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The Problem With Pragmatism… and Inflation

Pragmatism is seeking immediate solutions with little to no consideration for the longer-term benefits and consequences. An excellent example of this is the Social Security system in the United States. In the Depression-era, a government-sponsored savings plan was established to “solve” for lack of retirement savings by requiring contributions to a government-sponsored savings plan.  At the time, the idea made sense as the population was greatly skewed towards younger people.  No one seriously considered whether there would always be enough workers to support benefits for retired people in the future. Now, long after those policies were enacted and those that pushed the legislation are long gone, the time is fast approaching when Social Security will be unable to pay out what the government has promised.

Pragmatism is the common path of governments, led by politicians seeking re-election and the retention of power. Instead of considering the long-term implications of their policies, they focus on satisfying an immediate desire of their constituents.

In his book Economics in One Lesson, Henry Hazlitt made this point very clear by elaborating on the problems that eventually transpire from imprudent monetary and fiscal policy.

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Nine-tenths of the economic fallacies that are working such dreadful harm in the world today are the result of ignoring this lesson.”

Inflation

One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. When asked to define inflation, most people say “rising prices,” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation is a disequilibrium between the amounts of currency entering an economic system relative to the productive output of that same system.

In today’s world, there is only fiat (“by decree”) currencies. In other words, the value of currencies are not backed by some physical commodity such as gold, silver, or oil. Currencies are only backed by the perceived productive capacity of the nation and the stability of the issuing government. If a government takes unreasonable measures in managing its fiscal and monetary affairs, then the standard of living in that society will deteriorate, and confidence in it erodes.

Put another way, when the people of a nation or its global counterparts lose confidence in the fiscal and monetary policy-makers, the result is a loss of confidence in the medium of exchange, and a devaluation of the currency ensues. The influence of those in power will ultimately prove to be unsustainable.

Inflation is an indicator of confidence in the currency as a surrogate of confidence in the policies of a government. It is a mirror. This is why James Grant is often quoted as saying, “The gold price is the reciprocal of the world’s faith in central banking.”

Confidence in a currency may be lost in a variety of ways. The one most apparent today is creating too many dollars as a means of subsidizing the spending habits of politicians and the borrowing demands of corporations and citizens.

Precedent

There is plenty of modern-day historical precedent for a loss of confidence from excessive debt creation and the inevitable excessive currency creation. Weimar Germany in the 1920s remains the modern era poster child, but Zimbabwe, Argentina, and Venezuela also offer recent examples.

Following the 2008 financial crisis, many believed that the actions of the Federal Reserve were “heroic.” Despite failing to see the warning signs of a housing bubble in the months and even years leading up to the crisis, the Fed’s perspective was that it exists to provide liquidity. As the chart below illustrates, that is precisely what they did.

Data Courtesy Bloomberg

That pragmatic response failed to heed Hazlitt’s warning. What are the longer-term effects for the economy, the bailed-out banking system, and all of us? How would these policies affect the economy, markets, society, and the wealth of the nation’s citizens in five, ten, or twenty years?

Keeping interest rates at a low level for many years following the financial crisis while the economy generally appears to have recovered raises other questions. The Fed continues to argue that inflation remains subdued. That argument goes largely undisputed despite credible evidence to the contrary. Further, it provides the Fed a rationalization for keeping rates well below normal.

Politicians who oversee the Fed and want to retain power, consent to low-rate policies believing it will foster economic growth. While that may make sense to some, it is short-sighted and, therefore, pragmatic. The assessment does not account for a variety of other complicating factors, namely, what may transpire in the future as a result? Are seeds of excess being sown as was the case in the dot-com bubble and the housing bubble? If so, can we gauge the magnitude?

Policy Imposition

In the mid-1960s, President Lyndon Johnson sought to escalate U.S. involvement in the Vietnam War. In doing so, he knew he would need the help of the Fed to hold interest rates down to run the budget deficits required to fund that war. Although then-Fed Chairman William McChesney Martin was reluctant to ease monetary policy, he endured various forms of abuse from the Oval Office and finally acquiesced.

