I’ve been writing this blog for something over five years. I’ve decided to do a short retrospective by republishing ten of the most popular posts since inception. The Best series starts on Monday.
Monthly Archives: May 2014
“smart beta” (ll): traditional active management in a “passive” package
how active manager operate
Active managers create portfolios that differ from a benchmark index, such as the S&P 500. The do so in an effort to achieve higher returns than the index. History shows that very few manages with public records succeed. They follow one or both fo two basic strategies:
–they hold stocks that are not in the index, as substitutes for index constituents, and/or
–they hold index constituents in different proportions than the index–having more or less depending on their assessment of valuation and future prospects, as well as the strength of their conviction.
Conceptually, it’s as simple as that.
smart beta
Purveyors of “smart beta” say they’re not active managers. What they do instead of seeking (dumb) alpha is to change the index being used by the client–not through subjective judgment but by using flat-out rules, enforced not by a fallible human but by a computer program!
The simplest smart beta “product” is to use an equal-weighted index rather than a capitalization-weighted index like the S&P 500. The difference? Let’s say we’re using the members of the S&P 500 as our universe of names. Capitalization weighting means percentage changes in the value of stocks with gigantic market values, like AAPL, XON or MSFT, count for more than tiny ones. Equal weighting means each stock counts the same–.2% of the index total.
The result is a substantial shift in emphasis away from large-cap stocks and toward small ones. The decision to do so is clearly a subjective judgment made by a human being. By calling it “beta,” however, it is being packaged as a passive/index judgment that supposedly doesn’t introduce more risk into the portfolio.
More ambitious smart beta products include collecting analyst earnings estimates, calculating forward PE ratios and creating a portfolio that’s tilted more or less strongly toward the lowest PE, highest earnings growth members of the investment universe. Subjective rules about what combination of factors should be favored/disfavored are crystallized into a computer program that performs the requisite rebalancing of the portfolio as new information emerges.
This is straight out of The Wizard of Oz. Don’t look behind the curtain!
There’s nothing passive about this approach except the name. Having worked at Value Line, which used a more sophisticated version of this approach fifty years ago, I recognize what’s going on very clearly. Only Value Line was more upfront about what it was doing.
Smart beta is almost exactly what many traditional active value managers do in practice. They’re extremely rules bound, although, unlike smart beta, they reserve the right to override the rules in unusual circumstances.
why is this approach appealing?
Several reasons:
–pension plan sponsors whose plans are seriously underfunded–and that’s those of most government bodies–are in a very difficult position. They need either to up the returns they are achieving on their assets, or ask their bosses to increase contributions to the plans. The latter is probably the first step on the (short) road to unemployment. So these sponsors are very open to any approach that promises high returns without extra risk. Look at the explosion of investment into hedge funds, despite these vehicles’ sub-par performance records.
–the idea that an “objective” computer is running the show rather than a fallible group of individuals has, for some reason, a lot of appeal
–smart beta products up the risk of an overall portfolio. But it’s not 100% obvious that they’re doing so. So there’s some chance of explaining away underperformance if it occurs
–in addition to being less obvious as active management, they may be cheaper than hiring a new active manager.
To my mind, this will all end in tears, both for the purveyors of these products and the buyers. The Value Line experience is a case in point.
what is “smart beta”? (l): alpha and beta
I’m going to write about this in two posts.
Today’s will give some basic background. Tomorrow’s will look at smart beta itself.
alpha and beta
Right after WW II many professional investors, and academics as well, were eager to apply newly emerging computer technology to analyzing the stock market. Harry Moskowitz, an IBM scientist, was the first. He suggested using computers to record and analyze the interrelations in price action among all the stocks in the market. But measuring the reciprocal influences on even relatively small numbers of stocks proved too daunting for the computing machines of the day.
That led to the idea that the task be simplified by not relating each stock in a universe like the S&P 500 to each of the other 499. Study, instead, how they each behave in relation to some common standard–in fact, relate each to the index itself. un a regression analysis that correlates the daily price change in each stock with the price change in the index.
An equation showing the results for a stock “y” would be in the form:
y = α + βx + an error term that can be ignored
So the price change “y” for any stock can be broken down into two elements:
—systematic,return, or beta, the portion due to market fluctuations. For academics, this is a constant “β” derived from the regression, multiplied by “x,” the price change in the market and,
—a non-systematic term or alpha,, an “extra” return, that can be either positive or negative.
By definition, the β of the market = 1.0 (the sum of all the returns of the market components = the return on the market).
In the strange world of academic financial orthodoxy, it’s impossible to achieve a positive α. The only was investors can achieve a higher return than the market is by arbitrage–by borrowing money and buying what amounts to an index fund.
The popularity of this view–whose only virtue as I see it is its simplicity–shows itself in industry jargon. Active managers are said to be “seeking alpha.” Pension plan sponsors routinely separate their equity assets into active and passive, the latter being moneh invested in “safe” index products.
