Tuesday, July 28, 2015

Hedge Funds: Balancing Risk & Reward?

This recent article by Brett Arends points out hedge funds have not performed all that well this year.

The same goes for recent years. Arends writes those "who put 20% of their money in a federally insured bank savings account, and the other 80% in a random collection of stocks from around the world, picked by monkeys," outperformed in a meaningful way hedge funds in 2012, 2013, 2014, and so far in 2015.

Well, at least to me, that seems a rather too short time frame to judge relative performance.

In this article, Morgan Housel looked at a somewhat longer period of time. He points out, from 2002-2013, hedge funds underperformed a simple mix of 60% in stocks and 40% in bonds.*

The 60/40 mix had slightly higher returns along with slightly lower volatility.**

Some hedge funds argue that their goal isn't to match or beat the S&P 500, it's to balance potential rewards with downside risk and limit volatility or something similar. So, with this in mind, both Arends and Housel chose to compare hedge fund returns to a mix that similarly attempts to balance rewards with downside risk.

I'd add that some make the assumption that risk and reward need always be positively correlated.

Well, that's just not necessarily the case.

Now, consider that the typical fees of a hedge fund will be something like two percent of assets under management plus twenty percent of the profits generated (if any).

The two percent is generally paid by investors whether there's a profit or loss.

Arends points out that this means...

"Do the math. If the average investment portfolio earns 6% a year, your hedge fund manager has to earn 9.5% before fees before you even break even. In other words, the manager has to beat the market by about 60%. Per year. Good luck with that."

It may not be impossible to outperform by that much, but consider how many experts underperform over the longer run with, in general, a much lower frictional drag from fees. Also, consider how these fees impact the risk-reward for investors. In other words, the act of reducing fees would, in itself, take out some of the downside risk which is what the hedge funds often contend is a prime objective.

And the above hedge fund results just might be an optimistic take. It turns out that the "hedge-fund indexes flatter the industry's performance, because they are weighted heavily towards the funds that survive and report data."

So how has hedge fund performance affected investor behavior?

Is there any evidence investors are moving out of hedge funds?

Not at all.

From an article in the Wall Street Journal:

"Large corporate pension funds have quadrupled the share of their portfolios invested in hedge funds over the past five years..."

More generally, hedge fund assets under management is now, depending on the source, something like like $ 2.5 trillion or maybe even $ 3.0 trillion in assets. Big numbers. That compares to just $ 38 billion in 1990. So hedge funds have been gathering assets in a substantial way over the past two and a half decades (and in more recent years). At their current size, these funds will collect some serious fees from their investors, including those pension funds, with just mediocre performance.
(The management fees alone would be $ 50-60 billion even if no profits are generated.)

I'm not necessarily surprised by this sort of thing. Better to simply recognize why the behavior exists then do whatever can be done to avoid it.

This paper looks specifically at hedge fund investor performance from 1980-2008:

"...we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008.The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought."

This inevitably now has a big impact on institutional investors (pensions, foundations, educational institutions). Why? Apparently, at least 60% of the money invested in hedge funds these days comes from institutional investors.


Related posts:
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Vanguard Balanced Index Fund (60/40). The fund, like many from Vanguard, is rather low cost relative to peers.
** Volatility is not the definition of risk though some choose to treat it that way.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, July 21, 2015

Analyst Ratings: When It Pays To Do The Opposite

According to this Barron's article, the highest rated stocks by Wall Street analysts between 2002-2014 collectively returned 9.5%.

So the highest rated stocks collectively did more than just fine. The funny thing is that the stocks liked least by the analysts -- those with the lowest ratings -- collectively performed even better.

In fact, the lowest rated stocks produced a 13.2% average annual return.*

Now, this outperformance by the most hated stocks apparently doesn't just apply to the 2002-2014 time period.

Back in 2006, Barron's published an article on a study that covered from 1995-2004 that noted a similar outcome:

"From 1995 through 2004, the stocks with the lowest earnings-growth forecasts and worst ratings beat those with the highest."

In the same article Charles Schwab's Greg Forsythe notes:

"You are better off doing the opposite..."

So we've got a solid couple of decades to look at here and, well, going with the opposite -- the lowest rated -- would have produced better results.

