more on absolute vs. relative performance

One of the earlier posts I wrote on this blog had to do with absolute vs. relative performance.  I reread it today and am generally satisfied with what I wrote then.  One exception, though.  I think the post came at the topic from the rather narrow perspective of a professional investor, who is already convinced that the best way–or at least one good way–to achieve absolute performance is to try to achieve relative results.

In this post, I’d like to broaden my discussion of the topic by adding two observations, one psychological, the other economic:

1.  One of the most important of the (many) clichés Wall Street uses is that market turns, especially upturns, come out of nowhere and catch most investors by surprise.  Not only that, but the initial move up can cover a lot of ground in a short time.  Missing this initial surge, so the argument goes, is virtually impossible to recover from.  Brokers typically cite academic studies that the greatest part of the market’s gains over a business cycle come in only about 10% of the trading days.  Be out of the market on those days and you’re toast.

I think there’s something to that argument.  I’d like to add my own twist to it, though.

In my experience, lots of professionals can either tell when the market is getting toppy or when it’s stunningly cheap.  But I don’t know anyone who has been able to do both.  Wall Street is a very gossipy place, so if there were such a person, word would get around–despite the individual’s desire to keep his ability to time the market a secret (so others wouldn’t begin to study his every move and his skill would remain his edge alone).  In addition, just off the top of my head I can think of three former professional acquaintances who “called” the top of the market, one in 1984 and two in 1986, with disastrous results for both them (two were fired) and their clients.

Look at the record of hedge funds, whose aggregate performance failed to match that of the S&P 500 every year since 2003.

Anyway, I think some investors have bearish temperaments and can call tops but not bottoms.  Others, like me, have a bullish cast of mind.  We can call bottoms but not tops.

2.  Assume that we live in a world that’s characterized by:  a) inflation; and b) economic growth.  Each implies that stock prices will tend to rise.

a.  Modern economics comes out of systematic study of the Great Depression of the 1930s.  One of the highest goals of monetary policy around the world is to avoid a recurrence.  In particular, the world wants to avoid a repeat of the deflation that marked that period.

Other than in the case of Japan, which has consistently chosen to have deflation rather than permit structural societal change, the world has been successful in doing so.  Let’s suppose (and fervently pray) that this continues.  What does this mean for stocks?

Stocks are priced in nominal terms, in dollars of the day.  But they represent ownership claims on real assets and business operations.  Inflation means that nominal prices in general are rising.  So there should be a tendency for the nominal value of the corporations whose shares of stock are publicly traded to rise as well.  Ultimately, this should translate into a tendency for stock prices to rise, even in the absence of real economic growth.

b.  But, as an empirical observation, there’s real economic growth all over the place.  The US economy, which has been closer to the caboose of the world economic train than the locomotive, is still 50% larger than it was a decade ago.  New nations have entered world commerce.  We have notebooks, netbooks, tablets, iPhones, iPods, social networking, online shopping, biotech, medical advances–lots of stuff we didn’t have ten years ago.  Why?  …because many people around the world like to build and invent new things.  Publicly traded firms–where else do entrepreneurs get the money they need to grow their companies–participate very substantially in this growth.

My point is that the path of least resistance for stocks–due to inflation and to real economic growth–is up.

Yes, I believe what I’ve just written is true.  Maybe it’s a cartoon version of the truth, but it’s true.  That’s not really what I’m trying to convey in this post, though.  What I want to say is that professional investors in general opt to try for relative performance rather than absolute because they believe this, too.

No more reversion to the mean?–Mohamed El-Erian (I)

“uncertainty changing investment landscape”

The other day I was paging through some old newspapers that I never got to during August (yes, I read the business news on paper).  Sometimes it gives you a sense of perspective to read, a couple of weeks after the event, what trivial things people were thrilled or fearful about at a certain moment.  But mostly I got lazy when the weather got hot and read novels instead of news.  So I was catching up.

I ran across an article from August 2nd with the above title in the Financial Times. It was written by Mohamed El-Erian and Richard Clarida, a professor of economics at Columbia.  Mr. El-Erian is the chief executive of the mammoth bond manager Pimco and an occasional columnist for the FT; Mr. Clarida consults for Pimco.

