Tag Archives: portfolio-strategy

GSAM Makes The Case For Multimanager Alternatives

By DailyAlts Staff Record-low interest rates and historically high stock valuations have more and more investors considering liquid alternative investments, which Goldman Sachs Asset Management (“GSAM”) defines as “daily liquid investment strategies” that seek to deliver “differentiated returns from those of core assets” and the potential to mitigate overall portfolio risk and severe drawdowns. In a recent Strategic Advisory Solutions white paper, GSAM makes the case for a multimanager approach to liquid alternative investing – through single turnkey multimanager funds, allocations across multiple managers of the investor’s choosing, or a combination of both. Why Diversify an Alternatives Allocation? GSAM categorizes the liquid alts universe into five peer groups: Equity long/short Event driven Relative value Tactical trade/macro Multistrategy As shown in the table below, the median returns of each peer group have very little persistence from year to year. Therefore, by diversifying across peer groups, investors can avoid the highs and lows of any given year in any given strategy. Building from Scratch One approach to diversifying across liquid alternative peer groups is to “weave” several liquid alts into a “unified portfolio construction framework.” This approach may be best for investors seeking to express high-conviction market views of their own, or for those who possess deep knowledge of particular strategies and managers. But in GSAM’s view, the process of selecting liquid alts requires expertise in the asset class, knowledge of manager capabilities, and judgment of manager and strategy risks, among other things. This makes the “build” approach research-intensive, which may be a bit much for many investors. Turnkey Solutions On the opposite end of the spectrum is the “turnkey” approach – a pre-assembled package of alts, such as a multimanager alternative mutual fund. In this approach, investors effectively outsource the research-intensive process cited above to professional managers. On the downside, investors employing this approach don’t get a customized allocation, which means that their specific investment needs could potentially be better-served. What are some other risks to the multialternative approach? GSAM lists several, including: Performance may depend on the ability of the investment advisor to select, oversee, and allocate funds to individual managers, whose styles may not always be complementary. Managers may underperform the market generally or underperform other investment managers that could have been selected instead. Some managers have little experience managing liquid alternative funds, which differ from private investment funds. Investors should be mindful of these and other risks, according to GSAM. The Best of Both Worlds? GSAM calls combining the “build from scratch” and “turkey” approaches “Buy & Build.” This hybrid approach generally entails complementing a multialternative fund with one or more high-conviction managers the investor believes can potentially contribute to specific investment objectives. This “middle ground” between pure customization and an off-the-shelf solution gives investors additional flexibility with a fraction of the research-intensity. Conclusion In conclusion, GSAM states the company’s belief that multimanager strategies have the potential to help investors pursue additional sources of returns and to diversify their alternative investment allocations. In the firm’s view, investors who are new to investing generally opt for the single package approach to multimanager investing, while more experienced liquid alternative investors often consider building from scratch. The important thing, in GSAM’s estimation, is to understand the potential that liquid alts offer as an additional driver of portfolio returns. For more information, download a pdf copy of the white paper . Jason Seagraves contributed to this article.

