| Arete Insights Q411 |
Welcome
“Greece Schmeece” I can almost hear people say as they roll their eyes. “What does it matter to us?”
I certainly empathize with this view. Sometimes the news coming out of Europe seems like a soap opera that never ends. While it can certainly be tiresome and tempting to dismiss, it really is important for us to watch.
The reason Europe matters so much (and Asia too, but let’s stay on one topic at a time) is because so many parts of its financial system and economy are interconnected with those in the US. Just like a group of mountain climbers that are tied together by a rope, if one climber falls, the adjoining climbers will certainly feel the pressure of the additional weight.
In normal conditions, this may be just fine. The fallen climber can be supported temporarily by his fellow climbers until he regains his hold. In adverse conditions, however, the fellow climbers may not be able to maintain support. They also may eventually succumb to the additional weight and lose their grip. When they fall, it can precipitate a cascade whereby everyone falls.
The technical term for this type of situation is “tight coupling.” When components have close causal relationships and propogate shocks very quickly to other components, a system is tightly coupled. The mountain climbers are tied together so as soon as one falls, the adjacent climbers feel the effect immediately. There are a lot of other examples of tight coupling such as just-in-time (JIT) manufacturing, and the global financial system.
In very broad terms then, Greece is the fallen climber. They will not be able to repay all of their government debt. Since many banks across Europe hold Greek debt, they will need to write it down. Since many of these banks are undercapitalized, they will need to find a way to raise capital in a very difficult environment. In many cases this will likely lead to reduced lending. Since banks provide a much larger share of funding in Europe than in the US, this is likely to create a significant impediment to growth there. Lower growth will mean yet more bad loans for banks to absorb. US companies that do business in Europe or that borrow from European banks will be affected. In short, this all matters to US markets.
It shouldn’t be any surprise that tight coupling is a situation to be managed very carefully. Rick Bookstaber, author of Demons of our own Design, goes so far as to attribute one of the primary causes of the 2008 financial crisis to tight coupling. Tight coupling contributed because there were close causal relationships between many components of the financial system. This was exacerbated by complexity because the vast array of interconnections were too numerous and diverse to manage or control.
An extremely important step in any risk management effort is recognizing when you are dealing with a complex, tightly coupled system. When these conditions exist, which they unfortunately still do, the system remains especially vulnerable to significant disruption. In other words, things have the potential to get bad quickly.
Bookstaber describes a common mistake, “It might be reasonable to consider crises as hundred year flood events if we mistakenly treated them as being drawn from the same distribution as those normal market days. But they are not.” In other words, it is appropriate to treat crises as conditional probabilities. They don’t happen that often, but they are far more likely when certain, identifiable conditions exist.
Another important step in risk management is simply to avoid areas of heightened risk. An important aspect of avoidance is nothing more than having the will to do so. In his blog article, “Common Sense Crisis Risk Management,” Bookstaber acknowledges the challenge for managers: “It is not hard to take steps to protect against a crisis . . . [but] it is exactly the opposite of what makes money as the market is building into a crisis.”
One of the things that drives me crazy is when I hear investment advisors who are dismissive of risk. I don’t particularly care if they don’t know, don’t see it, are not even bothering to look, or see it but lie about it. The end result is that investors can get hurt. I don’t expect anyone to be perfect, but I do expect them to try to provide a clear assessment of the investment landscape.
Anyone who knows me knows that I don’t have any aversion to adverse conditions. I am perfectly happy to gear up and walk through rain, wind, snow, whatever. I have even been accused of enjoying it. Where I draw the line though is when conditions present a real danger to safety. Whether it is a lightning storm in the Grand Tetons or a white-out in a snow-bound pass in Glacier National Park, when I see dangerous conditions, I turn around.
I take the same approach to managing risk in the Arete Mid Cap Core strategy. I spend a lot of time to scan the investment environment and to identify relevant risks. Arete is very well positioned to provide “weather forecasts” and to communicate closely with investors in ways that they are extremely unlikely to find at larger competitors. If you have questions or would like to follow up with anything I address, please always feel free to call or email.
Best regards,
David Robertson, CFA
CEO, Portfolio Manager
“Greece Schmeece” I can almost hear people say as they roll their eyes. “What does it matter to us?”
