Observations on the Science and Art of Investing

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Portfolio Management

Warren Buffett once said:

You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple.

I love this quote from Buffett. It expresses the philosophy of contrarian value investing. When everyone is fearful the prices of assets are likely to be depressed and its the best time to buy when assets are on discount. At the same time, this quote reminds me that investing is also an emotional activity. Just imagine how difficult it is to be a contrarian in real life scenarios when everyone else around you is fearful or panicking.

Here is another great quote, from Howard Marks this time (Marks p.31):

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is an essential – I think the essential – element in investing.

What Marks is telling us is that dealing with risk is inevitable when we make investment decisions. Dealing with risk is difficult on two accounts. On the one hand, our knowledge of future events is limited. On the other hand, our emotions interfere with our thinking and cause various forms of bias in our expectations of future outcomes. Buffett says it is simple to be greedy when everyone is fearful, but he did not say it was easy.

Investment decision making involves both a process of logical thinking and requires an emotional state that enables us to trust our convictions. We need both. Being right but not trusting our decisions to act on them is useless. On the other hand, having a great conviction but being wrong leads to disasters. Never the less, right or wrong, we must make decisions. Even doing nothing is a decision to do nothing.

Having an appreciation of the emotional element in the investment decision making process helps explain why there are so many different successful investment styles and strategies that work for different individuals.

Rigorous mathematical methods and investment principles have been developed in an attempted to make investment decision making scientific. Our culture seems to trust anything scientific. We understand something to be scientific when its truth is universal. In other words, anyone using the same method will replicate the same results. However, we have not yet developed a fully scientific method to predict the future. Risk management remains an inevitable part of the investment decision making process.

We also have examples of highly successful investors that seem to outwit the mathematical models and scientific methods of investing. They remind us that investing is a human activity after all. It requires both courage and clarity of conviction. Those who understand people have an advantage. Investing is an art just as much as it is a science.

It seems to me that investing can never become fully scientific because investing is a zero sum game. Generating excess returns from investing, known as alpha, is possible when one party knows more than the other party. If investing actually becomes fully scientific, with universal formulas, then everyone will use the same methods and generate the same results. There will be no alpha.

I will not be solving the active vs. passive investing debate, however I do want to make a final point on the underlying assumptions. In my view, passive indexers are more closely associated with a ‘scientific’ investment mind set. They do not trust individual skill, or art, possessed by an individual investment manager who can beat the rest of the market – at least not after fees are accounted for, they say.

Passive indexers are essentially saying they don’t trust their skill to choose neither superior investments, nor trade at the right time, or be able to choose the right fund manager to beat the market. Their answer to dealing with the inevitable problem of risk in investing is to be extremely diversified and to hold it for the long term. They are neither greedy nor fearful or perhaps they are both !

Instead, they prefer to ride the market waves. Its a compromise of sorts. They do not require the courage of a strong contrarian conviction. Yet even they have to have some degree of fortitude to ride the waves of the market. They take comfort in the idea that everyone else is keeping the markets efficient by trading and bringing prices to ‘equilibrium’ – a very scientific word to describe fair valuations.

In conclusion, I cannot accept that skill, individual art, and superior decision making are non-existent in investment decision making. Successful investing requires character, a sort of persistence and endurance, as well as an intellectual curiosity and a rigorous thinking process. I believe all investors should cultivate these traits to become better investors.

Works Cited

Marks, Howard. The Most Important Thing: Uncommon Sense for the Thoughtful Investor. New York: Columbia University Press, 2011. Print.

ETF’s Achilles’ Heel – Illiquidity !

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ETF, Portfolio Management

Investors have been cautiously monitoring movements in interest rates over the last couple of years. What is making investors particularly nervous is the expectation that an inevitable rise in interest rates will reduce the value of their bonds. Investors have had their fingers on the SELL trigger and are becoming increasingly anxious. As soon as they believe that interest rates are actually rising they will sell their bonds in on order to cash in on their investments before the price of their bonds collapses too much.

In his annual letter to shareholders (2014), Warren Buffet states that, cash “is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.” Similarly, as long as investors believe interest rates are going to stay at current levels they perceive no need to sell their investments and convert them into cash. However, when interest rates will eventually rise it is cash that is going to be on their mind.

