEC. The placebo effect of insanely accommodative forward guidance that has zero impact on the real economy is in full swing. Oil prices are driven by forward guidance and the dollar, not real world supply and demand . Every day that Yellen talks up global risks and talks down the dollar is another day of a pain-relieving injection, regardless of whether or not that talk is “real” therapy. Does this mean that we’re off to the races in the market? Nope. The notion that we have a self-sustaining recovery in the global economy is laughable, and that’s what it will take to stimulate a new greed phase of a rip-roaring bull market. But by the same token I have no idea what makes this market go down, so long as we have monetary policy convergence rather than divergence, and so long as we have a Fed that loses its nerve and freaks out if the stock market goes down by more than 5%. So long as the words of a monetary policy truce hold strong, this isn’t a world that ends in fire and it isn’t a world that ends in ice. It’s the long gray slog of an entropic ending . Anyone else intrigued by the potential of a covered call strategy in this environment? I sure am. But wait, Ben, isn’t a covered call strategy (where you’re selling call options on your long positions) the opposite of convexity? Haven’t you been saying that a portfolio should have more convexity – i.e. optionality, i.e. buying options rather than selling options – rather than less? Yes. Yes, I have. But optionality isn’t the same thing as owning options. In the same way that I want portfolio optionality that pays off in a fire scenario (a miracle happens and global growth + inflation surges forward) and portfolio optionality that pays off in an ice scenario (China drops a deflationary atom bomb by floating the yuan), so do I want portfolio optionality that pays off in a gray slog scenario. That’s where covered calls (and covered puts for short positions) come into play. It’s all part of applying the principles of minimax regret to portfolio construction , where we don’t try to assign probabilities and expected return projections to our holdings, but where we think in terms of risk tolerance and minimizing investment pain for any of the market scenarios that could develop in a politically fragmented world. It’s all part of having an intentional portfolio , where every exposure plays a defined role with maximum capital efficiency, as opposed to an accidental portfolio where we just slather on layer after layer of “quality” large cap stocks . The Silver Age of the Central Banker gives me a headache. I bet it does you, too. Let’s take our relief where we can find it, placebo or no, but let’s not mistake forward guidance for a cure and let’s not forget that sometimes pretty words just aren’t enough. The truth is that the global trade pie is still shrinking and domestic politics are still anti-growth in both the US and Europe . Neither math nor human nature gives me much confidence that the currency truce can hold indefinitely, and I still think that every policy China has undertaken is exactly what I would do to prepare for floating (i.e. massively devaluing) the yuan. It’s at moments like this, though, that I remember the short seller’s creed: if you’re wrong on timing, you’re just wrong. I don’t know the timing of the bigger headaches to come, the ones that words and placebos won’t fix. What I do know, though, is that an investable rally in risk assets today gives us some breathing space to prepare our portfolios for the even more policy-controlled markets of the future. Let’s not waste this opportunity.