bizzXceleration: Performance, Value and Profit

 

Active Investment Management: Allocation and Asset

Before we dive into our Four Factor Active Management approach we'll point out that this is not the first time we've tried to make some of these points. In fact we did it on this blog a couple of years ago (hence the 4Factor summaries stretching back a ways) and tried it earlier for our network, both with little effect. But we're far from the only voice. Let's quote an excerpt from a WSJ story from 2003, which along with what we think are other must-reads, is in the Readings section after the break.

 But instead of rising to the occasion, I fear Wall Street will once again go for the quick buck, flogging flaky investments and using underhanded sales tactics. Why this pessimism? Unfortunately, many brokerage houses and financial-planning firms just aren't ready for prime time.

 Let's dig into our alternative approach to relying on the paid guidance of advisors (think of it as a kindness from a stranger). Our approach is presented in this graphic, which will be a little complicated in practice. Which will also be up to you.

First off we distinguish four Investor Strategies: Conservative, Moderate, Active and Trader. The differences lie in goals (preserving capital, ability to manage/tolerate risk, and work). The more work you're willing to invest the more active you can afford to be. For each of those four we suggest a long-run portfolio allocation.

Now when we say Active Allocation what we intend is that you're adjusting the % to the four factors at any given time. And, the critical lesson, not even conservative investors can afford not to be active allocators. When we say Active Investing we're talking about digging into asset classes, specific assets and investments and understanding key themes and instruments. If we were going to do a lot more of the work we'd need to build a current allocation recommendation for each timeframe for each investor type. Timeframe is another key thing as well. If you recall each factor tends to play out over different timeframes and, here, we're suggesting that the more active you are the more you need to be adapting in shorter timeframes. At the same time, another fundamental lesson for another Lost (Turbulent) Decade is that everybody needs to be constantly monitoring their investments. Even in the last decade, where a clear trend set in from 2003 to 2007, and you could have gone in and stayed constant for five years or more you need to monitor. With no bubbles in sight, enormous uncertainty and sustained turbulence you need to monitor your investments and the Factors every month and re-validate your strategy, allocation and investments every quarter at least. In the New Normal a quarter is five years and a month could be a year.

Themes and Instruments

Themes and Instruments are key terms. A Theme, as we mean it, is an investing idea that will hold true and drive performance over one or all of the timeframes. Instruments are specific investment types, that is the tool which you use to realize and implement your decision, and you need to have some knowledge of them. Do you pick stocks directly or use a mutual fund? If a fund an index or active fund, or what about an equivalent ETF? If an ETF how about considering inverse ETFs or leveraged ETFs? In general you have to adapt the instrument to the asset - if you've done your Graham-Buffett homework then by all means buy the stock. If you haven't then you need to consider a fund. When you go foreign it's much harder to do the homework so it becomes more feasible to go the fund or ETF route. If you want to go with the big theme you might pick an ETF, for example the emerging markets EEM, or having done some work and paid attention to our earlier writings you'd focus on Brazil of the BRICs and go with EWZ. If you actually listened to the WT clip you got what we think are some excellent themes for the year, and the decade. There's a whole section of WealthTrack recent shows in the readings btw as well as a link to Bob Doll's themes for 2010 and the Decade. We don't entirely agree perfectly with all of them but think everyone make sense.

How might that all play out? Well if we look back to 2003 when at least we had the luxury of clearer trends and lower turbulence we can work an example. A standard portfolio mix is 60% equity and 40% bonds. One could even call it canonical. By late 2006 it was clear that job and GDP growth was falterring which meant, clearer in hindsight of course, that it was time to shift more toward a 40/60 split. Here's another little trick to play - you don't have to be all one investor type or another. You could keep some percent (say 50 or 90) of your investable wealth in the Conservative portfolio and pursue a more active strategy with the rest, blending the two. Anyway, in January 2008 we explicitly recommended to everybody that they get into cash or shorter-term bonds, which would have paid off very well. Especially if you'd been in Treasuries given the surge in prices for low-risk bonds. If you wanted to be more active, and accept more volatility, we strong suggest inverse ETFs, especially for the emerging markets, at the same time. Thru March of 2008 that would have paid off handsomely. Now our assessment of the markets then and since has been pretty pessimistic but one way to deal with that as they turned was to start scaling back in until you reached the appropriate allocation.

One of THE dominant themes for the next decade will be the shift in the world economy, something that Mohamed El-Erian of PIMCO noticed around 2003 when he pointed out that EM bonds were much better investments because for the first time in history the emerging markets were becoming well-run and reliable. But were under-valued and under-priced. Now right now the show is on the other foot - the EM have run to far and too fast, especially China. Which means it's time to reduce your exposure and past.

