| Arete Quarterly Q412 |
Welcome
One of the neat things about the investment industry is that there are a lot of smart people who are constantly coming up with new ideas and perspectives. One of the fun things about running Arete is having the freedom to implement or incorporate many of these ideas well before they become more widely accepted.
A good example of a great idea comes from Michael Mauboussin in his new book, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. In it, he describes the futility of the widely accepted practice of focusing on past performance when evaluating investment managers. His recommendation, in short, is to focus on process, not outcome.
The logic behind this recommendation is powerful. Mauboussin explained to a recent audience for the Baltimore CFA Society, “Outliers exist due to extreme skill and extreme luck combined,” and continued, “where there is luck, there is reversion to the mean.” In the world of investment products, this means for certain periods the best performing funds can attribute much, and oftentimes all, of that success to luck. Luck, by definition, is not persistent (it is random) and therefore it is not predictive. As a result, performance makes a poor basis for evaluation.
The characteristic that is persistent and therefore can provide predictive value is investment process. This involves the regularity and repeatability of actions made to identify and purchase securities that are mispriced by the market. One of the best single indicators of robust process is active share. High active share (see Arete Insights Q4 11) indicates a high degree of conviction in holdings and is a uniquely effective way for a manager to leverage investment insights enough to overcome management costs and still outperform relevant benchmarks.
So the choice for investors evaluating managers really comes down to relying on the easily available performance numbers that have no useful predictive value, or to doing a little extra work and evaluating processes which do. Arete Mid Cap Core’s active share is greater than 90% which demonstrates clearly how truly distinct it is from the benchmark.
For investors who do decide to analyze active share, they will also find information content in the degree of transparency. Many firms don’t want you to know how much you are paying for a fund so similar to its benchmark. If it is hard or impossible to get active share information, you can safely assume the answers are not good.
Given the challenging landscape for investors and fiduciaries alike, it will become increasingly important to work with investment managers with strong processes and high incentives to serve their clients’ best interest. If you are looking for help now or are simply planning for the future, we would appreciate you keeping Arete in mind.
One of the neat things about the investment industry is that there are a lot of smart people who are constantly coming up with new ideas and perspectives. One of the fun things about running Arete is having the freedom to implement or incorporate many of these ideas well before they become more widely accepted.
A good example of a great idea comes from Michael Mauboussin in his new book, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. In it, he describes the futility of the widely accepted practice of focusing on past performance when evaluating investment managers. His recommendation, in short, is to focus on process, not outcome.
The logic behind this recommendation is powerful. Mauboussin explained to a recent audience for the Baltimore CFA Society, “Outliers exist due to extreme skill and extreme luck combined,” and continued, “where there is luck, there is reversion to the mean.” In the world of investment products, this means for certain periods the best performing funds can attribute much, and oftentimes all, of that success to luck. Luck, by definition, is not persistent (it is random) and therefore it is not predictive. As a result, performance makes a poor basis for evaluation.
The characteristic that is persistent and therefore can provide predictive value is investment process. This involves the regularity and repeatability of actions made to identify and purchase securities that are mispriced by the market. One of the best single indicators of robust process is active share. High active share (see Arete Insights Q4 11) indicates a high degree of conviction in holdings and is a uniquely effective way for a manager to leverage investment insights enough to overcome management costs and still outperform relevant benchmarks.
So the choice for investors evaluating managers really comes down to relying on the easily available performance numbers that have no useful predictive value, or to doing a little extra work and evaluating processes which do. Arete Mid Cap Core’s active share is greater than 90% which demonstrates clearly how truly distinct it is from the benchmark.
For investors who do decide to analyze active share, they will also find information content in the degree of transparency. Many firms don’t want you to know how much you are paying for a fund so similar to its benchmark. If it is hard or impossible to get active share information, you can safely assume the answers are not good.
Given the challenging landscape for investors and fiduciaries alike, it will become increasingly important to work with investment managers with strong processes and high incentives to serve their clients’ best interest. If you are looking for help now or are simply planning for the future, we would appreciate you keeping Arete in mind.
