Tag Archives: journal

Lessons Learned From The Rise Of ETFs

For a large part of the 1980’s, 1990’s and the early 2000’s, hedge funds were equated with enormous financial success. Serving as investment vehicles primarily marketed towards the wealthy, hedge funds use a plethora of aggressive investing strategies in an effort to generate outsized returns. These strategies worked very well for the funds and for their clients for a short while. Yet, as the Securities and Exchange Commission (SEC) began to change the rules and monitor the actions of these funds more closely, the hedge fund game changed forever. In 2004, hedge fund managers were required to register their operation formally with the SEC and tie their name to that of their firm. This was mainly intended to keep portfolio managers accountable as fiduciaries. Then, after the global financial crisis in 2008, lawmakers in Washington D.C. took more decisive action to protect domestic financial markets. The Dodd-Frank Wall Street Reform Act of 2010 passed and brought with it more significant regulations to the United States’ financial sector. The restrictions on hedge funds were far more severe than what happened in 2004, such as extensive screening of investors and the presentation of sensitive data on trading positions. Because of the more stringent regulations, the risks that hedge funds once were able to take became almost impossible. Most notably, the Volcker rule has been placed into effect, which placed higher restrictions on speculative investments and proprietary trading that do not benefit the customers of funds. The success of the exchange-traded-fund (ETF) blossomed. ETFs are low-cost funds that track market indexes, asset classes, or commodities and are publicly traded like stocks. There is a stunning cost difference between ETFs and hedge funds. Hedge funds require a significant amount of active management and they usually charge a two percent annual management fee and a 20 percent fee on all profits (aka “two and twenty”). ETFs, however, charge anywhere between less than one and six percent on the basket of securities. Additionally, ETFs have the potential to attract the same clientele that hedge funds have traditionally won over: high net worth individuals. With high tax efficiency and low fees, ETFs are a no-brainer for high net worth portfolios. Understanding their advantageously low costs and taking into account the massive losses hedge funds incurred during the crisis, ETFs became a very desirable investment vehicle. Following 2008, total account balances in ETFs grew at an exponential rate and have continued to grow at an enormous annual rate of around fifteen percent compared to that of hedge funds’ annual rate of around nine percent. This past summer marked a big milestone for ETFs because total account balances for ETFs over took total account balances for hedge funds. (click to enlarge) Assets under management (The Economist) What this highlights above all is a shift in demand from active to passive investment management. In recent years, active investment managers have seen large fluctuations in their ability to beat passive funds. Ben Johnson, Morningstar’s director of global exchange-traded-fund research notes that “more than anything, fees matter” when seeking compounded capital gains. The theoretical debate on whether passive or active investing is truly more advantageous in the long run has been going on for quite some time at this point. First, we must discuss Modern Portfolio Theory (MPT). MPT dictates that investment diversification should play a complimentary role. Indeed, each investment in a given portfolio should play off the successes or failures of other investments to maximize return. MPT teaches us that there is a possible combination of assets that assumes very little risk and comparatively large return. This is all well and good, but one of the main assumptions of MPT is information efficiency and that is where the theory gets tricky. Given efficient markets, then all known factors will be priced into different stocks making it nearly impossible to beat the market in any case. Information asymmetry, the exact opposite as information efficiency, is actually the case, the effort, let alone the capital, necessary to achieve the proper asset diversification that mitigates a significant amount of risk and generates sizable returns. With the facets of MPT in mind, we can now begin to weigh in on active and passive investing aspects. Active investors assume more financial risk when trying to beat market indices, but passive investors take a significantly lower amount of risk when riding along with the successes or downfalls of markets. While the difference in returns of these two investing styles can be enormous, it is often enough that active investors, in fact, find themselves unable to generate returns that properly justify their assumed risk. (click to enlarge) Active vs passive performance (Forbes) What is so specifically important about the ETF versus hedge fund account balance trend is that when it comes to assuming financial risks, most investors don’t seem to really want to make double-digit returns when it means that their losses could be of equal magnitude. Kenneth French, Finance Professor at the Tuck School of Business at Dartmouth College, has commented extensively on the chance of investors doing better than indices. Indeed, Professor French’s Efficient Market Hypothesis (EMH) postulates that in the indefinite long run it is impossible to beat the market without acquiring high-risk investments. It would appear that the people are beginning, more so, to agree. Even if beating the market is possible in the short run, it takes effort. Stretching that effort into the long run and observing that beating the market is nearly impossible, it would seem that the effort is not worth it. ETFs are here to stay for the long-term. As more people want to find a cost and effort-effective way to participate in the markets and gather sizable returns, the more popular ETFs will continue to grow.