There's one other major card we've palmed here if you look at the Allocation Table closely - the percentages don't look at all like the standard canonical forms of standard practice. Cliff Asness of AQR investments (again the clip link is in the readings), one of the best hedge fund managers around, has pointed out that what you need to do is diversify but what you really need to do is diversify by risk. Bonds are 1/3 as risky as equities while commodities are 2X as risky. So, for any given situation your Bond:Equity:Commodity allocation should be 3:1:.5, or 60:20:10. We've taken his idea (btw - he has some really interesting comments on which classes have which risks) and applied it so our basic Conservative model follows it but the others accept more risk relative to the baseline. But we've also upped the proportion of offshore assets considerably once things return to normal (recognizing three different domains: US, Foreign (Europe, Jpn) and Rapidly Emerging Economies (REE)).

Timeframes, Themes and Allocations

Now we've got another WealthTrack clip for you, this time with Neill Ferguson (the historian, pundit and pontificator) who's bright, charming, has some major insights but doesn't quite know all about everything quite as he thinks. Nonetheless his sketch of the evolution of a new geo-political order and the impact of debt on long-term growth are well grounded and fairly accurate so we'd second theme.BtW - any trouble with seeing the clip and the BlipTV link for WT is after the break.

Speaking of timeframes and good advice if you put the pieces together,listened to the clips and try to boil it down here's where we end up. The market is getting tired and is due for a correction. If you're conservative now is the time to start shortening up on bonds and building cash. For any investor group now is not the time to be getting in. So as cash accumulates put it into ST Bonds. In fact we've tried to summarize where we think your overall posture ought to be, given an allocation strategy and specific investment decision. In the ST we're suggesting that you move toward cash and ST Bonds. When we say neutral we mean with respect to the target allocation, i.e. work your way back to the % you want and then actively manage your portfolio to maintain it with quarterly adjustments. That also means that we're Neutral with regard to equities in the short-term, anticipating a correction that you can hold thru, but once it turns increase your holdings with more emphasis on foreign and REE equities. But there are other changes and themes, e.g. it's not clear how inflation and rates will do but the fear is there as is the debt problem. So your choice of Investment, even as you move back longer term, should be for shorter duration bonds or TIPs. Similarly while Gold (which is almost it's own class for special reasons) and Commodities are over-priced right now we'd start moving out of them.

If you wanted to follow a more active strategy here's one rule of thumb to use: wait until the turning point is clear then adjust. If the market starts a correction you'll have more than a few days warning but you are also likely to not have a month. Be prepared and think thru ahead of time on what conditions you'll move and how and where you'll do it.

That's about as much as even one of our posts should cover. But in addition to WealthTrack we think you should monitor weekly Prieur du Pleis's Investment Postcards, particularly his weekly summary, and Jim Jubak's colum, and/or his blog. If you're looking for specific ideas, themes and suggestions it doesn't get any better. In particular his three portfolios are as good a place to start as there is.

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Refresh and Level Set

CHINA RULZ, BEARS ARE FOOLZ Perhaps it was always going to happen. After the hawkish drum beat of evidence for the prosecution going into Friday's payroll data, the employment figures were skewed well to the weak side of expectations. And while eurodollars gapped up and stayed up, the impact on other asset markets lasted, oh, at least forty-five minutes before "risk on, baby" re-asserted itself. And if that wasn't enough, Macro Man's email box was peppered with sell-side missives over the weekend trumpeting China's excellent export data. Even his equity-manager chum was talking about Chinese exports on the train this morning. To be sure, the figures were impressive. Macro Man is always somewhat bemused by the focus on Chinese exports, given that these are a) at least partially driven by the country's mercantilist policies, and b) as such, at least partially represent the vulturing of market share away from other producers. Far more interesting to Macro Man is China's import data, which was truly stunning; up 55% y/y, taking the nominal dollar amount to new highs. Unsurprisingly, this has been taken well by other markets, with developed-markets equity indices (and futures) reaching post-2008 highs. In many ways, it feels as if there is no market advantage to weighting risks and considering expected values on sundry investments. CHINA RULZ, BEARS ARE FOOLZ is looking like a manifestly superior investment methodology for the time being. In any event, whether it's "China rulz" or simply the ongoing abundance of liquidty available for certain types of investment, whatever is driving markets has spread its tentacles far and wide. Commodities have ripped higher; while oil could perhaps be explained by the cold weather gripping the entire Northern Hemisphere, gold has also made a Lazarus-like comeback after the $150/oz smackdown observed last December.