Business Update
A fascinating and rapidly developing trend is the vastly improving access to information. Despite technological advances breaking down many obstacles to access, there remain formidable barriers to the types of advice and information that actually make investors better off. There are some clear reasons why this happens: Conflicts of interest, organizational incentives, and industry structure can all serve as barriers to the efficient conversion of information and expertise into investor benefit.
This issue strikes close to home for me because every day I spend hours reading and analyzing research and news stories and have the overflowing files and bookshelves to prove it. This is the kind of work that most people simply don't have the time to do, the interest to pursue so aggressively, nor the expertise to fully absorb and exploit. It enables me to cut through much of the noise, to quickly differentiate the garbage from the useful, and to determine fruitful courses of action.
Certainly the result of much of this work goes into managing the Arete Mid Cap Core service. Unfortunately, for Arete, and I believe for many investors as well, much of this work and the expertise behind it goes largely unseen and unused.
Part of the challenge for Arete is an industry-wide issue. The issue is that investment expertise has been compartmentalized into relatively narrow silos. There are investment managers that research securities like stocks, there are consultants that apply asset risk and return studies, and there are a wide variety of advisors who apply sound financial practices to individual client situations.
These narrowly defined functional categories worked reasonably well during a period of economic calm, strongly appreciating markets, and little scrutiny on fees. In more difficult and uncertain times, however, this structure imposes an unwieldy layer of fees and perhaps even worse; it fragments investment expertise at a time when understanding the big picture is the most important.
Some of the larger and more successful hedge funds have been challenging the traditional fragmentation of industry expertise. Many have fused the management and allocation functions by combining multiple asset classes into flagship funds for some time.
That trend seems to be moving a step further now as recently reported in the September 17, 2012 issue of Pensions&Investments. The article, “Institutional investors turn to hedge fund managers for strategy, macro advice” noted that “Institutional investors desperately want knowledge transfer for the purpose of improving the asset allocation and returns of their whole portfolio." The thrust of the article was that there is a lot of investment expertise [here referring specifically to hedge funds] that can help investors to solve problems. I see this as a smart and healthy development and one that should be happening faster outside of the hedge fund community. While there is no doubt a great deal of talent in some hedge funds, there is also little doubt that part of this trend reflects an ulterior motive: The desire to retain very high fee structures.
I do believe this trend sheds light on an opportunity for me and Arete. I mentioned last quarter that I was experimenting with a knowledge database and I can happily announce that the AreteResearch site is up and running. Personally, I have found it to be a very useful way of assimilating and reviewing my own research. I hope it can also provide perspective and insights for other investors. I am still gathering feedback on it with the hope of commercializing it this year. If you are interested in gaining access, please let me know at [email protected].
Finally, this letter will be distributed on the fifth anniversary of the founding of Arete. I would like to take this opportunity to thank all of the investors in Arete for their support over the years. I say this because I mean it: It has been an honor to serve you. I would also like to thank Arete's many advocates who stay in touch, provide feedback, share ideas, and keep Arete in mind when they are looking for investment expertise. I really appreciate it and look forward to continuing to build on Arete's successes.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
A fascinating and rapidly developing trend is the vastly improving access to information. Despite technological advances breaking down many obstacles to access, there remain formidable barriers to the types of advice and information that actually make investors better off. There are some clear reasons why this happens: Conflicts of interest, organizational incentives, and industry structure can all serve as barriers to the efficient conversion of information and expertise into investor benefit.
This issue strikes close to home for me because every day I spend hours reading and analyzing research and news stories and have the overflowing files and bookshelves to prove it. This is the kind of work that most people simply don't have the time to do, the interest to pursue so aggressively, nor the expertise to fully absorb and exploit. It enables me to cut through much of the noise, to quickly differentiate the garbage from the useful, and to determine fruitful courses of action.