Even as equity markets are inching toward record highs, several large and influential asset managers have expressed some concerns about continued growth. To quote Bill Gross, the former manager of the largest bond fund, “Credit based oxygen is running out.” Furthermore, “Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others, warn investors that our 35-year investment supercycle may be exhausted.”

While ETFs have been increasing in popularity, they have yet to be tested in a market crisis. Increasing attention has been given to the vulnerability of fixed income ETFs, more particularly to its potential illiquidity.

According to Investopedia, liquidity is

1. The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.

2. The ability to convert an asset to cash quickly. Also known as “marketability.”

A proper understanding of liquidity includes both an ability to sell/buy without affecting the price too much and the speed of the execution. (Here is a short video that illustrates the concept of Liquidity from Investopedia)

The fundamental problem with liquidity is that “just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there.” (Howard Marks, Memo of March 25, 2015).

To summarize so far, just as investors need for cash increases the most so does liquidity decrease.

Several factors are combining to create some serious market meltdown for Fixed Income ETFs:

1. Investors who purchase ETF units often do so because they are attracted to the higher liquidity they provide when compared to mutual funds
2. We have seen the increasing willingness to own ETFs as a result of a desire to lower the cost of management fees
3. Investors have been pushed to chase higher yielding investments in “some esoteric corners of the bond market” because of the prolonged overall low interest rate environment
4. Banks no longer offer liquidity as they did before the financial crisis due to new regulations (i.e. the U.S. Volker Rule – which limits Bank’s ability to trade their proprietary capital) which is especially important for high yielding investment market

Due to the challenges of unexpected market opportunities, illiauidity and the immediate need for cash to take advantage of good investment opportunities, some mutual funds tactically choose to hold large percentages of their portfolios in cash. The other reason being the availability of cash to pay out to those mutual fund unit holders who wish to sell or redeem their units.

The difference between Mutual Funds and ETF unit pricing essentially boils down to the following: whereas a Mutual Fund unit pricing is determined only once a day (after the close of equity markets) based on precise accounting of the underlying assets, the ETF pricing is determined by the forces of demand and supply for its units throughout the trading day that may deviate from the actual final value of the underlying securities. As a result, occasionally the ETF unit prices can differ from the actual underlying asset prices, whereas that does not happen with mutual funds.

According to Howard Marks, “no investment vehicle should promise greater liquidity than is afforded by its underlying assets.” This is exactly the problem with esoteric fixed income ETFs. The Chairman of the Financial Stability Board, Mark Carney, has expressed similar concerns:

market participants need to be mindful of risks of diminished market liquidity, asset price discontinuities, and contagion across markets… it is important to ensure that any financial stability risks are properly understood and managed. For example, members noted current concerns about rising risks stemming from the overestimation by investors of the degree of liquidity fixed income markets as well as the growth of assets under management in funds that offer on-demand redemptions but invest in less liquid assets.

The concern is focused on the potential market meltdown when the fixed income ETF unit holders are going to want to sell all at the same time i.e. in case of a firesale. The problem is a double edged sword for fixed income ETFs. On the one end, who will be the buyer in a firesale of bonds if banks are limiting their exposure to trade with their own capital? On the other end, what would happen when there will be a large divergence between the ETF unit prices and the actual prices of the underlying fixed income investments? In other words, how are the ETF companies going to remain solvent?

The answer: ETF companies have been extending their credit facilities should a market meltdown happen. (The irony is that those credit facilities are guaranteed by the same banks that are limited from trading in the securities themselves) The ETF asset managers are simply protecting themselves from potential large losses should fixed income investors hit the SALE button all at once at the ETF unit’s traded price, while the asset manager may actually have difficulty executing the sale of the underlying illiquid assets at that promised price.

In conclusion, there are some caution signs for investors in fixed income ETFs to heed when interest rates actually rise. ETFs have yet to be tested under a market meltdown. According to Howard Marks, the best defense for “bouts of illiquidity” is to invest in securities with the conviction to hold them for the long term.