I certainly empathize with this view. Sometimes the news coming out of Europe seems like a soap opera that never ends. While it can certainly be tiresome and tempting to dismiss, it really is important for us to watch.
The reason Europe matters so much (and Asia too, but let’s stay on one topic at a time) is because so many parts of its financial system and economy are interconnected with those in the US. Just like a group of mountain climbers that are tied together by a rope, if one climber falls, the adjoining climbers will certainly feel the pressure of the additional weight.
In normal conditions, this may be just fine. The fallen climber can be supported temporarily by his fellow climbers until he regains his hold. In adverse conditions, however, the fellow climbers may not be able to maintain support. They also may eventually succumb to the additional weight and lose their grip. When they fall, it can precipitate a cascade whereby everyone falls.
The technical term for this type of situation is “tight coupling.” When components have close causal relationships and propogate shocks very quickly to other components, a system is tightly coupled. The mountain climbers are tied together so as soon as one falls, the adjacent climbers feel the effect immediately. There are a lot of other examples of tight coupling such as just-in-time (JIT) manufacturing, and the global financial system.
In very broad terms then, Greece is the fallen climber. They will not be able to repay all of their government debt. Since many banks across Europe hold Greek debt, they will need to write it down. Since many of these banks are undercapitalized, they will need to find a way to raise capital in a very difficult environment. In many cases this will likely lead to reduced lending. Since banks provide a much larger share of funding in Europe than in the US, this is likely to create a significant impediment to growth there. Lower growth will mean yet more bad loans for banks to absorb. US companies that do business in Europe or that borrow from European banks will be affected. In short, this all matters to US markets.
It shouldn’t be any surprise that tight coupling is a situation to be managed very carefully. Rick Bookstaber, author of Demons of our own Design, goes so far as to attribute one of the primary causes of the 2008 financial crisis to tight coupling. Tight coupling contributed because there were close causal relationships between many components of the financial system. This was exacerbated by complexity because the vast array of interconnections were too numerous and diverse to manage or control.
An extremely important step in any risk management effort is recognizing when you are dealing with a complex, tightly coupled system. When these conditions exist, which they unfortunately still do, the system remains especially vulnerable to significant disruption. In other words, things have the potential to get bad quickly.
Bookstaber describes a common mistake, “It might be reasonable to consider crises as hundred year flood events if we mistakenly treated them as being drawn from the same distribution as those normal market days. But they are not.” In other words, it is appropriate to treat crises as conditional probabilities. They don’t happen that often, but they are far more likely when certain, identifiable conditions exist.
Another important step in risk management is simply to avoid areas of heightened risk. An important aspect of avoidance is nothing more than having the will to do so. In his blog article, “Common Sense Crisis Risk Management,” Bookstaber acknowledges the challenge for managers: “It is not hard to take steps to protect against a crisis . . . [but] it is exactly the opposite of what makes money as the market is building into a crisis.”
One of the things that drives me crazy is when I hear investment advisors who are dismissive of risk. I don’t particularly care if they don’t know, don’t see it, are not even bothering to look, or see it but lie about it. The end result is that investors can get hurt. I don’t expect anyone to be perfect, but I do expect them to try to provide a clear assessment of the investment landscape.
Anyone who knows me knows that I don’t have any aversion to adverse conditions. I am perfectly happy to gear up and walk through rain, wind, snow, whatever. I have even been accused of enjoying it. Where I draw the line though is when conditions present a real danger to safety. Whether it is a lightning storm in the Grand Tetons or a white-out in a snow-bound pass in Glacier National Park, when I see dangerous conditions, I turn around.
I take the same approach to managing risk in the Arete Mid Cap Core strategy. I spend a lot of time to scan the investment environment and to identify relevant risks. Arete is very well positioned to provide “weather forecasts” and to communicate closely with investors in ways that they are extremely unlikely to find at larger competitors. If you have questions or would like to follow up with anything I address, please always feel free to call or email.
Best regards,
David Robertson, CFA
CEO, Portfolio Manager
Insights
The world of investing is largely a segregated one with the big institutional investors generally having access to better managers and lower fees than individual investors do. Individual investors have the same wants and needs from their investment services, but generally do not have the same resources to verify the quality of their services providers. Instead, individuals often resign themselves to selecting among whichever services are sold to them.
