The risk story behind expected profitability

Investors demand higher returns for taking on more risk.  Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market.  The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return.  The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk?  If a company is profitable, wouldn't the market include that information in the price?  To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns.  When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.

All else equal, the market will place a higher relative price on a company with higher expected profitability.  If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A.  Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets.  So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.

The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class.  This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model.  It has now been found that the poor performance of small cap growth companies can be explained by low profitability.  This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.

Original post at pwlcapital.com

High Frequency Trading

The promotion of Michael Lewis' new book has caused a significant amount of discussion in the media around whether or not High Frequency Trading (HFT) causes harm to the integrity of financial markets.  The debate is very interesting.  One argument says that HFT makes markets more efficient and expedites the arbitrage of the occasional inefficiency, while the other says that it is a big scam causing investors to lose out on profits.

With the right investment philosophy, there is no need to be overly concerned by either side of this debate.  The ability of High Frequency Traders to rapidly create small profits using superior technology is not a new phenomena; it is an issue that is generally present when dealing with market orders and order routing.  As an example, an active manager who wants to trade specific securities within a short period time would be affected by these issues.

A market based approach to investing does not require large market orders, and it does not require rapid trade execution. Investing in asset classes rather than the latest hot issue means that individual stocks with the right characteristics become interchangeable parts in a much broader strategy.  The flexibility in this approach eliminates the need for the immediate liquidity that HFT is able to profit from.

Original post at pwlcapital.com

Is Picking Mutual Funds any Different from Picking Stocks?

Today I received an email from an advisor that continues to work with actively managed mutual fund providers to serve his clients.  He sent me a document that a fund company had produced for him showing that actively managed mutual funds have consistently beaten their benchmark ETFs, and asked me what I thought.  My response follows:

Thank you for thinking to send this over.

I think it’s very interesting that the active management vs. ETF/passive debate is important enough for this fund company to have made this document.  I think it is even more interesting that they are pushing their advisors to sell their active funds while they are also making ETFs on the side.

But look, the thing you have to understand is that there will be funds that outperform just like there will be stocks that will outperform. I could go and find a bunch of stocks that have beaten a benchmark over the last ten years and say that it’s possible to beat the market.  It's important to understand that with a mutual fund, any time you are not holding the whole benchmark there can be periods when you outperform and periods when you underperform.  I could go and find a bunch of funds that have not beaten their benchmark over the last ten years just as easily as they found ones that did.

The key though, is that you or I, or even the fund managers don’t know when they will be winners or when they will be losers.  You can go and say "ok, the XX was up 11% over the S&P/TSX last year, I’m going to put my client in that one". But you know as well as I do that past performance does not indicate future performance.  You are betting on that fund doing well on your client’s behalf based on how well it did last year; you have no idea if it will be up or down in the future.  If you don’t know what the fund will do in the future, why not just accept the market’s returns and get rid of the high MER instead of hoping that the fund happens to be up during the period that your client is invested?

Picking funds is on the same level as picking stocks in my opinion.  You can say "well this manager has tons of experience and the fund has done well in the past" and so on, but that’s no better than looking at the financials of a company and saying "oh they have strong earnings, good management, and a stable dividend I will pick that one".  There is simply too much information in both cases to make an accurate prediction AND your clients are paying high fees for you to place these bets... it just doesn’t sit well with me.

Original post at pwlcapital.com

How Hard is it to Beat the Market?

How hard can it really be to beat the market?  If I say that all available information is included in the price of a security, it follows that someone had to act on the available information in order for it to be included in the price.  Someone had to get the information, make a decision to buy or sell the security, and then execute a trade for that information to be included in the price.  So every time someone can be the first to act on new information they must make a profit, right?

In 1945, F.A. Hayek pointed out that there are two types of information:

  1. general information that is widely available to all market participants, and
     

  2. specific information about particular circumstances of time and place, including the preferences and needs of each unique investor. 

As a pricing mechanism, the market is able to aggregate all information into a single metric.  That metric is the price, and it is constantly influenced by participants competing with each other to be the first to bring information to the market in order to make a profit.  As hard as they try, no single market participant can have the full set of information because new information is being randomly generated constantly.  If someone overhears a conversation between two Apple employees, they are in possession of information that nobody else has; if someone sees an oil tanker sink in the middle of the ocean, they have unique information; if a pension fund manager goes on a site visit to a mine and hears something before everyone else, they have specific information particular to their circumstances – there is an infinite amount of information like this being constantly generated, and due to the nature of the market, people want to use their information to profit.  What does this mean for investors?  It means that all available information can be included in the price of a security without any single provider of information being able to profit from the information that they contributed.