Glamour Stocks And Anchoring On The Changing P/E

Glamour stocks – Over the long-term, value investing as a style outperforms growth (if you’re looking for the evidence to support this statement, you can find it here , here and here ). We’ve known this to be the case for the past five decades. Why then does growth remain a popular strategy? This question formed the basis of a recent study conducted by Anderson, Keith P. and Zastawniak, Tomasz. The results of the study were published at the end of October in a paper entitled, Glamour, Value and Anchoring on the Changing P/E . Citation: Anderson, Keith P. and Zastawniak, Tomasz, Glamour, Value and Anchoring on the Changing P/E (October 23, 2015). Available at SSRN . Glamour, Value and Anchoring on the Changing P/E It has been known since 1960 that a portfolio of low P/E ‘value’ shares will produce better returns than a portfolio of high P/E ‘glamour/growth’ shares (Nicholson, S.F. 1960. Price-earnings ratios. Financial Analysts Journal, 16(4): 43-45.). Many studies have attempted to establish why this is the case but most of these studies have had one key flaw. Indeed, the studies in question have all revolved around the belief that value shares are riskier than glamour shares, which isn’t true. Shleifer and Vishny (Lakonishok, J., Shleifer, A. & Vishny, R. 1994. Contrarian investment, extrapolation, and risk. The Journal of Finance, 49(5): 1541-78.) concluded that value shares are not fundamentally riskier than glamour shares and they went on to give one possible behavioral explanation as to why investors may prefer glamour stocks: they want to appear more prudent. In other words, because glamour shares have been going up in the period before buying, their acquisition is easier to justify. Anderson, Keith P. and Zastawniak, Tomasz argue that a different behavioral explanation is behind the value/glamour split – a well-known feature of investors’ own bounded rationality: anchoring . “Investors may anchor on the P/E ratio currently attached to a stock when they invest in it. Having bought the stock, they expect the P/E to change slowly, if at all. As time goes on, the P/E decile changes, and different prospects for returns attach to each decile. If there is a differential drift in the P/E and hence returns between value and glamour stocks that is not expected by investors, this could account for why glamour investors end up disappointed.” – Glamour, Value and Anchoring on the Changing P/E . (click to enlarge) (click to enlarge) Glamour stocks vs. value Source: Brandes Institute titled, ” T he Role Of Expectations In Value And Glamour Stock Returns. ” Glamour stocks: Three questions With this hypothesis in place, Anderson, Keith P. and Zastawniak, Tomasz focused their research on answering three fundamental questions: Is there justification for the P/Es of value and glamour shares to change at different rates and the fact that value shares outperform glamour shares? What are the observed changes in P/Es and the returns that attach to them, and do investors’ decisions appear to be affected by anchoring ? Can glamour shares’ returns match or exceed those of value shares over any time period? With respect to question one, the study finds that by applying option pricing theory and Merton’s model to prices, and thus P/Es, of value and glamour shares can indeed be expected to move differently. The answer to question two is that glamour shares give three times the returns of value shares if they stay in the same decile, but they have a much greater tendency to move decile, which seems to be the reason behind value’s historical outperformance. Moreover, glamour investors appear to be underestimating the tendency of their shares to change P/E decile by at least 18%. This helps answer question three. Based on the study’s research, glamour investors will be subject to unimpressive returns whatever their time horizon. Glamour stocks: Key findings The major findings of Anderson, Keith P. and Zastawniak, Tomasz’s paper are rather interesting. The paper concludes that the main reason many investors continue to buy glamour shares is because they perceive the high P/E ratios of glamour stocks to be more permanent than they really are. A result of investors’ own behavioural bias of anchoring on the high initial values. However, glamour stocks whose P/E remained elevated throughout the study did outperform value stocks over the same period. Nevertheless, the tendency for the P/E of glamour stocks to change suddenly, and without notice, explains why glamour investors have, and will continue to see poorer returns than those following a value strategy. Disclosure: None

A Case For Active Investment Management

