Does the evidence on persistence in top performing active managed mutual funds actually mean anything?

There is a fair amount of “buzz” around why successful actively managed mutual funds can not be successfully chosen ex-ante (beforehand) given that there is little evidence of persistence of mutual funds that outperform their peer group from one period to the next. In otherwords only a fraction of mutual funds that originally outperformed in the first measured period outperformed in the second measured period.

 

Vanguard’s research on persistence (PDF: The Case for Indexing) published 04/14 highlights its version of the persistence challenge.  Researchers at Vanguard looked at 5,945 mutual funds with 5 year track records at the end of 2008.  It reported that only 145 funds of the original 5,945 remained in the top 20% of top performing funds.  That’s 2.4% of the original funds!  While that sounds like some disappointing results — maybe its not so bad.

 

But first, it seems strange to me that any valid information can come out of a study when 32.1% of the original funds were merged or liquidated/closed at the end of 2013.  Again 1,910 of the 5,945 funds did not complete the second 5 year measurement period.  That seems to be an issue that should be addressed before any conclusions can really be made.

 

Regardless, the key takeaway from these types of studies on persistence should be that no style of investing works in all market conditions.  Sometimes growth companies outperform value companies and large companies outperform small companies.  The value premium has been shown to be variable not unlike the equity premium.  Therefore persistence shouldn’t be expected through a market cycle.  That’s the education that investors should be given.  In passing Vanguard acknowledged this in a brief comment in their study:

 

Another key factor is that of consistency—that is, keeping
a good manager, once one is found, rather than rapidly
turning over the portfolio. Maintaining the ability to filter
out noise—especially short-term measures of performance
versus either benchmarks or peers—is furthermore crucial.

 

At the end of the day — there is plenty of evidence of active management falling short of generating excess returns over its appropriate benchmark but it seems that there are too many structural flaws in the mutual fund industry to take these types of studies seriously. A mutual fund not being persistent in outperformance over a rolling 1, 3, or 5 year period still might seem shortsighted as Vanguard duly notes.

 

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Regarding the Evidence in Evidence-Based Investing

One of the best things about evidence-based investing — well, is the evidence.  The challenge for practitioners and investors is in how to interpret the results and/or data from an evidence-based research study.  Conclusions can often be ambiguous and papers so dense with statistics and mathematics that we rely on others to interpret the data.  But I have often found that these papers can be used for marketing ideas even if the the conclusions are twisted enough to fit a particular world view.

 

For instance we have the paper from Barber and Odean titled “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” published in April 2000.  The paper was quoted in a book titled “The Only Guide to a Winning Investment Strategy You’ll Ever Need” in chapter 2 titled “Active Portfolio Management Is a Loser’s Game” as evidence against active investing.  Now I think there are many valid arguments to be made against active strategies versus factor based strategies that are passive in nature, but that is not the point of this post.  Rather the point is comparing the conclusion of the authors of the paper as stated in the book versus the conclusion of the authors of the paper as stated in the paper.

 

The quote from the book (pg 12,13):

 

Their conclusion: Individual investors aren’t as bad at stock picking as many people think.  They’re worse!  The study found that stocks individual investors buy trail the overall market and stocks they sell beat the market after the sale …. The authors concluded: Individuals shouldn’t be trying to pick stocks …

 

Now I was curious about the study myself given it is evidence.  In the abstract the last sentence contained this sentence:

 

Our central message is that trading is hazardous to your wealth.

 

The study was focused on the impact of trading and testing 2 theories of household behavior on trading activity. Now as the authors note, they found that the households that were studied underperformed the relevant benchmarks after a “reasonable” accounting for transaction costs.  Interestingly the authors stated:

 

During our sample period, an investment in a value-weighted market index earns an annualized geometric mean return of 17.9%, the average household earns a gross return of 18.7%, and in aggregate households earn a gross return of 18.2%.

 

Where households did worse was when considering transactions costs and the impact of liquidity (bid ask spread).  They found that the turnover was 75% and that trades over $1,000 cost 3% in commissions and a 1% cost via the bid-ask spread.  They go on to state:

 

It is the cost of trading and the frequency of trading, not portfolio selections, that explain the poor investment performance of households during our sample period.

 

Based on the above I am struggling to conclude that the authors concluded that households are bad at stock picking as the stocks the investors bought outperformed the market?  The second part regarding the sale is a valid point after factoring the costs.

 

Rather what was somewhat terrifying to this reader was not picked up by the book author nor the researchers.  The following from the author’s data:

 

On average during our sample period, the mean household holds 4.3 stocks worth $47,334, though each of these figures is positively skewed.  The median household holds 2.61 stocks worth $16,210.