The bullying these days comes from President Trump. Although his arguments for easier policy contradict what he said on the campaign trail in 2016, Jerome Powell is compliant. Until recently, the economy appeared to be running at full employment and all primary fundamental metrics were well above the prior peaks set in 2007.

Additionally, Congress, at Trump’s behest and as the chart below illustrates, has deployed massive fiscal stimulus that created a yawning gap (highlighted) between fiscal deficits and the unemployment picture. This is a divergence not seen since the Johnson administration in the 1960s (also highlighted) and one of magnitude never seen. As is very quickly becoming clear, those actions both monetary and fiscal, were irresponsible to the point of negligence. Now, when we need it most as the economy shuts down, there is little or no “dry powder”.

Data Courtesy Bloomberg

President Johnson got his way and was able to fund the war with abnormally low interest rates. However, what ensued over the next 15 years was a wave of inflation that destroyed the productive capacity of the economy well into the early 1980s. Interest rates eventually rose to 18%, and economic dynamism withered as did the spirits of the average American.

The springboard for that scenario was a pragmatic policy designed to solve an immediate problem with no regard for the future. Monetary policy that suppressed interest rates and fiscal policy that took advantage of artificially low interest rates to accumulate debt at a relatively low cost went against the American public best interests. The public could not conceive that government “of, by and for the people” would act in such a short-sighted and self-serving manner.

Data Courtesy Bloomberg

The Sequel

Before the COVID-19 pandemic, the Congressional Budget Office (CBO) projections for U.S. budget deficits exceeded $1 trillion per year for the next 10-years. According to the CBO, the U.S. Treasury’s $22.5 trillion cumulative debt outstanding was set to reach $34.5 trillion by 2029, and that scenario assumed a very optimistic GDP growth of 3% per year. Further, it laughably assumed no recession will occur in the next decade, even though we are already in the longest economic expansion since the Civil War. In the event of a recession, a $1.8 trillion-dollar annual deficit would align with average historical experience. Given the severity of what is evident from the early stages of the pandemic, that forecast may be very much on the low end of reality.

The 1960s taught us that monetary and fiscal policy is always better erring on the side of conservatism to avoid losing confidence in the currency. Members of the Fed repeatedly tell the public they know this. Yet, if that is the case, why would they be so influenced by a President focused on marketing for re-election purposes? Alternatively, maybe the policy table has been set over the past ten years in a way that prevents them from taking proper measures? Do they assume they would be rejected despite the principled nature of their actions?

Summary

Inflation currently seems to be the very least of our worries. Impeachment, Iran, North Korea and climate change were all crisis head fakes.

The Fed was also distracted by what amounted to financial dumpster fires in the fall of 2019. After a brief respite, the Fed’s balance sheet began surging higher again and they cut the Fed Funds rate well before there was any known threat of a global pandemic. What is unclear is whether imprudent fiscal policies were forcing the Fed into imprudent monetary policy or whether the Fed’s policies, historical and current, are the enabler of fiscal imprudence. Now that the world has changed, as it has a habit of doing sometimes even radically, policymakers and the collective public are in something of a fine mess to understate the situation.

Now we are contending with a real global financial, economic, and humanitarian threat and one that demands principled action as opposed to short-sighted pragmatism.

The COVID-19 pandemic is clearly not a head fake nor is it a random dumpster fire. Neither is it going away any time soon. Unlike heads of state or corporate CEOs, biological threats do not have a political agenda and they do not care about the value of their stock options. There is nothing to negotiate other than the effectiveness of efforts required to protect society.

Given the potential harm caused by the divergence between stimulus and economic fundamentals, it would be short-sighted and irresponsibly pragmatic to count out the prospect of inflation. Given the actions of the central bankers, it could also be the understatement of this new and very unusual decade.

