Portfolio Management – Page 16

Gundlach vs Morningstar

Posted on 15 July 2015 by David Merkel

I’ve been on both sides of the fence. ?I’ve been a bond manager, with a large, complex (and illiquid) portfolio, and I have been a selector of managers. ?Thus the current squabble between Jeffrey Gundlach and Morningstar isn’t too surprising to me, and genuinely, I could side with either one.

Let me take Gundlach’s side first. ?If you are a bond manager, you have to be fairly bright. ?You need to understand the understand the compound interest math, and also how to interpret complex securities that come in far more flavors than common stocks. ?This is particularly true today when many top managers are throwing a lot of derivative instruments into their portfolios, whether to earn returns, or shed risks. ?Aspects of the lending markets that used to be the sole province of the banks and other lenders are now available for bond managers to buy in a securitized form. ?Go ahead, take a look at any of the annual reports from Pimco or DoubleLine and get a sense of the complexity involved in running these funds. ?It’s pretty astounding.

So when the fund analyst comes along, whether for a buy-side firm, an institutional fund analyst, or retail fund analyst who does more than just a little number crunching, you realize that the fund analyst?likely knows less about what you do than one of your junior analysts.

One of the issues that Morningstar had ?was with DoubleLine’s holdings of?nonagency residential mortgage-backed securities [NRMBS]. ?These securities lost a lot of value 2007-2009 during the financial crisis. ?Let me describe what it was like in a chronological list:

2003 and prior: NRMBS is a small part of the overall mortgage bond market, with relatively few players willing to take credit risk instead of buying mortgage bonds guaranteed by Fannie, Freddie and Ginnie. ?Much of the paper is in the hands of specialists and some life insurance companies.
2004-2006 as more subprime lending goes on amid a boom in housing prices, credit quality standards fall and life insurance buyers slowly?stop purchasing the securities. ?A new yield-hungry group of buyers take their place, with not much focus on what could go wrong.
Parallel to this, a market in credit derivatives grows up around the NRMBS market?with more notional exposure than the underlying market. ?Two sets of players: yield hogs that need to squeeze more income out of their portfolios, and hedge funds seeing the opportunity for a big score when the housing bubble pops. ?At last, a way to short housing!
2007: Pre-crisis, the market for NRMBS starts to sag, but nothing much happens. ?A few originators get into trouble, and a bit of risk differentiation comes into a previously complacent market.
2008-2009: the crisis hits, and it is a melee. ?Defaults spike, credit metrics deteriorate, and housing prices fall. ?Many parties sell their bonds merely to get rid of the taint in their portfolios. ?The credit derivatives exacerbate a bad situation. ?Prices on many NRMBS fall way below rational levels, because there are few traditional buyers willing to hold them. ?The regulators of financial companies and rating agencies are watching mortgage default risk carefully, so most regulated financial companies can’t hold the securities without a lot of fuss.
2010+ Nontraditional buyers like flexible hedge funds develop expertise and buy the NRMBS, as do some flexible bond managers who have the expertise in?staff skilled in analyzing the creditworthiness of bunches of securitized mortgages.

Now, after a disaster in a section of the bond market, the recovery follows a pattern like triage. ?Bonds get sorted into three buckets: those likely to yield a positive return on current prices, those likely to yield a negative return on current prices, and those?where you can’t tell. ?As time goes along, the last two buckets shrink. ?Market players revise prices down for the second bucket, and securities in the third bucket typically join one of the other two buckets.

Typically, though, lightning doesn’t strike twice. ?You don’t get another crisis event that causes that class of?securities to become disordered again, at least, not for a while. ?We’re always fighting the last war, so if credit deterioration is happening, it is in a new place.

And thus the problem in talking to the fund analyst. ?The securities were highly risky at one point, so aren’t they risky now? ?You would like to say, “No such thing as a bad asset, only a bad price,” but the answer might sound too facile.

Only a few managers devoted the time and effort to analyzing these securities after the crisis. ?As such, the story doesn’t travel so well. ?Gundlach already has a lot of money to manage, and more money is flowing in, so he doesn’t have to care whether Morningstar truly understands what DoubleLine does or not. ?He can be happy with a slower pace of asset growth, and the lack of accolades which might otherwise go to him…

But, one of the signs of being truly an expert is being able to explain it to lesser mortals. ?It’s like this story of the famous physicist Richard Feynman:

Feynman was a truly great teacher. He prided himself on being able to devise ways to explain even the most profound ideas to beginning students. Once, I said to him, “Dick, explain to me, so that I can understand it, why spin one-half particles obey Fermi-Dirac statistics.” Sizing up his audience perfectly, Feynman said, “I’ll prepare a freshman lecture on it.” But he came back a few days later to say, “I couldn’t do it. I couldn’t reduce it to the freshman level. That means we don’t really understand it.”