 

The median household only held 2.61 stocks!  That is incredible.  That alone would speak to the overconfidence of households in terms of their portfolio construction, a topic the authors were addressing.  And no discussion of company specific or idiosyncratic risk as it was clearly not diversified away.  Rather it is impressive that the gross returns did as well as they did given households on average only owned 2 to 3 stocks at any given time. Our internally managed stock portfolio is 30 stocks and much less turnover.  And trading costs have come down significantly since the paper was written 14 years ago — but I digress.

 

The key takeaway is that the evidence is there for everyone to review and that we would recommend “trust but verify” when being presented data as proof of a particular position.  In the case above the paper highlighted some very important pieces of information and largely not what was being pushed by the author of the book.

 

A copy of the Barber and Odean paper in pdf format is available below.  Please see the evidence for yourself and let me know what you think!

 

 

 

 

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S&P 500 Valuation: Fundamental Approach

I’m not a big fan of using PE ratios to determine fair value estimates for the S&P 500.  If I do use earnings, I believe the 10-year average is more appropriate in order to capture the business cycle and even then its to estimate projected long-term returns.  I should note that Shiller’s CAPE, which does just that, has come under serious attack as the multiples have been above the long-term average for many years now (and beginning back in the 1990s).  For now we will pass on defending the validity of the CAPE and turn to working with a real-time valuation tool.

 

We can value the S&P 500 using a simple 5 year discounted cash flow model. The model requires us to estimate a) current cash flow, b) growth of cash flows, and c) discount rate. There are many ways to come up with these estimates and the following is one way that we can look at it.

 

Current Cash Flow:  Current cash returned to shareholders (dividends and buybacks) was estimated at $96.20 per share in the trailing twelve-months ended in March.  I am currently estimating $95.52 in the trailing twelve-months ended in June.

 

Growth: I am using the fundamental formula that considers all cash retained by corporations (retention ratio) is reinvested grows at the retention ratio times the return on equity.  Using a 10-year average retention ratio of 18% and a 10-year average return on equity of 14.6%, I am using a fundamental growth estimate of ~2.6%.

 

Discount Rate:  This is likely the most subjective estimate.  Equity risk premiums (ERP) seem to be somewhat volatile.  Saying that we are using a 5.0% ERP and a 2.5% yield on the 10-year treasury for a discount rate of 7.5%.  We can change the ERP estimate to see the level of sensitivity to our inputs.

 

With that all plugged into the 5 year discounted cash flow model, one should see a fair value of 1,970.  This compares to the recent market price of 1,991.  If we lower the ERP to 4.8% the estimated value jumps to 2,034.

 

This leaves us with some comfort that on a fundamental basis that the S&P 500 is likely not significantly over valued.  Outside of unexpected macroeconomic shocks, the risk to these estimates in my opinion is based on the relative level of earnings compared to sales, otherwise referred to as corporate profit margins.  A more detailed cash flow analysis which separates revenue growth and operating income growth can highlight the large impact bottom performance can be dictated by changes in corporate profitability.  Right now corporate profit margins are on the high side and likely will provide little upside moving forward.

 

 

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Corporate Profits As % of Gross National Product

I have updated the corporate profit decomposition as a percent of GNP.  In the first quarter of 2014, the profit rate dipped to 8.7% from 10.0% registered in the fourth quarter of 2013.  Net investment was down likely due to the harsh winter.  The dividends paid out to capital owners fell to 5.0% from 5.5% in the previous quarter.  Private savings also dipped modestly to 2.9% from 3.1%.  Offsetting the shift was a jump in federal government spending which increased to 5.6% from 5.1%.  Foreign savings jumped to a 2.4% versus 1.8% in the previous quarter.

Kaleck_Profits_Q114

 

While this is an imperfect measure, it is a useful tool.  The current long-run average since 1947 as been 6.2%.  While the higher than average level might be indicative in the change in global nature of corporate profits and how they are accounted for, clearly — the balance continues to be unsustainable based on the historical figures.  A private savings rate of 2.9% versus a long-run average of 6.1% is not a positive.  Net investment has historically been at 8.3% of GNP versus the current 3.2%.  Lastly, government deficit spending (negative savings) has pulled back from the spike in 2009 but still represents a 5.6% positive benefit to profits compared to its historical average of 2.5%.

 

 

 

 

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[Seeking Alpha] REITs: Leaning On Dividend Growth

We have a new article published at Seeking Alpha.  This is our second article in a new series looking into Real Estate Investment Trusts (REITS) as an asset class and investment.

