| Arete Quarterly Q213 |
Welcome
Summertime normally conjures up thoughts of vacations and slower, more relaxed times. For many of us, this is a welcome respite from overly busy lives. For those of us who like to read, we finally have a chance to catch up on our reading lists or to explore new works.
One form of literature that especially lends itself to summer reading is called magical realism. Some of the better known works of the genre are One Hundred Years of Solitude and Love in the time of Cholera by Gabriel Garcia Marquez. Authors such as Mario Vargas Llosa, a relatively recent Nobel prize winner, and Salman Rushdie with his famous Satanic Verses, have also made important contributions to the genre, among many others.
A good working description of magical realism compares it with other styles. With fantasy, you know it isn’t true. With science fiction, it could be true. With magical realism, however, you just don’t know. The gentle, surrealistic flows of story lines are wonderful companions for soft summer breezes that can take one’s mind to other places.
While magical realism makes for very entertaining stories, it is far less appropriate as a foundation for confident investing. Nonetheless, this is an apt description of the current investment environment. We just don’t know. We don’t really know how long central banks are going to continue overriding market signals with their own capricious interventions. This makes it hard to calibrate sustainable economic activity. As a result, we don’t really know what is safe or what assets are worth. As a result, it is extremely difficult to properly allocate risk exposures.
Indications of surrealism in the investment landscape abound. Bonds, for example, which are typically lauded as “safe” investments, suffered significantly in June. As the Financial Times recently reported, “Its [Vanguard’s] intermediate-term bond ETF has fallen 6.5% since the start of May and investors have pulled out $39m.” Bond investors must worry not just about rising rates but also outflows that force further selling. Unfortunately, we don’t have a good sense of when either (rising rates or money outflows) will really take hold.
Hedge funds, which have typically been considered “smart money”, have largely failed to convert their smarts into returns for investors. As reported by Forbes.com, “Over the past five years, the hedge fund index lost 13.6 percent, while the indices added 8.6 percent.” Further, “In 2013, most hedge funds have fallen even further behind, gaining 5.4 percent vs. the market’s rally of 15.4 percent.” Of course high fees and lockups add insult to injury by compounding these shortfalls.
The net result is that the investment landscape is challenging for everyone — which makes the task of sorting fact from fiction even more imperative in evaluating investment choices. In this regard, Arete’s substantial disclosures and separate account structure provide a solid contrast to many competitors. Non-fiction is the better genre for investors who want to avoid horror stories.
Summertime normally conjures up thoughts of vacations and slower, more relaxed times. For many of us, this is a welcome respite from overly busy lives. For those of us who like to read, we finally have a chance to catch up on our reading lists or to explore new works.
One form of literature that especially lends itself to summer reading is called magical realism. Some of the better known works of the genre are One Hundred Years of Solitude and Love in the time of Cholera by Gabriel Garcia Marquez. Authors such as Mario Vargas Llosa, a relatively recent Nobel prize winner, and Salman Rushdie with his famous Satanic Verses, have also made important contributions to the genre, among many others.
A good working description of magical realism compares it with other styles. With fantasy, you know it isn’t true. With science fiction, it could be true. With magical realism, however, you just don’t know. The gentle, surrealistic flows of story lines are wonderful companions for soft summer breezes that can take one’s mind to other places.
While magical realism makes for very entertaining stories, it is far less appropriate as a foundation for confident investing. Nonetheless, this is an apt description of the current investment environment. We just don’t know. We don’t really know how long central banks are going to continue overriding market signals with their own capricious interventions. This makes it hard to calibrate sustainable economic activity. As a result, we don’t really know what is safe or what assets are worth. As a result, it is extremely difficult to properly allocate risk exposures.
Indications of surrealism in the investment landscape abound. Bonds, for example, which are typically lauded as “safe” investments, suffered significantly in June. As the Financial Times recently reported, “Its [Vanguard’s] intermediate-term bond ETF has fallen 6.5% since the start of May and investors have pulled out $39m.” Bond investors must worry not just about rising rates but also outflows that force further selling. Unfortunately, we don’t have a good sense of when either (rising rates or money outflows) will really take hold.
