Friday, November 6, 2009

The Movable Bullseye - Alpha

In this issue:
1) What is the purpose of investing?
2) Beating Inflation
3) Beating Bonds
4) Beating a Risk Index
5) How to beat the chess grandmaster Bobby Fisher

Dear Friends, Colleagues, and Investors:

We have noticed that many investors, both sophisticated and small, don’t seem to understand the purpose of their investing. “Making money” is too simple an answer, as you can make money and still be worse off. The question is simply, “Why invest?” The answer to this question is philosophical and affects your pocket book in a deep way.

1) What is the purpose of investing?

The purpose of investing is not “making money.” That is the correct answer for investment advisors, as most make money off their clients’ ignorance and carelessness through layers of fat fees. A rational investor should do three things:

i) Preserve the after-inflation value of capital. This means an investor’s capital should buy the same amount, or more, of goods and services after a few years. An example:
-An investor has $100, which can buy 10 bread loaves and 2 massages.
-The $100 is invested and grows to $140 in 5 years.
-In year 5, the $140 can buy 10 bread loaves and 2 massages.
-The investor is on even ground – no losses and no gains. Despite “making money” she is no better off.
Any strategy that loses to inflation but beats its benchmarks, however numerous and glorious the benchmarks are, is bunk. Few equity mutual funds (less than 20%) have beaten their index benchmark in the last 5 and 10 years. Almost none have beaten inflation, which has averaged a little above 3% (no major US equity benchmark has beaten inflation in the last 5 years).

ii) Match or beat the “risk-free” opportunity cost of capital. Any investor can buy a risk-free asset and sleep safely. An opportunity cost is something that an investor forgoes. For example, if you get coffee at Starbucks, your opportunity cost is coffee from home, from Peets Coffee, or from the corner mom-and-pop vendor. More specifically to investing, if you invest in bond A, your opportunity cost is what bond B, C, or D could have given you. Generally, a diversified bond index like the Barclays Capital US Aggregate Bond Index (the “Barclays Agg,” formerly called the Lehman Aggregate) is probably the best marker for a risk-free investment, though on closer analysis this is a tough call. At the very least, investing in the securities market should get you a return better than your bank savings account or CD.

iii) Match or beat the “risk-taking” opportunity cost of capital: An investor that wants to take more risk can buy risk assets. She should measure her progress against three benchmarks: inflation, the risk-free bond benchmark, and a “risk index” that is appropriate to the type of risk she is taking. The most common “balanced” US risk index is a 60/40 blend of the S&P 500 and the Barclays Agg, but the appropriate risk index should be specific to an investor’s goals.

2) Beating Inflation

Beating inflation is a common sense benchmark. It is what sophisticated managers mean, explicitly or implicitly, when they promise “absolute returns.” Any investment strategy offering absolute returns, yet not beating inflation, is stale sugar water.

The more nuanced question here is, “What is inflation – which index should one use?” This is relevant for two reasons. First, investors have a global opportunity set: they can pick the currency of their portfolio and many measures of inflation. Second, official government measures of inflation aren’t that trustworthy.

The conventional wisdom is that investors should use their home country currency and the most commonly used home inflation indicator. For Americans, this would be the US dollar (USD) and the Consumer Price Index for Urban Consumers (CPI-U). Yet as the dollar weakens, smart investors are looking more to a basket of currencies or gold as alternate measures of their portfolio’s worth. Take gold as an example. Suppose your portfolio is worth $100K today (about 100 ounces of gold). Suppose it grows to $150K in 5 years, but that only buys 80 ounces of gold. You are poorer. For simplicity, it’s easy to just use your home currency as the base measure. Yet if your home currency isn’t the Chinese yuan (CNY), which seems undervalued, but rather the USD, you may want to think twice about the base unit.

Suppose you stay with the dollar. Is the CPI-U a good measure of inflation? Perhaps not. For decades, the US government defined CPI-U using a fixed basket of goods. In the 1990s, government officials changed this to include substitution effects and hedonic improvements. Basically, they reasoned that: if beef prices went up, people would substitute cheaper chicken, and so chicken should be weighted more in the basket hence higher beef may lead to lower inflation; if a computer selling for $1000 had much better performance stats, it should be weighted cheaper, hence lowering inflation, though you still paid $1000 your computer. Both these Clinton era changes brought CPI-U inflation way down in the US and UK, while consumers still felt ripped off. For more information on these games with inflation indexes, read what John Williams of ShadowStats writes and David Altig of the Atlanta Fed counters. Governments playing games with currencies and inflation is centuries old; rich countries like Argentina still play the game today. As Williams suggests, the best measure of inflation is intuitively an equal-weighted basket of goods and services, as the CPI-U was previously calculated (what Williams calls his I-7 or his SGS Alternate I-8 inflation measure). But you can’t get the I-8 from the Federal Reserve or the BLS, you need to go to