I usually skip over what Mr. El-Erian writes.  It typically reflects the economic consensus.  Besides that, Mr. El-Erian has seldom been known to use one small word when six or eight big ones will do the same job.  He’s also the public marketing face of Pimco, so we know in advance what his investment conclusion will be namely:

–The global economic landscape will be bleak for many years to come.

–Therefore bonds, even at today’s super-expensive levels, are still a buy; stocks, which are the same price today as a decade ago and the cheapest they’ve been vs. bonds for sixty years, are still a sell.  Pimco’s only change to this mantra over the past year or so has been to kick dividend paying stocks off the approved list.

Nevertheless, I did read this piece.  Despite the fact Mr. El-Erian comes to his usual (horribly incorrect, in my opinion) conclusion about stocks and bonds, I’m glad I did.  For once, Mr. El-Erian wrote something really thought provoking.

I’m going to write about this in two posts.  Today I’ll outline what Mr. El-Erian says.  Tomorrow I’ll write about where I disagree.

the article

The article makes five points.  Four of them are different facets of the same idea–that the disinflationary era that began with the appointment of Paul Volcker as Fed chairman in the US almost thirty years ago is over.  As a result, we can no longer depend on continuingly rising bond prices and falling yields to bail us out of investment mistakes.  Investors have to rethink and retest their strategies.

That isn’t the interesting part.  Equity investors have been soulsearching about excessive leverage and unwarranted risk-taking since the collapse of the Internet bubble in 2000.  (If so, how did the financial meltdown happen?  Investors made three basic mistakes:  we assumed the banks’ accounting statements were reasonably accurate; we wildly overestimated the capabilities and appetite of the regulators to enforce banking and securities laws; and we attributed to bank managements a level of integrity and risk-management competence that most American industrialists possess but many in this industry didn’t.)

The intriguing point is Mr. El-Erian’s first, that “investing on ‘mean reversion’ will be less compelling” in the future.  He implicitly describes the (bond) investing process over the past twenty-five years as having two steps:

–determine the consensus economic forecast, and

–find securities whose valuations imply an outcome that deviates markedly from the consensus.  If the imbedded expectations are too pessimistic, buy the security; if they are too optimistic, sell it short.

Why won’t this work anymore?  In the past, a compilation of expectations from professional economists would form a bell curve, with the areas at and around the mean having very high probability.  The “tails” of the distribution, that is, the forecasts that deviate a lot from the consensus, were short and stubby, that is, highly unlikely and increasingly so the farther away from the consensus they were.

Today, the compilation of forecasts looks less like a bell with a sharp, fat peak in the middle, and more like a straight line with a small bump up in the center.  The economic situation around the world is so uncertain, and the policy actions governments may take to stabilize their countries so unpredictable, that there is, in effect, no solid macroeconomic consensus to bet against.  Not only that, but the more extreme “long tail” outcomes, both bad and good, have become much more likely.

What do you do in a world like this?  Mr El-Erian’s answer is (surprise, surprise)–buy bonds, sell stocks.  You do so because (government) bonds are liquid and default-free.  Therefore, they protect you against the world going to hell in a handbasket.  I guess this means individual investors haven’t been panicking over the past year or more but responding rationally to the current situation by dumping their stocks and embracing bonds.  I suppose that if you really wanted to secure yourself against the worst, you should also think about a cabin in the woods, stocked with freeze-dried food and near a good source of water, maybe with a bow and arrows in case you need to hunt.  Maybe people are.

I’m with Mr. El-Erian up until his conclusion, with which, to put it mildly, I disagree.  Not so surprising, since I’ve spent all my investing life on Wall Street.  The real question, the thought-provoking aspect of the article I’ve linked to above, is to be able to say why I disagree.  What’s wrong with what he’s saying?

More tomorrow.

large realized losses (I): the position of many ETFs and actively managed US mutual funds today

I’m going to do this topic in two posts, today and tomorrow.

The bottom line is that many equity mutual funds and ETFs have large accumulated recognized losses.  These are akin to operating loss carryforwards that operating companies may have.  This was bad news for shareholders during the time the losses were racked up.  But it can be valuable good news for current or new shareholders.

