| Arete Insights Q413.pdf |
Welcome
As an equity analyst, I normally prefer to focus the vast majority of my efforts on company-specific valuation and fundamental analyses because that is typically what delivers the best results for clients. When things aren't normal, though, I adapt to whatever activities will produce the best returns for clients. Given Arete's long-term investment horizon, it is hard for me to conclude right now that anything is more important than understanding the credit system and the nature of money.
This may seem like more than a modest digression for a person trained in equities research, but there are some fundamentally sound reasons why it is less of a stretch than it first appears. First and foremost, I consider myself a steward of capital before any particular brand of analyst. As a result, I’m always going to be on the lookout for things that can especially help, or hurt, Arete’s clients.
In addition, I believe credit is poorly understood as a driver of stock prices. Stocks, like anything else, are driven by supply and demand. When more money and more credit are available, prices go up. This was especially true of housing in 2006 and is especially true of equities now.
The gentle but persistent effect of credit growth is much like a trailing wind when you are riding a bike. You don’t even really notice it when it is at your back. It just seems fun because it’s not very hard and you are going a little faster than usual. When you turn around, though, you get a surprise as to exactly how much help you were getting. If you aren’t careful, it can be really hard to get back with all of the extra energy you need to ride into the wind.
I’ve noted in the past that credit has provided a strong “trailing wind” for equities. More specifically, total credit in the U.S. (from the Fed’s Z.1 release) grew at 9.5% per year from 1964 to 2007. During the same period, income (nominal GDP) only grew a little over 7% per year. When we turn around, it’s going to feel a lot different than it has for the last few decades.
This basic message is illustrated much more comprehensively by Chris Martenson in his "Crash course" webcast series at www.peakprosperity.com. According to Martenson, the accumulation of debt at a much faster pace than income over the last 30 years is unsustainable and will lead to a major "reset" in the financial system.
This reset will create an environment extremely different from our recent past. As government debt increases well beyond levels that are serviceable, it is quite likely that significant inflation will be used as a policy mechanism to reduce the real value of that debt. As this happens, massive amounts of wealth will be transferred from those who save cash to those who own real assets. Martenson sums up his outlook with the assessment that “the next twenty years are going to be very different than the last twenty years”.
Radical positions like Martenson’s can often be easily dismissed as the ramblings of a crank or a crackpot. In the case of Martenson, however, he makes such a spectacularly lucid and reasoned case, it is hard to dismiss without serious consideration. Perhaps because of his academic training as a Ph.D. in toxicology, he intuitively understands how excessive debt can poison the financial system.
At very least, a future that is very different from our past will require very different planning. Certainly real assets will need to be considered as part of that plan and equities will likely play an important role too. Preserving wealth will be imperative.
As such, calibrating exposure to stocks is likely to be an ongoing challenge. While it would be easy and probably more profitable, at least in the short-term, to keep my head down by just researching stocks and ignoring the implications of a major credit disruption, I can’t in good conscience say this is the best thing for Arete’s clients. The stock market has been riding a long time with the wind at it’s back. Arete continues to serve as an antidote to the silliness that pretends otherwise.
Best regards,
David Robertson, CFA
CEO, Portfolio Manager
As an equity analyst, I normally prefer to focus the vast majority of my efforts on company-specific valuation and fundamental analyses because that is typically what delivers the best results for clients. When things aren't normal, though, I adapt to whatever activities will produce the best returns for clients. Given Arete's long-term investment horizon, it is hard for me to conclude right now that anything is more important than understanding the credit system and the nature of money.
This may seem like more than a modest digression for a person trained in equities research, but there are some fundamentally sound reasons why it is less of a stretch than it first appears. First and foremost, I consider myself a steward of capital before any particular brand of analyst. As a result, I’m always going to be on the lookout for things that can especially help, or hurt, Arete’s clients.
In addition, I believe credit is poorly understood as a driver of stock prices. Stocks, like anything else, are driven by supply and demand. When more money and more credit are available, prices go up. This was especially true of housing in 2006 and is especially true of equities now.
