| Arete Quarterly Q112 |
Welcome
The analytical and research skills we have honed over the years give us the tools to dig into just about any company or industry and get a very good idea of how it works. One of our favorite exercises is to turn the focus of our inquiry onto our own industry of money management. This is a useful way for us to calibrate to the business landscape, but is also a very good way to get signals from investors as to their 2008-2009, so they’ve moved assets to self-concerns and wants and needs. directed accounts.”
Our working hypothesis, and a signficant reason for founding Arete, is that a lot of investors are not especially happy with, or well served by, existing investment options. A recent article in Investment News by Andrew Osterland provided some interesting corroborating evidence.
Osterland quotes Sophie Schmidt with Aite Group LLC, “The online brokerages grew assets by close to $1 trillion between 2008 and 2010.” Further, the financial services research firm, Cerulli, predicts that assets in the direct market will grow to nearly $5 trillion by the end of 2014. In short, the numbers show that investors are moving huge amounts of money from being managed by someone else, to being managed by themselves.
We are not aware of direct evidence of the causes of this fairly dramatic trend, but there are reasonable hypotheses. Schmidt offered hers: “Investors got disgusted with financial advisors who didn’t help them in Disenchanment was not limited to small investors. Osterland noted, “High net worth investors ... have made an even more substantial shift to self-directed investing.” Katherine Wolf, associate director at Cerulli, describes what she sees: “Some investors want to try out their own ideas and compare them to results they get with a financial advisor. Others are just testing services elsewhere from where they have most of their money.”
Regardless of the reasons, it is clear investors are scrutinizing the value of investment services like never before. We tend to view this trend as rational, healthy, and if anything, overdue.
In taking on greater responsibilities for managing their own money, individual investors are fortunate to benefit from several positive trends. Discount brokers facilitate transactions at a tiny fraction of the cost of just a couple of decades ago. Further, there are several passive funds that provide exposure to a variety of markets and segments at very low cost. These trends provide extremely good and cheap access to markets.
Arete recognizes that investors have cheap access to passive investments, so we do more than just provide exposure to the market. We try to help investors out by leveraging our unique skills and by focusing on the things that provide the greatest value. For example, we do the research and analysis to find the most attractive stocks whether they are included in popular indexes or not. As a result, clients get a relatively concentrated portfolio of best ideas. Essentially, we apply a similar investment philosophy and process to that of many top hedge funds, but at a fraction of the management fees.
Some of the less positive news for investors is that the exercise of investing can be complicated and it is getting progressively more so. A lot of questions can arise. How can one tell if a stock is undervalued? What is a good asset allocation? How much should one be concerned about inflation?
Here too, Arete can help. The combination of education, experience with so many stocks, and ongoing research activities, puts us in a position from which to reasonably evaluate a wide variety of investment challenges. Sometimes a single nugget of insight or expertise can save a lot of trouble.
In sum, investors are taking a good hard look at what they need and who can help them. Some investors will find a great deal of value in an investment advisor and some will be perfectly happy managing their own money. Some will experiment with several different providers. For those who want to invest as wisely as possible, who can make good use of expertise, and who want conflict-free advice, Arete is well suited to serve. If you or someone you know may benefit from our service, please let us know!
The analytical and research skills we have honed over the years give us the tools to dig into just about any company or industry and get a very good idea of how it works. One of our favorite exercises is to turn the focus of our inquiry onto our own industry of money management. This is a useful way for us to calibrate to the business landscape, but is also a very good way to get signals from investors as to their 2008-2009, so they’ve moved assets to self-concerns and wants and needs. directed accounts.”
Our working hypothesis, and a signficant reason for founding Arete, is that a lot of investors are not especially happy with, or well served by, existing investment options. A recent article in Investment News by Andrew Osterland provided some interesting corroborating evidence.
Osterland quotes Sophie Schmidt with Aite Group LLC, “The online brokerages grew assets by close to $1 trillion between 2008 and 2010.” Further, the financial services research firm, Cerulli, predicts that assets in the direct market will grow to nearly $5 trillion by the end of 2014. In short, the numbers show that investors are moving huge amounts of money from being managed by someone else, to being managed by themselves.