How so?

They don’t appear in the net asset value calculation, so you don’t pay for them.  Nevertheless, they can be the single biggest asset a fund has.  Their value is that they offset the taxable distributions you would otherwise get when the fund sells stocks at a gain.  In other words, you get to keep the entire amount of the gain (inside the fund) rather than having to pay tax on the gain at either short-term or long-term capital gains rates.  Skillfully used by the fund management company, this ability could be worth 10% or more of the NAV of the fund.

Neither brokers nor fund companies talk about this topic.  This is mostly because doing so would highlight again the fund’s loss-making past that its marketing people hope everyone has forgotten about.

As it turns out, I’ve been hired more than once in my career to turn around a poorly performing fund that contained very large tax losses.  So I’ve seen the value of this asset first hand.  Along the way, I’ve been cited by Forbes a number of times for running very tax efficient portfolios.  I know this is an odd topic, but it can be a profitable one.

Let’s get started.


funds as corporations

Mutual funds and ETFs are, as legal entities, are a special type of corporation.  They are exempt from taxation of income at the corporate level in return for restricting their activities to portfolio investing and distributing virtually all their income and realized capital gains to shareholders (who are liable for paying income tax on the distributions).

individuals tend to buy high and sell low

The old brokers’ joke is that Wall Street is the only marketplace in the world where customers run out of the store when a 30% off sign is placed in the window.  It is a characteristic of the behavior of many individual investors that they tend to act in a highly emotional fashion.  This leads them to buy when prices have already been rising for a considerable time and the market is very enthusiastic and to sell after sharp drops and everyone is scared.

in the Great Recession

In the most recent instance of such behavior, according to the Investment Company Institute, equity mutual funds in the US had net outflows of about $150 billion between October 2008 and March 2009.  During this time the S&P 500 ranged from the high 600s to the high 800s–or 30% or more below today’s level.

In contrast, net inflows to equity mutual funds during the first half of 2007, when the S&P was above 1400–25% higher than now, were about $85 billion.

US funds vs. international

We can disaggregate these flows to see the behavior of investors toward US-oriented funds and their international/global counterparts.

US funds had virtually no net inflows during the first half of 2007 and about $100 billion in redemptions at the bottom–outflows equivalent to most of the money invested in them (at levels above 1200) since 2004.  (there’s a clear shift by investors away from domestic funds to ETFs during this period but that’s another story.)

Global/international funds, in contrast, captured just about all the $85 billion in inflows at the top and had “only” $50 billion in outflows at the bottom.

concentrating on US funds

If we assume that the $100 billion in redemptions occurred when the S&P was at 800 and that the stocks were bought on average when the S&P was at 1300, we can get a rough idea of the magnitude of the losses that this “sell low” trade engendered.  The two index levels imply that the stocks sold for $100 billion had a cost basis of about $165 billion–therefore that the selling funds created an aggregate loss of about $65 billion, much of which is still on the books of mutual funds.

Why still on the books?  For many funds, their share of this number dwarfs the unrealized gains they have on positions they still hold.  Given the (rare) occurrence of two bad bear markets during the last decade–the aftermath of the Internet bubble + the financial meltdown–a fund would likely have to have either bought stocks recently or held them since some time in the Nineties to have unrealized gains.


Not every fund has accumulated losses.  Not every fund has a skilled manager or a management philosophy that will allow them to use this asset effectively.  Although most funds are in a loss position because the past few years have been the worst for stocks since WWII, some have added to their woes because they’re not good investors.  This latter type is one to identify and avoid.


Many equity ETFs are passive entities.  They may have very large losses, but unrealized ones, because they became popular and received large inflows in 2006 and 2007.  Today those purchases are probably deeply under water.  To the extent that these funds are run by computers, not humans, it’s unclear how they’ll be able to realize and use these losses.

That’s it for today.   Tomorrow I’ll write about how to find and evaluate the loss position for any given mutual fund.  You’ll find the numbers buried in the fund balance sheet and accompanying footnotes.

2009 hedge fund performance–a bad year following an unusual one

Up 19% over the past year, according to the FT

The Financial Times published an article early on December 31st proclaiming that hedge funds produced gains of 19% for investors in 2009.

