Time for Active to Shine?

Picking active managers isn't easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.

For at least a decade now passive management (managers who attempt to mimic an index) has been all the rage.  Originally passive management advocates were only on posters in Tiger Beat, but now they are on the cover of Vanity Fair.  More and more we get research, white papers, even client calls extolling the virtue of passive management over their active counterparts (managers who attempt to beat an index).  The trend continues to move more and more toward passive managers.  Will this ever change?

No, at least not forever, and I am a big advocate of passive management.  The reason was highlighted to me in the article.*  Thesis: the trend will continue to move as millennials, who are skeptical of active management, migrate to passive managers and the older active managers, who make up the bulk of active management, retire leaving new managers with little track record.

But the reason the trend will eventually reverse is the same reason why the money ultimately started flowing that way – returns:

1. Active management became popular in the 80s as ways to get diversified* market exposure and good rates of return
2. As it gained in more popularity, more managers entered the field = lower % of managers beating their respective index as quality erodes. 
3. Many of these managers raised their fees given the increased demand, lessening their chance to beat the benchmark
4. So here comes passive managers, cheaper and better performing than active managers
5. Repeat steps 2 and 3 AND lower quality active managers leave the field as dollars move to passive AND if everyone is buying an index stocks will naturally become over and undervalued, creating a nice situation for active managers AND creates a self-reinforcing problem - during a market selloff who is buying if everyone is passive?  This is where we are at.
6. The small pool of high quality active managers who were probably in cash before the sell-off and may now be well positioned to outperform over the full market cycle
7. Start over again

The debate of for academics, but why does this trend matter to retail investors?  Opportunity.  With everyone moving towards passive management, quality active managers should be better situated to beat an index over a full market cycle.  Picking active managers isn’t easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.

Please see the important disclosures that apply to this commentary HERE.  See important definition on diversification at the same link.

Macro Musings via El-Erian

Josh Brown recently wrote a blog post highlighting what Mohamed El-Erian said at the PIMCO Investment Conference.   Since my invitation got lost in the mail, I had to settle for reading his summary, which was quite good. 

Like Mr. Brown, I think that Mohamed El-Erian is not only a great macro thinker, but communicates his/PIMCO’s views as clear as anyone.  Further, their track record has been extremely solid since before the financial crisis despite the occasional misstep.   I doubt you could find much better.

Three things really struck me.  For ease, the big bullets are Josh’s notes along with El-Erian’s quotes.  The highlights are mine to add emphasis.  My comments are in italics under their respective bullets.

1. Risk management: People used to think that diversification was good enough, but no more. "Diversification is necessary for any investor but it is not sufficient when central banks have distorted prices."  He says the way to think about insuring tail risk is the same as you would car insurance. You maintain it at all times, not try to guess when you'll need it. He is talking about far-out-of-the-money options that hedge against unforeseeable outlier events, which is what his fund does.
• I totally agree that diversification is no longer adequate to control risk, given how correlations move to 1 and -1 in times of stress.  Tail risk insurance, using momentum to move risk on/off, and/or stop-losses at waterlines are good ways to contain risk.  Diversification only manages to moderate risk.  That is an important distinction.
2. Beta heavy lifting:  He thinks the beta heavy lifting is probably over in asset markets. In bonds, he says the capital appreciation returns from treasuries, corporates and high yield bonds are done too.  Lastly, someone asked him a Vanguard-related passive indexing question. Mohammed tells a killer anecdote from early in his career about how EM bond indexes were once made up of 22% Argentinian bonds pre-default, and that the other managers who were hugging that index got hammered. He says that passive makes sense only if you'll be driving in reverse up a road that is completely straight. Because you're essentially looking at snapshot of the way things were.
• Passive is less preferable to active in this environment.  Again, I think he is spot on here, though PIMCO would have this view given they are an active shop.  This is especially true on the Fixed Income side.  I will say the caveat is finding the right active managers, which is more of a qualitative function and can prove to be difficult.
3. Central Bank Brand Management:  He says basically a brand is like a wedge you can shove in between fundamentals of your company or product and raise prices. But that brand wedge is finite and cannot keep things apart or elevated indefinitely, there is a limit to what a brand can do… Central banks are also a brand. The brand is "we can deliver outcomes today to improve the future."  Right now people believe in the central bank brand, watch out for when that belief in the brand turns. Right now the psychology about the Fed's brand is positive, "but psychology goes both ways."
• What if Central Bank psychology in regard to the market reverses?  Admittedly this is something I need to look into more.  He elaborated more on that thought recently.  His basic point is that even powerful brands can only continue for so long until fundamentals justify (or on the negative side, no longer justify) the price (e.g. he mentions APPL).  In this specific instance, it’s that central bankers are hoping that in increase in financial market prices will filter down to the real economy.  El-Erian is skeptical this will work, and notes risks about the unintended consequences. He wonders what happens if investors no longer believe the fundamentals justify the financial market prices, even if central bankers continue their current policies.  All of these are legit concerns; however, in my opinion they are all fixable.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Bonds Aren’t as Stupid as Their Yields Indicate