Hedge funds, which have typically been considered “smart money”, have largely failed to convert their smarts into returns for investors. As reported by Forbes.com, “Over the past five years, the hedge fund index lost 13.6 percent, while the indices added 8.6 percent.” Further, “In 2013, most hedge funds have fallen even further behind, gaining 5.4 percent vs. the market’s rally of 15.4 percent.” Of course high fees and lockups add insult to injury by compounding these shortfalls.
The net result is that the investment landscape is challenging for everyone — which makes the task of sorting fact from fiction even more imperative in evaluating investment choices. In this regard, Arete’s substantial disclosures and separate account structure provide a solid contrast to many competitors. Non-fiction is the better genre for investors who want to avoid horror stories.
Business Update
One of the things I probably don’t talk about enough is how pleased I am with operations at Arete. I keep getting better at everything I do and I keep getting better tools to do it as well. Having been there before, I also know that many of these things cannot be done as efficiently, or even at all, in large firms.
This has had a tremendously positive impact on infrastructure. Technology keeps making things cheaper, more efficient, and more robust – a trifecta of value. As a small company it has been easy to build in continuous improvement because the lock-in costs of old, inefficient processes are so low.
These benefits have also accrued to the research effort, most notably in knowledge management. Arete was a pioneer in using a wiki to manage research internally from its inception over five years ago, and has expanded that effort to increase access to information, to leverage insights from research, and to communicate those insights with clients and interested parties.
Another important development in the quarter was that I began working with Frank Paolantonio. Frank has graciously agreed to volunteer time during his college summer break in return for the chance to learn more about equity analysis and to put his skills to work in a real money management environment.
This relationship has been extremely beneficial to me and Arete in a couple of ways. Having some extra help has clearly gone a long way in researching more companies and doing more analysis. As such, it has been an excellent test case for showing how scalable Arete’s research effort is. Many small operations have several people dutifully serving a good analyst. Arete, in contrast, is built as a platform from which a handful of analysts can work and contribute in their own unique ways. In this small test case, it has performed beautifully.
Of course success is a two-way street and much of it is owed to the exceptional effort that Frank has put forth. I have been exposed to a lot of analysts through my work experiences, through my guest teaching stints, and through my roles on the board of the CFA Society of Baltimore, and rarely have I seen someone exhibit such energy and enthusiasm for equity analysis and for self-improvement. It’s been a lot of fun working with Frank and I really appreciate his help. Thanks Frank!
Although not initially a strong suit, Arete continues making progress on the marketing front as well. Since research is one of Arete’s strengths, I have always tried to share important insights through the newsletters and more recently through the AreteResearch site.
While I have certainly received positive feedback from a number of investors, it turns out demand for thoughtful interpretation runs farther and deeper than I had originally anticipated. Pensions and Investments recently reported, “Thought leadership has taken on new importance as institutional investors try to make sense of a vertiginous new world of volatile markets, an unsteady global economy and a proliferation of investment strategies.” Benjamin F. Phillips, partner at Casey Quirk & Associates LLC (a consultant to money managers) elaborated, “Increasingly, clients are looking not only for products but for ideas about how to use them; they're looking for intellectual capital.”
It is interesting to see the gathering momentum for intellectual capital and thought leadership moving right into the sweet spot of Arete’s strengths. One of the big advantages Arete has in this respect is that I get to decide what research and which insights seem most useful to investors. I don’t have to dilute the information (i.e. “spin”) content in order to make it palatable to a mass market. I get to do what I do best which is pulling together a lot of research and figuring out what it means.
Certainly institutions with a fiduciary duty are interested in thought leadership because it is their obligation to serve their constituents and there just aren’t many sources that have high information content. Smaller institutions typically have fewer resources at their disposal and therefore are in even greater need.