Words from the (investment) wise for the week that was (January 4–10, 2010) The declines in the Shanghai Composite Index came in the wake of investors’ concerns about a flood of initial public stock offerings (IPOs) and the authorities’ actions to slow down lending. Of all the major indices, the Shanghai Composite is the only one trading marginally below its 50-day moving average. Also, as shown by the declining green line in the bottom portion of the chart below, Chinese stocks have since July been underperforming the S&P 500 Index - a reversal of roles since China turned the bear market corner five months before most other markets in November 2008. Interestingly, Marc Faber told CNBC (via MoneyNews): “My feeling is that the US will outperform emerging economies in the first six months of 2010.” While on the topic of long-term charts, when considering S&P 500 monthly data, three momentum-type oscillators (RSI, MACD and ROC) all still signal a bullish trend. (As an aside, the long-term picture for US government bonds is in bearish mode as highlighted in a post a few days ago.) It goes without saying that the strong rally since March is bound to be followed by a correction at some stage. But rather than pre-empting (and more often than not getting it wrong as a result of short-term noise), I will be guided by the longer-term charts and the yield curve to identify a major top. Meanwhile, I am watching valuations carefully, and specifically how the Q4 earnings reports stack up. Although I am treading with caution after the 74% rally in the mature markets and 109% in emerging markets, I am not ignoring good old stock-picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty.

Bob Doll’s crystal ball into 2010 and the next decade BlackRock, Inc. (BLK) Vice Chairman Bob Doll has been putting out annual predictions for 15 years. Doll, who helps oversee about $3.2 trillion at BlackRock, the world’s biggest asset manager, just released his ten predictions for 2010 and for the next ten years. Eleven of the twelve predictions he made for 2009 were right. Below are highlights of his latest market forecasts. In general, Doll believes US stocks will outperform cash, Treasuries and other developed economies with S&P 500 rallying another 12% this year, reaching 1250 from its January 4 open of 1116.56. The US is on its way to recovery, but the economy will grow slower than that of a typical recovery mainly due to heavy debt load. Inflation will be a “non-issue” in the US, Europe and Japan this year even with rising prices of gold and oil. The US dollar will likely remain weak in a broad trading range with the euro and yen. Doll also noted structural issues in the economy would continue to present problems.

WealthTrack: BlipTV WT Episodes

WealthTrack 602 | 01-08-10 On this week's Consuelo Mack WealthTrack, Consuelo will ask three investment pros how they intend to make money in the New Year in stocks, bonds and foreign markets. BlackRock's Chief Equity Strategist Bob Doll runs three highly respected large cap funds; First Eagle Fund's Matthew McLennan just took over the global investment helm from legendary value investor Jean-Marie Eveillard; and veteran bond manager Marilyn Cohen just published her new book 'Bonds Now!'.

• WealthTrack 601 | 01-01-10 Charlie Dreyfus of Royce SmallCap
• David Winter of Wintergreen Investments on WealthTrack via Wintergreen's site.

WealthTrack 525 | 12-18-09 On this week's Consuelo Mack WealthTrack, two investment champions join us for a WealthTrack exclusive from independent research firm, ISI Group. Ed Hyman, Wall Street's number one ranked economist for an unprecedented thirty years running, and top ranked portfolio strategist, Francois Trahan, will share their 2010 forecasts.

WealthTrack 523 | 12-04-09 On this week's Consuelo Mack WealthTrack, our "Great Investors" series explores the inner workings of the hedge fund world with outspoken fund manager Cliff Asness of AQR Capital Management, who will discuss his quantitative strategies as well as the investing rules that all investors should follow.

WealthTrack 534 | 12-11-09 Neil Furguson on the long-term outlook for the decade.

Re-Thinking Financial Advice

Asking for Advice Is Asking for Trouble (WSJ 2003) Wall Street has a wonderful opportunity to help millions of investors. But it probably won't. This I believe: In the years ahead, giving financial advice has the potential to be a huge growth business, for three reasons. First, we have just had a harrowing stock-market collapse, and many folks are unsure what to do next. Second, thanks to the demise of traditional company pensions and their replacement with 401(k) plans, investors are now more in need of advice than ever before. Third, that need for advice will almost certainly grow, as the baby boomers quit the work force and grapple with the complexities of managing money in retirement. But instead of rising to the occasion, I fear Wall Street will once again go for the quick buck, flogging flaky investments and using underhanded sales tactics. Why this pessimism? Unfortunately, many brokerage houses and financial-planning firms just aren't ready for prime time. Here's why: Financial advice isn't solely about selecting investments. But try telling that to most investment advisers. Far too many brokers and financial planners hold themselves out as experts who can pick winning stocks and mutual funds. Yet, in reality, outguessing the market is extraordinarily difficult. Indeed, once you figure in the costs involved, most investors earn returns that lag far behind the market average. That's why the best brokers and financial planners direct their efforts elsewhere.