A scene from an episode of Seinfeld comes to mind. The title of that episode just happens to be "The Opposite":**

"If every instinct you have is wrong, then the opposite would have to be right." - Jerry Seinfeld speaking to George Costanza in "The Opposite"

Now, at least to me, it seems rather impractical to be attempting to buy and sell so many different stocks -- whether going with ALL the highest-rated or ALL the lowest-rated -- at just the right price/time in order to match these returns. Those who trade more frequently, or possibly some fund with enough scale, may be more comfortable with such an approach.

Also, the impact of frictional costs and mistakes on future returns must be considered. Observing what already happened in hindsight is very different than attempting to make sound investment decisions going forward, in an uncertain world, based upon the recommendations of others. Mr. Market usually throws a curve or two. Temperament, emotions, and biases become all-important factors that, in real-time, tend to have an effect on investor behavior and decision-making.

I happen to think making investment decisions based upon what others recommend is difficult at best if not inherently flawed.

The reason?

If nothing else, the necessary conviction likely won't be there when market price action happens to go the wrong way.

Lacking the necessary -- and, equally important, warranted -- conviction is just asking for inopportune buy/sell decisions.

Understanding the reason why you own something is essential. To me, that comes from doing the necessary work yourself and reaching your own conclusions. Each business comes with a unique set of risks and opportunities. Without some depth of understanding, the inevitable market fluctuations can become tough to handle. In other words, it's difficult to hang in there when a stock meaningfully drops in price if you are not rightly confident in what it's worth and how the value might change over time.

Keep in mind that knowing one's own capabilities and limits is easily as important -- if not more important -- as knowing the capabilities and limits of a particular investment opportunity.

Is it possible to buy/sell based upon the above ratings and reliably translate those actions into satisfactory real world future long-term results?

Someone may know how to do this but consider me a bit skeptical.

Will the performance of these ratings prove persistent over the long haul? What's the basis for figuring that out?

I mean, if such an approach were easy to implement, why isn't there a bunch of successful funds or individual investors out there doing just that?

None of this, of course, necessarily means owning all the highest rated or lowest rated stocks would fail going forward. Nor does it mean some clever though somewhat different approach using these ratings can't be made to work. I just think it's wise to suspect it would prove far from straightforward to implement and difficult to have justified confidence in beforehand.

Even when something does happen to work it's often difficult to judge how much of it came down to luck versus skill.

There are, in fact, many able analysts and the study of high quality research/analysis can be time well spent.***

Yet, for those who invest in individual stocks, it's likely not wise to delegate the buy/sell decision-making.

Essentially, that's what happens when an investor chooses to buy or sell a stock based upon a someone else's recommendation.

Still, if nothing else, it's at least mildly interesting that the vast majority of actively managed equity funds underperform yet the two studies seem to at least imply there might be a way to do much better than the market as a whole.

Maybe someone will figure out (has figured out?) how to convert these ratings into an approach that produces reasonable or better rewards going forward.
(If so, the results would need to be measured over decades and not just over a few years of future performance. Sometimes, an approach appears to be working until, well, it just doesn't.)

All I know is it won't be me. Even if there's some way to make these ratings work in a reliable way long-term -- and there just might be -- it's just not the kind of thing I'm interested in or capable or doing.

My interest is in figuring out, within a range, what a business is worth and, considering the risks/alternatives, whether it's likely to increase at an attractive rate over the long run. That's challenging enough. The approach taken should be compatible with your own nature. So I'll stick to buying, with the long-term in mind, shares of the businesses I can understand at a discount.

To me, the equity markets need as many market participants as possible focused on valuing individual businesses. A market where the vast majority are engaged in estimating per share intrinsic business value should at least be somewhat less likely to get mispriced (by emotions and other factors) in extreme ways.

Others may naturally have a very different view.

Recent bubbles (i.e. extreme and widespread mispricings on the high side) have revealed at least some of the economic consequences of broad-based mispriced assets.

There's certainly room for speculation in financial markets, and maybe even some gimmickry, but the proportion of participants involved in such things matters. A little bit is fine but at some point more becomes not such a wonderful thing.

Financial markets can and do facilitate the transfer of risk but shouldn't exist primarily to serve those who are inclined to gamble; they exist (or should exist) mostly to move capital that's been priced as appropriately as possible -- with an emphasis on long-term effects -- where it needs to be.