Another group, that I’ll call “savvy professionals”, also tends to seek out thought leadership. These are people who, whether they are still working or not, know the value of specialized expertise, and also know the costs of complacency. They typically ask excellent, penetrating questions to ensure competence and trustworthiness. Once they do, they are happy to have someone working for them.
All of these types of investors make great clients for Arete. Whether it is through providing an extra set of eyes, a new information source, or outright portfolio management, Arete’s thought leadership is becoming increasingly valuable to an important set of investors.
If you or someone you know falls into one of these groups and are interested in learning more about Arete, please let me know. Word of mouth and newsletter distribution are important and cost-effective ways to introduce Arete to investors and also allow me to continue its outstanding value proposition. As a result, I deeply appreciate any ideas you can pass on regarding potential interest.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
One of the things I probably don’t talk about enough is how pleased I am with operations at Arete. I keep getting better at everything I do and I keep getting better tools to do it as well. Having been there before, I also know that many of these things cannot be done as efficiently, or even at all, in large firms.
This has had a tremendously positive impact on infrastructure. Technology keeps making things cheaper, more efficient, and more robust – a trifecta of value. As a small company it has been easy to build in continuous improvement because the lock-in costs of old, inefficient processes are so low.
These benefits have also accrued to the research effort, most notably in knowledge management. Arete was a pioneer in using a wiki to manage research internally from its inception over five years ago, and has expanded that effort to increase access to information, to leverage insights from research, and to communicate those insights with clients and interested parties.
Another important development in the quarter was that I began working with Frank Paolantonio. Frank has graciously agreed to volunteer time during his college summer break in return for the chance to learn more about equity analysis and to put his skills to work in a real money management environment.
This relationship has been extremely beneficial to me and Arete in a couple of ways. Having some extra help has clearly gone a long way in researching more companies and doing more analysis. As such, it has been an excellent test case for showing how scalable Arete’s research effort is. Many small operations have several people dutifully serving a good analyst. Arete, in contrast, is built as a platform from which a handful of analysts can work and contribute in their own unique ways. In this small test case, it has performed beautifully.
Of course success is a two-way street and much of it is owed to the exceptional effort that Frank has put forth. I have been exposed to a lot of analysts through my work experiences, through my guest teaching stints, and through my roles on the board of the CFA Society of Baltimore, and rarely have I seen someone exhibit such energy and enthusiasm for equity analysis and for self-improvement. It’s been a lot of fun working with Frank and I really appreciate his help. Thanks Frank!
Although not initially a strong suit, Arete continues making progress on the marketing front as well. Since research is one of Arete’s strengths, I have always tried to share important insights through the newsletters and more recently through the AreteResearch site.
While I have certainly received positive feedback from a number of investors, it turns out demand for thoughtful interpretation runs farther and deeper than I had originally anticipated. Pensions and Investments recently reported, “Thought leadership has taken on new importance as institutional investors try to make sense of a vertiginous new world of volatile markets, an unsteady global economy and a proliferation of investment strategies.” Benjamin F. Phillips, partner at Casey Quirk & Associates LLC (a consultant to money managers) elaborated, “Increasingly, clients are looking not only for products but for ideas about how to use them; they're looking for intellectual capital.”
It is interesting to see the gathering momentum for intellectual capital and thought leadership moving right into the sweet spot of Arete’s strengths. One of the big advantages Arete has in this respect is that I get to decide what research and which insights seem most useful to investors. I don’t have to dilute the information (i.e. “spin”) content in order to make it palatable to a mass market. I get to do what I do best which is pulling together a lot of research and figuring out what it means.
Certainly institutions with a fiduciary duty are interested in thought leadership because it is their obligation to serve their constituents and there just aren’t many sources that have high information content. Smaller institutions typically have fewer resources at their disposal and therefore are in even greater need.