Like it or not, the Morningstar folks have a job to do, and they will do it whether DoubleLine cooperates or not. ?As in other situations in the business world, you have a choice. ?You could task smart subordinates to spend adequate time teaching the Morningstar analyst your thought processes, or, live with the results of someone who fundamentally does not understand what you do. ?(This applies to bosses as well.)

In the end, this may not matter to DoubleLine. ?They have enough assets to manage, and then some. ?But in the end, this could matter to Morningstar. ?It says a lot if you can’t analyze one of the best funds out there. ?That would mean you really don’t understand well the fixed income business as it is presently configured. ?As such, I would say that it is incumbent on Morningstar to take the initiative, apologize to DoubleLine, and try to re-establish good communications. ?If they don’t, the loss is Morningstar’s, and that of their subscribers.

How To End Index Gaming

Posted on 11 July 201512 July 2015 by David Merkel

There was an article at Bloomberg on gaming additions to and deletions from indexes, and at least two comments on it (one, two). ?You can read them at your convenience; in this short post I would like to point out two ways to stop the gaming.

Define your index to include all securities in the class (say, all US-based stocks with over $10 million in market cap), or
Control your index so that additions and deletions are done at your leisure, and not in any predictable way.

The gaming problem occurs because index funds find that they have to buy or sell stocks when indexes change, and more flexible investors act more quickly, causing the index funds to transact at less favorable prices. ?You never want to be in the position of being forced to make a trade.

The first solution means using an index like the Wilshire 5000, which in principle covers almost all stocks that you would care about. ?Index additions would happen at things like IPOs and spinoffs, and deletions at things like takeovers — both of which are natural liquidity events.

Solution one would be relatively easy to manage, but not everyone wants to own a broad market fund. ?The second solution remedies the situation more generally, at a cost that index fund buyers would not exactly know what the index was in the short-run.

Solution two destroys comparability, but the funds would change the target percentages when they felt it was advantageous to do so whether it was:

Make the change immediately, like the flexible investors do, or
Phase it in over time.

And to do this, you might ask for reporting waivers from the SEC for up to x% of the total fund, whatever is currently in transition. ?The main idea is this: you aren’t forced to trade on anyone else’s schedule. ?The only thing leading you would be what is best for your investors, because if you don’t do well for them, they will leave you.

Now, that implies that if you were to say that your intent is to mimic the S&P 500 index, but with some flexibility, that would invite easy comparisons, such that you would?be less free to deviate too far. ? But if you said your intent was more akin to the Russell 1000 or 3000, there would be more room to maneuver. ?That said, choosing an index is a marketing decision, and more people want the S&P 500 than the Wilshire 5000, much less the US Largecap Index.

So, maybe with solution two the gaming problem isn’t so easy to escape, or better, you can choose which?problem you want. ?Perhaps the one bit of practical advice here then is to investors — choose a broad market index like the Wilshire 5000. ?At least your index fund won’t get so easily gamed, and given the small cap effect over time, you’ll probably do better than the S&P 500, even excluding the effects of gaming.

There, a simple bit of advice. ?Till next time.

Asset-Liability Mismatches and Bubbles

Posted on 9 July 2015 by David Merkel

There’s a lot of talk about the Chinese stock market falling. I look at it as an opportunity to talk about why bubbles develop in markets, and why governments don’t take steps to avoid them until it is too late — also, why they try to prop the bubbles up, even though it is hopeless. ?But first an aside:

Three weeks ago, I was interviewed on RT/America Boom/Bust. ?Half of the interview aired — the part on domestic matters. ?The part on Greece and China didn’t air, and what a pity. ?I argued that China today was very much like Japan in the late ’80s, where the Japanese had a hard time investing abroad, and had an expansive monetary policy. ?People had a hard time figuring out where to put their money. ?Savings and fixed income didn’t offer much. ?Real Estate was great if you could afford it. ?The stock market was a place for putting money to work — and it had a lot of momentum behind it.