We are not aware of direct evidence of the causes of this fairly dramatic trend, but there are reasonable hypotheses. Schmidt offered hers: “Investors got disgusted with financial advisors who didn’t help them in Disenchanment was not limited to small investors. Osterland noted, “High net worth investors ... have made an even more substantial shift to self-directed investing.” Katherine Wolf, associate director at Cerulli, describes what she sees: “Some investors want to try out their own ideas and compare them to results they get with a financial advisor. Others are just testing services elsewhere from where they have most of their money.”
Regardless of the reasons, it is clear investors are scrutinizing the value of investment services like never before. We tend to view this trend as rational, healthy, and if anything, overdue.
In taking on greater responsibilities for managing their own money, individual investors are fortunate to benefit from several positive trends. Discount brokers facilitate transactions at a tiny fraction of the cost of just a couple of decades ago. Further, there are several passive funds that provide exposure to a variety of markets and segments at very low cost. These trends provide extremely good and cheap access to markets.
Arete recognizes that investors have cheap access to passive investments, so we do more than just provide exposure to the market. We try to help investors out by leveraging our unique skills and by focusing on the things that provide the greatest value. For example, we do the research and analysis to find the most attractive stocks whether they are included in popular indexes or not. As a result, clients get a relatively concentrated portfolio of best ideas. Essentially, we apply a similar investment philosophy and process to that of many top hedge funds, but at a fraction of the management fees.
Some of the less positive news for investors is that the exercise of investing can be complicated and it is getting progressively more so. A lot of questions can arise. How can one tell if a stock is undervalued? What is a good asset allocation? How much should one be concerned about inflation?
Here too, Arete can help. The combination of education, experience with so many stocks, and ongoing research activities, puts us in a position from which to reasonably evaluate a wide variety of investment challenges. Sometimes a single nugget of insight or expertise can save a lot of trouble.
In sum, investors are taking a good hard look at what they need and who can help them. Some investors will find a great deal of value in an investment advisor and some will be perfectly happy managing their own money. Some will experiment with several different providers. For those who want to invest as wisely as possible, who can make good use of expertise, and who want conflict-free advice, Arete is well suited to serve. If you or someone you know may benefit from our service, please let us know!
Business Update
As I mentioned last quarter, after four years in business now, I thought it would be a good idea to revisit and refresh Arete’s business and marketing plans. This endeavor was motivated in large part by my belief that it is simply a good practice to review plans on a regular basis.
In the process, one issue that became clear is that I have not done as good a job of describing Arete as I could have. While it is true that I have spent a good deal of my career analyzing mid cap stocks and managing mid cap portfolios, I did not form Arete just to create a replacement job for myself. If that were my only motivation, it would have been far easier and more rewarding economically to find a job as a mid cap portfolio manager at another firm.
Instead, I founded Arete as a much, much bigger vision. While I love researching and analyzing mid cap stocks, I also really wanted to make sure my work did some good. I wanted to make sure investors didn’t pay too much, that they got good information, and above all else, that they could absolutely trust that their interests were being served and protected. In the context of many dissatisfied investors, I wanted Arete to be part of the solution, not part of the problem.
On the investment side, being part of the solution means managing only those asset groups or strategies that provide real opportunities for active management. Mid cap stocks are perfectly consistent with this vision because they provide such an interesting and vibrant universe of ideas. There are several other asset groups, however, that also provide meaningful opportunities for active management. In my vision, Arete will host many of them someday.
There is so much more to the vision though. A big part of the opportunity was to start from scratch in building an organization unencumbered by legacy practices and vested interests. With a clean slate I could ask questions about every single aspect of the business, “What practice would serve investors best? Who is doing it really well?”
Going through this exercise, it was obvious that many of the decisions would fall outside the expertise and perhaps even awareness of most investors. In these cases, my ideal was the best possible structure for investors upon which a decent business could also be built. In fact, I felt so strongly about quality permeating the organization, that I named the company Arete, from its meaning of functional excellence in Greek philosophy. Arete (excellence) is more than a name, it is also a daily reminder of my vision.
Another issue that emerged from the plan review was that I need to more clearly articulate the benefit that Arete provides. It is not just an investment product. It is not just a mid cap strategy. Rather, the benefit that Arete provides is ultimately to help investors. I think of Arete’s primary purpose as converting the firm’s investment expertise into material benefit for its clients.