How could they know so soon?

My first thought was, How could anyone know this, with one trading day still to go before yearend?   So I checked the referenced Hedge Fund Research website and found that the 19% figure is performance is actually for the twelve months ending November 30, 2009.  Other sites show performance as somewhat lower.

Way under the S&P

In all cases, though, performance was way below the 25%+ return an S&P 500 index fund would have achieved over the same time span.  In the relative performance world, losing over 600 basis points to the index in a year is really bad. It would mean at the very least no bonus and could easily result in your being fired.

The 2009 numbers reinforced my view–which I still hold–that hedge funds are by and large a marketing phenomenon, the successor to oil and gas or real estate limited partnerships.  They feed the egos of the buyers by establishing that they’re wealthy enough to “need” the product, while delivering net returns that are inferior to more prosaic vehicles like stock and bond index funds.  Their leading characteristic is that they generate huge fees for the product promoters.

Look at 2008, though!

Then I looked at the 2008 hedge fund numbers.

Hedge fund performance aggregators show average results for 2008 that range from -15% to -18%, depending on the source.  This compares with -38% for the S&P 500 and -13% for an indexed balanced fund (a fund indexed 60% each to large-cap US stocks and 40% to long-term Treasury bonds).

How could relative performance have been this good vs. stocks?  How could a simple balanced fund–devoid of exotic trading strategies (and high fees) have done better?

Twists and turns

Hedge fund performance may not have been quite so good as advertised, for one thing.  There are several complicating factors in 2008 results, namely:

survivor bias. 700 hedge funds, or about 10% of the worldwide total, went out of business in 2008.  That’s a BIG percentage. They were presumably not the best performers.  So by default the survivors look a bit better.

withdrawals not allowed. Unlike mutual funds or ETFs, hedge funds are able to–and in 2008 did on a widespread basis–decline investor requests to return their money.  This reduced downward pressure on any illiquid holdings of the hedge funds.  At the same time, it probably put additional negative pressure on non-hedge fund assets, which would an owner would, by default, be forced to sell if he needed to raise cash.

pricing issues. A recent NYU academic study covering about 10% of the industry, commissioned by a hedge fund due diligence firm, found that 28% of the hedge funds analyzed provided incorrect or unverifiable information about investment performance, assets under management or other investment issues.  In a fifth of the cases, managers lied in face-to-face interviews about investment performance, assets under management or their education or experience, even though they knew the interviewers were going to check all the information given (see my post Are hedge funds honest?:  an NYU study for details).

This raises the question of whether some hedge funds used “creative” pricing techniques to ascribe a high value to illiquid assets, in the same way that the big commercial and investment banks did–thereby overstating their investment results.

Customers were not happy

You might guess that the questions raised above mean the actual performance of hedge funds in 2008 was closer to -20% to -22% than the -15% to -18% reported.  But even that is still a mile better than the -38% the S&P achieved, a distance so large that it indicates a significant performance differential, absent Bernie Madoff-style accounting.

In relative performance-land, -22% would make you, if not exactly a hero, at least a top-level performer.  Why, then, have hedge fund customers been unhappy?

My thoughts as to why

I have several guesses, but–not being an institutional hedge fund customer–I honestly don’t know.  Here’s what I think:

1.  Clients knew intellectually that hedge fund managers might freeze redemptions, but really didn’t believe it would ever happen.  Purchasers underestimated the illiquidity of hedge fund holdings and may have mischaracterized them to their bosses.

2.  They really believed the credo of absolute performance–that in a down year for other asset classes, hedge funds wouldn’t lose money.  If your expectation is + something, -15% looks really ugly.

3.  In the same vein, clients who invested in hedge funds in 2003 experienced a string of years of underperforming an S&P index fund.  I can almost hear the hedge fund marketers saying that the big payoff from holding on would come in the inevitable down year for the stock market.  After all, that’s what happened in 2001-2002.

Well, the down year came and, with it, significant outperformance of the S&P.  But maybe it was only enough to offset the underperformance of the prior five years.  And in 2009 underperformance resumed.  If it walks like a low-beta stock fund and quacks like one, too, what makes it a hedge fund, other than the fee structure?