Summary Investing in fundamentally strong companies. Active Management vs. Benchmarking. Potential for reduced exposure to declining markets. “The most successful investment managers generally possess three qualities: independent thought, discipline, and consistency of application” – John Train in his book The Money Masters. “It is impossible to produce superior performance unless you do something different from the majority.” – Sir John Templeton. Screening for Fundamentally Strong Companies For over 15 years I have been a multi-asset class investor, advisor and analyst. My teams over the years have managed a variety of active strategies. While different in focus, every equity based strategy incorporates fundamental investment principles. Regardless of the fad of the day or the hot company everyone is talking about, consistent performance and risk management depends on these principles. I have recently collaborated with a group of CFA charterholders to form an all-cap equity strategy from our most successful strategies with the sole purpose of generating exceptional risk adjusted returns. Below is a summary of the parameters we use. All Alpha Strategy Parameters Price to Book < 1.5 7 years of positive operating margin 3 years roe > 15% Lowest 20% of growth adjusted free cash flow multiple Companies with above average operating and net margin within their respective industry Below average debt to equity Positive cash flow ROA growing D/E declining Current ratio, gross margin, asset turnover growing Cash flow > net income Consistent earnings growth Momentum parameters Thanks to Henry Crutcher and Equities Lab for creating a great quantitative tool that enables us to generate and successfully back test the performance of our fundamental and technical based strategies for the periods we don’t have actual trading history. See the output since 1997 from the program below. Here is a list of every trade for the past 15 years. Recently passing companies: (click to enlarge) The results from the model were strong. Upon verifying the data, 13.12% annualized is accurate. I then combined it with a proprietary risk management model that helps us anticipate significant market declines and the results were even more encouraging. I nvesting in fundamentally strong companies Investing “is pursued most successfully in a simple, straightforward way.” – Brad Perry, Winning the Investment Marathon. Buy stocks of high-quality companies at good prices and continue holding them as long as the companies’ performance merits doing so. Do this consistently and the probability an investor will enjoy above average returns substantially increases. Below are brief descriptions of the investment parameters. 1. Price to Book < 1.5 As a primary measure of value, the price to book ratio is an initial screen that seeks to pass securities that have moved away from their true value due to neglect and are typically out of favor. These securities over time have proven to be successful investments. 2. 7 years of positive operating margin Consistent operating margins are a positive sign a company's underlying business is successful and seemingly sustainable. 3. 3 years roe > 15% Strong and consistent return on equity is essential. 4. Lowest 20% of growth adjusted free cash flow multiple Using price/free cash flow multiplied by 5 year growth of free cash flow is a valuation measure. 5. Companies with above average operating and net margin within their respective industry This measure helps us choose the leaders in each investment’s respective industry. 6. Below average debt to equity Because overleveraged companies are not attractive. 7. ROA growing We prefer the companies we invest in to get better at what they do over time. Additionally, we look for companies that invest internally and that return produces consistently growing ROA. Otherwise, our money is better invested elsewhere. This is a year over year measure. 8. D/E declining Efficient use of debt is important, as well as consistent retirement of debt. 9. Current ratio, gross margin, asset turnover growing Measures of liquidity, profitability and business activity. 10. Cash flow from Operations > net income This is a simple accrual accounting check to avoid companies that may be attempting to manage earnings. 11. Consistent earnings growth Earnings growth attracts attention. We again use year over year measures that help us identify companies that are poised to move. 12. Momentum parameters in the form of relative strength play an important role in our growth oriented screen. It helps identify companies with attractive price movement but remain appropriately valued. In addition, we tend to focus our attention to price movers that are within 15% of recent highs. Active Management vs. Benchmarking So I guess you now have me pegged as an active investor. I personally don’t consider myself active or passive, I consider myself a fundamentally based technical investor, meaning I buy when it makes sense and sell when things start looking uncertain. My current domestic exposure, managed with a beta weighted futures overlay on a long portfolio, is 100% hedged due to current volatile economic conditions. The exposure metric was derived by analyzing market valuations and economic indicators. It is updated monthly, which may also be considered an actively managed strategy. Regardless of my