| Arete Quarterly Q312 |
Welcome
The lively and ongoing debate about climate change can also be aptly applied to the investment management business. While the climate is certainly changing for money management, in this case it is getting distinctly cooler.
For perspective, it helps to harken back to the beginning of the major bull market in
1982. At the time interest rates were extremely high as a function of expectations for continued high inflation. The market finally turned when inflation was brought under control by tight monetary policy.
History shows us that the stock returns from 1982 to 2000 were hugely anomalous relative to any other period and bond returns have been exceptional from 1982 through the present day. In addition, during that time, productivity increased and mutual funds and defined contribution programs vastly broadened access to markets, adding fuel to the fire.
This all amounted to a warm and bountiful environment for money managers. They grew in three ways: through high returns on portfolios, from new money flowing in, and from increasing profitability driven by economies of scale. There was little push-back on fees which looked small in comparison to high returns. Many money management firms became huge, sprawling entities without extraordinary effort, just by feeding off the abundant landscape. They became dinosaurs.
The financial crisis of 2008 finally marked the end of the gig for a problem that had been brewing for many years: Persistent trade imbalances and unchecked credit creation had led to asset bubbles and unsustainably high debt in many countries. While the initial response by the government was very good in providing emergency liquidity and fiscal stimulus, successive efforts have largely failed to address the core issues.
Instead, the Fed has responded with monetary policy that is primarily designed to buy time. This program consists of various forms of monetary easing of which quantitative easing has been prominent. One of the key effects of these actions is to artifically lower interest rates (that a free and open market would establish) such that the costs to maintain high levels of debt remain manageable (see Market Overview for more).
This policy of extended low rates also has other effects. By suppressing rates, the Fed is also inhibiting the returns savers and investors can expect to achieve. High levels of debt and suppressed interest rates inhibit investment returns in much the same way cooler weather stunts plant development. It’s harder to grow and there is more risk things go wrong.
The low rate environment has very significant implications for the investment management business. All the factors of growth are negatively affected. Lower expected returns reduce the growth rate of exisiting assets and reduces the prospect of new inflows, and may even lead to outflows. If assets decline, economies of scale work in reverse and profits fall disproportionately.
The prospect for low returns also signficantly compromises the value proposition. Since existing management fees will consume a much larger portion of of returns, they will be harder to justify. Investment clients have already begun pushing back on fees and this trend rightfully shows every sign of continuing. Insofar as it does, the business model of a large investment firm, which depends on large fees to support its massive body, will be seriously challenged. If such firms fail to evolve, they are likely to go the way of the dinosaur.
What will work? We suspect the successful investment management firm in this new cooler environment will be a lean and efficient creature that doesn’t require massive resources to sustain. Further, it is likely to be one that is also nimble, adept at searching for and finding nourishment, as well as hearty and resilient to changes in climate.
For a long time, size was considered to be an enormous advantage in investment management and often connoted quality as well. As the investment environment changes, however, size is beginning to look like a distinct disadvantage in many respects. We believe Arete is well suited to the new investment climate and look forward to competing in it. We also look forward to helping investors manage through these very interesting, and different times.
The lively and ongoing debate about climate change can also be aptly applied to the investment management business. While the climate is certainly changing for money management, in this case it is getting distinctly cooler.
For perspective, it helps to harken back to the beginning of the major bull market in
1982. At the time interest rates were extremely high as a function of expectations for continued high inflation. The market finally turned when inflation was brought under control by tight monetary policy.
History shows us that the stock returns from 1982 to 2000 were hugely anomalous relative to any other period and bond returns have been exceptional from 1982 through the present day. In addition, during that time, productivity increased and mutual funds and defined contribution programs vastly broadened access to markets, adding fuel to the fire.
This all amounted to a warm and bountiful environment for money managers. They grew in three ways: through high returns on portfolios, from new money flowing in, and from increasing profitability driven by economies of scale. There was little push-back on fees which looked small in comparison to high returns. Many money management firms became huge, sprawling entities without extraordinary effort, just by feeding off the abundant landscape. They became dinosaurs.
The financial crisis of 2008 finally marked the end of the gig for a problem that had been brewing for many years: Persistent trade imbalances and unchecked credit creation had led to asset bubbles and unsustainably high debt in many countries. While the initial response by the government was very good in providing emergency liquidity and fiscal stimulus, successive efforts have largely failed to address the core issues.
Instead, the Fed has responded with monetary policy that is primarily designed to buy time. This program consists of various forms of monetary easing of which quantitative easing has been prominent. One of the key effects of these actions is to artifically lower interest rates (that a free and open market would establish) such that the costs to maintain high levels of debt remain manageable (see Market Overview for more).