* Sources: Bespoke Investment Research and Bloomberg. The S&P 500 returned 6.5% annually over the same time frame. So it's not like the highest rated stocks did badly. Not at all. It's just that the lowest rated stocks did even better.
** In the episode, George Costanza implements an effective strategy to overcome his innately terrible instincts: 

"A job with the New York Yankees! This has been the dream of my life ever since I was a child, and it's all happening because I'm completely ignoring every urge towards common sense and good judgment I've ever had." - George Costanza in "The Opposite"

Maybe the approach isn't as crazy as it sounds.
*** Though, at least for me, it all starts with an in-depth review and analysis of the 10-Ks and 10-Qs over as many years as possible (depending on the business). Reading widely -- and thinking carefully about a particular investment -- is a crucial part of the investment process.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, July 14, 2015

Buffett & Munger: Embracing the Unconventional

"Develop your eccentricities while you are young. That way, when you get old, people won't think you're going ga-ga." - David Ogilvy

Historically, Berkshire Hathaway (BRKa) has often held -- especially when compared to the norm among professional investors -- a rather concentrated equity portfolio.*

To say anything less would be a gross understatement.

In fact, having sixty percent or more of the Berkshire portfolio in just five stocks has been not at all uncommon.**

At times the portfolio has been even more concentrated. In the 1980s and early 1990s Berkshire's top equity positions frequently made up eighty to ninety percent plus of the portfolio.

1987 was one of those years.

Here's how Warren Buffett explained their approach in the 1987 Berkshire letter:

"...our insurance companies own three marketable common stocks that we would not sell even though they became far overpriced in the market. In effect, we view these investments exactly like our successful controlled businesses - a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price."

It's portfolio concentration combined with a very long holding period.***

"A determination to have and to hold, which Charlie [Munger] and I share, obviously involves a mixture of personal and financial considerations. To some, our stand may seem highly eccentric."

In the letter Buffett writes, referring to the quote at the beginning of this post, that they've "long followed" the advice of David Ogilvy and went on to explain their attitude the following way:

"...in the transaction-fixated Wall Street of recent years, our posture must seem odd: To many in that arena, both companies and stocks are seen only as raw material for trades.

Our attitude, however, fits our personalities and the way we want to live our lives. Churchill once said, 'You shape your houses and then they shape you.' We know the manner in which we wish to be shaped. For that reason, we would rather achieve a return of X while associating with people whom we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones."

Similarly, Charlie Munger once said the following:

"...Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we've turned that quirk into a positive outcome for ourselves."

It's not always about maximizing returns.

There's nothing wrong with embracing what's a bit unconventional when comfortable with the reasons why. On the other hand, simply being different for different's sake might prove expensive or, at the very least, a distraction.

The kind of portfolio concentration practiced by Berkshire, for example, is certainly not for everyone.

More from the Berkshire letter:

"We really don't see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings such as these. In each case we try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price."

The need for a huge discount to intrinsic value is more a bonus than a necessity for the highest quality businesses.

In other words, the margin of safety that's required -- while still crucial -- can be at least somewhat reduced when an enterprise has a tough to dislodge competitive position and sound long run core economics.


Long position in BRKb established at much lower than recent market prices

* The views of Warren Buffett and Charlie Munger on diversification was covered to an extent in the previous post. Berkshire's
 equity portfolio remains concentrated in its top positions but, due to the company's current size and breadth (including the controlled businesses), it is necessarily rather more diversified overall these days.
** See Table V of a study with the title "Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway".
*** One of the three common stocks mentioned is now a Berkshire controlled business (GEICO). As for the other two stocks: Capital Cities/ABC, Inc. was acquired by Disney (DIS) back in the 1990s, while The Washington Post Company has become Graham Holdings (GHC) with Berkshire reducing its stake last year after decades of ownership. Inevitably, no matter how long the intended holding period happens to be, corporate actions, changes to the competitive landscape, and other events will end up having an impact on the actual holding period. 
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, July 7, 2015

Portfolio Diversification: What's the Right Amount?

Portfolio diversification, something I briefly covered toward the end of this recent post, is an investment topic that necessarily leads to a wide array of opinions.

At the 2014 Daily Journal (DJCO) shareholder meeting, Charlie Munger explained that his investments are primarily invested in Berkshire Hathaway (BRKa), Costco (COST), and one other fund. He then added:*

Now, you could go to the rest of finance, they think they know how to handle money, and they'd say it's totally unthinkable, Munger doesn't know what the hell he's doing. Doesn't fit our models. But I'm right and they're wrong.

If you're shrewd enough to choose well, three holdings – any one of which would support your family in perpetuity — is enough security.