Finally, investment managers who earn performance-based fees (carry) make off like rogues and bandits when inflation is higher than expected. Few investment funds have a hurdle rate, and often the hurdle is low (4 to 6%). In a world of high inflation, esp. when inflation is above the hurdle rate, all assets go up in price and your investment manager takes a disproportionate cut of your principal while adding no value.

Beating inflation is a no-brainer. So how come so few institutional investors write it in their contracts with managers? Why don’t more managers compare their return to inflation? The dirty secret is that many managers would do quite poorly and so they don’t want to measure their value-add (or value-subtract) by this bulls eye.

3) Beating Bonds

Beating bonds should be the next goal of any investment plan. Today, it’s easy to invest your money in a low-cost, diversified bond index and sleep safely. Bonds give you safety of principal and some idea of an expected return: the SEC yield, yield-to-maturity, and yield-to-worst approximate what you will earn. In the US in the 20th century, short term bonds (1-3 year maturities), beat inflation in almost every 10-year period (if the bonds were held to maturity). Hence investing in bonds is one step above beating inflation; it’s better than getting a smidgen of a nominal return from a savings account or bank CD. Of course an investor can make bad individual bond bets and lose money quickly: she can buy 30-year Treasuries when rates are low (4%) and sell them just as rates peak at a higher lever (12%); or she can buy high yield bonds when spreads and defaults rates are low, right before a business cycle turns negative. Also bond math and bond investing can be quite complicated. Experts can use Taylor series, linear programming, or option pricing models to price bonds. Yet a diversified index of bonds, like Vanguard’s Total Bond Market Index Fund, is a safe and simple place to be most of the time (not before sudden shifts from deflation/low inflation to high inflation, though).

Again there are some nuances. Investors can argue about:
-the best reference bond index should be US-based or Global-cum-US (to take currency exposures into account)?
-what to do before high inflation hits (buying low duration or linker bonds)?
-whether the index include just government bonds or a diversified pool of bonds (government, corporate, agencies, loans, etc.)?
The answers to these questions depend on the sophistication of the investor.

Beating bonds is a goal that most equity or other risk-asset investors do not acknowledge. Today, many absolute return hedge fund managers or long-only equity managers will point to their returns relative to an equities index (the S&P 500, Wilshire 5000, Dow Jones Industrials, etc.). Yet if they underperformed a bond reference index, like the Barclays US Aggregate Bond Index, these equity managers have destroyed your wealth. If you’re not getting a premium from stocks over the safer counterparts of bonds, your managers are fleecing you. And 3, 5, and 7 year returns are the best timeframe to measure this. In any single year, bonds can beat stocks. If bonds beat stocks for more than 3-years, you have a bad manager.

4) Beating a Risk Index
From the discussion above, investing is easy. You save money. You stick your saved money in a diversified bond index, from a trusted provider (Vanguard, Fidelity, Pimco), to “own” the bond market. If the experience of the US bond markets from 1900 to 2009 offers any future guidance, a diversified bond investor can expect a steady return about 2-3% points above inflation.

Yet bond returns may not be enough for investors who want to take more risk and earn higher returns (but keep in mind you can take more risk, bad risk, and earn lower returns!). In about 60% of all ten-year periods from 1900-2009, stocks and other risk assets beat bonds. When evaluating managers of risk-assets, investors should find an appropriate risk-index to measure performance. Find and set a bulls-eye and don’t let the manager change it if she underperforms. Some thoughts on the bulls eye of manager measurement:

i) All managers should be compared to inflation and a bond index. Investing in stocks, real estate, hedge funds, and private equity is sexy but silly if these asset classes and managers underperform inflation or bonds for any 3-year period or longer. Inflation and bonds are absolute benchmarks for all risk assets to beat; don’t let managers play mental jujitsu with you and try to convince you otherwise. Beyond inflation and a bond index, managers should only be compared to a single risk index.