One of the most important characteristics that many large, well-managed institutional funds look for in money managers is a focus on “best ideas”. Large funds want the benefit of the pure expertise of their managers. When they hire active managers, they don’t want to pay up for a number of holdings that can be acquired cheaply through index funds.
A study from researchers Martijn Cremers and Antti Petajisto of the Yale School of Management corroborates the efficacy of this approach. After reviewing the performance of over two thousand mutual funds over a twenty-three year period, they found that a measure called Active Share was useful in predicting fund performance.
Active Share is defined as the “percentage of stock holdings in a manager’s portfolio that differ from the benchmark index” (Investopedia). The study concluded that funds with Active Share of 80% or higher beat their benchmark indexes by about 1.5% after fees.
In an important sense, this shouldn’t be surprising. After all, how can a fund significantly outperform an index unless it is significantly different from an index? Many skeptics point to the fact that most funds underperform their benchmarks as evidence that active management is a foolish endeavor.
The Active Share study suggests a more nuanced view: The more important indicator of performance is not that a fund is actively managed, but rather how a fund is actively managed. Funds that have an enormous overlap with benchmark holdings but have [higher] fees for active management must overcome significant headwinds in order to outperform.
Although portfolios with high Active Share have significant advantages, they also have drawbacks. The main one is that concentrated, “best ideas” portfolios can be volatile in the short-term. Impatient, short-term investors can easily be frustrated by this approach. More sophisticated investors, on the other hand, tend to have a long-term investment horizon and can take short-term volatility in stride. Further, they also understand that what matters most are fundamental underlying values — which can vary from market prices for significant periods of time.
At the end of the day, sophisticated investors are really just trying to get a good value from the fees they pay their money managers. They understand that Active Share is a good indicator that a manager is playing to win, to outperform. They also understand that there are a lot of other ways to make money in the business which don’t provide as much value to investors.
Since Arete’s strategy was borne from experiences in the large institutional market, its value proposition reflects the accumulation of knowledge and insight from the toughest critics. One of the highlights of that strategy is a relatively concentrated portfolio of “best ideas” that boasts an extremely high Active Share of 92.5%. These ideas are the product of intense fundamental research and modeling and represent the unique findings of the portfolio manager. We work hard to deliver the kind of value large, sophisticated investors expect.
The difference with Arete is that you get the same kind of service available with a $100,000 account that is normally only available for $10 or $100 million accounts. Wouldn’t it be nice to compete on a level playing field for a change?
The world of investing is largely a segregated one with the big institutional investors generally having access to better managers and lower fees than individual investors do. Individual investors have the same wants and needs from their investment services, but generally do not have the same resources to verify the quality of their services providers. Instead, individuals often resign themselves to selecting among whichever services are sold to them.
One of the most important characteristics that many large, well-managed institutional funds look for in money managers is a focus on “best ideas”. Large funds want the benefit of the pure expertise of their managers. When they hire active managers, they don’t want to pay up for a number of holdings that can be acquired cheaply through index funds.
A study from researchers Martijn Cremers and Antti Petajisto of the Yale School of Management corroborates the efficacy of this approach. After reviewing the performance of over two thousand mutual funds over a twenty-three year period, they found that a measure called Active Share was useful in predicting fund performance.
Active Share is defined as the “percentage of stock holdings in a manager’s portfolio that differ from the benchmark index” (Investopedia). The study concluded that funds with Active Share of 80% or higher beat their benchmark indexes by about 1.5% after fees.
In an important sense, this shouldn’t be surprising. After all, how can a fund significantly outperform an index unless it is significantly different from an index? Many skeptics point to the fact that most funds underperform their benchmarks as evidence that active management is a foolish endeavor.
The Active Share study suggests a more nuanced view: The more important indicator of performance is not that a fund is actively managed, but rather how a fund is actively managed. Funds that have an enormous overlap with benchmark holdings but have [higher] fees for active management must overcome significant headwinds in order to outperform.
Although portfolios with high Active Share have significant advantages, they also have drawbacks. The main one is that concentrated, “best ideas” portfolios can be volatile in the short-term. Impatient, short-term investors can easily be frustrated by this approach. More sophisticated investors, on the other hand, tend to have a long-term investment horizon and can take short-term volatility in stride. Further, they also understand that what matters most are fundamental underlying values — which can vary from market prices for significant periods of time.