The people who make these crazy decisions don't actually have envy: what they have is clients who will fire them if they don't get the same results as everybody else. That is a crazy system. Everybody gets on the same merry-go-round.

Munger has offered a similar view on prior occasions and there's, to say the least, much to be learned from it. Yet, while this certainly makes sense for someone with his investing background and abilities, it hardly means such a concentrated portfolio is a brilliant way to go for everyone. The appropriate amount of diversification will be specific to an investor's capabilities and situation.

It'd likely prove a big mistake to think otherwise.

Consider that Munger also once said:

"Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund."

The question of whether it makes sense to own individual stocks at all first needs to be answered. After that question is answered, those who do decide they're comfortable picking stocks may, unlike Charlie Munger, still prefer to own more than just a few.
(Though it's generally unwise to be risking funds on a 50th best idea when those funds could, instead, be put into a top idea.)

So it's very much an individualized decision, and that decision must always be made in the context of the price environment.

More from the Daily Journal meeting:

...the consultants and investment bankers keep selling the same nostrum that you can save yourself by paying thirty times earnings for the kind of business you wish you had, instead of the one you've got.

It wasn't all that difficult to find stocks selling for huge discounts to intrinsic value four to six years ago or so.

That's far from the case now.

When shares get cheap enough (i.e. price nicely lower than intrinsic value per share offering substantial margin of safety) it's easier to accumulate lots of what you like.

In contrast, a concentrated portfolio of stocks bought at premium prices is, in the long run, just asking for trouble. Consistent correctness in such a situation is whole lot easier in theory than in the real world.

It's worth noting what initially appears to be a premium valuation at times proves to be otherwise. Sometimes, what's richly valued turns out to be worth it and then some. Figuring this out, in a reliable way, beforehand without making big mistakes and incurring big losses that mostly offset other gains -- or, maybe, more than offset other gains -- is, of course, the tough part.

In other words, the range of outcomes quickly become unacceptably wide and there's too much downside if things don't go as expected.

The avoidance of permanent capital loss is paramount. Well, paying a big premium for a stock with the hope that optimistic assumptions about the future come to fruition isn't really compatible with portfolio concentration.

The same goes for investor overconfidence.

Overconfidence combined with a concentrated portfolio -- or, for that matter, any portfolio -- is an investment disaster in the making.

A healthy dose of doubt and careful consideration of possible misjudgments can serve the investor well.

The price paid should always protect against disappointments and mistakes.

Munger was asked later at the same meeting what he viewed as the right number of companies in a portfolio. His answer was simple:

I don't think there's any one answer to that.

The right number of stocks to own is necessarily not one size fits all.

The fact is many over the long run will end up better off investing in low-cost index funds -- and this doesn't just apply to inexperienced individual investors, it also can apply to, in enough cases to matter, very able and experienced market participants** -- while avoiding leverage, the temptation to trade excessively, and needless frictional costs.

That's difficult enough to do well if for no other reason that fear, greed, and other behavioral factors come into play in a way that too often leads to inopportune buy/sell decisions and, ultimately, adverse investing outcomes.

Some will focus on the analytical challenge that's in front of them but underestimate the temperamental/emotional discipline that's required.

Buffett, also one who generally prefers portfolio concentration when possible, said the following in his most recent letter:

"Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."

Essentially, in Buffett's own investing approach, he has a preference for less diversification, but is well aware that "inadequate diversification" can get an investor in trouble. From the 1993 letter:

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you."

A very concentrated equity portfolio works just fine for some.

A diversified low-cost index fund -- accumulated over time but otherwise traded minimally -- works just fine for many.***

Portfolio concentration can work under the right circumstances but it's hardly for everyone.

Figuring out the "right circumstances" requires -- among many other things -- careful consideration of one's own temperament, aptitude, limitations, and resources.

Those who choose to concentrate their portfolio without the requisite proficiency are likely to make substantial and costly mistakes.

Deciding on the appropriate amount of diversification isn't always easy to figure out.

It's best to act accordingly and give it the careful consideration it deserves.


Long position in BRKb established at much lower than recent market prices; no position in other stocks mentioned.

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Some seem willing to believe otherwise despite evidence that refutes it. Naturally, there are some very capable investors with excellent track records but a whole bunch simply can't match their relevant benchmark index over the long haul.
*** Not necessarily a single fund. Some will consider multiple funds to be more appropriate.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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