December 2015 – Page 2 – The Aleph Blog

We Eat Dollar Weighted Returns ? VII

Posted on 8 December 2015 by David Merkel

I intended on writing this at some point, but Dr. Wesley Gray (an acquaintance of mine, and whom I respect) beat me to the punch. ?As he said in his blog post at The Wall Street Journal’s The Experts blog:

WESLEY GRAY: Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance.? ?No problem,? you might think?buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.?s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn?t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund?s performance and what the typical fund investor actually earned can be explained by the ?behavioral return gap.?

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund?s sound long-term process, the ?dollar-weighted? returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

That’s why I wanted to write this post. ?Ken Heebner is a really bright guy, and has the strength of his convictions, but his investors don’t in general have similar strength of convictions. ?As such, his investors buy high and sell low with his funds. ?The graph at the left is from the CGM Focus Fund, as far back as I could get the data at the SEC’s EDGAR database. ?The fund goes all the way back to late 1997, and had a tremendous start for which I can’t find the cash flow data.

The column marked flows corresponds to a figure called “Change in net assets derived from capital share transactions” from the Statement of Changes in Net Assets in the annual and semi-annual reports. ?This is all public data, but somewhat difficult to aggregate. ?I do it by hand.

I use annual cashflows for most of the calculation. ?For the buy and hold return, i got the data from Yahoo Finance, which got it from Morningstar.

Note the pattern of cashflows is positive until?the financial crisis, and negative thereafter. ?Also note that more has gone into the fund than has come out, and thus the average investor has lost money. ?The buy-and-hold investor has made money, what precious few were able to do that, much less rebalance.

This would be an ideal fund to rebalance. ?Talented manager, will do well over time. ?Add money when he does badly, take money out when he does well. ?Would make a ton of sense. ?Why doesn’t it happen? ?Why doesn’t at least buy-and-hold happen?

It doesn’t happen because there is a Asset-Liability mismatch. ?It doesn’t matter what the retail investors say their time horizon is, the truth is it is very short. ?If you underperform for less?than a few years, they yank funds. ?The poetic justice is that they yank the funds just as the performance is about to turn.

Practically, the time horizon of an average investor in mutual funds is inversely proportional to the volatility of the funds they invest in. ?It takes a certain amount of outperformance (whether relative or absolute) to get them in, and a certain amount of underperformance to get them out. ?The more volatile the fund, the more rapidly that happens. ?And Ken Heebner is so volatile that the only thing faster than his clients coming and going, is how rapidly he turns the portfolio over, which is once every 4-5 months.

Pretty astounding I think. ?This highlights two main facts about retail investing that can’t be denied.

Asset prices move a lot more than fundamentals, and
Most investors chase performance

These two factors lie behind most of the losses that retail investors suffer over the long run, not active management fees. ?remember as well that passive investing does not protect retail investors from themselves. ?I have done the same analyses with passive portfolios — the results are the same, proportionate to volatility.

I know buy-and-hold gets a bad rap, and it is not deserved. ?Take a few of my pieces from the past:

If you are a retail investor, the best thing you can do is set an asset allocation between risky and safe assets. ?If you want a spit-in-the-wind estimate use 120 minus your age for the percentage in risky assets, and the rest in safe assets. ?Rebalance to those percentages yearly. ?If you do that, you will not get caught in the cycle of greed and panic, and you will benefit from the madness of strangers who get greedy and panic with abandon. ?(Why 120? ?End of the mortality table. 😉 Take it from an investment actuary. 😉 We’re the best-kept secret in the financial markets. 😀 )

Okay, gotta close this off. ?This is not the last of this series. ?I will do more dollar-weighted returns. ?As far as retail investing goes, it is the most important issue. ?Period.

Ten Investing Books to Consider

Posted on 5 December 20156 December 2015 by David Merkel

Recently I got asked for a list of investment books that I would recommend. These aren’t all pure investment books — some of them will teach you how markets operate in general, but they do so in a clever way. I have also reviewed all of them, which limited my choices a little. Most economics, finance, investment books that I have really liked I have reviewed at Aleph Blog, so that is not a big limit.

