| Arete Quarterly Q214.pdf |
Welcome
Since Arete was founded, a key competitive advantage has been the strategic integration and implementation of technology. This serves many higher goals not least of which is to keep expenses down for our clients. Thoughtful application of technology has also vastly improved nearly every aspect of Arete's operations including increasing the efficiency of various administrative processes, reducing error rates, and improving the entire process of building and manufacturing knowledge.
With this as context, it should be no surprise that we are again in the process of leveraging technology to improve our services. This time around we will be establishing a blog to share much of our commentary with you. The Arete Quarterly letter will remain, but in a significantly abbreviated form that will focus much more specifically on numbers and portfolio commentary. Broader commentary about the markets, the investment management business and other content will be shifted to the blog format.
This move is designed to achieve a couple of things. First and foremost, we have heard from a number of readers that while they enjoy the content, there is just too much to comfortably read in one sitting. Not only will the blog format make the content available in more digestible pieces, it will also enable us to reach a broader audience on a more regular basis.
Since essentially all of the content of Arete Insights is commentary (as opposed to quantitative analysis), we will most likely discontinue its publication. We will retain the archives on the website, however, and will continue to provide all of the various types of insights we have in the past; we’ll just be doing it in a different form.
Finally, for everyone who reads our commentary and stays in touch with our work, thanks for your attention, your feedback, and your continued support. We appreciate it!
Since Arete was founded, a key competitive advantage has been the strategic integration and implementation of technology. This serves many higher goals not least of which is to keep expenses down for our clients. Thoughtful application of technology has also vastly improved nearly every aspect of Arete's operations including increasing the efficiency of various administrative processes, reducing error rates, and improving the entire process of building and manufacturing knowledge.
With this as context, it should be no surprise that we are again in the process of leveraging technology to improve our services. This time around we will be establishing a blog to share much of our commentary with you. The Arete Quarterly letter will remain, but in a significantly abbreviated form that will focus much more specifically on numbers and portfolio commentary. Broader commentary about the markets, the investment management business and other content will be shifted to the blog format.
This move is designed to achieve a couple of things. First and foremost, we have heard from a number of readers that while they enjoy the content, there is just too much to comfortably read in one sitting. Not only will the blog format make the content available in more digestible pieces, it will also enable us to reach a broader audience on a more regular basis.
Since essentially all of the content of Arete Insights is commentary (as opposed to quantitative analysis), we will most likely discontinue its publication. We will retain the archives on the website, however, and will continue to provide all of the various types of insights we have in the past; we’ll just be doing it in a different form.
Finally, for everyone who reads our commentary and stays in touch with our work, thanks for your attention, your feedback, and your continued support. We appreciate it!
Business Update
One of the core objectives of Arete is to help people become better consumers of investment services. Part of the reason for this is that personally I have no desire to foist inappropriate things upon people just for the purpose of making money, a practice which has become endemic in the industry. I don't like it and it seems a terrible waste of investment skills. Further, having gone through high school and college with virtually no exposure to the investment business myself, I know firsthand how difficult it is to get in a position where you feel reasonably comfortable that you know what’s going on and that you're doing the right thing. I'd rather try to be part of the solution rather than part of the problem.
To further the goal of being a terrific resource for investing, I have posted new content on the website at http://www.areteam.com/learn.html which addresses several key points for investing. This is all original material and reflects my ongoing research and evaluation of the business landscape for investment services. That landscape is changing and it's important to understand the various currents in order to avoid getting pulled under by them.
I also want to make a couple of quick notes about the website. The first is that I have renamed the section that used to be "Ideas" to "Learn" in order to better reflect my intent. I still consider ideas to be the "functional currency" at Arete, but they aren't there just for kicks; they are designed for the purpose of helping you out. In this section I will focus on building knowledge that can help you think clearly through various investment challenges and sidestep avoidable pitfalls.
In addition, I want to announce that I will be starting to use some illustrations in these writings. My hope is that illustrations will enhance the communication by visually complementing the text and also make the subject matter more accessible.
Helping me in this pursuit will be Saul Embuscado, a freelance graphics artist who designed Arete’s logo. Saul has a terrific ability to depict ideas visually and is also terrific to work with. I look forward to being able to produce even richer communications with his talents.
Another part of the reason I want to help people become better consumers of investment services, however, is a more selfish one. I believe that the more people learn more about consuming investment services wisely, the more they will come to appreciate all of the thought and effort that goes into Arete's services. In short, I think there is a terrific business opportunity in being a reliable resource in a business where there just aren't nearly enough of them.
One of the reasons Arete focuses so intently on knowledge development and transfer is because I think it is one of the huge deficiencies in the investment industry. I honestly believe there are a lot of really smart people in the business. I also believe that a huge chunk of that knowledge fails to benefit clients anywhere near to the extent that it should.