This policy of extended low rates also has other effects. By suppressing rates, the Fed is also inhibiting the returns savers and investors can expect to achieve. High levels of debt and suppressed interest rates inhibit investment returns in much the same way cooler weather stunts plant development. It’s harder to grow and there is more risk things go wrong.
The low rate environment has very significant implications for the investment management business. All the factors of growth are negatively affected. Lower expected returns reduce the growth rate of exisiting assets and reduces the prospect of new inflows, and may even lead to outflows. If assets decline, economies of scale work in reverse and profits fall disproportionately.
The prospect for low returns also signficantly compromises the value proposition. Since existing management fees will consume a much larger portion of of returns, they will be harder to justify. Investment clients have already begun pushing back on fees and this trend rightfully shows every sign of continuing. Insofar as it does, the business model of a large investment firm, which depends on large fees to support its massive body, will be seriously challenged. If such firms fail to evolve, they are likely to go the way of the dinosaur.
What will work? We suspect the successful investment management firm in this new cooler environment will be a lean and efficient creature that doesn’t require massive resources to sustain. Further, it is likely to be one that is also nimble, adept at searching for and finding nourishment, as well as hearty and resilient to changes in climate.
For a long time, size was considered to be an enormous advantage in investment management and often connoted quality as well. As the investment environment changes, however, size is beginning to look like a distinct disadvantage in many respects. We believe Arete is well suited to the new investment climate and look forward to competing in it. We also look forward to helping investors manage through these very interesting, and different times.
Business Update
Of course this cooling climate also affects investors directly and they are feeling the impact in a variety of ways. Feelings of disappointment, confusion, and being overwhelmed are commonplace among investors who have seen their stocks make them no better off after ten years and yet are confronting greater uncertainty than ever before.
Investors are responding to these changes, although priorities differ substantially. Some, as I mentioned in The Arete Quarterly Q112, are finding better advisors. Some are trying to maintain investment income. Some are trying to better manage risk in order to preserve wealth.
What is clear to me is that a lot of people are trying to find a way to become more confident with their investing. It is also clear to me that the priorities of many investors are much more fundamental than the investment service Arete provides with its mid cap core strategy.
To be sure, I am still a very firm believer in the terrific value proposition Arete presents. For an investor with a long investment horizon that is looking for a very thoughtful and disciplined investment process designed for performance, a highly secure separate account structure, and an extremely reasonable management fee, I think s/he will be hard pressed to find a better value. But I also realize this is not the highest priority right now for many investors. In this sense Arete’s vision may be a little ahead of the business prospect.
As such, I am actively exploring ways in which Arete can help investors who aren’t ready or aren’t interested in mid cap investing right now. I also mentioned in The Arete Quarterly Q112 that “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.”
It is also true that being a student of investing, I consume a great deal of non-stock specific research and material. This ranges from books, to academic articles, to articles discussing the business environment for investment management. I do this largely because it helps me gain perspective regarding investment challenges, investors’ needs, and useful solutions, but I also learn a lot about how to better manage my own investments.
Historically this has been an informal exercise, but now I am trying to formalize the insights and knowledge I gain from the effort. As such, I am experimenting with a knowledge database constructed out of the pieces of information I gather on a regular basis. The goals are twofold: To better organize and manage knowledge internally, and to create a vehicle by which more investors may be able to benefit from the work. This is a natural manifestation of Arete’s value proposition: “Leveraging our investment expertise for your success.”
My hunch is that this could prove quite useful for a number of investors. In addition to the market’s own challenges, investors often also contend with misinformation in the form of vastly differing opinions and insights from a wide variety of vendors. Not surprisingly, many exclusively offer advice which extols the virtues of their own products at the expense of other more appropriate options. Too often investors are left without a neutral arbiter to validate arguments or to highlight inconsistencies.
A key impetus for this project was my own curiosity for better understanding this unique investment environment. Given the distinct prospects of the environment remaining difficult for some time, I have also been studying a variety of ideas for managing through it. I refer to the exercise as the “Investment Challenge” and would be happy to discuss it with you or to present it to your organization.
Finally, I would like to say that as Arete rapidly approaches its fifth anniversary, I have occasions to compare the environment at Arete to situations at other firms. While I do at times get frustrated that Arete is not yet reaching as many people as I would like, I can also honestly say that I have never felt so intellectually stimulated, so uninhibited to reason through issues, or so free to brainstorm new ways to help investors. These are the reasons why I chose investment management as a career and I still have a ton of fun with it!