This post was also prompted by a post by another blogger of sorts publishing at LinkedIn. ?I liked his post in a broad sense, but felt that most books by or about traders are too hard for average people to implement. ?The successful traders seem to have systems that go beyond the simple systems that they write about. ?If that weren’t true, we’d see a lot of people prosper at trading for a time, until the trades got too crowded, and the systems failed. ?That’s why the books I am mentioning are longer-term investment books.

General Books on Value Investing

The Intelligent Investor?(Ben Graham)
The Aggressive Conservative Investor?(Marty Whitman)
Margin of Safety?(Seth Klarman)
Accounting for Value?(Stephen Penman)

Don’t get me wrong. ?I like many books on value investing, but the first?three are classic. ?Graham is the simplest to understand, and Klarman is relatively easy as well. ?Like Buffett, Klarman recognizes that we live in a new world now, and the simplistic modes of value investing would work if we could find a lot of stocks as cheap as in Graham’s era — but that is no longer so. ?But even Ben Graham recognized that value investing needed to change at the end of his life.

Whitman takes more of a private equity approach, and aims for safe and cheap. ?Can you find mispriced assets inside a corporation or elsewhere where the value would be higher?if placed in a different context? ?Whitman is a natural professor on issues like these, though in practice, the?stocks he owned during the financial crisis were not safe enough. ?Many business models that were seemingly bulletproof for years were no longer so when asset prices fell hard, especially those connected to housing. ?This should tell us to think more broadly, and not trust rules of thumb, but instead think like Buffett, who said something like, “We’re paid to think about the things that seemingly can’t happen.”

The last book is mostly unknown, but I think it is useful. ?Penman?takes apart GAAP accounting to make it more useful for decision-making. ?In the process, he ends up showing that very basic forms of quantitative value investing work well.

Books that will help you Understand Markets Better

The first link is two books on the life of George Soros. ?Soros teaches you about the nonlinearity of markets — why they overshoot and undershoot. ?Why is there momentum? ?Why is the tendency for price to converge to value weak? ?What do markets look and feel like as they are peaking, troughing, etc? ?Expectations are a huge part of the game, and they affect the behavior of your fellow market participants. ?Market movements as a result become self-reinforcing, until the cash flows can by no means support valuations, or are so rich that businessmen buy and hold.

Consider what things are like now as people justify high equity valuations. ?At every turning point, you find people defending vociferously why the trend will go further. ?Who is willing to think differently at the opportune time?

Triumph of the Optimists is another classic which should teach us to be slightly biased toward risk-taking, because it tends to win over time. ?They pile up data from around 20 nations over the 20th century, and show that stock markets have done very well through a wide number of environments, beating bonds?by a little and cash by a lot.

For those of us that tend to be bearish, it is a useful reminder to invest most of the time, because you will ordinarily make good money over the long haul.

Books on Managing Risk

The Crisis of Crowding?(Chincarini)
Pandora?s Risk?(Osband)
Risk and the Smart Investor?(Martin) also?The Nature of Risk?(also Martin)
The Hedge Fund Mirage?(Lack)

After the financial crisis, we need to understand better what risk is. ?Risk is the likelihood and severity of loss, which is not constant, and cannot be easily compressed into simple figure. ?We need to think about risk ecologically — how is an asset priced relative to its future prospects, and is there any possibility that it is significantly misfinanced either internally or by its holders. ?For the latter, think of the Chinese using too much margin to carry stocks. ?For the former, think of Fannie Mae and Freddie Mac. ?They took risks that forced them into insolvency, even though over the long run they would have been solvent institutions. ?(You can drown in a river with an average depth of six inches. ?Averages reveal; they also conceal.)

Hot money has a short attention span. ?It needs to make money NOW, or it will leave. ?When an asset is owned primarily by hot money, it is an unstable situation, where the trade is “crowded.” ?So it was with housing-related assets and a variety of arbitrage trades in the decade of the mid-2000s. ?Momentum blinded people to the economic reality, and made them justify and buy into absurdly priced assets.