Clearly, one important way Arete can help clients is by producing good long-term returns with its mid cap investment strategy. Given Arete’s tremendous experience and expertise with the universe of mid cap stocks and with sophisticated valuation models, the firm has significant competitive advantages in offering such a strategy.
Also, however, in the process of researching, analyzing, and valuing a lot of companies for the mid cap strategy, Arete develops a lot of important insights into the market that can be extremely useful to investors. These insights inform and guide a wide variety of investment decisions. Since you can always reach me, Arete offers a truly unique combination of insights and access. If you have a question about something, there is a good chance I can provide some useful perspective or relevant information based on other work I have done.
The last major issue that emerged from the plan review is that Arete is now in a position where it needs to add resources and better leverage the resources it does have. I feel like Arete does a lot of things really well, it keeps getting better, and it is extremely well positioned to compete effectively as the investment landscape evolves. Key competencies such as valuation, mid cap universe expertise, and knowledge development are working well and continue to improve.
In order to really blossom and grow, however, Arete will need to add resources to amplify and leverage the practices and structures that are proving successful. A big part of this effort will be reaching out to various people and interested parties to identify opportunities to help each other.
In this effort, I will be paying special attention to opportunities to boost Arete’s sales and research efforts. If you or someone you know may be interested in some capacity, please let us know or pass on the word. I am always happy to brainstorm creative ways to make things work.
In sum, I am very happy with what Arete is, but it does need to grow in order to reach its potential. When I originally created Arete, I decided to put an outline of an acorn in the “A” of the Arete logo as a symbol of the great potential for client portfolios. This was also a nice tie-in because the white oak is the state tree of Maryland. That acorn probably also serves as a good symbol for Arete as a business: Enormous potential still to be realized.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
As I mentioned last quarter, after four years in business now, I thought it would be a good idea to revisit and refresh Arete’s business and marketing plans. This endeavor was motivated in large part by my belief that it is simply a good practice to review plans on a regular basis.
In the process, one issue that became clear is that I have not done as good a job of describing Arete as I could have. While it is true that I have spent a good deal of my career analyzing mid cap stocks and managing mid cap portfolios, I did not form Arete just to create a replacement job for myself. If that were my only motivation, it would have been far easier and more rewarding economically to find a job as a mid cap portfolio manager at another firm.
Instead, I founded Arete as a much, much bigger vision. While I love researching and analyzing mid cap stocks, I also really wanted to make sure my work did some good. I wanted to make sure investors didn’t pay too much, that they got good information, and above all else, that they could absolutely trust that their interests were being served and protected. In the context of many dissatisfied investors, I wanted Arete to be part of the solution, not part of the problem.
On the investment side, being part of the solution means managing only those asset groups or strategies that provide real opportunities for active management. Mid cap stocks are perfectly consistent with this vision because they provide such an interesting and vibrant universe of ideas. There are several other asset groups, however, that also provide meaningful opportunities for active management. In my vision, Arete will host many of them someday.
There is so much more to the vision though. A big part of the opportunity was to start from scratch in building an organization unencumbered by legacy practices and vested interests. With a clean slate I could ask questions about every single aspect of the business, “What practice would serve investors best? Who is doing it really well?”
Going through this exercise, it was obvious that many of the decisions would fall outside the expertise and perhaps even awareness of most investors. In these cases, my ideal was the best possible structure for investors upon which a decent business could also be built. In fact, I felt so strongly about quality permeating the organization, that I named the company Arete, from its meaning of functional excellence in Greek philosophy. Arete (excellence) is more than a name, it is also a daily reminder of my vision.
Another issue that emerged from the plan review was that I need to more clearly articulate the benefit that Arete provides. It is not just an investment product. It is not just a mid cap strategy. Rather, the benefit that Arete provides is ultimately to help investors. I think of Arete’s primary purpose as converting the firm’s investment expertise into material benefit for its clients.
Clearly, one important way Arete can help clients is by producing good long-term returns with its mid cap investment strategy. Given Arete’s tremendous experience and expertise with the universe of mid cap stocks and with sophisticated valuation models, the firm has significant competitive advantages in offering such a strategy.
Also, however, in the process of researching, analyzing, and valuing a lot of companies for the mid cap strategy, Arete develops a lot of important insights into the market that can be extremely useful to investors. These insights inform and guide a wide variety of investment decisions. Since you can always reach me, Arete offers a truly unique combination of insights and access. If you have a question about something, there is a good chance I can provide some useful perspective or relevant information based on other work I have done.