Certainly the result of much of this work goes into managing the Arete Mid Cap Core service. Unfortunately, for Arete, and I believe for many investors as well, much of this work and the expertise behind it goes largely unseen and unused.
Part of the challenge for Arete is an industry-wide issue. The issue is that investment expertise has been compartmentalized into relatively narrow silos. There are investment managers that research securities like stocks, there are consultants that apply asset risk and return studies, and there are a wide variety of advisors who apply sound financial practices to individual client situations.
These narrowly defined functional categories worked reasonably well during a period of economic calm, strongly appreciating markets, and little scrutiny on fees. In more difficult and uncertain times, however, this structure imposes an unwieldy layer of fees and perhaps even worse; it fragments investment expertise at a time when understanding the big picture is the most important.
Some of the larger and more successful hedge funds have been challenging the traditional fragmentation of industry expertise. Many have fused the management and allocation functions by combining multiple asset classes into flagship funds for some time.
That trend seems to be moving a step further now as recently reported in the September 17, 2012 issue of Pensions&Investments. The article, “Institutional investors turn to hedge fund managers for strategy, macro advice” noted that “Institutional investors desperately want knowledge transfer for the purpose of improving the asset allocation and returns of their whole portfolio." The thrust of the article was that there is a lot of investment expertise [here referring specifically to hedge funds] that can help investors to solve problems. I see this as a smart and healthy development and one that should be happening faster outside of the hedge fund community. While there is no doubt a great deal of talent in some hedge funds, there is also little doubt that part of this trend reflects an ulterior motive: The desire to retain very high fee structures.
I do believe this trend sheds light on an opportunity for me and Arete. I mentioned last quarter that I was experimenting with a knowledge database and I can happily announce that the AreteResearch site is up and running. Personally, I have found it to be a very useful way of assimilating and reviewing my own research. I hope it can also provide perspective and insights for other investors. I am still gathering feedback on it with the hope of commercializing it this year. If you are interested in gaining access, please let me know at [email protected].
Finally, this letter will be distributed on the fifth anniversary of the founding of Arete. I would like to take this opportunity to thank all of the investors in Arete for their support over the years. I say this because I mean it: It has been an honor to serve you. I would also like to thank Arete's many advocates who stay in touch, provide feedback, share ideas, and keep Arete in mind when they are looking for investment expertise. I really appreciate it and look forward to continuing to build on Arete's successes.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
Market returns for 2012 were far better than we ever expected in light of still- significant underlying risks. As a result, we believe the investment landscape continues to merit caution. The risks have been exemplified by the “fiscal cliff” debate which we have all heard too much about. Nonetheless, we believe the “fiscal cliff” debate provides a useful opportunity to frame what is really going on.
We have mentioned this several times in the past, but it always bears keeping in mind: The huge problem we are facing, and will continue to face, is massive global deleveraging. This is the big picture. This is the single most important factor in the investment landscape and will be for years.
The ultimate result of such significant deleveraging is that much of the debt simply will not get paid back. This will create some irreversible holes in balance sheets and will wipe out a fair amount of equity. One way or another, what it means for investors is that we have less than we think we do.
In its raw form, this is an extremely unpalatable and politically incorrect, though still inevitable, consequence. As a result, it suggests two challenges for politicians. First, the electorate must be diverted from close scrutiny of the main problem by creating dramatic and entertaining distractions. The fiscal cliff debate was a good example. There will be plenty more to come.
Second, any serious effort on tackling the main problem must be done in small, digestible, chunks and slowly enough such that anger over the situation can diffuse rather than foment. This is akin to boiling a frog. Increase the heat gently enough and he’ll never know.
Another manifestation of this playbook has been occurring with unemployment. The visibility of this particular statistic was increased when the Fed specifically linked further policy action to it in December.
The reported number for unemployment, the one that people read in papers and hear on the news, was 7.8%. It is still a little higher than the 7.3% reported in December 2008, but it is down from its peak of 10.0%.