As for the last book, hedge funds as a group are a dominant form of hot money. ?They have grown too large for the pool that they fish in, and as a result, their returns are poor as a group. ?With any individual hedge fund, your mileage may vary, there are some good ones.

These books as a whole will teach you about risk in a way that helps you understand the crisis in a systemic way. ?Most people did not understand the situation that way before the crisis, and if you talk to most politicians and bureaucrats, they still don’t get it. ?A few simple changes have been made, along with a bunch of ineffectual complex changes. ?The financial system is a little better as a result, but could still go through a crisis like the last one — we would need a lot more development of explicit and implicit debts to get there though.

An aside: the book The Nature of Risk is simple, short and cute, and can probably reach just about anyone who can grasp the similarities between a forest ecology under threat of fire, and a financial system.

Summary

I chose some good books here, some of which are less well-known. ?They will help understand the markets and investing, and make you a bigger-picture thinker… which makes me think, I forgot the second level thinking of?The Most Important Thing, by Howard Marks. ?Oops, also great, and all for now.

PS — you can probably get Klarman’s book through interlibrary loan, or via some torrent on the internet. ?You can figure that out for yourselves. ?Just don’t spend the $1600 necessary to buy it — you will prove you aren’t a value investor in the process.

Ten Questions and Answers on ETFs and Other Topics

Posted on 3 December 2015 by David Merkel

I was asked to participate with 57 other bloggers in a post that was entitled?101 ETF Investing Tips. ?It’s a pretty good article, and I felt the tips numbered?2, 15, 18, 23, 29, 35, 44, 48, 53, 68, 85, 96, and 98 were particularly good, while?10, 39, 40, 45, 65, 67, 74, 77, 80, and 88 should have been omitted. ?The rest were okay.

One consensus finding was that Abnormal Returns was a “go to” site on the internet for finance. ?I think so too.

Below were the answers that I gave to the questions. ?I hope you enjoy them.

1) What is the one piece of advice you?d give to an investor just starting to build a long-term portfolio?

You need to have reasonable goals.? You also have to have enough investing knowledge to know whether advice that you receive is reasonable.? Finally, when you have a reasonable overall plan, you need to stick with it.

2) What is one mistake you see investors make over and over?

They think investment markets are magic. They don?t save/invest anywhere near enough, and they think that somehow magically the markets will bail out their woeful lack of planning.? They also panic and get greedy at the wrong times.

3) In 20 years, _____. (this can be a prediction about anything — investing-related or otherwise)

In 20 years, most long-term public entitlement and private employee benefit schemes that promised fixed payments/reimbursement will be scaled back dramatically, and most retirees will be very disappointed.? The investment math doesn?t work here ? if anything, the politicians were more prone to magical thinking than na?ve investors.

4) Buy-and-hold investing is _____.

Buy-and-hold investing is the second-best strategy that average people can apply to markets, if done with sufficient diversification. It is a simple strategy, available to everyone, and it generally beats the performance of average investors who buy and sell out of greed and panic.

5) One book I wish every investor would read is _____. (note that non-investing books are OK!)

One book I wish every investor would read is the Bible. The Bible eliminates magical thinking, commends hard work and saving, and tells people that their treasure should be in Heaven, and not on Earth.? If you are placing your future hope in a worry-free, well-off retirement, the odds are high that you will be disappointed.? But if you trust in Jesus, He will never leave you nor forsake you.

6) The one site / Twitter account / newsletter that I can?t do without is _____.

Abnormal Returns provides the best summary of the top writing on finance and investing every day.? There is no better place to get your information each day, and it comes from a wide array of sources that you could not find on your own.? Credit Tadas Viskanta for his excellent work.

7) The biggest misconception about investing via ETFs is_____.

The biggest misconception about investing via ETFs is that they are all created equal.? They have different expenses and structures, some of which harm their investors.? Simplicity is best ? read my article, ?The Good ETF? for more.

8 ) Over a 20-year time horizon, I’m bullish on _____. (this can be an asset class, fund, technology, person — anything really!)

Over 20 years, I am bullish on stocks, America, and emerging markets.? Of the developed nations, America has the best combination of attributes to thrive.? The emerging markets offer the best possibility of significant growth.? Stocks may have a rough time in the next five years, but in an environment where demographic and technological change is favoring corporate profits, stocks will do better than other asset classes over 20 years.