The last major issue that emerged from the plan review is that Arete is now in a position where it needs to add resources and better leverage the resources it does have. I feel like Arete does a lot of things really well, it keeps getting better, and it is extremely well positioned to compete effectively as the investment landscape evolves. Key competencies such as valuation, mid cap universe expertise, and knowledge development are working well and continue to improve.
In order to really blossom and grow, however, Arete will need to add resources to amplify and leverage the practices and structures that are proving successful. A big part of this effort will be reaching out to various people and interested parties to identify opportunities to help each other.
In this effort, I will be paying special attention to opportunities to boost Arete’s sales and research efforts. If you or someone you know may be interested in some capacity, please let us know or pass on the word. I am always happy to brainstorm creative ways to make things work.
In sum, I am very happy with what Arete is, but it does need to grow in order to reach its potential. When I originally created Arete, I decided to put an outline of an acorn in the “A” of the Arete logo as a symbol of the great potential for client portfolios. This was also a nice tie-in because the white oak is the state tree of Maryland. That acorn probably also serves as a good symbol for Arete as a business: Enormous potential still to be realized.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
Although our valuation based investment philosophy is sound over longer periods of time, the last few years have been challenging. Extraordinary measures of monetary easing have artificially boosted some stocks while forestalling a real recovery in the economy for others. All of the valuation oriented managers we follow have faced similar headwinds as we have the last two years.
One manager in particular, Horizon Kinetics, made the case that significant purchases and high trading volume of exchange traded funds (ETFs) and other passive products have been distorting the valuations of underlying securities.
While it is no mystery that ETFs have been popular, the extent to which this is the case is impressive. “Since 1999, the number of ETFs has expanded from fewer than 100 to more than 1,100, even as the number of listed stocks in the U.S. has declined by one-third,” according to their fourth quarter commentary. In dollar terms, over $1 trillion has flowed into ETFs with even more going to index mutual funds. These huge flows have had a significant effect on the market.
In addition to huge fund flows, some of the popular ETFs also attract huge trading volume. For example, “The annual turnover of the SPDR S&P 500 ETF is on the order of 12,000%.” Further, “The dollar value of all ETF shares traded now accounts for about 50% of total U.S. equity market trading.”
Some of the funds flow to ETFs is undoubtedly cash seeking higher returns, and some appears to be active equity investors switching to passive funds. The only explanation for such incredibly high turnover of some of these ETFs, however, is that there is a significant cohort of participants making short-term bets on the direction of the market. This phenomenon has important implications for other participants.
Vitaliy Katsenelson, a well known value investor recently described in Institutional Investor, “Speculators are indifferent to what asset they hold (junk or quality). Their time horizon is much shorter, and they are just looking for a greater fool on whom they can unload their stuff. The next tick in price is the only variable that matters to them.” He continues, “Speculators are the ones driving stock prices up (and down) in the short run, but they leave as quickly as they arrive.”
Because this frenetic trading activity in ETFs is speculative, it means that the market prices themselves are more prone to deviate significantly from fair valuations. As a result, and perversely, it has meant gaining exposure to the market through an ETF now implicitly also involves making short-term bets. As Horizon Kinetics describes, “Indexes, which are meant to measure the performance of, and provide exposure to, groups of stocks, have come to distort the prices of the stocks they are meant to measure.”
That’s not all they do. A recent article by Rodney N. Sullivan, CFA and James X. Xiong, CFA in the Financial Analysts Journal also shows that “A meaningful relationship [exists] between passive investing and a rise in equity market risk.” Put another way, “The average beta for all equity segments over 1997 – 2010 shifted meaningfully higher.”
Sullivan and Xiong show in their article, “How Index Trading Increases Market Vulnerability” that the consequences of increased passive investing, “plainly suggest a decrease in the ability of investors to diversify risk in recent decades.”
The insights of Horizon Kinetics, and Sullivan and Xiong, go a long way in explaining our concern regarding the health of the market. For one, the high trading volume of major ETFs, combined with the increasing weight of ETFs in the market, is causing far more trading action to be based on short-term trading rather than long-term valuation. For another, since equity risk has risen, a 100% equity portfolio today is far riskier than a 100% equity portfolio of fifteen years ago.