China has the added complexity of wealth management products which are opaque and many are Ponzi schemes. ?Also, the fixed income markets in China are not as mature as Japan’s markets 30 years ago. ?Both have the difficulties that they are too big for some of the indexes that international investors use.

Another reason for the bubbly behavior was use of margin, both formal and informal, and, the tendency for stock investors to have very short holding periods. ?Short-termism and following momentum is most of what creates bubbles. ?Ben Graham’s voting machine dominates, until the weighing machine takes over, and the voting machine votes the opposite way.

Long term assets like stocks should be financed with equity, or at worst, long-term debt. ?Using a lot of margin debt to finance equity leads to a rocket up, and a rocket down. ?When the amount of equity in the ?account gets too low, more assets have to be added, or stocks will have to be liquidated to protect the margin loan that the broker made. ?When enough stocks in margin accounts are forced to be sold, that can drive stock prices down, leading to a self-reinforcing cycle, until the debt levels normalize at much lower levels. ?This is a part of what happened in the Great Depression in the US.

Now governments never argue with bubbles when they expand, because no one dares to oppose a boom. ?(Note: that article won a small award. Powerpoint presentation here.) ?The powers that be love effortless prosperity, and no one wants to listen to a prophet of doom when the Cabaret is open.

Now, the prosperity is mostly?fake, because all of the borrowing is temporarily pulling future prosperity into the present. ?When the bubble pops, that will revert with a vengeance, leaving behind bad debts.

Despite the increase in debts, and speculative changes in economic behavior, most policymakers will claim that they can’t tell whether a bubble is growing or not. ?Their bread is buttered on the side of political contributions from financial firms.

But when the bubble pops, and things are ugly, governments will try to resist the deflating bubble — favoring relatively well-off asset owners over not-so-well-off taxpayers. ?In China at present, they are closing down markets for stocks (if it doesn’t trade, the price must not be falling). ?They are trying to be more liberal about liquidating margin debt. ?They are limiting share sales by major holders. ?They are postponing IPOs. ?They are inducing institutions to buy stock.

China thinks that it can control and even reverse the deflating bubble. ?I think they are deluded. ?Yes, they are relatively more powerful in their own country than US regulators and policymakers. ?But even if their institutions were big enough to suck up all of the stock at existing prices, it would merely substitute on problem for another: the institutions would be stuck with assets that have?low forward-looking returns. ?If you use those to fund a defined benefit pension plan, you will likely find that you have embedded a loss in the plan that will take years to reveal itself.

As a result, since China is much larger than Greece, its problems get more attention, because they could affect the rest of the world more. ?For Western investors without direct China exposure, I’m not sure how big that will be, but with highly valued markets any increase in volatility could cause temporary indigestion.

The one bit of friendly advice I might offer is don’t be quick to try to catch a falling knife here. ?It might be better to wait. and maybe buy stocks in countries that get unfairly tarred by any panic coming out of China, rather than investing in China itself. ?Remember, margin of safety matters. ?More on that coming in a future post.

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

My last post has many implications. I want to make them clear in this post.

When you analyze?a manager, look at the repeatability of his processes. ?It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life. ?Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero. ?It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself. ?It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
Often when countries open up to foreign investment, valuations are relatively low. ?The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money. ?Eventually an adjustment comes, and shakes out the undisciplined investors. ?But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc. ?After the paper is published, money starts getting applied to the idea, and the strategy will do well initially. ?Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels. ?Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies. ?Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist. ?Those are almost always the best years for a factor (or other) anomaly strategy.
During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by?the early purchasers. ?During a credit bust, it is rare for a new security type to fare well.
Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety. ?Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
Always think about the carrying capacity of a strategy when you look at an academic paper. ?It might be clever, but it might not be able to handle a lot of money. ?Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
Also look at how an academic paper models trading and liquidity, if they give it any real thought at all. ?Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds. ?I.e., there should be “new money allowed” indexes.
Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing. ?It produced great returns 9 years out of 10. ?but once distressed investing and event-driven because heavily done, the idea lost its punch. ?Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not?do as well in the future.
The same applies to a lot of clever managers. ?They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past. ?If they have the opportunity to sell, they will disproportionately do so then.
Corporate management teams are like rock bands. ?Most of them never have a hit song. ?(For managements, a period where a strategy improves profitability far more than most would have expected.) ?The next-most are one-hit wonders. ?Few have multiple hits, and rare are those that create a culture of hits. ?Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it. ?Thus, advantages accrue to those who can spot clever managements before the rest of the market. ?More often this happens in dull industries, because no one would think to look there.
It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this. ?You will end up getting there once the period of genius is over, and valuations have adjusted. ?It might be better to buy the burned out stuff and see if a positive surprise might come. ?(Watch margin of safety…)
Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway. ?Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably. ?if you must pay attention to macro in investing, always ask, “Is it priced in or not? ?How much of it is priced in?”
Most asset allocation work that relies on past returns is easy to do and bogus. ?Good asset allocation is forward-looking and ignores past returns.
Finally, remember that some ideas seem?right by accident — they aren’t actually right. ?Many academic papers don’t get published. ?Many different methods of investing get tried. ?Many managements try new business ideas. ?Those that succeed get air time, whether it was due to intelligence or luck. ?Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here. ?Just be cautious with new investment strategies, whatever form they may take. ?Make sure that you maintain a margin of safety; you will likely need it.