Thanks for your support!
David Robertson, CFA
CEO, Portfolio Manager
Of course this cooling climate also affects investors directly and they are feeling the impact in a variety of ways. Feelings of disappointment, confusion, and being overwhelmed are commonplace among investors who have seen their stocks make them no better off after ten years and yet are confronting greater uncertainty than ever before.
Investors are responding to these changes, although priorities differ substantially. Some, as I mentioned in The Arete Quarterly Q112, are finding better advisors. Some are trying to maintain investment income. Some are trying to better manage risk in order to preserve wealth.
What is clear to me is that a lot of people are trying to find a way to become more confident with their investing. It is also clear to me that the priorities of many investors are much more fundamental than the investment service Arete provides with its mid cap core strategy.
To be sure, I am still a very firm believer in the terrific value proposition Arete presents. For an investor with a long investment horizon that is looking for a very thoughtful and disciplined investment process designed for performance, a highly secure separate account structure, and an extremely reasonable management fee, I think s/he will be hard pressed to find a better value. But I also realize this is not the highest priority right now for many investors. In this sense Arete’s vision may be a little ahead of the business prospect.
As such, I am actively exploring ways in which Arete can help investors who aren’t ready or aren’t interested in mid cap investing right now. I also mentioned in The Arete Quarterly Q112 that “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.”
It is also true that being a student of investing, I consume a great deal of non-stock specific research and material. This ranges from books, to academic articles, to articles discussing the business environment for investment management. I do this largely because it helps me gain perspective regarding investment challenges, investors’ needs, and useful solutions, but I also learn a lot about how to better manage my own investments.
Historically this has been an informal exercise, but now I am trying to formalize the insights and knowledge I gain from the effort. As such, I am experimenting with a knowledge database constructed out of the pieces of information I gather on a regular basis. The goals are twofold: To better organize and manage knowledge internally, and to create a vehicle by which more investors may be able to benefit from the work. This is a natural manifestation of Arete’s value proposition: “Leveraging our investment expertise for your success.”
My hunch is that this could prove quite useful for a number of investors. In addition to the market’s own challenges, investors often also contend with misinformation in the form of vastly differing opinions and insights from a wide variety of vendors. Not surprisingly, many exclusively offer advice which extols the virtues of their own products at the expense of other more appropriate options. Too often investors are left without a neutral arbiter to validate arguments or to highlight inconsistencies.
A key impetus for this project was my own curiosity for better understanding this unique investment environment. Given the distinct prospects of the environment remaining difficult for some time, I have also been studying a variety of ideas for managing through it. I refer to the exercise as the “Investment Challenge” and would be happy to discuss it with you or to present it to your organization.
Finally, I would like to say that as Arete rapidly approaches its fifth anniversary, I have occasions to compare the environment at Arete to situations at other firms. While I do at times get frustrated that Arete is not yet reaching as many people as I would like, I can also honestly say that I have never felt so intellectually stimulated, so uninhibited to reason through issues, or so free to brainstorm new ways to help investors. These are the reasons why I chose investment management as a career and I still have a ton of fun with it!
Thanks for your support!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
The third quarter was characterized by relatively strong returns, and significant short-term trading activity around economic statistics and macro news. These conditions have prevailed most of the past two years due to the Fed’s continued commitment to quantitative easing.
While it is tempting to see rising stock prices as evidence of economic and financial improvement, we see something very different. Our valuation work and fundamental research shows that stock market prices continue to be meaningfully separated from intrinsic values on both the positive and negative sides.
We aren’t the only ones seeing this. In a recent article in the Financial Times, Mohamed El-Erian from PIMCO described, “Essentially, the Fed is inserting a sizeable policy wedge between market values and underlying fundamentals . . . In the process, many asset prices have been taken close to what would normally be regarded as bubble territory, with some already there.”
As stocks have run up, so has interest in gaining exposure to markets in classical herd behavior. Significant inflows continue to be booked by exchange traded funds (ETFs) and other passive vehicles. Conversely, virtually no active managers are outperforming right now and money continues to flow out of active funds.
Given these observations, what should long-term investors be doing? Some nuances of the investment landscape can be better understood by analyzing the Fed’s actions, intent, and rationale in a critical light.
For example, we know, based on Chairman Bernanke’s own statements, that he believes money easing will inflate stock prices and that higher stock prices increase consumption due to the “wealth effect”.