The gentle but persistent effect of credit growth is much like a trailing wind when you are riding a bike. You don’t even really notice it when it is at your back. It just seems fun because it’s not very hard and you are going a little faster than usual. When you turn around, though, you get a surprise as to exactly how much help you were getting. If you aren’t careful, it can be really hard to get back with all of the extra energy you need to ride into the wind.
I’ve noted in the past that credit has provided a strong “trailing wind” for equities. More specifically, total credit in the U.S. (from the Fed’s Z.1 release) grew at 9.5% per year from 1964 to 2007. During the same period, income (nominal GDP) only grew a little over 7% per year. When we turn around, it’s going to feel a lot different than it has for the last few decades.
This basic message is illustrated much more comprehensively by Chris Martenson in his "Crash course" webcast series at www.peakprosperity.com. According to Martenson, the accumulation of debt at a much faster pace than income over the last 30 years is unsustainable and will lead to a major "reset" in the financial system.
This reset will create an environment extremely different from our recent past. As government debt increases well beyond levels that are serviceable, it is quite likely that significant inflation will be used as a policy mechanism to reduce the real value of that debt. As this happens, massive amounts of wealth will be transferred from those who save cash to those who own real assets. Martenson sums up his outlook with the assessment that “the next twenty years are going to be very different than the last twenty years”.
Radical positions like Martenson’s can often be easily dismissed as the ramblings of a crank or a crackpot. In the case of Martenson, however, he makes such a spectacularly lucid and reasoned case, it is hard to dismiss without serious consideration. Perhaps because of his academic training as a Ph.D. in toxicology, he intuitively understands how excessive debt can poison the financial system.
At very least, a future that is very different from our past will require very different planning. Certainly real assets will need to be considered as part of that plan and equities will likely play an important role too. Preserving wealth will be imperative.
As such, calibrating exposure to stocks is likely to be an ongoing challenge. While it would be easy and probably more profitable, at least in the short-term, to keep my head down by just researching stocks and ignoring the implications of a major credit disruption, I can’t in good conscience say this is the best thing for Arete’s clients. The stock market has been riding a long time with the wind at it’s back. Arete continues to serve as an antidote to the silliness that pretends otherwise.
Best regards,
David Robertson, CFA
CEO, Portfolio Manager
Insider’s View
For better and worse, the remarkable growth of most asset prices over the past thirty years has also had a powerful influence on investment service providers. Driven by demographics, rapid credit growth, and strong asset returns, each part of the services eco-system has adapted business models, services offerings, and revenue structures that thrive in this environment.
A natural consequence has been that many providers are essentially designed to ride the "wave" of capital markets growth. One manifestation of this condition is that an unusually large proportion of providers base revenues on assets under management (in order to benefit disproportionately from attractive equity returns) regardless of economic logic for doing so. Another manifestation is that there are lots of undifferentiated offerings. Indeed, offerings that are truly different can stand out in an awkwardly undesirable way.
Such unchecked growth and uniformity has its downside, though. Anything that thrives in one very narrowly defined environment almost by definition is not well suited to a very different environment. Indeed it’s not surprising, as John Kay recently noted in the Financial Times that, "The established firm more often responds by using its market and political power to resist change."
It’s not unfair to hypothesize that in the event of a significant change in the investment environment, most incumbent firms will actually be handicapped by their past success. "We are all reluctant bulls now, say fund managers" is a recent Financial Times headline that speaks volumes about the resistance of many money management practices to change. According to the article, "Summing up the research, BofA says investors are 'like a bull in the headlights', unable to move from a potentially dangerous situation."
If it is accepted that the investment environment is likely to change materially at some point, long-term investors will care less about whether that change happens over a few years or whether it happens tomorrow. The important thing to know is that almost all the old rules of thumb and old business practices will be wrong.