So in short, it’s really really hard to beat the market.

Original post at pwlcapital.com

Risks Worth Taking

Wealth creation takes place when cash flow is steady, there is time to recover losses, and risk is tolerable. 

It's not uncommon for the ability to take risk in the market to be confused with the desire to gamble.  There are some risks worth taking, and some risks that can turn an investment account into a sophisticated platform for placing bets.

Of course, it's a lot of fun to do research and be immersed in the latest information about a company or an industry with the hopes of taking action before the market does.  Consider, though, the amount of other individuals, and more importantly institutions and mutual funds, that are trying to do the same thing.

By the time you read a Bloomberg News headline, the market has already reacted.  By the time the company you're following discovers a new reserve, institutions have already started trading.  The ability of the collective players in the market to price a security as soon as new information develops is intimidating.

It's easy to think that with enough research, it should be possible to outsmart the market by predicting new information before it happens, but new information develops randomly.  If we could predict all new information accurately we wouldn't need the market to create wealth.

So what's a risk worth taking?   It has been proven through years of research that small cap and value stocks produce superior returns over the long term.  Constructing a portfolio tilted toward these asset classes can increase expected returns without relying on speculation.  With these tilts in place, diversifying globally, and across asset classes can almost eliminate non-systematic risk.  You may never make 200% on a speculative bet, but major losses will likewise be reduced.

In creating wealth, the sequence of returns is just as important as the returns themselves.  It's very difficult to beat the long term compounded returns of a robust portfolio with a series of speculative bets.

This may not sound exciting, and it shouldn't.  Well documented research stands behind these remarks - I'm talking about using science to invest, and science is not nearly as exciting as gambling. 


Market Based Investing

In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management.  The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market.  Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time.  It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.

I am happy to disagree with the idea of predictive investment management, but don’t condone the idea of passive investing either. I stand behind a strategy called market based investing.  It is the idea of harnessing what the market has to offer, while taking advantage of asset classes within the market that have been shown over the long term to produce higher returns than the market itself. The idea is to hold the entire market, and then increase the proportion of certain asset classes relative to the market to take advantage of their higher expected returns. Trying to determine which markets would be the best to apply this strategy at any given time would be betraying a scientific approach in favor of prediction. The solution is to build globally diversified portfolios in order to capture the returns of markets around the world while reducing the impact of any single market.

These globally diversified portfolios tilted towards specific asset classes are then rebalanced systematically to eliminate predictive and emotional tendencies as markets move. Implementing this rules-based system ensures that emotions and predictions are removed from investment decisions, and sets a market based portfolio apart from the active vs. passive debate.

The Grossman-Stiglitz Paradox

I have mentioned this paradox before, so I thought it deserved some discussion.  The Grossman-Stiglitz paradox states:


  1. If markets are efficient and securities' prices reflect all available information and,
  2. obtaining information about securities requires resources (time, money)

Then

  1. Why do people commit resources to researching securities at all, and
  2. if people don't need to commit resources to researching securities, then how did the prices get right to begin with?

To me it is a very simple relationship. If there are people that do believe that there are mispricings to be exploited, they will spend their resources to exploit them. It only takes a few mispricings to make people believe that it is possible to find more mispricings. When mispricings do exist, as soon as enough people exploit them, the prices will tend toward their true value. So, markets are efficient because there are a bunch of people out there that don't think that markets are efficient. It becomes an equilibrium situation.

I remember a discussion with a Carleton University finance professor where I asked what would happen if everyone started to buy the index and stopped trying to beat the market. Following our discussion, if everyone started to buy the index, mispricings would start to develop regularly, and arbitrageurs would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. It really all comes back to psychology; nobody wants to accept being average and moving with the market when there are hot shot managers out there that promise to produce double digit returns. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market.

At the end of the day some people will beat the market, sometimes. Statistically, it is very unlikely that anyone will consistently beat the market over a long period of time, and whenever one manager beats the market, another manager must underperform. I love the idea of active management. It is flashy, glamorous, and exciting. Nobody wants to accept being average, but it is far better to be consistently average than to outperform the market one year and underperform the next. Remember how important the effects of compound returns are in building up wealth.