Certainly, traders have been compelled to bid up prices in response to the Fed’s easing based on the conventional wisdom, “Don’t fight the Fed”. Not only has the Fed signaled its intention of wanting higher stock prices, but rock-bottom interest rates provide virtually no opportunity costs for speculators interested in taking a flier. As a result, short-term trading activity has been a prominent feature of market activity since the Fed began its major interventions.
So, one message for long-term investors is: understand that most prices are being set by short-term interests which are often very different than yours.
We also argue that the effort to invoke the wealth effect by inflating stock prices misses a very basic reality: Houses are by far the most important asset for the vast majority of individuals. Stocks aren’t even close. And we know that on average, home equity has crashed over the last thirty years.
Households with mortgages had equity in their homes of almost 50 percent of the house’s value, on average, in the early 1980s (Gary Shilling, The Age of Deleveraging). The most recent figure for home equity, reported in Shilling’s October 2012 Insight newsletter, is less than half that at 20.5%. Further, almost a quarter of mortgages are under water. Shilling reports concisely, “median net worth of families fell 39% in these years [from 2007 – 2010].”
As a result, we suspect that many households are no longer in a position in which they feel they can take risks with investments. They simply can’t afford to lose any more. In other terminology, they have lost their “animal spirits”. Given the massive decline in housing and two market crashes in the last twelve years, we also suspect many have lost faith in institutions such as the Fed to improve their lot in life.
In light of this analysis, it’s a fair question to ask: Why would the Fed continue pursuing such an extreme and experimental monetary policy (and it is extreme!) in light of compelling evidence that it is ineffective and perhaps even counterproductive?
We believe this question leads to the one of the most important and least appreciated elements of the current investment landscape. While bank lending remains weak, it is well known and documented. What is far less appreciated is that other forms of credit provided by the shadow banking system are continuing to unravel. In short, a big part of the reason the Fed is flooding the system with money is to offset the losses from shadow banking.
Without getting into the details, many aspects of shadow banking are the deals referenced by incomprehensible acronyms like CMBS, ABS, RMBS, etc. One of the key features of shadow lending is that it adds credit to the system without any reserves backing it up. This worked beautifully as asset prices kept going up. Once that stopped, however, the gig was up. Further, the shadow banking system is not trivial; it accounts for several trillions of dollars of credit. Since it started drying up in 2007, it has created a massive vacuum of demand in the economy. This is the hole the Fed is trying to fill with quantitative easing.
This insight really helps define the problem for investors now. We aren’t dealing with a little incremental fix here or there. The Fed is trying to offset the loss of trillions of dollars of credit by printing money. In doing so, it is balancing the risk of a sudden and substantial loss of demand if it replaces credit too slowly vs. the risk of inflation if it prints too much money or fails to withdraw it soon enough when things pick up again.
Another message for long-term investors, then, is: In the face of strong headwinds of deleveraging, be very leery of substantial, and sustained, increases in demand any time soon.
As a result, our view of the market is nuanced. On one hand, we believe the job of balancing a recovery without help from complementary fiscal policy will be fraught with danger. Shorter-term trading activity has bid a great number of stocks up well past reasonable targets making them unattractive. Further, we have been shocked by the almost complete absence of considerations for the fiscal cliff or for financial market dislocation in calendar 2013 earnings estimates.
On the other hand, there are a number of stocks which currently discount financial disaster, which is unlikely to happen. The magnitude of disparity normally spells significant opportunity for active, valuation-based investors, although the opportunity has proven elusive in this market. We will be watching for evidence that the market is ready to acknowledge valuation/fundamentals disparities with third quarter earnings.
Finally, as is so often the case in the capital markets, the thing that you really want for the next ten years is very different than what has been exciting for the last couple of years. Looking forward, we think Treasuries will perform miserably and simple index exposure to the stock market will have its own dangers. Although Fed policy can certainly forestall things for some period of time, we believe conditions are setting up for a very profitable new age of active, valuation-based management.
The third quarter was characterized by relatively strong returns, and significant short-term trading activity around economic statistics and macro news. These conditions have prevailed most of the past two years due to the Fed’s continued commitment to quantitative easing.
While it is tempting to see rising stock prices as evidence of economic and financial improvement, we see something very different. Our valuation work and fundamental research shows that stock market prices continue to be meaningfully separated from intrinsic values on both the positive and negative sides.
We aren’t the only ones seeing this. In a recent article in the Financial Times, Mohamed El-Erian from PIMCO described, “Essentially, the Fed is inserting a sizeable policy wedge between market values and underlying fundamentals . . . In the process, many asset prices have been taken close to what would normally be regarded as bubble territory, with some already there.”