March Madness: Having A Process For A Winning Outcome

We are coming upon that time of year when the markets play second fiddle to debates about which twelve seed could be this year’s Cinderella in the NCAA basketball tournament. For college basketball fans, this particular time of year is dubbed March Madness. The widespread popularity of the NCAA tournament is not just about the games, the schools, and the players, but just as importantly, it is about the brackets. Brackets refer to the office pools based upon correctly predicting the 67 tournament games. Having the most points in a pool garners bragging rights and, in many cases, your colleague’s cash.

Interestingly the art, science, and guessing involved in filling out a tournament bracket provides insight into how investors select assets, structure portfolios, and react during volatile market periods. Before we explain answer the following question:

When filling out a tournament bracket, do you:

A) Start by picking the expected national champion and then go backwards and fill out the individual games and rounds to meet that expectation?

B) Analyze each opening round matchup, picking winners, and then repeat the process with your second round matchups until you make your best guess at who the champion will be?

If you chose answer A, you fill out your pool based on a fixed notion for which team is the best in the country. In doing so, you disregard the potential path, no matter how hard, that team must take to become champions.

If you went with the second answer, B, you compare each potential matchup, analyze each team’s respective records, strengths of schedule, demonstrated strengths and weaknesses, record against common opponents and even how travel and geography might affect performance. While we may have exaggerated the amount of research you conduct, such a methodical game by game evaluation is repeated over and over again until a conclusion is reached about which team can win six consecutive games and become the national champion.

Outcome-Based Strategies

Outcome-based investment strategies start with an expected result, typically based on recent trends or historical averages. Investors following this strategy presume that such trends or averages, be they economic, earnings, prices, or a host of other factors, will continue to occur as they have in the past. How many times have you heard Wall Street “gurus” preach that stocks historically return 7%, and therefore a well-diversified portfolio should expect the same return this year? Rarely do they mention corporate and economic fundamentals or valuations. Many investors blindly take the bait and fail to question the assumptions that drive the investment selection process.

Buy and hold and constant dollar cost averaging along with a host of passive strategies, all of which are largely agnostic to valuation, are outcome based strategies. These strategies can appear full proof for years on end as we have been witnessing. However, as seen twice in the last 20 years, when these strategies are followed blindly without appreciating a portfolio’s risk/return profile, dramatic losses will eventually occur. Outcome-based strategies break a cardinal rule of building wealth; avoid as much of the downside as possible in bear markets.

“The past is no guarantee of future results” is a typical investment disclaimer. However, it is this same outcome-based methodology and logic that many investors rely upon to allocate their assets.

Process-Based Strategies

Process-based investment strategies, on the other hand, have methods that establish expectations for the factors that drive asset prices in the future. Such analysis normally includes economic forecasts, technical analysis, and a bottom-up assessment of an asset’s ability to generate cash flow. Process-based investors do not just assume that yesterday’s winners will be tomorrow’s winners, nor do they diversify just for the sake of diversification. These investors have a method that helps them forecast the assets that are likely to provide the best risk/reward prospects and they deploy capital opportunistically.

Well managed process-based strategies, at times, hold significant amounts of cash. To wit, Warren Buffett is currently sitting on $128 billion in cash. This may have cost him over the last few years, but he has a reason for being so risk averse and is sticking to his process.

Buffett and others are certainly not enamored with historically low cash yields on their cash per se, but they have done significant research and cannot find enough assets offering a suitable value/risk proposition in their opinion. These managers are not compelled to buy an asset because it “promises” a historical return.

What Are We?

At RIA Advisors, we follow a process. We use a combination of technical and fundamental analysis, along with a strong assessment of macroeconomic factors to develop an investing framework and investment guidelines. This process allows us to:

  • Properly choose assets for the short term as well as the longer term (trading vs. investing).
  • Determine the proper allocations to various asset classes and sub-asset classes.
  • Measure and monitor risk which helps limit downside by forcing us to exit positions when we are wrong, and take profits to rebalance asset weightings when we are right.