4.  Clients could have achieved hedge fund results, or maybe better, in 2008 with a more prudent allocation among asset classes.

Where to from here?

Anecdotal evidence suggests that assets under management in the hedge fund industry have stabilized and net inflows are beginning again for the first time in two years.  Hedge Fund Research indicates this as well.

The MAN Group, a publicly-traded hedge fund group (whose statements I think are therefore more reliable than those of the industry in general) said in November that withdrawals from Europe were being partially offset in the first half by new money coming in from the Middle East and Asia.

Barclays Capital, in a news release filled with corporate-speak from its prime brokerage division, emphasizes it’s being told by its hedge fund customers about gross inflows, but is not clear about the net situation.  It does say that the sales cycle is taking longer, as potential investors require a clearer explanation of exactly what a given hedge fund manager does. In addition to being better informed before turning over their assets, Barclay’s seems to indicate that clients are redirecting money away from smaller hedge funds (where in the past most of the very good returns have been achieved) toward their larger, more established rivals.

It will be interesting to see how fully the hedge fund industry will be able to recover from its long period of not-as-promised performance, and the scandals like that of Madoff and Galleon that have emerged during the financial markets collapse.

There are powerful constituencies in the hedge fund corner.  Wall Street now depends heavily on hedge fund trading revenues; its margin borrowing is the life-blood of the brokers’ prime brokerage arms.

More important from the pension fund perspective, though, hedge fund consulting is the latest offshoot of the pension fund consulting business, which derives very large income from being hired (as a kind of risk-shifting away from the pension plans themselves) to perform the pension plans’ task of creating an asset allocation plan, and analyzing and selecting specialist managers to implement it.  Consultants ply their trade among asset managers, as well, advising them on how to make themselves appealing to pension clients.  Here, at least from a short-term point of view, it’s in all the players’ economic interests to have increasingly complex and specialized products to ponder, since these allow maximum risk-shifting and generate maximum fees.

On the other hand, the fact that hedge funds in general don’t perform as advertised is a powerful force in the other direction.

We’ll see.

Absolute vs. Relative Performance

Absolute performance

Most individual investors judge investing success by asking whether at the end of some standard time period, say, a year, they have more money than they started with or less.  In other words, they judge performance on an absolute standard:  +8% is a good year, -3% is a bad one.

Relative performance

Professional investors normally use a different yardstick.  They, and their customers,  judge their performance by a relative standard.  How has the manager done versus a benchmark index?  How has the investor done in comparison with a universe of his peers?  Looking at performance this way, if the benchmark is the S&P 500 and it’s +10% for the year, then +8% isn’t so hot.

If the client wants a low risk approach and has said, in effect, try to get some outperformance if you can but it’s very important that you not underperform by more than 100 basis points (=1%), then +8% is horrible.  (One might reasonably ask why a client would ever hire an active manager and give him instructions like this, but I’ve seen it done.)  On the other hand, if the client wants a higher risk approach and has hired a manager he thinks will outperform over a market cycle but who will be +/- 400 bp in any given year, then two percentage points under the index isn’t so bad.

Performance vs. peers

Performance vs. peers is a secondary measure that institutional investors use.  Almost always, it’s a weaker criterion than performance vs. the index, especially so in the US.  Here, almost no active manager beats the index.  But one can argue that a manager has at least some skill if he does better than other managers.  There are times, however, when comparison vs. peers serves a very useful function.  For international managers during the Nineties, the “lost decade” for Japan, for example, virtually every manager beat the international EAFE index by underweighting the Japanese market.  So customers began to differentiate performance either by separately analyzing performance vs the index in Japan and in non-Japanese markets or, more commonly (I think) by comparing managers with each other.

Individual investors

Individual investors strike me as wanting the best of both worlds.  They want index-beating performance in the up markets, and also expect to avoid making a loss in the down years.  Hence, the appeal of Bernard Madoff or of hedge funds.  After a good several-year run, the average hedge fund has underperformed the S&P 500 every year from 2003 onward, before completely blowing up in 2008.  We all know the Madoff story.