As stocks have run up, so has interest in gaining exposure to markets in classical herd behavior. Significant inflows continue to be booked by exchange traded funds (ETFs) and other passive vehicles. Conversely, virtually no active managers are outperforming right now and money continues to flow out of active funds.
Given these observations, what should long-term investors be doing? Some nuances of the investment landscape can be better understood by analyzing the Fed’s actions, intent, and rationale in a critical light.
For example, we know, based on Chairman Bernanke’s own statements, that he believes money easing will inflate stock prices and that higher stock prices increase consumption due to the “wealth effect”.
Certainly, traders have been compelled to bid up prices in response to the Fed’s easing based on the conventional wisdom, “Don’t fight the Fed”. Not only has the Fed signaled its intention of wanting higher stock prices, but rock-bottom interest rates provide virtually no opportunity costs for speculators interested in taking a flier. As a result, short-term trading activity has been a prominent feature of market activity since the Fed began its major interventions.
So, one message for long-term investors is: understand that most prices are being set by short-term interests which are often very different than yours.
We also argue that the effort to invoke the wealth effect by inflating stock prices misses a very basic reality: Houses are by far the most important asset for the vast majority of individuals. Stocks aren’t even close. And we know that on average, home equity has crashed over the last thirty years.
Households with mortgages had equity in their homes of almost 50 percent of the house’s value, on average, in the early 1980s (Gary Shilling, The Age of Deleveraging). The most recent figure for home equity, reported in Shilling’s October 2012 Insight newsletter, is less than half that at 20.5%. Further, almost a quarter of mortgages are under water. Shilling reports concisely, “median net worth of families fell 39% in these years [from 2007 – 2010].”
As a result, we suspect that many households are no longer in a position in which they feel they can take risks with investments. They simply can’t afford to lose any more. In other terminology, they have lost their “animal spirits”. Given the massive decline in housing and two market crashes in the last twelve years, we also suspect many have lost faith in institutions such as the Fed to improve their lot in life.
In light of this analysis, it’s a fair question to ask: Why would the Fed continue pursuing such an extreme and experimental monetary policy (and it is extreme!) in light of compelling evidence that it is ineffective and perhaps even counterproductive?
We believe this question leads to the one of the most important and least appreciated elements of the current investment landscape. While bank lending remains weak, it is well known and documented. What is far less appreciated is that other forms of credit provided by the shadow banking system are continuing to unravel. In short, a big part of the reason the Fed is flooding the system with money is to offset the losses from shadow banking.
Without getting into the details, many aspects of shadow banking are the deals referenced by incomprehensible acronyms like CMBS, ABS, RMBS, etc. One of the key features of shadow lending is that it adds credit to the system without any reserves backing it up. This worked beautifully as asset prices kept going up. Once that stopped, however, the gig was up. Further, the shadow banking system is not trivial; it accounts for several trillions of dollars of credit. Since it started drying up in 2007, it has created a massive vacuum of demand in the economy. This is the hole the Fed is trying to fill with quantitative easing.
This insight really helps define the problem for investors now. We aren’t dealing with a little incremental fix here or there. The Fed is trying to offset the loss of trillions of dollars of credit by printing money. In doing so, it is balancing the risk of a sudden and substantial loss of demand if it replaces credit too slowly vs. the risk of inflation if it prints too much money or fails to withdraw it soon enough when things pick up again.
Another message for long-term investors, then, is: In the face of strong headwinds of deleveraging, be very leery of substantial, and sustained, increases in demand any time soon.
As a result, our view of the market is nuanced. On one hand, we believe the job of balancing a recovery without help from complementary fiscal policy will be fraught with danger. Shorter-term trading activity has bid a great number of stocks up well past reasonable targets making them unattractive. Further, we have been shocked by the almost complete absence of considerations for the fiscal cliff or for financial market dislocation in calendar 2013 earnings estimates.
On the other hand, there are a number of stocks which currently discount financial disaster, which is unlikely to happen. The magnitude of disparity normally spells significant opportunity for active, valuation-based investors, although the opportunity has proven elusive in this market. We will be watching for evidence that the market is ready to acknowledge valuation/fundamentals disparities with third quarter earnings.
Finally, as is so often the case in the capital markets, the thing that you really want for the next ten years is very different than what has been exciting for the last couple of years. Looking forward, we think Treasuries will perform miserably and simple index exposure to the stock market will have its own dangers. Although Fed policy can certainly forestall things for some period of time, we believe conditions are setting up for a very profitable new age of active, valuation-based management.
RSS Feed