Investing can be easy at times as it was for most of 2019. It can also be very difficult as we are currently witnessing. Having a process and adhering to it does not eliminate risk, but it helps manage risks and limit mistakes. It also helps us sleep at night and avoids letting our emotions dictate our trading activity.

A or B?

Most NCAA basketball pool participants fill out tournament brackets, starting with the opening round games and progress towards the championship match. Sure, they have biases and opinions that favor teams throughout the bracket, but at the end of the day, they have done some analysis to consider each potential matchup.  So, why do many investors use a less rigorous process in investing than they do in filling out their NCAA tournament brackets?

Starting at the final game and selecting a national champion is similar to identifying a return goal of 10%, for example, and buying assets that are forecast to achieve that return. How that goal is achieved is subordinated to the pleasant but speculative idea that one will achieve it. In such an outcome-based approach, decision-making is predicated on an expected result.

Considering each matchup in the NCAA tournament to ultimately determine the winner applies a process-oriented approach. Each of the 67 selections is based on the evaluation of the comparative strengths and weaknesses of teams. The expected outcome is a result of the analysis of the many factors required to achieve the outcome.

Summary

Winning a bracket has its benefits, while the costs are minimal. Managing wealth, however, can provide great rewards but is fraught with severe risks at times. Accordingly, wealth management deserves considerably more thoughtfulness than filling out a bracket.

Over the long run, those that follow a well-thought out, time-tested, process-oriented approach will raise the odds of success in compounding wealth by limiting damaging losses during major market setbacks and by being afforded generational opportunities when others are fearfully selling.

A Black Swan In The Ointment

A good person is as rare as a black swan”- Decimus Juvenal

In 2007, Nassim Taleb wrote a bestselling and highly impactful book titled The Black Swan: The Impact of the Highly Improbable. The book uses the analogy of a black swan to describe negative events that appear to be very rare and occur without warning.  Since the book was published, the term black swan has been overused to describe all kinds of events that were predictable to some degree.

Last April, we wrote A Fly in the Ointment, which was one of a few articles that pointed out the risk of higher inflation to the markets and economy. Thinking about inflation in the context of the Corona Virus and the Fed’s aggressive monetary policy, might our fly be a black swan.

Corona Virus

The economic impact of the Corona Virus has been negligible thus far in the U.S., but in a growing list of other countries, the impact is high. In China, cities more populated than New York City are being quarantined. Citizens are being told to stay at home, and schools, factories, and shops are closed. Japan just closed all of its schools for at least a month. Airlines have reduced or suspended flights to these troubled regions.

From an inflation perspective, the impact of these actions will be two-fold.

Consumers and businesses will spend less, especially on elastic goods. Elastic goods are products that are easy to forego or replace with another good. Examples are things like movies, coffee at Starbucks, cruises, and other non-necessities. Inelastic goods are indispensable or those with no suitable replacement. Examples are essential medicines, water, and food. Many items fall somewhere between perfectly elastic and perfectly inelastic, and in many cases, the classification is dependent upon the consumer.

On the supply side of the inflation equation, production suspensions are leading to shortages of parts and final goods. Companies must either do without them and slow/suspend production or find new and more expensive sources.

We are purposely leaving out the role that the supply of money plays in inflation for now.

With that as a backdrop, we pose the following questions to help you assess how the virus may impact prices.

  • Will producers of elastic goods lower prices if demand falters?
  • If so, will lower prices induce more consumption?
  • Can producers lower the prices of goods if the cost to produce those goods rise?
  • How much margin compression can companies tolerate?
  • Will producers of inelastic goods try to pass on the higher costs of goods, due to supply chain problems, to consumers?
  • Inflationary or deflationary?