Superficially it sounds decent and gives the impression progress is being made. This holds true only until you dig just a little deeper. As it turns out, the number that really matters to the economy (and to us individually!) is the number of jobs. That number was 143.305 million in December 2012 and 143.369 million in December 2008. In other words, the number of people working is almost exactly the same. No new jobs over four years.
Further, the number of people unemployed has actually increased from 11.286 million to 12.206 million. This brief analysis reveals that the labor market has gone nowhere and that the only reason the unemployment rate is anywhere close to where it is today is because a lot of people are no longer even looking for jobs because they have become discouraged by their meager prospects.
In order to truly appreciate the impact of the employment condition (on the economy and on individuals), however, it helps to know that the average number of people on food stamps increased from 28.2 million in 2008 to an average of 46.6 million in 2012. Given the much uglier reality, it is quite clear why government authorities have focused attention on headline unemployment instead.
The extremely important lesson in all of this is that it is imperative that investors be fully aware of these efforts at misdirection and misinformation. Those who aren’t aware of the misinformation, or can’t see the big picture, or don’t act on the core trends will be the suckers at the poker table as wealth gets reallocated.
To better appreciate the challenge, it is important to understand that with the prospects for slower economic growth and the burden of too much debt, the nature of competition within society fundamentally changes. When things are growing nicely, everyone's share of the pie increases. A rising tide lifts all boats.
When growth slows or stops, the only way to get ahead is to take shares of pie from others. The end result is that competition gets nastier. Those who are too busy or too oblivious, or who quietly acquiesce, will lose out in this competition. Being passive is likely to carry increasing risks.
With this broad overview of the market and the political environment, we can now try to make sense out of the Fed's actions and what it implies for investors. For starters, it is quite clear that the Fed is “all-in”. This means it is going to do whatever it can to fight deflation which means it is also expressly trying to increase the price of risk assets. With such a formidable player as the Fed pushing for higher asset prices, why would anyone want to resist?
While we certainly do not predict an imminent collapse in asset prices, we do believe the market is fragile and therefore vulnerable to unexpected shocks. As a result, we have a much more nuanced and measured view towards investment opportunities.
We substantiate our caution by highlighting an example from very recent history. We just need to go back to the mid-2000s to see that that the Fed completely missed the housing bubble and as a result, completely failed to take any action to prevent significant losses. Arguably, monetary policy was kept too loose for too long which facilitated the inflation of the bubble.
This policy error was exceptionally costly to many people because for most, their home is their biggest asset. This assessment is not meant to be exceptionally critical of the Fed, but is merely intended to emphasize the evidence that the Fed is neither omniscient nor omnipotent. Further, when mistakes are made, it is investors who are left holding the bag and therefore it is investors who bear the burden of managing the risks implicit in such policies.
The limits of knowledge have also been explicitly voiced by the Fed’s own Jeffrey Lacker, president of the Federal Reserve Bank of Richmond. He admits, “We’re at the limits of our understanding of how monetary policy affects the economy.” As a result, while we have greater clarity regarding the intentions of the Fed, we have less clarity regarding the ultimate impact of such extraordinary and experimental monetary policy.
The immediate and substantial problem that central banks have addressed is financial system liquidity. As a result, we don’t need to worry too much about a 2008-type financial crisis repeating soon.
U.S. banks are in far better shape and some of the key risks of the private sector are now being assumed by the public sector.
Herein lies the rub. While there is less risk of a Lehman Brothers-type private sector crisis, there is increasing risk of a public sector crisis. As such, we judge that there is still a very high, and arguably growing, amount of systemic risk in the markets.
Risk itself is not a bad thing, and in fact, it is what investors get paid to accept. What they get paid is increasingly our concern. While we cannot predict the path of the economy, we do know that the economic cycle will turn down at some time and that the current expansion is already longer than usual. We also know that despite this, major market indexes are reaching five year highs. When the economy does turn down, there will be little left for the Fed to do to ease the pain. As a result, our analysis shows that investors are getting paid very little right now to take on ever-greater risks.