This presents yet another challenge, and opportunity, for investors. Not only must special consideration be given to one’s portfolio construction, but also to one’s service providers. Among these, who can handle a major market disruption? Who is working to create new and better solutions as opposed to resisting change? Who can help you navigate the complex investment landscape?
It is hard to understand how a permanently bullish perspective serves clients’ long term interests, although it is likely to help grow revenues for many firms. In a competitive landscape muddled by such self-serving and counterproductive blather, it will be useful to search for new and fresher sources of help. The alternative is to wax nostalgic and hope things don’t change.
For better and worse, the remarkable growth of most asset prices over the past thirty years has also had a powerful influence on investment service providers. Driven by demographics, rapid credit growth, and strong asset returns, each part of the services eco-system has adapted business models, services offerings, and revenue structures that thrive in this environment.
A natural consequence has been that many providers are essentially designed to ride the "wave" of capital markets growth. One manifestation of this condition is that an unusually large proportion of providers base revenues on assets under management (in order to benefit disproportionately from attractive equity returns) regardless of economic logic for doing so. Another manifestation is that there are lots of undifferentiated offerings. Indeed, offerings that are truly different can stand out in an awkwardly undesirable way.
Such unchecked growth and uniformity has its downside, though. Anything that thrives in one very narrowly defined environment almost by definition is not well suited to a very different environment. Indeed it’s not surprising, as John Kay recently noted in the Financial Times that, "The established firm more often responds by using its market and political power to resist change."
It’s not unfair to hypothesize that in the event of a significant change in the investment environment, most incumbent firms will actually be handicapped by their past success. "We are all reluctant bulls now, say fund managers" is a recent Financial Times headline that speaks volumes about the resistance of many money management practices to change. According to the article, "Summing up the research, BofA says investors are 'like a bull in the headlights', unable to move from a potentially dangerous situation."
If it is accepted that the investment environment is likely to change materially at some point, long-term investors will care less about whether that change happens over a few years or whether it happens tomorrow. The important thing to know is that almost all the old rules of thumb and old business practices will be wrong.
This presents yet another challenge, and opportunity, for investors. Not only must special consideration be given to one’s portfolio construction, but also to one’s service providers. Among these, who can handle a major market disruption? Who is working to create new and better solutions as opposed to resisting change? Who can help you navigate the complex investment landscape?
It is hard to understand how a permanently bullish perspective serves clients’ long term interests, although it is likely to help grow revenues for many firms. In a competitive landscape muddled by such self-serving and counterproductive blather, it will be useful to search for new and fresher sources of help. The alternative is to wax nostalgic and hope things don’t change.
Insights
“It’s a tough old world out there, not least for institutional asset owners. Complexity and volatility combined with a low-return environment are forcing asset owners to reconsider their traditional ways of managing investments. It’s a situation that has been a long time building.” This was the message delivered in the article “Outsourcing hits its stride” from a recent Pensions & Investments supplement. As the process of investing is becoming progressively more difficult, more and more organizations are looking for help with some or all of the various functions.
While this message rings true for many individuals and small institutions, those looking for help through outsourcing extend into much large organizations. “More sophisticated, larger clients are looking at outsourcing because the process of managing complex investment portfolios has become much harder,” says Russell’s Macy. “Markets are volatile and dynamic. Decisions cannot be made at quarterly meetings. It’s a real-time job. So even clients with $1 billion or $2 billion portfolios are looking outside for expertise.” The challenges are affecting everyone.
Given the economies of scale in the investment management industry, many of the most sophisticated approaches are only implemented at the very largest funds. The good news for smaller funds, though, is that these approaches offer roadmaps to best practices and improvement. Further, with rapid and ongoing improvements in both technology and knowledge management, such best practices often don’t have to take long to become much more broadly accessible to individuals and small institutions.
The providers that are most naturally positioned to deliver outsourced investment services are investment consultants and money managers because the strengths of both groups overlap naturally with many of the demands for outsourcing. Both groups have weaknesses as well, though.
