I apologize for being a bit late this month with our letter. I have been a little selfish, taking a two week adventure away from everyone. My quest was to seek out oddities dedicated to planes, trains and automobiles throughout North America. I’ve seen statues dedicated to the Underground Railroad on the side of a river in Michigan, a plaque dedicated to the builders of the Trans-Canada highway somewhere in Ontario. I took a ride in the aero-car in Niagara Falls and welcomed the cog train into the station at the top of Pikes Peak. I stopped by the little sign that is dedicated to the car that broke the sound barrier in the desert of Nevada and took the tour of the Titan Missile museum in Green Valley Arizona. I rode the free ferry in Galveston, traveled across the world’s longest continuous bridge over water at Lake Pontchartrain and then turned around and went over it again, the other way. Took a look at a racetrack and could not help myself but to take a trip on both sides of the first superhighway in America, the Pennsylvania turnpike. Plus another fifty or so other special sites dedicated to someone or something.
I have heard, whether it is true or not, that 85% of all wealth managers use investment products, i.e., mutual funds, separate account managers, alternative investment managers and others, instead of building and maintaining a portfolio directly. This is probably the appropriate way to go for most, in that the skill set for security analysis and portfolio management is quite different than the skill set needed for financial, tax and estate planning. It is possible for a firm to have both levels of expertise, but I am afraid that is the exception, not the rule.
I have also heard that many in the wealth management industry consider investment managers nothing more than a commodity and are not worth much as investment returns are driven by asset allocation, not investment selection. Once again, this may or may not be true, although there are numerous studies that attempt to prove such a thing. Of course, many of these studies are written by individuals who make their living through asset allocation not security selection.
Knowing these things still leaves me asking why so many financial professionals have chosen not to pursue financial analysis, investment selection or portfolio management as a career. Could it be that Warren Buffett gave us the answer in his 1996 chairman’s letter?
This is what he said: “To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well taught courses – How to Value a Business, and How to Think About Market Prices.”
Mr. Buffett recognized in 1996 that security selection did not have top billing in a finance curriculum. From my own knowledge, today’s business schools seem only to discuss individual securities as trading vehicles used in and by speculators, not by serious investors. It is also obvious, at least to me, that business schools send a message to students that any serious investor will utilize the power of a computer to apply mathematical formulas based on the work of Harry Markowitz, Robert Merton, William Sharpe, Kenneth French, Eugene Fama, Fischer Black, Myron Scholes and a host of other less known, but highly influential academics to manage their investment portfolio.
Since this quantitative approach to portfolio management dominates the world of investing today it is important to have a little background information. So let’s explore the history book of quants.
A Brief History of Quantitative Investing
In the year 1900, Louis Bachelier wrote a paper titled “The Theory of Speculation” in which he completed a statistical study on the behavior of stock prices. Most believe this is the first scientific attempt to use math as a basis to understand and profit from prices changes in common stocks. Without fanfare, computers and the ease of distribution, the paper sat on a shelf and collected dust for decades.
It wasn’t until the 1950’s that the world was introduced to the concept of “Modern Portfolio Theory” in a paper written by Harry Markowitz. Unlike Mr. Bachelier’s paper, Harry’s took off because it was written shortly after the first commercial computers were accessible to a broad group of academics and investment practitioners. They loved the idea of computing power and its ability to crunch numbers faster than any human possible. This theory and the computer led to William Sharpe’s Capital Asset Pricing Model, and Fama and French’s three-factor CAPM.
These early practitioners developed ideas that could explain how market returns were generated historically. Of course it did not take long before enterprising investment managers took this historical explanation of market returns and used these findings in hopes that they would repeat themselves in the future thus earning excess returns for themselves and their clients.
Over the past sixty years, the use of a historical relationship between asset classes, combined with the increasing power of the desktop computer, has taken the simplicity of the Markowitz model and morphed it into hundreds of quantitative approaches to investment management. The most basic approach is used by the vast majority of traditional security analysts including our firm; using the computer’s ability to store and quickly recall fundamental data and screening out certain unwanted characteristics from the pool of over 25,000 individual securities available for purchase. In our case, we screen by a multiple of factors including market cap, liquidity, cash flow and debt. This reduces the number of securities to less than 250 before we begin the rigorous work of valuation. Once again, the computer and the data provided allow us to rank securities on a relative basis to the market averages, historical pricing of individual securities relative to themselves and other securities within their industry, and more importantly, determine a fair price for a business as a whole based on its future ability to generate cash to its owners.
This approach may be used by the majority of security analysts, but each will use their own data differently from each other to find a few securities that they believe will provide superior returns. However, the majority of investment advisors today do not seek out individual securities, but groups of securities with similar characteristics. It may be groups with small, medium or large market capitalization. It could be based on the geographic location of the company’s home, such as the U.S., Europe, Asia, China or South America. For fixed income investors it could be based on the average maturity or quality of the bonds within a portfolio of bonds. The ability to group securities and the investment industries willingness to create packaged products of specific groups of individual securities to meet the characteristics desired by wealth managers gives each organization the ability to implement an investment program to their liking. In all cases these quantitative managers are trying to use broad diversification and a historical relationship between each group in hopes that they will achieve superior risk-adjusted returns.