One of the causes of the disconnect between professional knowledge and investor benefit is short term incentives. Many analysts, advisers, and portfolio managers know they are judged and paid on the basis of short term results and as a result become guided by relativism. This structural characteristic of the industry creates a great deal of friction with long term outcomes.
It doesn’t have to be this way and at Arete it is not. One clear alternative to the rudimentary motivation of short term financial incentives is what David Brooks calls, "an intense desire to figure stuff out." With such a focus, I am much more interested in poking around and asking questions about what kinds of trends are developing, what kinds of weak signals may forebode significant changes, and how best to prepare for them, than I am in fixating on short term fluctuations. It’s a lot more interesting and ultimately a lot more rewarding.
One may wonder if investment insights are not applied to the purpose of taking a stand against consensus but rather are subordinated to an imperative to just go with the flow, what is the value of such insights? Indeed. It is unfortunate that investors tend to get such a low return on investment knowledge.
Arete will keep plugging away with its efforts to be different and to be better by keeping you informed and making sure you benefit. If you have any questions or any suggestions, please always feel free to contact me by phone or email.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
One of the core objectives of Arete is to help people become better consumers of investment services. Part of the reason for this is that personally I have no desire to foist inappropriate things upon people just for the purpose of making money, a practice which has become endemic in the industry. I don't like it and it seems a terrible waste of investment skills. Further, having gone through high school and college with virtually no exposure to the investment business myself, I know firsthand how difficult it is to get in a position where you feel reasonably comfortable that you know what’s going on and that you're doing the right thing. I'd rather try to be part of the solution rather than part of the problem.
To further the goal of being a terrific resource for investing, I have posted new content on the website at http://www.areteam.com/learn.html which addresses several key points for investing. This is all original material and reflects my ongoing research and evaluation of the business landscape for investment services. That landscape is changing and it's important to understand the various currents in order to avoid getting pulled under by them.
I also want to make a couple of quick notes about the website. The first is that I have renamed the section that used to be "Ideas" to "Learn" in order to better reflect my intent. I still consider ideas to be the "functional currency" at Arete, but they aren't there just for kicks; they are designed for the purpose of helping you out. In this section I will focus on building knowledge that can help you think clearly through various investment challenges and sidestep avoidable pitfalls.
In addition, I want to announce that I will be starting to use some illustrations in these writings. My hope is that illustrations will enhance the communication by visually complementing the text and also make the subject matter more accessible.
Helping me in this pursuit will be Saul Embuscado, a freelance graphics artist who designed Arete’s logo. Saul has a terrific ability to depict ideas visually and is also terrific to work with. I look forward to being able to produce even richer communications with his talents.
Another part of the reason I want to help people become better consumers of investment services, however, is a more selfish one. I believe that the more people learn more about consuming investment services wisely, the more they will come to appreciate all of the thought and effort that goes into Arete's services. In short, I think there is a terrific business opportunity in being a reliable resource in a business where there just aren't nearly enough of them.
One of the reasons Arete focuses so intently on knowledge development and transfer is because I think it is one of the huge deficiencies in the investment industry. I honestly believe there are a lot of really smart people in the business. I also believe that a huge chunk of that knowledge fails to benefit clients anywhere near to the extent that it should.
One of the causes of the disconnect between professional knowledge and investor benefit is short term incentives. Many analysts, advisers, and portfolio managers know they are judged and paid on the basis of short term results and as a result become guided by relativism. This structural characteristic of the industry creates a great deal of friction with long term outcomes.
It doesn’t have to be this way and at Arete it is not. One clear alternative to the rudimentary motivation of short term financial incentives is what David Brooks calls, "an intense desire to figure stuff out." With such a focus, I am much more interested in poking around and asking questions about what kinds of trends are developing, what kinds of weak signals may forebode significant changes, and how best to prepare for them, than I am in fixating on short term fluctuations. It’s a lot more interesting and ultimately a lot more rewarding.
One may wonder if investment insights are not applied to the purpose of taking a stand against consensus but rather are subordinated to an imperative to just go with the flow, what is the value of such insights? Indeed. It is unfortunate that investors tend to get such a low return on investment knowledge.
Arete will keep plugging away with its efforts to be different and to be better by keeping you informed and making sure you benefit. If you have any questions or any suggestions, please always feel free to contact me by phone or email.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
One of the most notable characteristics of the market the last few years, and especially recently, has been its exceptionally low volatility. In well- functioning markets, comprised of active buyers and sellers, such low volatility typically indicates that investors anticipate very stable conditions. Conventional wisdom is that low volatility is a signal of stability.