The Fed’s “all-in” strategy may work, but we take our duty as fiduciaries very seriously and we cannot justify betting the ranch on risk assets amid current conditions. Not only would we deem such action imprudent, but in doing so, we would also forsake our responsibility to allocate capital responsibly and in a disciplined way. At the end of the day, that is what we are hired to do.
It is too bad current market valuations are so stretched because our longer-term outlook for stocks is still positive. We still absolutely believe in the fundamental ability of U.S. companies to adapt and innovate and grow. We also know that after thirty years of declining interest rates and with the distinct prospect of future inflation, bonds are likely to be horrible investments over the next three decades. Finally, in a low return environment with a wide range of potential outcomes, there will be a significant premium for effective active management to hunt down attractive investments at good prices.
We're not the only ones who think this way. Warren Buffett has said as much and two premier bond firms, PIMCO and DoubleLine, have both indicated significant moves into equities recently.
During the interim, however, we will continue doing our primary job of allocating assets thoughtfully and prudently on behalf of our investors. We will continue watching for evidence that the market mechanism is functioning better. As we find exceptionally attractive individual stocks and windows of opportunity, we will have a lot of dry powder to put to work.
Market returns for 2012 were far better than we ever expected in light of still- significant underlying risks. As a result, we believe the investment landscape continues to merit caution. The risks have been exemplified by the “fiscal cliff” debate which we have all heard too much about. Nonetheless, we believe the “fiscal cliff” debate provides a useful opportunity to frame what is really going on.
We have mentioned this several times in the past, but it always bears keeping in mind: The huge problem we are facing, and will continue to face, is massive global deleveraging. This is the big picture. This is the single most important factor in the investment landscape and will be for years.
The ultimate result of such significant deleveraging is that much of the debt simply will not get paid back. This will create some irreversible holes in balance sheets and will wipe out a fair amount of equity. One way or another, what it means for investors is that we have less than we think we do.
In its raw form, this is an extremely unpalatable and politically incorrect, though still inevitable, consequence. As a result, it suggests two challenges for politicians. First, the electorate must be diverted from close scrutiny of the main problem by creating dramatic and entertaining distractions. The fiscal cliff debate was a good example. There will be plenty more to come.
Second, any serious effort on tackling the main problem must be done in small, digestible, chunks and slowly enough such that anger over the situation can diffuse rather than foment. This is akin to boiling a frog. Increase the heat gently enough and he’ll never know.
Another manifestation of this playbook has been occurring with unemployment. The visibility of this particular statistic was increased when the Fed specifically linked further policy action to it in December.
The reported number for unemployment, the one that people read in papers and hear on the news, was 7.8%. It is still a little higher than the 7.3% reported in December 2008, but it is down from its peak of 10.0%.
Superficially it sounds decent and gives the impression progress is being made. This holds true only until you dig just a little deeper. As it turns out, the number that really matters to the economy (and to us individually!) is the number of jobs. That number was 143.305 million in December 2012 and 143.369 million in December 2008. In other words, the number of people working is almost exactly the same. No new jobs over four years.
Further, the number of people unemployed has actually increased from 11.286 million to 12.206 million. This brief analysis reveals that the labor market has gone nowhere and that the only reason the unemployment rate is anywhere close to where it is today is because a lot of people are no longer even looking for jobs because they have become discouraged by their meager prospects.
In order to truly appreciate the impact of the employment condition (on the economy and on individuals), however, it helps to know that the average number of people on food stamps increased from 28.2 million in 2008 to an average of 46.6 million in 2012. Given the much uglier reality, it is quite clear why government authorities have focused attention on headline unemployment instead.
The extremely important lesson in all of this is that it is imperative that investors be fully aware of these efforts at misdirection and misinformation. Those who aren’t aware of the misinformation, or can’t see the big picture, or don’t act on the core trends will be the suckers at the poker table as wealth gets reallocated.