The Phases of an Investment Idea

Posted on 27 June 201528 June 2015 by David Merkel

Investing ideas come in many forms:

Factors like Valuation, Sentiment, Momentum, Size, Neglect…
New technologies
New financing methods and security types
Changes in government policies will have effects, cultural change, or other top-down macro ideas
New countries to invest in
Events where value might be discovered, like recapitalizations, mergers, acquisitions, spinoffs, etc.
New asset classes or subclasses
Durable competitive advantage of marketing, technology, cultural, or other corporate practices

Now, before an idea is discovered, the economics behind the idea still exist, but the returns happen in a way that no one yet perceives. ?When an idea is discovered, the discovery might be made public early, or the discoverer might keep it to himself until it slowly leaks out.

For an example, think of Ben Graham in the early days. ?He taught openly at Columbia, but few followed his ideas within the investing public because everyone was still shell-shocked from the trauma of the Great Depression. ?As a result, there was a large amount of companies trading for less than the value of their current assets minus their total liabilities.

As Graham gained disciples, both known and unknown, they chipped away at the companies that were so priced, until by the late ’60s there were few opportunities of that sort left. ?Graham had long since retired; Buffett winds up his partnerships, and manages the textile firm he took over as a means of creating a nascent conglomerate.

The returns generated during its era were phenomenal, but for the most part, they were never to be repeated. ?Toward the end of the era, many of the practitioners made their own mistakes as they violated “margin of safety” principles. ?It was a hard way of learning that the vein of financial ore they were mining was finite, and trying to expand to mine a type of “fool’s gold” was not a winning idea.

Value investing principles, rather than dying there, broadened out to consider?other ways that securities could be undervalued, and the analysis process began again.

My main point this evening is this: when a valid new investing idea is discovered, a lot of returns are generated in the initial phase. For the most part they will never be repeated because there will likely never be another time when that investment idea is totally forgotten.

Now think of the technologies that led to the dot-com bubble. ?The idealism, and the “follow the leader” price momentum that it created lasted until enough cash was sucked into unproductive enterprises, where the value was destroyed. ?The current economic value of investment ideas can overshoot or undershoot the fundamental value of the idea, seen in hindsight.

My second point is that often the price performance of an investment idea overshoots. ?Then the cash flows of the assets can’t justify the prices, and the prices fall dramatically, sometimes undershooting. ?It might happen because of expected?demand that does not occur, or too much short-term leverage applied to long-term assets.

Later, when the returns for the investment idea are calculated, how do you characterize the value of the investment idea? ?A new investment factor is discovered:

it earns great returns on a small amount of assets applied to it.
More assets get applied, and more people use the factor.
The factor develops its own price momentum, but few?think about it that way
The factor exceeds the “carrying capacity”?that it should have in the market, overshoots, and burns out or crashes.
It may be downplayed, but it lives on to some degree as an aspect of investing.

On a time-weighted rate of return basis, the factor will show that it had great performance, but a lot of the excess returns will be in the early era where very little money was applied to the factor. ?By the time a lot of money was applied to the factor, the future excess returns were either small or even negative. ?On a dollar-weighted basis, the verdict on the factor might not be so hot.

So, how useful is the time-weighted rate of return series for the factor/idea in question for making judgments about the future? ?Not very useful. ?Dollar weighted? ?Better, but still of limited use, because the discovery era will likely never be repeated.