Gains every year are hard (impossible?) to achieve

Why is absolute return so hard to achieve, apart from holding cash-like instruments like a money market fund or treasury bills (both of which are yielding pretty close to zero at the moment)?  It’s because interest rates change with the business cycle.

Take the case of a 10-year treasury bond.  Suppose you buy one for $1000.  It’s currently yielding about 3%.  So you’ll get a payment of $30 yearly from the treasury and your $1000 back in 2019.  That won’t change, no matter what happens in the economy between now and then.  The 3% yield is more or less determined by the federal funds rate (the overnight lending rate between banks) has been set very close to zero–say, .25%–because the economy is so weak.

Over the next few years, we hope, the economy will get better and the fed funds rate will rise to a more normal 3%.  The yield on a 10-year bond newly issued then will probably be around 6%.  What happens to the price of your bond?  Well, if a yearly payment of $60 plus return of principal at the end of the bond’s life is worth $1000, then our yearly payment of 3% plus return of principal must be worth less.  It’s possible that, in a given year, that the decrease of value of our bond will be greater than the 3% coupon payment we receive.  In other words, we’ll have a loss that year on our investment.

That may not matter so much to us.  We have a guaranteed stream of income and we’ll get all our principal back at the end of ten years.  So our investment objectives are probably all being met.  In fact, if we thought a bout it a little more we might conclude that what we really want is stability of income.    In addition, it may well be that having a temporary loss (short-term volatility) isn’t a particularly important investment objective for most people, even though it is the most common measure of risk used by academics and pension consultants.

Why relative performance?

What makes relative performance, as hard as index outperformance may be to achieve, so popular a way of judging managers?

For one thing, the practical task of management is easier. The question of which stock will likely perform better, AAPL or DELL, is almost entirely about the strengths and weaknesses of the two companies and about the relative valuation of their stocks.  If I’m competing against an index that has DELL in it and I hold AAPL instead, I’ll outperform if AAPL does better, no matter whether they go up or down.  In contrast, the question of whether AAPL will go up or not is also one about the state of the world economies and the direction of currencies and interest rates, among other things.  And in the past year or so, we’ve seen the stock go from about $200 a share down into the $80s, without much change in the underlying company’s results.

It allows managers to specialize.  If a manager runs a health care portfolio or specializes in Pacific Basin stocks, he can presumably develop a depth of knowledge–both about the stocks and about the composition of the index–that will enhance his returns.

Part of the responsibility for portfolio risk shifts back to the client, or at least away from the manager.  In most cases, the client has an advisor–a financial planner, a broker, a pension consultant–who helps make the ultimate decision about where a given manager fits in the client’s overall portfolio.

Another aspect of the last two points is that the manager doesn’t have to coordinate his actions with other portfolio managers, or even understand the risk perameters of the client’s overall holdings.  That’s done by the advisor or the client himself.

This way of operating–multiple managers operating in isolation but coordinated by a third party–got a huge boost from the Employee Retirement Income Security Act (ERISA) of 1974.  By setting more stringent requirements for the professional training and experience of pension managers, ERISA encouraged companies to seek third-party managers for their pension funds.  This gave rise to a bevy of consulting firms to help companies develop asset allocation strategies for their pensions, as well as to help select and monitor third-party investment managers.  The consultants promoted a philosophy of centrally (company + consultant) developed investment plan carried out by a diversified group of highly specialized managers.  As luck would have it, this created a key role, rich in fee income, for the pension consultants themselves.  Companies didn’t mind that much, because they were transferring the risk of underperformance from themselves to the managers and the risk of picking the wrong investment firms to the consultants.  Since managing corporate pensions was an immense growth business for investment companies in the Seventies and the Eighties, the consultant-approved model of highly focused managers became the industry norm.

Individuals and a Hybrid Model

The traditional model for a retiree has had two parts:

–to secure a steady stream of income through a defined benefit pension plan + social security, using an absolute standard for assessing what is good enough; and

–to hedge agains unforseen circumstances, including inflation, by holding equities, whose performance would be judged (if at all) by a relative standard.

This traditional world has been turned upside down in recent years.  But that”s a story for another day–actually it’s the story this blog hopes to tell for some time to come.

Note:  See more recent comments on this topic in my 9/29/10 post.