Picking Stocks For The Long Term Is Harder Than You Think – So Don’t

Summary It is important to distinguish between stock picking and index investing, because they require different approaches. A common assumption with index investing is that, over the long term, indexes will rise. Often, investors make the same assumption when picking individual stocks, but they shouldn’t. It is extraordinarily difficult to find individual stocks that offer value, long-term predictability, and index out-performance. That doesn’t mean that we should abandon stock-picking. It just means that it is very important to take into account the medium-term prospects of a stock. Alpha is more likely to be achieved if one develops a medium-term investment thesis and then sticks to it. I generally try to avoid referencing super-investors for a variety of reasons, but this article will be an exception. There have been many, many articles and comments on Seeking Alpha that reference Warren Buffett’s investing advice. What is often not taken into account, however, is that Buffett’s advice is directed at two distinct categories of investors: active, knowledgeable investors; and passive, less knowledgeable investors. For passive investors, Buffett’s basic advice is to invest the majority of one’s capital into a low-cost S&P 500 index fund, and perhaps hold some capital in cash in case there is a downturn in which one needs money and does not wish to sell their stocks while the stocks are undervalued. The reasoning behind this is that over the long-term, a large basket of US stocks are likely to outperform other asset classes, and you can purchase a large basket of US stocks rather cheaply. As for investors who are active, intelligent, and knowledgeable, they should look for some combination of value and long-term predictability, and also have a high portfolio concentration, low turn-over, and if possible, aim to seek out companies with small capitalization. (This is summarizing a lot of what Buffett has said, done, and written over the years into one sentence. I would be happy discuss any reasonable objections of the summary in the comments section.) It is important to note that these two investing approaches are often mutually exclusive. You cannot have a high concentration and index at the same time. You also cannot assume that an individual stock that has a low correlation with its respective index will rise over long periods of time like you can with an index. In fact, I think that the relationships may be opposite one another. (Meaning the longer you commit to holding an individual stock, the more likely it is the stock will decline in value, while the longer you commit to holding a US focused index fund, the more likely it is that it will rise in value.) Not everything is mutually exclusive between the two approaches. You can buy a small-cap value fund that charges only small fees (but you can also expect more volatility if you do so). You can limit turnover when purchasing individual stocks, just as many indexes do. You can also try to find long-term individual stocks to purchase, but consider this: If Warren Buffett and Charlie Munger–two of the best investors in the world–can only find one or two worthy long-term picks in any given year, what makes you think that you can find more than that? So, while there is some potential overlap between the approaches, the areas that are mutually exclusive are often forgotten by investors, and the ones that aren’t mutually exclusive either have high volatility or are difficult to find. The mistake I see is that often times investors want to combine an indexing approach–and the assumptions that come with it–with a stock picking approach. Specifically, investors want to (1) be diversified beyond 3-10 holdings even though long-term value stocks are hard to find, (2) assume the historical bias toward long-term index gains applies to individual stocks, (3) assume that picking individual blue-chip stocks that have a high correlation with indexes will outperform indexes, and (4) assume that their goals are unrelated to the performance a benchmark. I will set assumptions 1, 3, and 4 to the side for this article, #1 would make this article too long, #3 is obviously a poor assumption, and #4 is simply a different topic altogether. So this article will focus on why investors have to be careful not to assume that the long-term historical upward bias of index funds also applies to individual stocks that are weakly correlated with the index. The Problem with Visibility: Visibility of the long-term future of individual stocks is more cloudy than people think. Quite often investors will assume that a company will perform well twenty years from now because it has performed well in the decades leading up to that point in time. If the investor purchases the stock and the stock price drops, quite often the investor will insist that the drop in price is okay because they are “holding for the long term”, and long term the company will be fine. It is absolutely critical the investors realize just how difficult it is to forecast out ten or twenty years on an individual stock. That is a key difference between an index and an individual stock. It might be okay to assume the S&P 500 index will be higher in twenty years than it is now. But if one were to pick an individual stock at random from the S&P 500, there is a greater than 50% chance that in twenty years the company will not even qualify as part of index. Half of the components of the S&P 500 in 1999 are not in the index today , only 16 years later. But, Cory, you say, I am not picking my stocks at random, I am picking only blue-chip stocks like Johnson & Johnson (NYSE: JNJ ), Coca-Cola (NYSE: KO ), Exxon Mobil (NYSE: XOM ), Procter & Gamble (NYSE: PG ), and Kinder Morgan (NYSE: KMI ) –I’m only partially kidding about Kinder Morgan. Your picks are probably not going to be perfect, right? My response is that if you only purchase huge, blue-chip, depression resistant companies, and you are going to diversify beyond ten of them just in case a couple of them turn out to be duds, then your performance will probably be similar to an S&P 500 index. You cannot assume that big, widely followed blue-chip companies will be available for purchase at value investor prices very often. And you cannot assume that value opportunities with small-cap companies will possess the same long-term visibility as big, blue-chips. It seems clear that those who purchase only the biggest and safest stocks are few and far between. Many stock-pickers might have a core portfolio of these companies, but they also branch out to other areas in search of alpha with regard to either yield or total return. In many cases what we have are stock-pickers who are moving beyond the confines of blue-chips in search of alpha who are carrying with them the assumptions that rightly apply only to indexes or the blue-chip stocks that are highly correlated with the indexes. Specifically, the assumption that if they just hold on to something long enough, it will rise or pay out steady dividends for the next ten or twenty years while also out-performing the market. This assumption can lead to under-performance or disaster. It is not an assumption that should be made. So, if one wants to seek alpha by picking individual stocks, what is it one could do to deal with the emotions and short term volatility in the stock market that compel investors to sell at the wrong time, without resorting to the fallback of aiming to hold for the long-term? I think the solution is to develop both a short and medium-term thesis while picking stocks, and only when a thesis comes to fruition should one consider holding a stock for the long-term. In my next article, I will explain the method I have been using recently with some success. Note: Please consider “following” me for real-time notification of my latest articles. My views are a constant work in progress and I am always interested in hearing other points of view, so if you have any thoughts, please feel free to share them in the comments section.