REITs: Leaning On Dividend Growth

 

Introduction

Last September we put out our first note on the REIT sector with a focus on Vanguard’s REIT Index ETF (VNQ). At that time the ETF was recovering from the initial market shock towards the Federal Reserve’s initial communication strategy regarding how it would taper its ongoing Large Scale Asset Purchase Program (LSAP), known colloquially as QE3.

At that time it seemed reasonable that based on an estimated ~3.3% dividend yield of our sample REIT group (through Q2 data) which reflected a positive ~0.6% spread to the 10-year treasury — that a price range of $63-$64 was fair for VNQ (a slight discount to its price at the time of ~$68). However based on the proximity of the 200-day moving average to VNQ’s price, the REIT ETF would be volatile near-term between these price areas.

……..

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[Seeking Alpha] S&P 500 Valuation: Earnings Expectations Versus Reality

Latest note at Seeking Alpha discussing my latest look at S&P 500 earnings and broad market outlook as compared to current estimates of future earnings:

 

  • 93% of companies in the S&P 500 have reported earnings with current TTM As Reported EPS (AREPS) at $87.66, reflecting a decline of 2.4% on an inflation adjusted basis; peak cycle earnings on an inflation adjusted basis remain at $89.97 set in February of 2012.
  • 10-year Cyclically Adjusted Price-to-Earning (CAPE) based on recent S&P 500 prices stands at 24.0X compared to 21.8X a year ago; multiple expansion driven by a year-over-year price index increase of 17.6%, offset by 9% growth in CAPE earnings.
  • Forward earnings expectations reflect outsized growth of 25.5% and 22.9% on a nominal and real basis, respectively; this is in stark contrast to the recent deceleration of recent earnings relative to its 10-year trend.
  • Aggressive monetary policy remains the major catalyst supporting a constructive outlook on the equity markets and likely already discounted based on elevated valuations.
  • Recent earnings trends, questionable economic data, and imbalances in the financial and economic landscape suggest current growth expectations will not be met and risks remain to the down side.
  • Despite recent strength in defensive sectors, investors should be selective and focus on higher quality names with long track records of dividend and earnings growth through entire business cycles

 

For the complete article please follow the link.

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Low-Volatility Investing

There is short article at Morningstar today discussing low-volatility as an investing strategy.  I highlight it because at Smith Patrick, we are strong advocates of this type of investing.

 

Volatility is the measure of the dispersion (range of results) around an average.  The wider the dispersion/range then the higher the volatility measure.  In finance, volatility is a measure of risk.  We view volatility as part of the risk equation.  Increased volatility creates scenarios where true risk could be realized and that is loss of capital. This happens in situation such as 1) when investors must draw down an investment portfolio as depressed levels and 2) create an emotional roller coaster ride which leads to investors selling assets at the worst time.  Thus avoiding volatility is a handy tool to help remove the true risk of capital losses.

 

From Morningstar:

 

 

Low-volatility stocks tend to be big, boring, and dividend-paying. H.J. Heinz is a classic example. Boom or bust, Heinz ketchup sells with clockwork regularity, insulating Heinz’s earnings from the business cycle. Stocks like Heinz are as bondlike as they can get. Interestingly, in nearly every market studied, low-volatility stocks have greatly outperformed high-volatility stocks on a risk-adjusted basis, a finding at odds with many investors’ notions of risk and return.

 

There are three compelling reasons why this may be the case. The best is leverage aversion. Investors who target above-market returns may be unwilling or unable to use leverage to reach their expected-return targets. By resorting to volatile stocks (more accurately, high-beta stocks), which theoretically should outperform less-volatile stocks, they hope to earn above-average profits. Ironically, their collective bet on high-beta stocks leads to low risk-adjusted returns. Another is the fact that high-volatility stocks are systematically overpriced by investors seeking “lottery tickets”–stocks with a small chance of huge upside (Tesla Motors (TSLA), for example). Finally, asset managers tied to benchmarks and unable to employ leverage actually have a disincentive to own low-volatility stocks with below-average expected returns, regardless of how fabulous the expected risk-adjusted returns may be, and an incentive to own high-volatility stocks with above-benchmark expected returns, even if their prospective risk-adjusted returns are terrible

 

The Morningstar analyst goes on to highlight various ETFs (Exchange Traded Funds) that one can invest in to achieve a low-volatility investment strategy.  For those interested in low-volatility ETFs, I would suggest reviewing the PowerShares ETF line up, which has expanded its low-volatility ETF availability to include both international and emerging market regions and now by market cap size.

 

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Cognitive dissonance and Investing: Cyprus?

From Wikipedia:

 

In modern psychology, cognitive dissonance is the feeling of discomfort when simultaneously holding two or more conflicting cognitions: ideas, beliefs, values or emotional reactions. In a state of dissonance, people may sometimes feel “disequilibrium”: frustration, hunger, dread, guilt, anger, embarrassment, anxiety, etc.