Now Even Millionaires Can See the Benefits of Budgeting The Boston Consulting Group predicted this week that worldwide wealth would not return to 2007 precrisis levels until 2013. It also said it found that the number of millionaires was down 18 percent and that, across the board, clients of wealth management firms had lost trust in their advisers. “There is a shattered confidence we haven’t seen in a long time,” said Bruce Holley, senior partner at the firm. “The wealth management business is a very emotional business, and people can react in kind to that.”  This explains how someone with more than $100 million in assets can ask her adviser to put her on a budget. As far-fetched as it may sound to someone struggling to make a mortgage payment, such a request reflects the changes in attitudes about wealth in the last year. SHOW ME THE MONEY Watching where your money goes is more than just having a budget. “One of my families said, ‘If you’re worried about spending, then you’re not wealthy,’ ” Mr. Bickel said. “But across the board, there is greater discernment with use of discretionary income.” Or, as Mr. Cochran put it, “Many people thought they were gunslingers.” Now, he said, “They’re not gunslingers any more.” Mr. Holley described the sentiment as a return to “meat and potatoes” investing. Now, that group is focused more on the risk of an investment than its possible return. One result is they are poring through all the disclosures before investing, and they are not as worried about missing out if they are pressured to invest too quickly. The second group is older and held wealth longer. They exhibited almost a knee-jerk reaction to the crisis and put a lot of money into cash early on. They continued to stand on the sidelines through the initial rebound. Only now are they looking to invest in safe assets, like prerefunded bonds secured by United States government obligations. “We are very gradually working with them,” Ms. Rooney said. “For many of them, it was a loss of confidence in themselves as well as in the markets.”  Mr. Cochran said he believed many clients thought the world was coming to an end last September. That it did not end has not consoled them. They are still hesitant with new investments.

Rethinking Stocks' Starring Role For at least a generation, financial professionals have urged mutual-fund investors to put more money in stocks than in bonds. The logic: Stocks power a portfolio, while bonds provide some protection. Now some pros are questioning that conventional wisdom. After last year's stock crash, and ahead of a potentially weak economic recovery, they're arguing that bonds and alternative asset classes such as commodities deserve more weight. What's more, the classic 60-40 split between stocks and bonds—the formula that many balanced funds use to allocate investments—ignores alternative asset classes that can deliver returns with different levels of risk. "The whole 60-40 idea is almost like Betamax videotapes—it's now passé," says Andrew Silverberg, co-manager of Alger Balanced Fund. "It gained popularity while we were still in a bull market." Asset allocation should be "more dynamic," Mr. Silverberg says. "There are a lot of opportunities on the other side of the balance sheet," he adds, referring to corporate bonds. Earlier this year, Alger Balanced's stock allocation was 48%, though it has since increased to about 56%. Gibson Smith, co-chief investment officer at Janus Capital Group and co-manager of Janus Balanced Fund, doesn't stick with the 60-40 formula either. "We're not just about driving returns, but also preserving capital," he says.

Active Managers Get the Cold Shoulder A growing number of big investors are concluding that stock and bond pickers failed to add any value during the market turmoil and are shifting to index funds, a move that threatens to cut profits for asset managers. "Active managers have not given us the added performance in a down market that we hoped for," says Bill Atwood, executive director of the $9 billion Illinois State Board of Investment. Disappointing returns by some large- and small-stock managers led his fund to move about $400 million to index funds. "Now that we think we're close to the bottom, we feel we can access the upside just as well with index managers," Mr. Atwood says. The move toward more-passive investments is part of a broader reconsideration by many investors about what went wrong in 2008 and how they can reposition their portfolios to avoid a rerun of that dismal performance. Active managers promise to beat, rather than match, the market's overall returns and charge fees that can be at least 10 times higher than those of index funds. In a recent survey by Greenwich Associates, a Greenwich, Conn., consulting firm, about one in five institutional investors said they have recently shifted money away from active managers and into passive index strategies. That is up from just 4% who expected to make that shift when asked from July to October 2008. The active-versus-passive debate is shaping up as a driving force behind industry consolidation. When BlackRock Inc. agreed this month to acquire Barclays PLC's Barclays Global Investors, the giant index and exchange-traded-fund business, BlackRock CEO Laurence Fink cited investor efforts to cut costs through passive strategies as an impetus for the deal.