bias, active management has taken a beating over the past few years and rightfully so, in many instances, such as the “active” managers that are more concerned about underperforming than actually providing value to their clients. In other cases, active management can provide an investor peace of mind and tremendous value if the strategy is fundamentally sound and is implemented consistently. William Sharpe stated in the Arithmetic of Active Management (The Financial Analysts’ Journal Vol. 47, No. 1, January/February 1991. pp. 7-9): If “active” and “passive” management styles are defined in sensible ways, i t must be the case that 1. before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and 2. after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar The problem with this statement from William Sharpe is that it assumes the active manager seeks to benchmark a specific market such as large cap, small cap, etc. As a business, active managers live and die on performance against their respective benchmarks. Knowing this, many use enhanced benchmarking. Enhanced benchmarking involves an active manager investing in an essentially passive portfolio of securities that mimic a benchmark. However in addition to this passive allocation, these active managers will use derivatives or some other portable alpha to “enhance” portfolio performance in an attempt to reduce the risk of underperforming the benchmark and providing the possibility of outperforming at any random time. Additionally, active managers may also stray from their benchmark allocations by adding smaller cap and potentially higher returning securities. This is known as style drift and measured by tracking error. Oftentimes, these additional measures do not add sufficient alpha to offset higher risk and fees. These are reasons a high percentage of active managers perform poorly after fees compared to passive index investing. Potential for reduced exposure to declining markets As seen in the Business Cycle Overlay data, the potential for reduced exposure to declining markets can be substantial if executed properly. The model effectively reduces equity risk when valuations become rich and economic conditions warrant more caution. Returns from effectively managing downturns is termed the buy-and-hold equalizer. The buy-and-hold equalizer (Why Market Timing Works, Journal of Portfolio Management, Summer 1997), represents the increased leverage an active investment strategy gains by preserving capital during a market drop. The more money an investor has to invest when the market turns up, the greater the performance leverage. The following passage is from NAAIM . When properly implemented, active management strategies should lessen an investor’s exposure to declining markets, blunting the impact of bear markets and preserving capital and the majority of prior gains. Moving out of the market prior to the majority of a decline means you have more money to invest when the market heads upward. Active investment management is most effective over a full market cycle (3 to 5 years). The reality of down markets provides the rational for active management. Down markets hurt investors in a number of ways. First, the more investors lose money in a down market, the more they lose valuable time and opportunity. Over the past 70 years, the major indices spent nearly 60% of the time sitting out bear markets and then returning to earlier highs. Only about 40% of the time were real gains being made. Through the use of active management strategies, money managers seek investment approaches that moderate the volatility of the market, helping investors stay the course and benefit from the long-term gains of the market and improve risk adjusted returns. Additionally, active management offers potential benefits beyond performance. Unlike with passive approaches, active managers are not required to invest cash inflows at the time of receipt when market conditions or prices may not be conducive. They can screen for quality and use buy/ sell triggers as a means of reducing risk. While a passive manager must own everything in an index, an active managers have the freedom to look for attractive stocks across the targeted universe. Summary Active management is an effective tool if used properly. It can not only lead to larger gains, but also reduce risk. However, it is very important for investors to understand the underlying investment strategy of a particular investment regardless of whether it is active or passive. Moreover, an investor should compare the statistics of an active strategy (Total Return, Standard Deviation, Calmar Ratio, Sharpe Ratio, Information Ratio, and Tracking Error) to that of a similar passive to determine if the higher fees are producing sufficient additional gains to warrant an investment. I will follow up this article with regular investment and economic analysis specific to these strategies, highlighting passing companies and providing economic rationale for managing an investment portfolio. Follow me to stay informed.