“Many consultants saw outsourcing as a good business opportunity,” says Russell’s Macy. “Many have 30 years experience of giving investment advice to asset owners – plan sponsors, endowments – but just three years of implementation experience. This presents huge challenges. Money managers on the other hand are really good at money management, but do they have the experience of mapping out long-term strategic advice for clients? Not a lot of firms are equally strong in both areas.”
The question of whether or not one should consider outsourcing depends on a couple of factors. Most fundamentally, owners should ask, “Are our current arrangements fit for purpose in today’s financial market environment? And further, can we move fast enough to take advantage of short-term investing opportunities and to stem a tide of losses?” In short, the volatile and fragile nature of today’s markets often demands a fresher and more robust approach.
In addition, asset owners should determine which skills and expertise they need most. Outsourcing can span a wide array of activities including evaluating vendors, reviewing investment policy, assessing asset allocation, as well as educating and training fiduciaries about the financial markets.
The really good news in all of this for investors is that outsourcing is one area in which the investment industry seems to be changing for the better – because it focuses on outcomes. Very specific and narrowly defined service offerings are likely to have a shrinking role in a very complicated environment challenged by limited return opportunities. Conversely, service providers that can forgo a narrow focus on returns and actually help investors achieve desirable outcomes are likely to become ever more important.
“It’s a tough old world out there, not least for institutional asset owners. Complexity and volatility combined with a low-return environment are forcing asset owners to reconsider their traditional ways of managing investments. It’s a situation that has been a long time building.” This was the message delivered in the article “Outsourcing hits its stride” from a recent Pensions & Investments supplement. As the process of investing is becoming progressively more difficult, more and more organizations are looking for help with some or all of the various functions.
While this message rings true for many individuals and small institutions, those looking for help through outsourcing extend into much large organizations. “More sophisticated, larger clients are looking at outsourcing because the process of managing complex investment portfolios has become much harder,” says Russell’s Macy. “Markets are volatile and dynamic. Decisions cannot be made at quarterly meetings. It’s a real-time job. So even clients with $1 billion or $2 billion portfolios are looking outside for expertise.” The challenges are affecting everyone.
Given the economies of scale in the investment management industry, many of the most sophisticated approaches are only implemented at the very largest funds. The good news for smaller funds, though, is that these approaches offer roadmaps to best practices and improvement. Further, with rapid and ongoing improvements in both technology and knowledge management, such best practices often don’t have to take long to become much more broadly accessible to individuals and small institutions.
The providers that are most naturally positioned to deliver outsourced investment services are investment consultants and money managers because the strengths of both groups overlap naturally with many of the demands for outsourcing. Both groups have weaknesses as well, though.
“Many consultants saw outsourcing as a good business opportunity,” says Russell’s Macy. “Many have 30 years experience of giving investment advice to asset owners – plan sponsors, endowments – but just three years of implementation experience. This presents huge challenges. Money managers on the other hand are really good at money management, but do they have the experience of mapping out long-term strategic advice for clients? Not a lot of firms are equally strong in both areas.”
The question of whether or not one should consider outsourcing depends on a couple of factors. Most fundamentally, owners should ask, “Are our current arrangements fit for purpose in today’s financial market environment? And further, can we move fast enough to take advantage of short-term investing opportunities and to stem a tide of losses?” In short, the volatile and fragile nature of today’s markets often demands a fresher and more robust approach.
In addition, asset owners should determine which skills and expertise they need most. Outsourcing can span a wide array of activities including evaluating vendors, reviewing investment policy, assessing asset allocation, as well as educating and training fiduciaries about the financial markets.
The really good news in all of this for investors is that outsourcing is one area in which the investment industry seems to be changing for the better – because it focuses on outcomes. Very specific and narrowly defined service offerings are likely to have a shrinking role in a very complicated environment challenged by limited return opportunities. Conversely, service providers that can forgo a narrow focus on returns and actually help investors achieve desirable outcomes are likely to become ever more important.
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