What should we do then to make decisions about any factor/idea for purposes of future decisions? ?We have to look at the degree to which the factor or idea is presently neglected, and estimate future potential returns if the neglect is eliminated. ?That’s not easy to do, but it will give us a better sense of future potential than looking at historical statistics that bear the marks of an unusual period that is little like the present.

It leaves us with a mess, and few?firm statistics to work from, but it is better to be approximately right and somewhat uncertain, than to be precisely wrong with tidy statistical anomalies bearing the overglorified title “facts.”

That’s all for now. ?As always, be careful with your statistics, and use sound business judgment to analyze their validity in?the present situation.

Stocks or Bonds?

Posted on 19 June 201521 June 2015 by David Merkel

I was writing to potential clients when I realized that I don’t have so much to write about my bond track record as I do my track record with stocks. ?I jotted down a note to formalize what I say about my bond portfolios.

One person I was writing to asked some detailed questions, and I told him that the stock market was likely to return about 4.5%/yr (not adjusted for inflation) over the next ten years. ?The model I use is the same one as this one used by pseudonymous Philosophical Economist. ?I don’t always agree with him, but he’s a bright guy, what can I say? ?That’s not a very high return — the historical average is around 9.5%. ?The market is in the 85th-90th percentiles of valuation, which is pretty high. ?That said, I am not taking any defensive action yet.

Yet.

But then it hit me. ?The yield on my bond portfolio is around 4.5% also. ?Now, it’s not a riskless bond portfolio, as you can tell by the yield. ?I’m no longer running the portfolio described in Fire and Ice. ?I sold the long Treasuries about 30 basis points ago. ?Right now, I am only running the Credit sensitive portion of the portfolio, with a bit of foreign bonds mixed in.

Why am I doing this? ?I think it has a good balance of risks. ?Remember that there is no such thing as generic risk. ?There are many risks. ?At this point this portfolio has a decent amount of credit risk, some foreign exchange risk, and is low in interest rate risk. ?The duration of the portfolio is less than?2, so I am not concerned about rising rates, should the FOMC ever do such a thing as raise rates. ?(Who knows? ?The economy might actually grow faster if they did that. ?Savers will eventually spend more.)

But 10 years is a long time for a bond portfolio with a duration of less than 2 years. ?I’m clipping coupons in the short run, running credit risk while I don’t see any major credit risks on the horizon aside from weak sovereigns (think the PIIGS), student loans, and weak junk (ratings starting with a “C”). ?The risks on bank loans are possibly overdone here, even with weakened covenants. ?Aside from that, if we really do see a lot of credit risk crop up, stocks will get hit a lot harder than this portfolio. ?Dollar weakness and US inflation (should we see any) would also not be a risk.

I’ve set a kind of a mental stop loss at losing 5% of portfolio value. ?Bad credit is the only significant factor that could harm the portfolio. ?If credit problems got that bad, it would be time to exit because credit problems come in bundles, not dribs and drabs.

I’m not doing it yet, but it is?tempting to reposition some of my IRA assets presently in stocks into the bond strategy. ?I’m not sure I would lose that much in terms of profit potential, and it would increase the overall safety of the portfolio.

I’ll keep you posted. ?That is, after I would tell my clients what I am doing, and give them a chance to act, should they want to.

Finally, do you have a different opinion? ?You can email me, or, you can share it with all of the readers in the comments. ?Please do.

At RT/America’s Boom/Bust

Posted on 16 June 2015 by David Merkel

I had the fun today of taping a segment with Ameera David on RT Boom/Bust. The above video covers the first half of the session, and lasts about seven minutes. We covered the following topics (with links to articles of mine, if any are applicable):

Bond Market Illiquidity
Stock Market Valuations
The Slowness of the FOMC
Why?many retail investors get skunked by the market
How to invest in this environment
Potential?Equity Market Sector Picks

The second half, should it make it onto the show, deals mostly with international issues. ?Enjoy the video, if you want to.

Coping With Zero

Posted on 6 June 2015 by David Merkel

This will be a short piece, because what I have to say is simple. ?My portfolio rule eight requires me to make changes to the portfolio 3-4 times a year. ?Here’s the rule:

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

It’s a useful rule, but what if the search that I do doesn’t come up with any suitable candidates for purchase better than what I currently own?

That is what has happened in the second quarter of 2015.

This hasn’t happened before.