These findings support Arete’s actions in a couple of ways. First, in our role as stewards of our clients’ capital, we work hard to earn attractive risk-adjusted returns. Since equity risk is higher now, that means generating either higher returns or lower risk. High valuations preclude widespread opportunities for high returns, so we have opted to raise cash in order to lower risk — until we find better return opportunities.
Second, these phenomena really highlight the importance of our best ideas approach. The highest correlation, and therefore least diversifying value, resides among stocks in major indexes. Since the active share of the Arete Mid Cap Core strategy is so high (over 90%), our stocks act differently than the index and therefore provide much greater diversification value.
Although our valuation based investment philosophy is sound over longer periods of time, the last few years have been challenging. Extraordinary measures of monetary easing have artificially boosted some stocks while forestalling a real recovery in the economy for others. All of the valuation oriented managers we follow have faced similar headwinds as we have the last two years.
One manager in particular, Horizon Kinetics, made the case that significant purchases and high trading volume of exchange traded funds (ETFs) and other passive products have been distorting the valuations of underlying securities.
While it is no mystery that ETFs have been popular, the extent to which this is the case is impressive. “Since 1999, the number of ETFs has expanded from fewer than 100 to more than 1,100, even as the number of listed stocks in the U.S. has declined by one-third,” according to their fourth quarter commentary. In dollar terms, over $1 trillion has flowed into ETFs with even more going to index mutual funds. These huge flows have had a significant effect on the market.
In addition to huge fund flows, some of the popular ETFs also attract huge trading volume. For example, “The annual turnover of the SPDR S&P 500 ETF is on the order of 12,000%.” Further, “The dollar value of all ETF shares traded now accounts for about 50% of total U.S. equity market trading.”
Some of the funds flow to ETFs is undoubtedly cash seeking higher returns, and some appears to be active equity investors switching to passive funds. The only explanation for such incredibly high turnover of some of these ETFs, however, is that there is a significant cohort of participants making short-term bets on the direction of the market. This phenomenon has important implications for other participants.
Vitaliy Katsenelson, a well known value investor recently described in Institutional Investor, “Speculators are indifferent to what asset they hold (junk or quality). Their time horizon is much shorter, and they are just looking for a greater fool on whom they can unload their stuff. The next tick in price is the only variable that matters to them.” He continues, “Speculators are the ones driving stock prices up (and down) in the short run, but they leave as quickly as they arrive.”
Because this frenetic trading activity in ETFs is speculative, it means that the market prices themselves are more prone to deviate significantly from fair valuations. As a result, and perversely, it has meant gaining exposure to the market through an ETF now implicitly also involves making short-term bets. As Horizon Kinetics describes, “Indexes, which are meant to measure the performance of, and provide exposure to, groups of stocks, have come to distort the prices of the stocks they are meant to measure.”
That’s not all they do. A recent article by Rodney N. Sullivan, CFA and James X. Xiong, CFA in the Financial Analysts Journal also shows that “A meaningful relationship [exists] between passive investing and a rise in equity market risk.” Put another way, “The average beta for all equity segments over 1997 – 2010 shifted meaningfully higher.”
Sullivan and Xiong show in their article, “How Index Trading Increases Market Vulnerability” that the consequences of increased passive investing, “plainly suggest a decrease in the ability of investors to diversify risk in recent decades.”
The insights of Horizon Kinetics, and Sullivan and Xiong, go a long way in explaining our concern regarding the health of the market. For one, the high trading volume of major ETFs, combined with the increasing weight of ETFs in the market, is causing far more trading action to be based on short-term trading rather than long-term valuation. For another, since equity risk has risen, a 100% equity portfolio today is far riskier than a 100% equity portfolio of fifteen years ago.
These findings support Arete’s actions in a couple of ways. First, in our role as stewards of our clients’ capital, we work hard to earn attractive risk-adjusted returns. Since equity risk is higher now, that means generating either higher returns or lower risk. High valuations preclude widespread opportunities for high returns, so we have opted to raise cash in order to lower risk — until we find better return opportunities.
Second, these phenomena really highlight the importance of our best ideas approach. The highest correlation, and therefore least diversifying value, resides among stocks in major indexes. Since the active share of the Arete Mid Cap Core strategy is so high (over 90%), our stocks act differently than the index and therefore provide much greater diversification value.
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