An Unexpected Reason Behind This Strategy’s Outperformance

One of the great anomalies of investing: the historical long-term outperformance of certain smart beta or factor-based strategies relative to the broader equity market (think choosing stocks based on their valuations, momentum, low volatility or quality metrics such as profitability). For example, according to data from MSCI, the MSCI USA Minimum Volatility (USD) index’s Sharpe ratio, a common way to measure risk-adjusted returns, was 0.61 for the last ten years, above the benchmark MSCI USA Index’s 0.44 ratio. The persistence of smart beta strategies’ outperformance relative to the broader market is surprising, because it doesn’t line up with the idea of an efficient market, one in which investors shouldn’t be able to simultaneously buy and sell securities for a profit without taking extra risk (the so-called “no arbitrage” principle ). In other words, in an efficient market, equity portfolios exhibiting low volatility, for instance, shouldn’t be able to earn comparable returns to their higher-risk counterparts. It’s no wonder, then, that numerous academic and financial industry research papers have been written on this topic, and there are various explanations for factor strategies’ outperformance. According to BlackRock’s smart beta experts, including my fellow Blog contributor Sara Shores, this outperformance can generally be attributed to a risk premium, structural impediment or behavioral anomaly. In other words, the outperformance is to compensate investors for taking on what’s actually a higher level of risk, a reflection of market supply-and-demand dynamics or the result of common decision-making biases. Personally, no shocker for my regular readers, I think explanations for this return performance anomaly rooted in behavioral finance add valuable insights to the discussion. In today’s highly connected world, where we can follow each other’s every move via social media, where we’re bombarded by data from every angle – including information on other investors’ positioning and trades – and where it can be hard to tune out the noise, human behavior may be a stronger performance driver than ever. Put another way, I believe investor behavior likely has a lot to do with the strategies’ outperformance. Behavioral explanations focus on investors’ cognitive biases, and the human tendency to use simple rules of thumb to make quick intuitive decisions, with individuals’ collective decision-making mistakes translating into security price distortions. Here’s a look at explanations for the outperformance of four commonly used equity factors. Value: Value stocks are ones that appear cheap in light of their sales, earnings and cash flow trends. Their returns, according to proponents of the efficient market hypothesis, have to do with investors rationally requiring extra compensation for investing in value firms, which tend to be procyclical, have high leverage and have uncertain cash flows. From a behavioral finance perspective, the outperformance of the value factor may have to do with a common decision-making mistake: people’s tendency to look at recent data trends and believe those trends will continue . If investors extrapolate past positive sales or earnings growth data into the future, they may overpay for growth stocks and underpay for value stocks. As a result, the prices of growth stocks may become too high relative to their fundamentals, predicting future reversal and the outperformance of value stocks. Alternatively, some researchers believe people’s tendency to strongly prefer avoiding losses over achieving gains (known as loss aversion) can help explain this anomaly . They hypothesize that loss-averse investors may perceive value stocks as riskier than they truly are, given the stocks’ recent underperformance, and may therefore require a higher future return from these investments. Momentum: This factor focuses on stocks that have strong price momentum , i.e., they have performed well over the past 6-12 months, and strong fundamental momentum, i.e. their earnings have recently been revised upward by security analysts. One explanation for this factor’s outperformance: Investors rationally demanding a higher return for investing in momentum stocks, which tend to be highly correlated and are perceived to perform poorly in times of distress. The behavioral finance explanation for this equity factor’s outperformance, on the other hand, has to do with analysts and investors putting too much weight on their prior beliefs at the expense of new information, leading to slow dissemination of firm-specific information , delayed price reactions to news and price continuation. For example, if investors like a stock and believe it has high earnings growth potential, they tend not to immediately adjust their beliefs sufficiently in light of new negative information – an investing mistake arising in behavioral finance from ” the anchoring-and-adjustment heuristic .” In other words, investors frequently drive price trends by projecting past wins onto future investments, creating a ” herding effect .” Quality: Quality generally describes financially healthy firms with high return on equity, with stable earnings growth and low financial leverage. They can effectively be characterized as having less risk based on their fundamentals . Behaviorally, people may ignore these potentially profitable, yet also perhaps more boring, companies, and instead, veer toward potentially more exciting, yet also less stable, growth and lottery-like stocks (for example, because the more exciting stocks tend to be featured in colorful news stories). As a result, they may end up overpaying for the less-stable stocks, which quality strategies seek to avoid. This predicts future reversal and potential outperformance of quality stocks. Low volatility: The low, or minimum volatility, factor loads up on stocks with low volatility. Low volatility stocks’ excess returns may be rationally explained by leverage constraints. In the absence of access to leverage, investors may overpay for high-volatility stocks in an attempt to increase risk in their portfolios, potentially leading lower-volatility stocks to become more attractively valued and outperform in the future. From a behavioral perspective, these stocks’ outperformance may be due people’s tendency to overestimate small, and underestimate, large probabilities . The idea is that this tendency leads to a preference for lottery-like stocks with a small chance of a very high payoff, and this preference, in turn, drives up the prices of high-volatility stocks disproportionately, suggesting future underperformance. Further, overconfident individuals may veer toward riskier securities in expressing their outsized faith in their own investing and stock-picking abilities, exacerbating the anomaly. To be sure, while focusing on factor and smart beta strategies has historically, over longer periods of time, earned higher risk-adjusted returns relative to the broader market, there have been stretches, even long ones, when factor-based approaches underperformed (think value during the 1990s), according to data accessible via Bloomberg . Finally, while in an efficient market, these anomalies should diminish in size and ultimately disappear, a widespread belief in the factors’ outperformance may also become a self-fulfilling prophecy. This post originally appeared on the BlackRock Blog.