9) The one site / Twitter account / newsletter that I can?t do without is _____.

Since you asked twice, the Aleph Blog is one of the best investing blogs on the internet, together with its Twitter feed.? It has written about most of the hard questions on investing in a relatively simple way, and is not generally marketing services to readers.? For the simple stuff, go to the personal finance category at the blog.

10) Any other ETF-related investing tips or advice?

For a fuller view of my ETF-related advice, go to Aleph Blog, and read here.? Briefly, be careful with any ETF that is esoteric, or that you can?t draw a simple diagram to explain how it works.? Also realize that traders of ETFs tend to do worse than those that buy and hold.

Stocks That Can Double, Can Give You Trouble

Posted on 2 December 2015 by David Merkel

I haven’t written about promoted penny stocks in a long time. ?Tonight I am not writing about promoted stocks, only penny stocks as promoted by a newsletter writer. ?He profits from the newsletter. ?Ostensibly, he does not front-run his readers.

Before we go on, let me run the promoted stocks scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 12/1/15	Decline	Annualized	Dead?
GTXO	5/27/2008	2.45	0.011	-99.6%	-51.5%
BONZ	10/22/2009	0.35	0.000	-99.9%	-68.5%
BONU	10/22/2009	0.89	0.000	-100.0%	-100.0%
UTOG	3/30/2011	1.55	0.000	-100.0%	-100.0%	Dead
OBJE	4/29/2011	116.00	0.000	-100.0%	-100.0%	Dead
LSTG	10/5/2011	1.12	0.004	-99.6%	-74.2%
AERN	10/5/2011	0.0770	0.0001	-99.9%	-79.8%
IRYS	3/15/2012	0.261	0.000	-100.0%	-100.0%	Dead
RCGP	3/22/2012	1.47	0.180	-87.8%	-43.4%
STVF	3/28/2012	3.24	0.070	-97.8%	-64.7%
CRCL	5/1/2012	2.22	0.001	-99.9%	-87.2%
ORYN	5/30/2012	0.93	0.001	-99.9%	-85.4%
BRFH	5/30/2012	1.16	1.000	-13.8%	-4.1%
LUXR	6/12/2012	1.59	0.002	-99.9%	-86.3%
IMSC	7/9/2012	1.5	0.495	-67.0%	-27.9%
DIDG	7/18/2012	0.65	0.000	-100.0%	-100.0%
GRPH	11/30/2012	0.8715	0.013	-98.5%	-75.4%
IMNG	12/4/2012	0.76	0.012	-98.4%	-75.0%
ECAU	1/24/2013	1.42	0.000	-100.0%	-94.9%
DPHS	6/3/2013	0.59	0.005	-99.2%	-85.5%
POLR	6/10/2013	5.75	0.005	-99.9%	-94.2%
NORX	6/11/2013	0.91	0.000	-100.0%	-97.5%
ARTH	7/11/2013	1.24	0.245	-80.2%	-49.3%
NAMG	7/25/2013	0.85	0.000	-100.0%	-100.0%
MDDD	12/9/2013	0.79	0.003	-99.7%	-94.5%
TGRO	12/30/2013	1.2	0.012	-99.0%	-90.9%
VEND	2/4/2014	4.34	0.200	-95.4%	-81.6%
HTPG	3/18/2014	0.72	0.003	-99.6%	-95.9%
WSTI	6/27/2014	1.35	0.000	-100.0%	-99.9%
APPG	8/1/2014	1.52	0.000	-100.0%	-99.8%
CDNL	1/20/2015	0.35	0.035	-90.0%	-93.1%

	12/1/2015		Median	-99.9%	-87.2%

If you want to lose money, it is hard to do it more consistently than this. ?No winners out of 31, and only one company looks legit at all — Barfresh.

But what of the newsletter writer? ?He seems to have a couple of stylized facts that are misapplied.

Every day, around 45 stocks double or more in price.
Some wealthy investors have bought stocks like these.
Wall Street firms own these stocks but never recommend them to ordinary individuals
The media censors price information about these stocks so you never hear about them

Every day, around 45 stocks double or more in price.