Wary Investors Are Seeking Out Objective Voices In the aftermath of the financial-market crisis, investors are leaving Wall Street to sign on with independent investment advisers. Last year, registered investment advisers brought in more than $108 billion of net new assets into the three largest custodians, according to Charles Schwab Corp., which holds roughly $500 billion in assets for such advisers. By contrast, the four major Wall Street brokerage firms saw an outflow of $8 billion in 2008. Investors seeking to repair their damaged nest eggs say the chief lure of independent advisers is more-objective guidance. Connie Ashline of Kankakee, Ill., decided to follow her adviser from Smith Barney, Dorie Rosenband, when the New Yorker started her own firm in March. “I feel that by my paying her as an independent adviser, she would be in a greater position to take my best interests at heart,” says Ms. Ashline, 75 years old. “The reality is that the brokerage firms are set up for the brokerage of products,” says Ms. Rosenband. And even though brokers’ titles may have changed over the years to “financial advisers and consultants,” she says the culture at the firms hasn’t. As a result, clients were often confused about what they were getting, she says, adding that she brought over about 20% of her clients, mainly those who were primarily interested in a long-term approach.

Think Like Warren Buffett 1. Think of Stocks as a Business Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions. 6. Recognize the Psychological Aspects of Investing Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking. More than anything, investors' own emotions can be their worst enemy. 8. Wait for the Fat Pitch Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player. Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.

• Warren Buffett: How He Does It
• A Baby Buffett Portfolio: His 6 Best Long-Term Picks

Masterclass: Buffett on Investing and Business Analysis At the end of the last post we laid down a, perhaps the, challenge for these interesting times:

"As this sorting goes on the real winners will be the firms and industries who have an effective business model or who re-invent one. Finding them will be the interesting challenge. "

So how does one go about sorting things out. Well there's our interesting little mantra of economy - industry - firm but we thought, beyond that, we'd appeal to the words of the Master. Mr. Warren Buffett himself. Now at some point you've probably seen Warren's basic principle's in some business article or heard him on Rose or someplace else. Certainly the AAII article does a superb job of translating those principles into a screening set, within the limits. We'd summarize/paraphrase them roughly as: 1) Understand the business and be absolutely confident in it as a business for the long-haul, 2) view investments as buying a piece of the business and be comfortable not trading them for 10 years, 3) look for companies with sustainable competitive advantages that protect the core value proposition and 4) pick companies with good management. Listening to Warren takes those simple-sounding principles and fleshes them out with examples and discussions that makes them meaningfully operational. Beyond that though we got several surprises that, as long we thought we'd been following Buffett, were eye-openers: 1. Understand the business - everybody's heard that he make a decision in 5-10 mins. What's new news to us is that a) he adds develop a circle of competency, say 30+ companies, you really understand and follow and b) it takes a lot of digging and research. It turns out the Warren spent a long...long time and a lot of effort learning how businesses really work, i.e. what their business models are. Since this is our central mantra we were extremely gratified to hear it. 

Alternative Assets for the Masses Institutional investors have long used private equity and hedge funds to achieve overall returns far higher than those eked out by individuals. In the 10 years ended Dec. 31, 2008, Hedge Fund Research's Fund Weighted Composite Index gained 7% per year, on average, while the Thomson Reuters U.S. Private Equity Performance Index returned an annual average of 17%. That compares with a 13% cumulative loss for the Standard & Poor's (MHP) 500-stock index. Until recently the masses lacked easy access to these asset classes. Over the past year, however, the number of products that offer individual investors ways to invest in alternative assets has swelled. Should individuals jump in now that they have the chance? Darek Wojnar, head of product strategy and research at iShares, thinks the business of alternative assets is "in its adolescence." As retail products proliferate, the asset class will become more user-friendly compared with the hedge funds of old, he says: "Why would investors want to invest in vehicles that are expensive, have no transparency, have significant liquidity restrictions, and do not disclose exposure?" Already, JPMorgan (JPM), and Schwab (SCH) are among the big shops offering retail funds. Exchange-traded funds have also popped up, such as iShares Diversified Alternatives Trust (ALT), which has an expense ratio, or the annual cost to investors expressed as a percentage of the total amount they have invested, of 0.95%. A newer player in the fund field, IndexIQ in Rye Brook, N.Y., offers two ETFs that use hedge fund strategies, both priced at 0.75%. But don't be persuaded by the low fees alone. Lo warns that some ETFs use short positions and are "potentially misleading," because they offer short exposure on a daily basis rather than over a period of time. Check with a financial adviser or fund ratings service before buying.