Buying and holding bonds in the current environment might make you ill.  If you hold a Treasury Bond for 10 years you receive roughly 2% on that money annually for the next 10 years.   That’s in nominal terms too.  If inflation averages a little more than 2% that you essentially get 0%.  Higher quality corporate bonds aren’t much better.

Note: Left graph is based on 10-year Treasury bond coupled with inflation expectations.  Right graph is AA Corporate effective yields.

To summarize the graphs – buying and holding a Treasury or high quality corporate bond for 10 years is the investing version of Chinese water torture.   So why invest in bonds at all?

• They still will likely provide the best hedge against a declining equity market.  From November 07 to March 09 S&P 500 declined 44% with the Aggregate Bond Index was up 7%.
• Smart money is on Fed staying loose and keeping interest rates low for some time.  Even if they taper bond purchases later this year or early next year.
• Demographics and risk aversion provide a market for higher quality bonds. 
• Yields can stay low for a long time.  Ask Japan.
• Since 1976 the Aggregate Bond Index max loss over a 12 month period has been 9%.  Not what I would call a catastrophic loss so your principal probably won’t be decimated. 
• The world bond market is $90 trillion (compared to equity market size of $40 trillion), so there are a lot of places to seek out return (i.e. there are more than just Treasuries and Corporates out there).
• There isn’t a bubble, at least anecdotally.  How many investors you know brag about their bond portfolio over the past few years and compare that to their real estate portfolio in 2007 or their tech stock portfolio in 1999.
• Check this out:

That shows the 10 Year bond going from 2% to about 1.60% in a little less than 2 months.  It also shows the long bond ETF going up in value.  Point being, bond trades can capitalize on these quick moves in yield.

I take all of the above and come up with the following bond investment cocktail.

1. While the risk of buying and holding is probably low, the upside is muted when it comes to quality bonds.
2. Still given the depth of the bond market and short-term moves in yields, returns can be had.
3. Thus, move away from more passive buy and hold bond investing to quality managers who have the leeway and skill to navigate the fixed income space.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Draft Weekend

The NFL Draft was last weekend.  We now have the absurd post-draft grades, where despite these players never having played a down, teams are given an evaluation based on perceived value of the picks.

While not as absurd, I do find it silly that NFL GMs are considered great or horrible based on a handful of picks.  Think about it, if roughly 60% of picks pan out a GM is considered “good”.  That’s a bit better than a coin flip.

For simplicity, let’s assume the first two rounds present the only chance of producing legit starters, and assume a GM has about three years to show results.  Thus, in three years a GM must count on roughly 3.6 picks in the first two rounds to become good, if not great, starters.  If only two succeed he is a total failure, three he’s average, and four plus he is probably a success/genius. 

The sample size is extraordinary small, the success or failure probability is essentially even, and the margin of error is narrow; so the results of the pick are not a good indication of a GM’s skill or luck, at least over the course of a few years.  Thus, it’s the process that matters – how do GMs evaluate players?  The success of a player is probabilistic and therefore there is always a chance of failure.  A GM can do everything right in terms of his process, yet ultimately have a poor result. 

No, I haven’t started a sports blog, but I do see many parallels between a portfolio manager (PM) and a GM.  A PM can have years of underperformance, but have a strong process and will ultimately show skill and subsequent outperformance over the long-term (i.e. the skill of coming to solid probabilistic conclusion is born over a large sample size).  Therefore, it is how they invest, not the short-term returns, which are of concern to me.  Investors typically make the mistake of selling a manager early or passing on one altogether because of terrible one or three year returns, when qualitatively the same process is in place the has led to exceptional long-run performance.

For NFL GMs, unfortunately they aren’t graded on the same curve as I grade PMs.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.