Another group, that I’ll call “savvy professionals”, also tends to seek out thought leadership. These are people who, whether they are still working or not, know the value of specialized expertise, and also know the costs of complacency. They typically ask excellent, penetrating questions to ensure competence and trustworthiness. Once they do, they are happy to have someone working for them.
All of these types of investors make great clients for Arete. Whether it is through providing an extra set of eyes, a new information source, or outright portfolio management, Arete’s thought leadership is becoming increasingly valuable to an important set of investors.
If you or someone you know falls into one of these groups and are interested in learning more about Arete, please let me know. Word of mouth and newsletter distribution are important and cost-effective ways to introduce Arete to investors and also allow me to continue its outstanding value proposition. As a result, I deeply appreciate any ideas you can pass on regarding potential interest.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
Market moves in the second quarter were dominated by the remarks from Ben Bernanke which outlined the conditions for tapering the Fed’s quantitative easing program. The fact that words from a Fed chairman can have such a pronounced effect on markets, even more so right now than underlying fundamentals and valuations, highlights the degree to which investors are contending with a brand of surrealism. The irony of this situation in a land prideful of “free markets” is not lost on us.
Given the over-arching influence of the Fed in determining market outcomes right now, investors have two basic courses of action. The first is to simply follow temptation and increase exposure to risk assets. Clearly the Fed is trying both to increase temptation and to punish resistance. This is the easy route.
The more difficult route is to calibrate exposures relative to anticipated risk and return. In normal times, this approach bears prodigious rewards for patience and prudence. Given the Herculean efforts by the Fed to coerce investors into equities, however, limiting exposure to stocks has borne a significant opportunity cost. Further, many types of insurance have been painfully expensive. In short, it has taken something of a mythical constitution to continue adhering to sound investment principles.
This backdrop has created a market landscape in which the main game, the marginal trade, is taking the easy route and chasing exposure. Since a really, really, really, big market participant (the Fed) is trying to rig the game in one direction, one can reasonably ask, “What’s an investor to do?” Why fight it?
The answer, in short, is that investors should be wary of the easy route because the Fed is not omnipotent. It can affect market outcomes in the short-term, but cannot fundamentally control the market longer-term. As a result, the easy route is a game virtually nobody wins. It is one much more amenable to gamblers and Wall Street traders than long-term investors. At least when they lose everything they still “gain” a reputation for betting big.
Essentially, the proposition investors face is a Faustian bargain: Increase exposure to risk assets and prices will continue to go up (for a while). However, in return, investors must also accept an additional stick of dynamite with each price increase. What they don’t know is when the explosives are going to blow up their returns, or how bad the damage will be.
We caught a glimpse of the potential for explosiveness in late June. When Bernanke discussed the conditions around tapering its quantitative easing program, markets collapsed. Bonds got crushed and the Russell Midcap Index was down over 4% in two days. This was a useful depiction of the market’s fragility, even if the magnitude of the decline was fairly small. Regardless, it was scary enough to prompt several Fed governors to immediately backpedal by making public statements with softer language.
This fragility is caused to a significant degree by behavior. When things turn, some participants will immediately and violently change course. This causes big price declines. Seeing the big declines, another wave of participants sells causing further declines. The cascade is like an avalanche; you can’t stop it, you can only do your best to avoid avalanche conditions to begin with.
One of the things investors can do, then, is to embrace the reality that the value proposition for stocks is very different than it used to be. It is no longer reasonable to expect that stocks will continue cranking out double digit returns just so long as you hang on to them for a while. They are likely to be more volatile and to produce lower returns than many investors have experienced in the past.
This isn’t to say that investing in stocks is a bad idea; it just means the approach will need to adapt to a more challenging environment. There are attractive stocks and they will continue to be very attractive relative to many other investments. Therefore part of the adaptation will need to be distinguishing the merits of individual stocks versus those of the market as a whole. Both index funds, which take a passive approach, and hedge funds, which typically take very aggressive approaches, will have difficulty in this environment.