Observations on investing for retirement

As of May 2015, Vanguard – the leader in low cost investing – can boast the title of running the largest of both fixed income and equity market funds. A lot of attention has been attributed to the large losses suffered at PIMCO as a result of Bill Gross’ move to Janus Capital. What is equally interesting is the extent to which investors prefer index investing as a low cost investing alternative to actively managed strategies.

In the past few weeks the bond markets have been shaken by unexpected moves in inflation expectations. The volatility of the price of oil in combination with the Quantitative Easing policies implemented across the board — i.e. US., Europe, Japan and China — and the expected decoupling of the U.S. policy as it is trying to move toward monetary tightening created additional volatility in currency exchange rates and inflation expectations.

These uncertainties are pushing more investors towards passive investing solutions. There is a feeling that the central banks are running the show and no one wants to be caught wrong footed. Investors are inclined to think they are better off investing in passive investment solutions that cost less and avoid the feeling of guilt or the professional blame of making the wrong decisions.

These changes pose a real challenge for those who are planning for retirement. The percentage of retirees is expected to increase in Canada and the U.S. over the coming decades. Good financial planning requires an increasing allocation to fixed income solutions as a preparation for retirement.

Those who are planning for retirement face uncertainties regarding inflation expectations and the fear of running out of money as each generation lives longer. Added to these fears is the concern of not having enough money to start the retirement with.

Companies are increasingly trying to come up with attractive solutions to these concerns. One example of a product designed to address retirement income concerns is CI Guaranteed Retirement Cash Flow Series. The mutual fund’s goal is to address retirement cash flow while seeking growth at the same time. The G5|20 series guarantees 5% of the Guaranteed Asset Value (GAV) of the investment for 20 years. The GAV is reviewed every few years and can lock in higher amounts to guarantee a higher $ cash payout during those 20 years.

The G5|20 mutual fund offers a lower downside risk in market participation, with lower volatility, while maintaining the upside potential of participating in equity markets, all the while providing a guarantee of 5% of the GAV as cash flow.

At minimum, the G5|20 guarantees the return of the investor’s initial investment if there are no redemptions before the expiration date. The G5|20 seems better than holding cash. But is it going to keep up with inflation? No one knows for sure. Given the uncertainties inherent in the markets and the fear of being caught wrong footed it seems like this product can have its appeal with retail investors who wish for risk minimization and the emotional peace of mind.

For those investors who are not close to retirement, a passive indexing strategy seems to be more preferable than holding cash or investing in actively managed products. The passive indexing compromise seems to have to do as much with psychology as it does with empirical research.

It remains to be seen if fixed income indexing can follow the same path of growth as we have witnessed in equity market indexing products in the last few years.

Are ETF’s the answer investors are looking for?

The question that is often on investor’s minds these days has been well stated by John Authers in his FT article: “Is there not some way to try to beat the index while keeping costs low?”

Recent research suggests that investors should focus on lowering the fees they are paying for the investment management services they are getting. One such example is David Macdonald’s report in the Canadian Centre For Policy Alternatives. He concludes that “While there is plenty of choice between mutual funds, even in the best case scenario management fees remain several times higher than they are for pension plans. The practical result is that Canadians today will have to work many more years beyond age 65 (if they can) or retire with substantially smaller savings than if they had pension plans.”

Pension plans that are managed on behalf of employees are able to manage investments at a much lower cost to investors than the typical Mutual Fund available to retail investors who are relying on their own RRSP planning for their retirement. Such pension plans however are becoming more rare. So what can investors do?

According to the Canadian ETF Association statistics released as of February 28th, 2015, ETF Assets Under Management (AUM) hit a all time record in Canada totaling C$81.4 Billion. However, this number is dwarfed by the C$1.2 Trillion AUM invested in Mutual Funds in Canada as of the same date according to IFIC.

According to Authers, ETFs are the “vehicle of choice” for investors who are trying to match the performance of a chosen index. Indexing is the hallmark of a passive investment strategy. And a passive investment strategy is the ultimate low fee investment strategy. Therefore, the rise in ETF AUMs in Canada can be explained, at least partially, by an increased emphasis on indexing investment strategies.

By definition, indexing strategies can only deliver at best the market returns. Given the increasing pressure that investors face nowadays to increase their returns on their savings in order to be able to retire at the expected age of 65, it is very tempting to at least try to find some ways to beat the markets.