I do not want to leave out the huge number of professional and individual investors that use technically driven models. These models are by most accounts the oldest form of any quantitative strategy. The basic premise of all technical models is that the only things you need to know about any security are its price and trading volume. These two characteristics can provide you with a time to buy and sell, providing a pattern to be exploited that can earn better than average returns.
No matter what quantitative approach is used, they all fail in one respect, in that you must believe that history will repeat itself – or at least rhyme. This concept is what is causing my worries. What if history does not rhyme? What if it does but we cannot remember the rhyme? If our decisions are based on past history and history does not repeat itself then the solution to earning profitable returns based on the ideas of Markowitz’s efficient frontier and it’s siblings will not only lead to frustration, it will lead to monetary losses!
Two Harvard professors, Ronald Heifetz and Martin Linsky, attempted to address this problem and provide an outline to solve the problem in their book Leadership on the Line: Staying Alive through the Dangers of Leading. They attempted to break down problems into two basic types - technical and adaptive problems. Each type of problem requires a different response. Confusing the two will result in failure.
To solve a technical problem we use know-how and follow a set of procedures as provided to us by the professors.
- Problems are amenable to solutions.
- People already know what to do and how to do it.
- Leaders know the answer and take corrective actions.
- Problems are not trivial, but solutions are within a person’s abilities.
- Solutions are not necessarily easy, but expertise and knowledge are available.
Adaptive Problems, however, involve challenges to deeply held values and well-entrenched attitudes. Solving an adaptive problem requires new learning.
- Problems demand change in values, attitudes, and behaviors.
- People’s hearts and minds need to change, not only their likes and dislikes.
- Problems surface that no existing technical expertise can solve.
- Leaders ask questions that challenge people’s beliefs.
- Problems require a mindset shift that will result in some loss, especially for people who benefited from previous circumstances of patterns.
- People are challenged to use their competence to bring about new solutions. Leaders bring people’s attention to the problem and expect them to take responsibility for it.
- Problem solving involves new experiments, uncertainty, and loss.
Over the past decade we have seen a price bubble and the bursting of that bubble in real estate and common stocks. When the bubble burst, the historical relationships between all asset classes broke down. One would think that this breakdown of historical relationships would have been recognized as an adaptive problem, and over the past five years attempts of a new solution would have been encouraged by investment professionals.
I am sorry to say that has not happened. In fact, over the past five years, the belief in the historical quantitative approach to investment management has not only been defended, it has increased its control over investment capital. I know this statement may cause some backlash in the investment industry, but all the solutions I have seen simply rearrange the data set and the math while keeping the basic concept the same. The majority in the wealth management industry has the belief that the problem is a technical problem and the solution is well within our abilities. I however think we need an overhaul of the actual belief system itself.
The biggest challenge I see today is the relationship between interest rates and all other asset classes. From all the years that I have been helping people invest their savings, I know that there is a deep entrenched belief that bonds are safe and stocks are risky. Of course this belief has been rewarded over the past thirty years. It has been modeled into just about everyone’s quantitative approach to portfolio management. Bonds are safe, stocks are risky! If this belief holds true then my concerns are just that, concerns. They will have no consequences.
But what if over the next ten, twenty or thirty years this does not hold true. What if bonds are no longer the safe investments? What if bonds not only pay an interest payment less than the level of inflation, thus guaranteeing a real loss of capital, but also fail to be a secure source of capital preservation?
As I write this, the city of Detroit has filed for protection under our bankruptcy laws. What will happen to the billions of dollars owed to bond owners? Will this give the go-ahead light to hundreds of other cash strapped municipalities that are having a difficult time paying the interest on their debt let alone the principal when promised?
We believe that the next decade will be one that this underlying belief in the safety of bonds will breakdown. It is an adaptive problem that requires a new approach to portfolio management. It will require us to refrain from owning bonds or any other fixed income security with a maturity beyond a year or two until such time as interest rates exceed the rate of inflation with a good buffer to boot. It will require us to look at cash as a bond with a maturity of one day. It will require us to hold far more cash in our portfolios than we have in the past. It will require us to refrain from owning any interest rate sensitive security whose primary reason for purchase is current income. It will require us to be far more price conscience in the selection of common stocks as people will re-rate common stock prices lower with any increase in interest rates.
Because of these requirements it will increase the time for our new clients to become fully invested. During a rising stock market this will require patience on the part of both us and our new clients as other than fully invested portfolios will not have the same short term results as our long-term clients. Even so, we believe that this is mandatory, as the risk associated with buying high is far greater than waiting and buying when prices are more reasonable. How long this will take is unknown, but it will happen.
Until next time,
Kendall J. Anderson, CFA