That may be true, but most of those that do double or more in price don’t do so for fundamental reasons; they are often manipulated. ?Second, the stocks that do double in price can’t be found in advance — i.e., picking the day that the price will explode. ?Third, the prices more often fall hard for these tiny?stocks. ?Of the 30 stocks mentioned above that were not dead at the time of the last article, 10 fell more than 90% over the 10+ month period. ?13 fell less than 90%, 1 broke even, and 7 rose in price. ?The median stock fell 61%. ?This was during a bull market.

Now you might say, “Wait, these are promoted stocks, of course they fell.” ?Only the last one was being actively promoted, so that’s not the answer.

My fourth point is for the few that rise a lot, you can’t invest in them. ?The stocks that double or more in a day tend to be the smallest of the stocks. ?Two of the 30 stocks listed in the scoreboard?rose 900% and 7100% in the 10+ month period since my last article. ?How much could you have invested in those stocks? ?You could have bought both companies for a?little more than?$10,000 each. ?Anyone waving even a couple hundred bucks could make either stock fly.

So, no, these stocks aren’t a road to riches. ?Now the ad has stories as to how much money people made at some point buying the penny stocks. ?The odds of stringing several of these successful purchases in succession, parlaying the money into bigger and bigger stocks that double is remote at best, and your odds of losing a lot of it is high.

This idea is a less classy version of the idea promoted in the book?100 to 1 in the Stock Market. ?If it is difficult to find the 100-baggers 30 years in advance, it is more difficult to find a stock that is going to double or more tomorrow, much less a bunch of them in succession. ?You may as well go to Vegas and bet it all on Double Zero on the roulette wheel four times in a row. ?The odds are about that bad, as trying to get rich buying penny stocks.

The ad also lists three stock that at some point fit his paradigm — MeetMe [MEET],?PlasmaTech Biopharmaceuticals, Inc. (PTBI) which is now called?Abeona Therapeutics Inc. (ABEO), and?Organovo (ONVO). ?All of these are money-losing companies (MeetMe may be breaking into profitability?now) that have survived by selling shares to raise cash. ?The stocks have generally been poor. ?Have they had volatile days where the price doubled? ?At some point, probably, but who could have picked the date in advance, and found liquidity to do a quick in-and-out trade?

The author lists five future situations as a “come on” to get people to subscribe. ?I find them dubious.

As for wealthy investors, he mentions two: Icahn pulling of a short squeeze on Voltari (difficult to generalize from), and Soros with?PlasmaTech Biopharmaceuticals, Inc. ?It should be noted that Soros has a big portfolio with many stocks, and that position was far less than 1% of his assets. ?In general, the wealthy do not buy penny?stocks.

As for brokers and the media not mentioning penny stocks, that is being responsible. ?The brokers could get in hot water for recommending or buying penny stocks even under a weak suitability standard. ?The media also does not want to be blamed for inciting destructive speculation. ?Retail investors lose enough money through uninformed trading, why encourage them to do it where fundamentals are typically quite poor.

I’ve written two other pieces on less liquid stocks to try to explain the market better:?On Penny Stocks and?Good Over-the-Counter ?Pink? Stocks. ?It’s not as if there isn’t value in some of the stocks that “fly under the radar.” ?That said, you have to be extra careful.

Near the end of the ad, the writer describes how he is being extra careful also. ?Many of his rules make a lot of sense. ?That said, following those rules will get you boring companies that won’t double or more in a day. ?And that’s not a bad thing. ?Most significant money is made slowly — it doesn’t come in a year, much less in a day.

That said, I recommend against the newsletter because of the way that it tries to attract people. ?The rhetoric is over the top, and appeals to those who sense conspiracies keeping them from riches, so join my club where I hand out my secret knowledge so you can benefit.

In summary, as a first approximation, don’t invest in penny stocks. ?The odds are against you. ?Fools rush in where angels fear to tread. ?Don’t let greed get the better of you — after all, what is being illustrated is?an illusion that ?retail investors can’t generally achieve.