 

Now how about these headlines appearing today on popular financial news sites:

 

Cyprus is euro zone’s very own Lehman moment

Buy ‘Still Cheap’ US Stocks, Ignore Cyprus: Pro

 

If that doesn’t create dissonance I don’t know what will. From “The Psychology of Investing” by John Nofsinger

 

Investors seek to reduce psychological pain by adjusting their beliefs about the success of past investment choices.  For example, at one point in time, an investor will make a decision to purchase a mutual fund.  Over time, performance information about the fund will either validate or put into question the wisdom of picking that mutual fund.  To reduce cognitive dissonance, the investor’s brain will filter out or reduce the negative information and fixate on the positive information….

 

I bring this up because depending on what market valuation tools an investor could argue that today’s stock market is undervalued (Fed Model) or overvalued (Shiller PE10).  Likely depending on your “ideas, beliefs, values” you are likely to focus on one or the other.  From John Hussman and his weekly note sums it up:

 

No market condition is permanent, and even the late-1990’s advance included periods where favorable trend-following measures were not joined by hostile syndromes of overbought, overbullish conditions. If you believe that stocks will continue to advance in the months and years ahead, with no intervening bear market decline, those instances are the main points where “don’t fight the trend” might outweigh negative return/risk considerations more generally. For longer-term investors, consider the prospective return you can expect to achieve over time if you are buying, and that you can expect to forego if you are selling. Compare this with your tolerance for volatility, missed short-term returns, and deep interim losses. All of this is what I know and believe. It’s fine to believe something else. But please – insist on supporting evidence and long-term data. The Tinker Bell approach just won’t cut it.

 

And that Tinker Bell approach is created in my opinion by the cognitive dissonance just discussed.  How you consider Cyprus might be telling of your own view? I focus on Shiller PE10 and believe this is the most pragmatic way to approach investing given that the business cycle exists and there will always be ups and downs.  I believe Cyprus is a risk but it hasn’t changed my investment strategy nor should it change yours.  Your strategy should be able to coexist with such issues otherwise investment returns will likely be negatively impacted.

 

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[Seeking Alpha] Industrial Sector Review: Defense Stocks in the Bargain Bin

With the global business cycle (possibly) shifting out of first gear, we continue to look for mid-cycle industries to outperform the early cycle names found in the consumer discretionary and financial sectors. Last week we looked for opportunities in the material sector, which saw a mixed bag of valuations at best. This week’s sector review of industrial names shows more reasonable valuations as a group and some promise for contrarian investors willing to own companies tied to the U.S. defense budget.

As shown in figure 1, the S&P 500 Industrial sector (XLI) as a group has underperformed the broad market since 1H’11. Since October of last year, the group has shown some improvement against the overall index.

continued …. click here

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Bogleheads on Shiller PE10

I recently had an article published at Seeking Alpha on our current view of market valuations using the cyclically adjusted Shiller PE10. 

 

I was interested to catch some recent commentary from bogleheads (named after Jack Bogle of Vanguard fame) on the Shiller PE10. The thread can be found here.

 

One interesting note that came out of the thread besides some heavy hitters in the passive index investment world providing commentary was a research paper by Vanguard titled “Forecasting Stock Returns”.  Notice (image provided below) that the Shiler PE 10 while argued to be of some value, had the highest R-squared value at .43. Therefore of the group, it is still the best indicator for long-term future stock returns despite the figure title.

 

From Harvey Campbell in a paper on global tactical allocations:

 

“Predictability is often assessed via so-called R-squares in regressions. An R-square measures how much of the variation in returns that can be attributed to the conditional information variables.  It is common to find predictability of between 1% and 10% in terms of R-squares (depending on which type of asset, market, or sample period that is considered). Predictability has been shown to be particularly strong at longer horizons (3-5 years), with R-squares as high as 30%.”

 

The paper goes on to discuss predictability …

 

“In fact, one does not need much predictability to impact the asset allocation process.  Kandel and Stambaugh (1996) find that even with low precision (an R-square of only 2%), asset allocation can be dramatically altered as a result of the predictions. … That is, moderate predictability can be of large economic importance.”

 

Global Tactical Asset Allocation by Magnus Dahlquist and Campbell R. Harvey (Jan 31, 2001)

 

Now I understand one is relating to future returns and the other to business cycle and asset allocations — but, I believe the negative view from Vanguard relates to the inability to capture the cyclicality of  the investment time period.  I believe that to explain future returns one would be required to include additional conditional information to fine tune expectations such as interest rates etc.

 

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