A more robust approach is to develop processes for monitoring and identifying individual stocks and keeping enough powder dry to increase exposure when expected returns are high. Such an approach involves seeking out good and trustworthy information sources, being mindful of risk, and avoiding games that can’t be won over the long-term. While this course may not reap outsized rewards for some period of time, it is likely to outperform many other asset classes while also avoiding the types of losses that can be debilitating.
Market moves in the second quarter were dominated by the remarks from Ben Bernanke which outlined the conditions for tapering the Fed’s quantitative easing program. The fact that words from a Fed chairman can have such a pronounced effect on markets, even more so right now than underlying fundamentals and valuations, highlights the degree to which investors are contending with a brand of surrealism. The irony of this situation in a land prideful of “free markets” is not lost on us.
Given the over-arching influence of the Fed in determining market outcomes right now, investors have two basic courses of action. The first is to simply follow temptation and increase exposure to risk assets. Clearly the Fed is trying both to increase temptation and to punish resistance. This is the easy route.
The more difficult route is to calibrate exposures relative to anticipated risk and return. In normal times, this approach bears prodigious rewards for patience and prudence. Given the Herculean efforts by the Fed to coerce investors into equities, however, limiting exposure to stocks has borne a significant opportunity cost. Further, many types of insurance have been painfully expensive. In short, it has taken something of a mythical constitution to continue adhering to sound investment principles.
This backdrop has created a market landscape in which the main game, the marginal trade, is taking the easy route and chasing exposure. Since a really, really, really, big market participant (the Fed) is trying to rig the game in one direction, one can reasonably ask, “What’s an investor to do?” Why fight it?
The answer, in short, is that investors should be wary of the easy route because the Fed is not omnipotent. It can affect market outcomes in the short-term, but cannot fundamentally control the market longer-term. As a result, the easy route is a game virtually nobody wins. It is one much more amenable to gamblers and Wall Street traders than long-term investors. At least when they lose everything they still “gain” a reputation for betting big.
Essentially, the proposition investors face is a Faustian bargain: Increase exposure to risk assets and prices will continue to go up (for a while). However, in return, investors must also accept an additional stick of dynamite with each price increase. What they don’t know is when the explosives are going to blow up their returns, or how bad the damage will be.
We caught a glimpse of the potential for explosiveness in late June. When Bernanke discussed the conditions around tapering its quantitative easing program, markets collapsed. Bonds got crushed and the Russell Midcap Index was down over 4% in two days. This was a useful depiction of the market’s fragility, even if the magnitude of the decline was fairly small. Regardless, it was scary enough to prompt several Fed governors to immediately backpedal by making public statements with softer language.
This fragility is caused to a significant degree by behavior. When things turn, some participants will immediately and violently change course. This causes big price declines. Seeing the big declines, another wave of participants sells causing further declines. The cascade is like an avalanche; you can’t stop it, you can only do your best to avoid avalanche conditions to begin with.
One of the things investors can do, then, is to embrace the reality that the value proposition for stocks is very different than it used to be. It is no longer reasonable to expect that stocks will continue cranking out double digit returns just so long as you hang on to them for a while. They are likely to be more volatile and to produce lower returns than many investors have experienced in the past.
This isn’t to say that investing in stocks is a bad idea; it just means the approach will need to adapt to a more challenging environment. There are attractive stocks and they will continue to be very attractive relative to many other investments. Therefore part of the adaptation will need to be distinguishing the merits of individual stocks versus those of the market as a whole. Both index funds, which take a passive approach, and hedge funds, which typically take very aggressive approaches, will have difficulty in this environment.
A more robust approach is to develop processes for monitoring and identifying individual stocks and keeping enough powder dry to increase exposure when expected returns are high. Such an approach involves seeking out good and trustworthy information sources, being mindful of risk, and avoiding games that can’t be won over the long-term. While this course may not reap outsized rewards for some period of time, it is likely to outperform many other asset classes while also avoiding the types of losses that can be debilitating.
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