I say let the stock pickers, the gurus, and the hotshot managers try to beat the market. They get to have fun spending their clients' money to make bets and predictions, and they keep the markets efficient for the rest of us.  To look at it another way, it is all of the dollars paid to active fund managers that keep markets efficient - nothing's free, I'm just glad I'm not the one paying for it.

How To Construct a Portfolio:

The first step in constructing your investment portfolio is determining a goal for the investment.  Setting an objective allows you to create parameters that make it possible to determine the rate of return that you will require.  The return will be the number that is required to bridge the gap between the amount of capital that you will invest, and your ultimate goal.  Once this model has been created, the parameters and the required rate of return can be adjusted in order to arrive at a required rate of return that is plausible, and that fits with your investment style.  As an example, if you begin with a principal investment of $5000, make a $100 monthly investment, have a 20 year time horizon, and a goal of saving $100,000, you will require a compound annual growth rate of 8.7%.  If it is determined that 8.7% is not feasible, or if it does not fit with your preferred investment style, the parameters can be adjusted.  Following the same parameters, if we increase the principal to $10,000 and the monthly investment to $200, we only require a 3.8% annual return to achieve the goal.  In the charts below, the green bars are the invested principal and the blue bars are investment returns.  Take note of how heavily the person on the left is relying on investment returns to achieve their goal, if the market does not perform as expected they will have a much greater shortfall than the investor on the right.

$5000 principal, $100/month, 20 year horizon, $100K Goal

$5000 principal, $100/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

Armed with an idea of the rate of return that you will need to achieve your goal with your given parameters, the next step is to determine your tolerance for risk.  Risk and return are very closely related in that an intelligent investor will not assume more risk than is necessary to achieve a given return, and when more risk is assumed the investor expects to be compensated for assuming it.  If we look at the performance of the S&P 500 since 1950, the general volatility of the equity market can be observed.

S&P 500 Performance  - 1950 - 2013

S&P 500 Performance - 1950 - 2013

This chart shows the potential for gains, but it also shows the that capital can be lost in large amounts.  If an investor is able to stay invested when the market is in a dip, history tells us that the market will rise again with time.  This idea gets much more complicated when we factor in psychology and the time horizon of the investor.  If you panic when the market is low and liquidate your investments, you will miss the gains when the market recovers and be stuck holding your losses; similarly, if you have a set date where the capital will be needed and the market is low when you need it you will either be stuck with the losses or not be able to access the capital until the market recovers.  The above chart shows the S&P 500 index which is only an example of a group of stocks.  An investor can build a different portfolio of stocks that is subject to less risk, they can invest in bonds, they can invest in real estate - there is no shortage of investment opportunities, the challenge is building a portfolio that fits your individual needs and investment style.  The following chart from Vanguard illustrates the average returns, and the variability of returns for various portfolios consisting of stocks and bonds from 1926 through December 2012.  Selecting a mix of equities and fixed income securities is called asset allocation - asset allocation is how a portfolio is constructed to fit a risk profile.

BondVsStock.png

With the ideas of setting a goal, determining an acceptable level of risk to achieve that goal, and the right asset allocation to meet that risk level, we are ready to begin selecting the securities.  Picking individual securities is like going to the casino, or like flipping a coin.  The prices of securities reflect all publicly available information, and trying to guess at the new information that may affect the price is not a particularly effective practice.  I once had a pension fund manager tell me that even the best analysts are only right 70% of the time.  It is, however, possible to reduce the risk and increase the expected return of a portfolio through diversification.  Historically, returns of any asset class vary considerable from year to year, and combining assets classes in a portfolio can mitigate this volatility.  To further reduce volatility, global diversification reduces the effect of any single asset class or market.  The figure below shows the variability of returns across asset classes and geographies, common sense tells us that by combining securities across these asset classes and geographies in a meaningful we can reduce the overall volatility of that portfolio.

Variability of Returns.png

At this point we have taken the following steps to construct a suitable portfolio:

  1. Determined an objective for the investment
  2. Determined a time horizon and required rate of return to achieve the objective
  3. Determined a tolerance for risk
  4. Established an optimal asset allocation based on, time horizon, required return, and risk tolerance
  5. Diversify away the risks of investing in any single asset class, market, or geography
  6. The final step is determining a management strategy.  There are two ways that a portfolio can be managed; read after the jump.