We do not have the answers to the questions but make no mistake; inflation related to hampered supply lines could more than offset weakened demand and pose a real inflation risk.

The Fed’s Conundrum

Monetary policy has a direct impact on prices. To quote from our recent article, Jerome Powell & The Fed’s Great Betrayal:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

For the past decade, the Fed has consistently sought to generate more inflation. They have kept interest rates lower than normal given the tepid economic growth trends. Further, they employed four rounds of QE. QE provides reserves to banks, which increases their ability to create money. Easy money policies, the type we have grown accustomed to, is designed to increase inflation.

On March 3, 2020, the Fed cut interest rates to try to offset the negative economic impact of the Corona Virus.  How lower interest rates will cure a disease is a question for another day. Today’s big question is the Fed fueling the embers of inflation with this sudden rate cut?

Enter the Black Swan

What would the Fed need to do if inflation were to rise due to compromised supply lines and overly aggressive Fed actions? If inflation becomes a problem, they would need to do the opposite of what they have been doing, raise interest rates and reduce the assets on their balance sheet (QT).

Such policy worked well in the 1970s when Fed Chairman Paul Volker increased Fed Funds to 20% and restricted money supply to bring down double-digit inflation. Today, however, such a prudent policy response would be incredibly problematic due to the massive amount of debt the U.S. and its citizens have accumulated. The graph below shows that there is about three and a half times more debt than annual economic activity currently in the U.S.

Unlike the 1970s, when household, corporate, and public debt levels were much lower, higher interest rates and less liquidity today would inevitably result in massive defaults by both consumers and corporations. Further, it would cause a surge in the Federal budget deficit as interest expense on U.S. Treasury debt would rise.

Over the last few decades, we have seen a steady decline in interest rates. At times in this cycle, rates have risen moderately. Each time this occurred, a crisis developed as funding problems arose. What would happen today if mortgage rates rose to 7% and auto loans to 5%? What would happen to corporate profits if borrowing rates doubled from current levels? How would corporations that depend on routine, cheap refinancing of their debt obtain it?

In such an environment, taking on new debt would be much less appealing and servicing existing debt would require a larger portion of the budget. Clearly, an inflationary outbreak accompanied by higher interest rates would result in a severe recession.

Summary

What is a black swan? A black swan is an unforeseen event like the rapid spreading of the Corona Virus that results in inflation. It is not the obvious outcome but rather an obscure second or third-order effect. Our modern economic policy framework is not designed for inflation, nor are many people even thinking about it as a possibility. That is a black swan.  

Inflation is the one thing that prevents the Fed and other central banks from supporting the economy and markets in the way they have become accustomed.

As discussed in prior articles, we believe there is ample evidence of problematic inflation data for those who choose to look. At the same time, global central bankers continue to engage in imprudent policies that are inflationary in nature. Lastly, the Corona Virus threatens to hamper supply lines and change consumer spending habits.

Whether or not those factors result in inflation is unknown. Although one cannot predict the future, one can prepare for it. Inflation is not dead, but it has been hibernating for decades. Even if the odds of inflation are relatively low, that does not mean we should ignore them. As the sub-title to Taleb’s book says, “The Impact of the Highly Improbable” can be important. An event that has a 1% chance of occurring but would cause a massive loss of wealth should not be ignored.

Investing Versus Speculating

Value investing is an active management strategy that considers company fundamentals and the valuation of securities to acquire that which is undervalued. The time-proven investment style is most clearly defined by Ben Graham and David Dodd in their book, Security Analysis. In the book they state, “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

There are countless articles and textbooks written about, and accolades showered upon, the Mount Rushmore of value investors (Graham, Dodd, Berkowitz, Klarman, Buffett, et al.). Yet, present-day “investors” have shifted away from the value proposition these greats profess as the time-tested secret to successful investing and compounding wealth.  

The graph below shows running ten year return differentials between value and growth. Clearly, as shown, investors are chasing growth at the expense of value in a manner that is quite frankly unprecedented over the last 90 years.