Beating the markets, however, involves several conditions. First, an investor must have confidence that the chosen strategy can beat the expected market return. Second, an investor must be able to execute the strategy within their own time frame. Thirdly, what matters to an investor is the returns that are left after all the fees and taxes paid.

The investment industry has traditionally focused on the first two aspects. Recently, however, there is an increasing debate about the third aspect. There is an emerging wave of arguments that prioritizes fees as the most important factor to consider for future investment returns even before asset allocation strategies. According to Mr. Authers, in his article quoted above: “nothing ultimately matters more than keeping fees under control.”

Meb Faber has done some research on the most successful asset allocation strategies and published his conclusions in his new book titled Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies (2015). In an interview for ETF.COM, Faber concludes: “The point we made in the book is that while most people spend 90 percent of the time thinking about allocation, what they should be spending 90 percent of the time on—if they’re doing buy-and-hold—is minimizing fees and minimizing taxes.”

In conclusion, investors are increasingly concerned about paying high fees and they are increasingly utilizing ETFs in their portfolios in order to control the fees they are paying. To rephrase the question from the first paragraph, what if the return that the market is expected to make is not enough for most investors to retire by age 65 and they are already paying the lowest fees possible? The answer to this question forces investors to either deliberate about market beating investment strategies or to devise a new financial planning strategy to reduce costs and increase savings. While ETFs are a great low fee investment tool, they are not sufficient by themselves to solve the retirement crisis faced by most individual investors.

What is the new ‘normal’?

Tags

financial market volatility, Portfolio Management

The dominating theme in current financial markets is the divergence in monetary policies between the U.S. and the rest of the world. These monetary policies affect interest rates and therefore we can expect higher volatility in currency exchange rates as investors chase higher interest rate currencies. Interest rates also impact valuations of equities by affecting company borrowing rates and the discount rates applied to their expected future cash flows. In addition, equity valuations are also impacted by the currency exchange rates when applied to their company earnings. Given these apparent relationships, what are investors to do?

On the one hand the Bank of Canada Governor Stephen S. Poloz says that:

The recent rise in financial market volatility reflects a global economy that is beginning the process of getting back to normal

This would seem to reassure investors that things are about to get ‘normal’ again. By ‘normal’ Governor Poloz means that volatility is returning to historical averages. This implies that investors should start to orient their portfolios based on long term historical market asset class correlations and risk/return performance records to properly optimize their risk adjusted returns.

On the other hand there is the lingering skepticism about the improved health of the global economy. Peter Schiff from Euro Pacific Capital says:

The Fed’s hyper-stimulative monetary policy was a mistake from the start. It did not repair fundamental economic problems but merely delayed the inevitable pain associated with their resolution.

Peter poignantly asks,

what if, as appears likely, QE and zero percent interest rates were the only wheels? Take them off and the bike falls.

This later view suggests that investors should be cautious about a return to ‘normal’ because there are severe underlying economic problems that point towards long term economic headwinds. Under this assumption, investors should not use historical average volatility records as a good future indicator.

Investors have to face the difficult challenge of estimating expected returns given the prices that they are paying. What is a fair return given the risk that they are taking? The problem in understanding the new ‘normal’ is in estimating risk. With such a wide range of possible future outcomes intrinsic valuations become very difficult to estimate based on fundamentals. Therefore relative valuations, such as P/E ratios, are an appealing alternative. However, the danger is that investors might start chasing yields, going from one asset class to another, while hoping to avoid risk events and ignore fundamentals all together. Yet even a relatively safe asset may not be a good buy if its price is too high.

Passive indexing is an especially appealing strategy given the uncertainty inherent in attempting to produce above ‘normal’ returns. Some investors decide to focus on controllable aspects such as fees, taxes and trading expenses. Investors increasingly demand lower fees on their products and financial service companies increasingly offer reduced fees on their investment management services. The new normal only affirms the traditional principle of investing: diversification. A key component of the new normal is the inclusion of passive indexing strategies for individual retail investors. It is difficult to state what the new ‘normal’ is, and that seems to be the new ‘normal’.