At the end of the day, sophisticated investors are really just trying to get a good value from the fees they pay their money managers. They understand that Active Share is a good indicator that a manager is playing to win, to outperform. They also understand that there are a lot of other ways to make money in the business which don’t provide as much value to investors.
Since Arete’s strategy was borne from experiences in the large institutional market, its value proposition reflects the accumulation of knowledge and insight from the toughest critics. One of the highlights of that strategy is a relatively concentrated portfolio of “best ideas” that boasts an extremely high Active Share of 92.5%. These ideas are the product of intense fundamental research and modeling and represent the unique findings of the portfolio manager. We work hard to deliver the kind of value large, sophisticated investors expect.
The difference with Arete is that you get the same kind of service available with a $100,000 account that is normally only available for $10 or $100 million accounts. Wouldn’t it be nice to compete on a level playing field for a change?
Insider’s View
One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works. Another is to share with you some of the tips, tricks, and other tools we have incorporated into our work in order to demonstrate how we engage in our craft. In both cases, we hope to provide you some background and understanding so you can better evaluate the many investment services available.
Business involves tradeoffs and this is certainly true for investment management. In virtually any business, there are a number functions such as marketing, finance, and operations which are necessary to deliver the end product or service. In large companies, these departments often become functional silos. In smaller companies, these activities are often outsourced to external firms.
These organizational structures have the potential to provide benefits in the form of functional expertise and cost efficiency. Having good pieces doesn’t always make a great machine, however. When the parts are not well coordinated, friction arises, things slow down, and things can fall through the cracks. At worst, differing agendas can lead to internecine warfare. In all cases, quality can suffer.
We can cite many examples of the costs of poor coordination. We often see the benefit of a skilled portfolio manager eroded by high mutual fund marketing fees. Often legal agreements are written with the intent of unilaterally benefitting the lawyer’s client, without reference to the goal of a mutually beneficial relationship. Good intentions for stewardship can be undermined if insufficiently managed back office operations fail to provide timely and adequate disclosure.
Conversely, when every aspect of a business is consistent, the overall impact can be transcendent. One of the most illustrative cases is that of Steve Jobs and Apple. Through his vision and innovations, Apple’s iconic products have resonated with consumers in many important ways.
One of the hugely influential innovations Jobs brought to commercial products was the graphical user interface (GUI). It was notable in itself that Jobs created a step-function transformation in the way people interacted with computers. It is also notable that the motivation for the endeavor was a vision of what consumers wanted, but had not yet expressed. They didn’t know what was possible.
Another unique contribution of Jobs was the holistic vision he had for Apple. From the beginning he made sure that each aspect of a device was integrated with others. Software was integrated with hardware. He wanted devices to be simple to use, robust, and elegant. He even went so far as to ensure physical design, marketing and packaging were all reflective of this. The cumulative effect of this vision produced things that seemed to be of a higher order of quality than anything else.
The distinctive approach Jobs employed through Apple was artfully illustrated in a series of extremely successful commercials featuring Justin Long (personifying Apple) and John Hodgman (personifying PCs). The key point of the commercials was to highlight the differences in user experiences. Any user of PCs could relate to countless annoyances like setting up hardware, having software conflicts, having the computer freeze and having to reset, constantly defending against viruses, etc. It all seemed like work. It was easy to look with envy on Apple which was easy to use, was reliable, and was even fun.
While Arete makes no claim to rival the achievements of Apple, there are important similarities in the approaches to serving customers.
For one, Arete also has a vision of what customers (individual investors) want. In our case, it is not anything as innovative as the GUI, it is simply what the big institutions also want. They want good value from their service providers, they want security and transparency, and they want to know their manager is completely dedicated to working on their behalf. Arete is fairly unique in making all of these attributes available at such a low minimum investment.
Another similarity Arete has with Apple’s approach to serving customers is its holistic approach to investing. Arete works hard to ensure all of the elements of the investment business are thoroughly integrated and consistent with the company’s mission of functional excellence in money management. For example, while we take the same intense and active approach many hedge funds take to generating performance, we refuse to charge the high fees they do because it detracts from the benefit to our clients.