Unfortunately, we investors cannot afford to be so cavalier as to assume such economic relationships still hold in the same way. Years of exceptionally loose monetary policy have crossed the wires of many familiar signals by distorting underlying economic interactions. Much like squeezing a balloon in one place causes distortions in others, quantitative easing is causing plenty of bulges to appear in other places. As a result, one important lesson for investors is to account for greater noise and less reliable signals when assessing the market.
Gillian Tett explored the issue of low volatility in her recent Financial Times piece, "Tranquil markets are enjoying too much of a good thing." She offered as one possible explanation that, "After several years of wild monetary experiments, investors are more willing to accept that western central bankers will do 'whatever it takes' to support the markets." According to this theory, low volatility may largely be a function of faith in the Fed.
While we suspect there is some truth in this, whether warranted or not, our own analysis suggests that the changing composition of the investor base is an even more important cause of low volatility. It really comes down to the supply and demand for insurance. In short, important changes in the market have reduced the demand for insurance and as result, volatility remains deceptively low.
One change is that since the failure of Lehman Brothers, it has become abundantly clear the extreme lengths the Fed will go to in order to backstop the big banks. As a result, large banks can deploy their massive excess reserves in the market with little concern for consequences. As one strategist noted in the Tett article, "There is no demand for protection [against turbulence]." There is no demand partly because the banks are already getting that protection essentially for free.
Another change that has affected demand for insurance has been the migration of funds away from active management to passive management. Since passive managers make no attempt to calibrate exposure to the market according to the attractiveness (or unattractiveness) of opportunity, this trend reduces demand for insurance on the margin. Conversely, active managers may implement insurance when they identify the market as being especially risky.
In addition, demand for insurance has also likely been affected by recent changes with middle class individual investors. Clobbered in the financial crisis by steep declines in their two biggest assets, houses and stocks, and restrained from full recovery by declining real income, far fewer middle class investors can afford to take the risk of investing in stocks; they simply can’t afford to lose any more. Avoiding the risk of stocks altogether completely mitigates the need for insurance against declines.
Another factor which may be artificially dampening volatility relates to the increasingly herd-like behavior of investment managers.
While we are not significant purveyors of mainstream financial media for a variety of reasons, a recent story on Yahoo Finance contained a useful insight, albeit probably not the one that was intended. With the headline, "No, stocks aren't wildly overvalued: Citi strategist finds hole in Shiller's CAPE", the author reveals how many managers contribute to the problem of distortions.
For background, the CAPE (cyclically adjusted P/E ratio) is a useful valuation concept partly because it applies to a relatively long period of time (ten years), which is reasonably consistent with most investors' investment horizons for stock holdings. It is also useful because it works; it does a remarkably good job of indicating future returns and thereby allowing long term investors to calibrate their exposure accordingly.
The "hole" in CAPE reported in the article turns out to be no hole at all. Citi's strategist Tobias Levkovich explains that since "nobody really invests with a 10-year time horizon anymore, "the CAPE ought to be adjusted for today's low rates. While acknowledging the utility of CAPE for long-term investors, Levkovich explains, "institutional investors can't afford to think much beyond the next 6-to-12 months."
It is exactly this commentary on the environment for "professional" investors that is illuminating. The problem is not that professional investors aren't smart or don't know a lot about investing, most of them do. The problem is that their business dynamics compel them to operate on a very short time horizon which often puts the interests of longer term investors at risk. A recent comment from The Economist sums it up well, "One investment strategist once told your correspondent, 'It makes no sense for me to predict a recession. If I'm right, no one will thank me and if I'm wrong, I will get fired.'" Wouldn’t you like to know that?
As a result, these investors contribute to the distortion of the volatility signal. Compelled to chase short term performance at the expense of longer term outcomes for clients, they eschew insurance irrespective of its investment value. In doing so, they reveal themselves as little more than highly paid puppets.
Finally, we cannot ignore the possibility that volatility measures are not just a function of market dynamics, but are also being directly manipulated. Certainly this is possible given the financialization (i.e., the creation of securities that can be traded) of many metrics. Zerohedge has followed this story for a while and highlighted it in the recent story, “The last minute VIX murder.”
In sum, there are a lot of good reasons to be skeptical of the value of the low volatility signal (and other signals) in the market right now. There is no logical or empirical reason for stocks to always go up (and volatility down) or for returns to always be positive. In fact, they tend to collapse at the most inopportune and inconvenient times.
Ongoing changes in the market combined with distortions caused by public policy are combining to diminish the usefulness of many of the signals we have come to rely upon. As such, we will be well-served to question old heuristics, to stay alert, and to make decisions based on hard information and reasoning.
One of the most notable characteristics of the market the last few years, and especially recently, has been its exceptionally low volatility. In well- functioning markets, comprised of active buyers and sellers, such low volatility typically indicates that investors anticipate very stable conditions. Conventional wisdom is that low volatility is a signal of stability.