“Smart beta” is a marketing approach by active managers to e a portion of their “safe” index assets to the “seeking alpha” pool. Apparently they’re successful, although the essence of their pitch is semantic—-they label their active managing activity as being “beta,” not alpha. It’s the equivalent of the old junk bond pitch, “all the safety of bonds, all the high returns of stocks.” We all know how that ended.
More tomorrow.
Macau casinos, after their stock market decline
a weak few months
Macau casinos, and their foreign parents, have been bludgeoned in the stock market over the past couple of months. Several reasons:
–general worry about stocks that had gone up a lot
–the Ukraine situation, which has unnerved European investors
–fear that the the current anti-corruption/anti-excessive consumption drive by Beijing will hurt the VIP business which has been the heart of Macau casino profits, and
–the possible proliferation of casino openings elsewhere in China, or in other Asian countries like the Philippines or Japan.
what, me worry?
Every portfolio investor acts on small amounts of imperfect information. That’s why we don’t put all our eggs in one basket (Bernard Baruch to the contrary). From where I sit, a lot of the negative things now being said about Macau seem to be (mistaken) attempts to explain the stock price drops. I don’t think they have much factual basis. Of course, even the best stock market investor is wrong 40%+ of the time.
For what it’s worth, here’s my take:
–So far there’s no hard evidence so far that Beijing’s anti-corruption campaign is having any negative effect on the VIP gambling business in Macau.
–More important, the Macau gambling market is no longer being driven solely by VIPs. The new sweet spot is the mass affluent, a market segment that’s now the source of most of the SAR’s growth. How so? VIPs bet huge amounts, but they’re semi-professional gamblers. They lose on average about 3% of the amount they bet; the casino rebates half of that, either to the high roller himself or to the middlemen who has brought him there. So margins are razor-thin. The mass affluent, on the other hand, are seeking entertainment. At table games, they make much smaller bets, but they lose about a quarter of what they wager–and they don’t care that much. A mass affluent pataca bet is worth 15x-20x in casino operating profit what a high roller pataca is. Hordes of them are now descending on Macau. (There’s also a shift among winners and losers within the market, but that’s another story.)
The mass affluent also want non-gambling entertainment. In the salad days of Las Vegas, shows, concerts, restaurants…brought in just as much profit as the casino operations. In Macau, this business is still in its infancy. But I see no reason why Macau in the end will be any different.
–Transportation links are still being built to allow more far-flung areas of China to reach Macau, meaning market saturation is still years off.
–It makes no sense to me to believe both (1) that Beijing’s crackdown is aimed squarely at casinos and (2) that the government will give permission for more casinos to open in other areas of China. But this is what some bears are saying.
–Macau has critical mass and lots of amenities. Chinese is the dominant language. Kidnapping high rollers isn’t an issue. Japanese casinos, whatever they may eventually look like, are years away. Singapore has already been up and running for a considerable while–and Chinese junket operators aren’t welcome there anyway. Some VIPs will certainly try out the Philippines or other venues. I just don’t see this as a big deal.
Yes, I trimmed my Macau exposure significantly last year–because my position size was much too large. At this point, I’m a potential buyer, not a seller.
once more on Amazon (AMZN)
I’ve been doing a lot of thinking/daydreaming/musing about AMZN lately. I don’t know quite why, since I’m probably not going to buy the stock. But my mind apparently doesn’t want to let go.
The latest thing to pop into my head is something I’d seen on the Value Line page for the stock but hadn’t paid much attention to. It’s that:
–during the bounceback from the 2000 collapse of the Internet Bubble, AMZN shares tended to trade at about 30x cash flow. In the recovery from the Great Recession, its cash flow multiple expanded to 50x. Both are mind-boggling figures, to be sure-the second more so.
What could cause this gigantic multiple expansion, particularly during a period when investors were scared out of their wits and therefore more cautious than usual?
…possibly a better appreciation of the transformative nature of the internet and AMZN’s premier position as online merchant. Cash generation from operations continues to grow at about 25% a year, virtually the same as before the GR, despite the company’s larger size. That’s both a plus and a minus. It’s an heroic achievement to maintain growth in the face of ballooning size. But that’s usually something that keeps the multiple from contracting, not that causes it to expand by 60%.
…so I can’t help thinking that a lot of the favorable move is due to the Fed’s super-accommodative money policy.
Which gets me to my point.
Let’s assume that the economy’s release from intensive care and a return to normal money policy cause AMZN’s cash flow multiple to shrink to a “mere” 30x. In simple terms, this means the stock should lose 40% of its value–maybe not all at once, but ultimately. Continuing relentless growth in cash flow could cushion the fall somewhat.
Since the end of January, when the Fed made it clear it would continue baby steps toward normal despite weakening economic indicators, AMZN shares have pretty much made the entire reverse movement already–they’ve lost 25% of their value in a flat market. They haven’t been alone, either. Every other story stock has fallen this much–or more.
This thought makes me want to speed up my efforts to dig through the rubble.