All of this goes to say that structure matters. There just aren’t many “Apples” in the money management world. That’s absolutely not to say that there aren’t a lot of really good, smart, well-intended people; there are. However, and it is a big however, what any individual advisor can do for you is significantly constrained by the structure and policies and practices of that advisor’s employing firm.
At the end of the day, most investors feel the same way about their investment programs as their computers; they just want them to work. If your investment program isn’t working, or if it requires too much attention, please let us know. You may be surprised how much value you can get.
One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works. Another is to share with you some of the tips, tricks, and other tools we have incorporated into our work in order to demonstrate how we engage in our craft. In both cases, we hope to provide you some background and understanding so you can better evaluate the many investment services available.
Business involves tradeoffs and this is certainly true for investment management. In virtually any business, there are a number functions such as marketing, finance, and operations which are necessary to deliver the end product or service. In large companies, these departments often become functional silos. In smaller companies, these activities are often outsourced to external firms.
These organizational structures have the potential to provide benefits in the form of functional expertise and cost efficiency. Having good pieces doesn’t always make a great machine, however. When the parts are not well coordinated, friction arises, things slow down, and things can fall through the cracks. At worst, differing agendas can lead to internecine warfare. In all cases, quality can suffer.
We can cite many examples of the costs of poor coordination. We often see the benefit of a skilled portfolio manager eroded by high mutual fund marketing fees. Often legal agreements are written with the intent of unilaterally benefitting the lawyer’s client, without reference to the goal of a mutually beneficial relationship. Good intentions for stewardship can be undermined if insufficiently managed back office operations fail to provide timely and adequate disclosure.
Conversely, when every aspect of a business is consistent, the overall impact can be transcendent. One of the most illustrative cases is that of Steve Jobs and Apple. Through his vision and innovations, Apple’s iconic products have resonated with consumers in many important ways.
One of the hugely influential innovations Jobs brought to commercial products was the graphical user interface (GUI). It was notable in itself that Jobs created a step-function transformation in the way people interacted with computers. It is also notable that the motivation for the endeavor was a vision of what consumers wanted, but had not yet expressed. They didn’t know what was possible.
Another unique contribution of Jobs was the holistic vision he had for Apple. From the beginning he made sure that each aspect of a device was integrated with others. Software was integrated with hardware. He wanted devices to be simple to use, robust, and elegant. He even went so far as to ensure physical design, marketing and packaging were all reflective of this. The cumulative effect of this vision produced things that seemed to be of a higher order of quality than anything else.
The distinctive approach Jobs employed through Apple was artfully illustrated in a series of extremely successful commercials featuring Justin Long (personifying Apple) and John Hodgman (personifying PCs). The key point of the commercials was to highlight the differences in user experiences. Any user of PCs could relate to countless annoyances like setting up hardware, having software conflicts, having the computer freeze and having to reset, constantly defending against viruses, etc. It all seemed like work. It was easy to look with envy on Apple which was easy to use, was reliable, and was even fun.
While Arete makes no claim to rival the achievements of Apple, there are important similarities in the approaches to serving customers.
For one, Arete also has a vision of what customers (individual investors) want. In our case, it is not anything as innovative as the GUI, it is simply what the big institutions also want. They want good value from their service providers, they want security and transparency, and they want to know their manager is completely dedicated to working on their behalf. Arete is fairly unique in making all of these attributes available at such a low minimum investment.
Another similarity Arete has with Apple’s approach to serving customers is its holistic approach to investing. Arete works hard to ensure all of the elements of the investment business are thoroughly integrated and consistent with the company’s mission of functional excellence in money management. For example, while we take the same intense and active approach many hedge funds take to generating performance, we refuse to charge the high fees they do because it detracts from the benefit to our clients.
All of this goes to say that structure matters. There just aren’t many “Apples” in the money management world. That’s absolutely not to say that there aren’t a lot of really good, smart, well-intended people; there are. However, and it is a big however, what any individual advisor can do for you is significantly constrained by the structure and policies and practices of that advisor’s employing firm.
At the end of the day, most investors feel the same way about their investment programs as their computers; they just want them to work. If your investment program isn’t working, or if it requires too much attention, please let us know. You may be surprised how much value you can get.
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