ii) Don’t let managers pick multiple indexes that are economically very different. Managers will then cherry pick the best index in his communications and claim victory. I’ve seen dozens of “top” managers do this. The S&P 500 is quite different than the Wilshire 5000 or the MSCI All-Country World Index. Many absolute return hedge fund managers use the S&P 500, the MSCI ACWI, and the US Barclays Bond Aggregate together. However, these are three very different indexes with low or negative correlations. Hence one index will always do poorly as the others do well. The crafty but unscrupulous manager will compare his returns to the worst index. The heroic and honest manager, if she chooses all three, will compare her returns to the best performing index for any period. Yet beating all three in nearly all periods is impossible and shouldn’t be the standard – it’s like asking for a spouse with movie star looks, Einstein’s brains, Oprah’s empathy, and eternal unconditional love and devotion to you. Hence honest managers should only be compared to a single risk index.

iii) A risk index should be as broad as a manager’s legal/strict mandate, and not narrow like what the manager voluntarily chooses to invest in any period. A manager who has the mandate to invest in global stocks but chooses to limit herself to US stocks has made a country/geographical bet. Don’t let her choose the S&P 500 as her index (note to Warren Buffett – pick a broader index!). If a manager has a mandate to invest in 3 countries, her benchmark should be the best-performing broad equity index from those three countries in that time period, or a static, blended benchmark of three indexes.

iv) Simplicity and openness: Avoid using too many benchmarks (more than 3) or complicated blended benchmarks, as people have a hard time following them (due to bounded rationality). Also, non-proprietary benchmarks (like those from Cambridge Associates or other niche firms) usually don’t release verifiable data and hence shouldn’t be trusted or used. For example, a private equity firm is better off comparing its returns to a broad public equity index plus an illiquidity premium (say the Wilshire 5000 plus 400 basis points), rather than comparing itself to the opaque Cambridge Associates Private Equity Index.

The basic point is that every investing strategy taking risk should have a benchmark set beforehand. At a minimum, a manager must beat inflation and bonds, carefully defined, over a three and five year period. Beyond that, it takes some creative thinking to come up with a benchmark.

For example, a pure global macro fund can theoretically invest in any security, country, or asset class. Hence even a traditional 60/40 benchmark of the S&P 500 and US Barclays Aggregate is too limiting for a macro manager. It’s like playing basketball without have to bounce a ball, respect the court boundaries, or follow any rules. Any idiot macro manager should be able to beat a single country’s equity index (but strangely, few do!). Since the vast majority of global wealth is spread between stocks, bonds, and real assets, perhaps a macro manager should be measured against a benchmark blend of the MSCI ACWI, the Barclays Global Aggregate Bond Index, and the S&P/Citigroup World REIT Index. For simplicity, all three indexes are global, liquid, transparent, and widely known – a 33% split avoids the problem of annually re-measuring the balance of global wealth. Of course the REIT index isn’t a great measure of global real assets, but using three other niche benchmarks to measure real assets would make the blend unbearably difficult to understand.

5) How to beat the chess grandmaster Bobby Fisher
Bobby Fisher was one of the great chess grandmasters. At 13, he won the “Game of the Century.” He was the youngest US grandmaster, dominated world chess championships in the 1960s, and wrote a wonderful beginner’s book on playing chess, called “Bobby Fisher Teaches Chess.” So how do you beat Bobby Fisher? Here’s the secret:

To beat Bobby Fisher, don’t play him in chess. Pick something else: basketball, Hollywood trivia, ballroom dancing, stage acting, arm wrestling, or paintball.

That is really the secret that most money managers use. They tell you they’re going to “make money” for you. That’s easy, like thumb wrestling with Bobby Fisher. The real difficulty is to consistently beat inflation, a bond index, and a risk index. Very few managers can do that.

Of course, evaluating investment managers is more complicated:
-Managers can make dodgy asymmetric bets where the tail risk is a bulldozer (selling out-of-the-money options), or can buy securities that go from being very liquid to frozen (CDS).
-Managers can also play performance games where they post great returns with small amounts of capital (make $30 million on $100 million), and then raise lots of money to destroy much more (raise $10 billion only to lose $4 billion). They prove themselves dangerous to society. Unfortunately, many famous hedge fund and mutual fund managers fall into this category.
-Managers can make money by doing unethical things. If you’re not a sociopath, social and ethical goals matter. You may not want a strategy with high returns that devastates the urban poor or some other part of society (what were subprime investors thinking?).
But these are advanced bulls eye topics.

Investing to make money isn’t enough. You have to beat inflation, a diversified bond index, and a well-chosen risk index. If you can’t beat the indexes, just buy the indexes (at low cost) and sleep soundly.

Your bemused investor who has seen far too many bogus manager pitches,
Copyright 2009 Risk Over Reward. All Rights Reserved

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Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably

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