I did my main search, and came up empty-handed. ?I then did about five additional searches that I never ordinarily do, but are other ways of sourcing portfolio buy ideas. ?Three also came up empty. ?One gave me an idea off of a spinoff happening later this month, and another idea that was kind of interesting, but made me edgy regarding margin of safety. ?The last search gave me four ideas that I am still working through, but none of them thrill me, for various reasons.

I?know what my most marginal ideas are in my current portfolio, and I can honestly say at present I like all of them more than all of the remaining ?ideas I am still kicking around, minus the spinoff. ?(The key question on the spinoff is how cheaply it trades post-spin.)

After all of my searching, it makes me wonder from a bottom-up point of view whether the market isn’t overvalued. ?Top down, the market should return about 4.5%/yr over the next ten years, which is about the 87th percentile in terms of expensiveness.

A lot of money can be lost speculating on that idea, and I am not a market timer, so I will let others fight about that. ?This is just a straw blowing in the wind. ?Practically, it means this period I do nothing with the portfolio, most likely. ?It gets tougher if this repeats next quarter.

Your opinions are welcome in the comments.

There’s a Reason for Risk Premiums

Posted on 3 June 2015 by David Merkel

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets. ?In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums? ?I don’t have the article in front of me but I’ll toss out a few.

Many were Credit-oriented. ?Lend and make money.
Some were volatility-oriented. ?Sell options on high volatility assets and make money.
Some were currency-oriented. ?Buy government bonds where they yield more, and short those that yield less.
Some had you act like a bank. ?Borrow short, lend long.
Some were like value investors. ?Buy cheap assets and hold.
Some were akin to arbitrage. ?Take illiquidity risk or deal/credit risk.
Others were akin to momentum investing. ?Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

Someone will start a hedge fund off this.
Many of these are correlated; with enough leverage behind it, the hedge fund?could leave a very large hole when it blows up.
Yes, who wouldn’t want to be a bank without regulations?
What an exercise in data-mining and overfitting. ?The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc. ?(Even those are not truly free; animals have to be fed and cared for.) ?They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that?pays all of its interest and principal. ?Usage: “Is it ‘money good?'” ?”Yes, it is ‘money good.'”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you. ?There are a few problems though:

Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another. ?What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle? ?What insurance company wouldn’t want to sell off its junk bonds at that time as well? ?And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing. ?Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be. ?Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

Book Review: The Great Minds of Investing

Posted on 29 May 2015 by David Merkel

This is a difficult book to review. ?Let me tell you what it is not, and then let me tell you what it is more easily as a result.

1) The book?does not give you detailed biographies of the people that it features. ?Indeed, the writing on each person is less than the amount that Ken Fisher wrote in his book, 100 Minds That Made the Market. ?If you are looking for detailed biographical sketches, you will be disappointed.

2) The book does not give detailed and comparable reviews of the portfolio performance of those that it features. ?There’s no way from what is written to tell really how good many of the investors are. ?I mean, I would want to see dollar-weighted rates of return, and perhaps, measures of dollar alpha. ?The truly best managers have expansive strategies that can perform well managing a large amount of money.

3) The book admits that the managers selected may not be the greatest, but are some of the “greats.” ?Okay, fair enough, but I would argue that a few of the managers don’t deserve to be featured even as that if you review their dollar-weighted performance. ?A few of them showed that they did not pay adequate attention to margin of safety in the recent financial crisis, and lost a lot of money for people at the time that they should have been the most careful.

4) If you wanted to understand the strategies of the managers, this is not the book for you. ?They are not described, except in the broadest terms.

5) There is no integration of any common themes of what makes an investment manager great. ?You don’t get a necklace; you just get a jar of pretty, non-comparable beads that don’t have any holes in them.

What do you get in this book? ?You get beautiful black and white photos of 33 managers, and vignettes of each of them written by six authors. ?The author writes two-thirds of the vignettes.

Do I recommend this book? ?Yes, if you understand what it is good for. ?It is a well-done coffee table book on thick glossy paper, with truly beautiful photographs.?It is well-suited for people waiting in a reception area, who want to read something light and short about several?notable investment managers.

But if you are looking for anything involved in my five points above, you will not be satisfied by this book.

One final note on the side — I would have somehow reworked the layout of Bill Miller’s photograph. ?Splitting his face down the middle of the gutter does not?represent him to be the handsome guy that he is.

If you would like?to buy it, you can buy it here: The Great Minds of Investing.

Full disclosure:?I?received a?copy from the author. ?He was most helpful.

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