To better appreciate the challenge, it is important to understand that with the prospects for slower economic growth and the burden of too much debt, the nature of competition within society fundamentally changes. When things are growing nicely, everyone's share of the pie increases. A rising tide lifts all boats.
When growth slows or stops, the only way to get ahead is to take shares of pie from others. The end result is that competition gets nastier. Those who are too busy or too oblivious, or who quietly acquiesce, will lose out in this competition. Being passive is likely to carry increasing risks.
With this broad overview of the market and the political environment, we can now try to make sense out of the Fed's actions and what it implies for investors. For starters, it is quite clear that the Fed is “all-in”. This means it is going to do whatever it can to fight deflation which means it is also expressly trying to increase the price of risk assets. With such a formidable player as the Fed pushing for higher asset prices, why would anyone want to resist?
While we certainly do not predict an imminent collapse in asset prices, we do believe the market is fragile and therefore vulnerable to unexpected shocks. As a result, we have a much more nuanced and measured view towards investment opportunities.
We substantiate our caution by highlighting an example from very recent history. We just need to go back to the mid-2000s to see that that the Fed completely missed the housing bubble and as a result, completely failed to take any action to prevent significant losses. Arguably, monetary policy was kept too loose for too long which facilitated the inflation of the bubble.
This policy error was exceptionally costly to many people because for most, their home is their biggest asset. This assessment is not meant to be exceptionally critical of the Fed, but is merely intended to emphasize the evidence that the Fed is neither omniscient nor omnipotent. Further, when mistakes are made, it is investors who are left holding the bag and therefore it is investors who bear the burden of managing the risks implicit in such policies.
The limits of knowledge have also been explicitly voiced by the Fed’s own Jeffrey Lacker, president of the Federal Reserve Bank of Richmond. He admits, “We’re at the limits of our understanding of how monetary policy affects the economy.” As a result, while we have greater clarity regarding the intentions of the Fed, we have less clarity regarding the ultimate impact of such extraordinary and experimental monetary policy.
The immediate and substantial problem that central banks have addressed is financial system liquidity. As a result, we don’t need to worry too much about a 2008-type financial crisis repeating soon.
U.S. banks are in far better shape and some of the key risks of the private sector are now being assumed by the public sector.
Herein lies the rub. While there is less risk of a Lehman Brothers-type private sector crisis, there is increasing risk of a public sector crisis. As such, we judge that there is still a very high, and arguably growing, amount of systemic risk in the markets.
Risk itself is not a bad thing, and in fact, it is what investors get paid to accept. What they get paid is increasingly our concern. While we cannot predict the path of the economy, we do know that the economic cycle will turn down at some time and that the current expansion is already longer than usual. We also know that despite this, major market indexes are reaching five year highs. When the economy does turn down, there will be little left for the Fed to do to ease the pain. As a result, our analysis shows that investors are getting paid very little right now to take on ever-greater risks.
The Fed’s “all-in” strategy may work, but we take our duty as fiduciaries very seriously and we cannot justify betting the ranch on risk assets amid current conditions. Not only would we deem such action imprudent, but in doing so, we would also forsake our responsibility to allocate capital responsibly and in a disciplined way. At the end of the day, that is what we are hired to do.
It is too bad current market valuations are so stretched because our longer-term outlook for stocks is still positive. We still absolutely believe in the fundamental ability of U.S. companies to adapt and innovate and grow. We also know that after thirty years of declining interest rates and with the distinct prospect of future inflation, bonds are likely to be horrible investments over the next three decades. Finally, in a low return environment with a wide range of potential outcomes, there will be a significant premium for effective active management to hunt down attractive investments at good prices.
We're not the only ones who think this way. Warren Buffett has said as much and two premier bond firms, PIMCO and DoubleLine, have both indicated significant moves into equities recently.
During the interim, however, we will continue doing our primary job of allocating assets thoughtfully and prudently on behalf of our investors. We will continue watching for evidence that the market mechanism is functioning better. As we find exceptionally attractive individual stocks and windows of opportunity, we will have a lot of dry powder to put to work.
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