Unfortunately, we investors cannot afford to be so cavalier as to assume such economic relationships still hold in the same way. Years of exceptionally loose monetary policy have crossed the wires of many familiar signals by distorting underlying economic interactions. Much like squeezing a balloon in one place causes distortions in others, quantitative easing is causing plenty of bulges to appear in other places. As a result, one important lesson for investors is to account for greater noise and less reliable signals when assessing the market.
Gillian Tett explored the issue of low volatility in her recent Financial Times piece, "Tranquil markets are enjoying too much of a good thing." She offered as one possible explanation that, "After several years of wild monetary experiments, investors are more willing to accept that western central bankers will do 'whatever it takes' to support the markets." According to this theory, low volatility may largely be a function of faith in the Fed.
While we suspect there is some truth in this, whether warranted or not, our own analysis suggests that the changing composition of the investor base is an even more important cause of low volatility. It really comes down to the supply and demand for insurance. In short, important changes in the market have reduced the demand for insurance and as result, volatility remains deceptively low.
One change is that since the failure of Lehman Brothers, it has become abundantly clear the extreme lengths the Fed will go to in order to backstop the big banks. As a result, large banks can deploy their massive excess reserves in the market with little concern for consequences. As one strategist noted in the Tett article, "There is no demand for protection [against turbulence]." There is no demand partly because the banks are already getting that protection essentially for free.
Another change that has affected demand for insurance has been the migration of funds away from active management to passive management. Since passive managers make no attempt to calibrate exposure to the market according to the attractiveness (or unattractiveness) of opportunity, this trend reduces demand for insurance on the margin. Conversely, active managers may implement insurance when they identify the market as being especially risky.
In addition, demand for insurance has also likely been affected by recent changes with middle class individual investors. Clobbered in the financial crisis by steep declines in their two biggest assets, houses and stocks, and restrained from full recovery by declining real income, far fewer middle class investors can afford to take the risk of investing in stocks; they simply can’t afford to lose any more. Avoiding the risk of stocks altogether completely mitigates the need for insurance against declines.
Another factor which may be artificially dampening volatility relates to the increasingly herd-like behavior of investment managers.
While we are not significant purveyors of mainstream financial media for a variety of reasons, a recent story on Yahoo Finance contained a useful insight, albeit probably not the one that was intended. With the headline, "No, stocks aren't wildly overvalued: Citi strategist finds hole in Shiller's CAPE", the author reveals how many managers contribute to the problem of distortions.
For background, the CAPE (cyclically adjusted P/E ratio) is a useful valuation concept partly because it applies to a relatively long period of time (ten years), which is reasonably consistent with most investors' investment horizons for stock holdings. It is also useful because it works; it does a remarkably good job of indicating future returns and thereby allowing long term investors to calibrate their exposure accordingly.
The "hole" in CAPE reported in the article turns out to be no hole at all. Citi's strategist Tobias Levkovich explains that since "nobody really invests with a 10-year time horizon anymore, "the CAPE ought to be adjusted for today's low rates. While acknowledging the utility of CAPE for long-term investors, Levkovich explains, "institutional investors can't afford to think much beyond the next 6-to-12 months."
It is exactly this commentary on the environment for "professional" investors that is illuminating. The problem is not that professional investors aren't smart or don't know a lot about investing, most of them do. The problem is that their business dynamics compel them to operate on a very short time horizon which often puts the interests of longer term investors at risk. A recent comment from The Economist sums it up well, "One investment strategist once told your correspondent, 'It makes no sense for me to predict a recession. If I'm right, no one will thank me and if I'm wrong, I will get fired.'" Wouldn’t you like to know that?
As a result, these investors contribute to the distortion of the volatility signal. Compelled to chase short term performance at the expense of longer term outcomes for clients, they eschew insurance irrespective of its investment value. In doing so, they reveal themselves as little more than highly paid puppets.
Finally, we cannot ignore the possibility that volatility measures are not just a function of market dynamics, but are also being directly manipulated. Certainly this is possible given the financialization (i.e., the creation of securities that can be traded) of many metrics. Zerohedge has followed this story for a while and highlighted it in the recent story, “The last minute VIX murder.”
In sum, there are a lot of good reasons to be skeptical of the value of the low volatility signal (and other signals) in the market right now. There is no logical or empirical reason for stocks to always go up (and volatility down) or for returns to always be positive. In fact, they tend to collapse at the most inopportune and inconvenient times.
Ongoing changes in the market combined with distortions caused by public policy are combining to diminish the usefulness of many of the signals we have come to rely upon. As such, we will be well-served to question old heuristics, to stay alert, and to make decisions based on hard information and reasoning.
RSS Feed