Data Courtesy French, Fama, and Dartmouth

In the 83 ten year periods starting in 1936, growth outperformed value only eight times. Five of those ten year periods ended in each of the last five years.

Contrast

Value stocks naturally trade at a discount to the market. Companies with weaker than market fundamental growth leads to discounted valuations and a perception among investors that is too pessimistic about their ability to eventually achieve a stronger growth trajectory.

Growth stocks are those that pay little or no dividends but promise exceptional revenue and earnings growth in the future.

The outperformance of growth over value stocks is natural in times when investors become exuberant. Modern-day market participants claim superior insight into this Fed-controlled, growth-friendly environment. Based on the media, it appears as if the business cycle is dead, and recessions are an archaic thing of the past. Growth stocks promising terrific streams of cash flow at some point in the future rule the day. This naturally leads to investors becoming too optimistic and extrapolate strong growth far into the future.

Meanwhile, value companies tend to retain an advantage by offering higher market yields than growth stocks. That edge may only be 1 or 2% but compounded over time, it is significant. The problem is that when valuations on the broad market become elevated, as they are now, that premium compresses and diminishes the income effect. The problem is temporary, however, assuming valuations eventually mean-revert.

One other important distinction of value companies is that they, more commonly than growth companies, end up as takeover targets. Historically, this has served as another premium in favor of value investing. Over the course of the past 12 years, however, corporate capital has uncharacteristically been more focused on growth companies and the ability to tell their shareholder a tale of wild earnings growth that accompany their takeover targets. This is likely due to the environment of ultra-low interest rates, highly accommodative debt markets, and investors that are not focused on the inevitability of the current business cycle coming to an end.

Active versus Passive

Another related facet to the value versus growth discussion is active versus passive investment management. Although active management may be involved in either category, value investing, as mentioned above, must be an active strategy. Managers involved in active management require higher fees for those efforts. Yet, as value strategies have underperformed growth for the past 12 years, many investors are questioning the active management logic.

Why pay the high fees of active managers when passive management suffices at a cost of pennies on the dollar? But as Graham and Dodd defined it, passive strategies are not investing, they are speculating. As the graph below illustrates, the shift out of active management and into passive funds is stark.

Overlooking the historical benefits and outperformance of value managers, current investors seek to chase returns at the lowest cost. This behavior is reflective of a troubling lack of discipline and suggests that investors are complacent about the possibility of having their equity wealth cut in half as it was in two episodes since 2000.

Pure passive investing, investing in a mutual fund or exchange-traded fund (ETF) that mimics an index, represents a low-fee approach to speculation. It does not involve “thorough analysis,” the promise of “safety of principal,” or an “adequate return.” Capital received is immediately deployed and invested dollars are weighted most heavily toward the most expensive stocks. This approach represents the opposite of the “buy-low, sell-high” golden rule of investing.

Active management, on the other hand, involves analytical rigor by usually seasoned managers and investors seeking out opportunities in good companies in which to invest at the best price.

Definition of Terms

To properly emphasize the worth of value investing, it is important first to define a couple of key terms that many investors tend to take for granted.

Risk – Contrary to Wall Street marketing propaganda, risk is not a number calculated by a formula in a spreadsheet. Risk is simply the likelihood of a substantial and permanent loss of capital with no ability to ever recover. Exposure to risk cannot be mitigated by blind diversification. Real risk cannot be quantified by processing the standard deviation of historical returns or the sophisticated variations of Value-at-Risk. These calculations and the many assumptions within them lead to misperceptions and misplaced confidence.

Wealth – Wealth is savings. It is that which is left over after consumption and is the accumulation of savings over time. Wealth results from the compounding of earnings. Wealth is not the net value of assets minus liabilities. That is a balance sheet metric that can change dramatically and suddenly depending on economic circumstances. An investor who seeks to sell high and buy low, like a business owner who prudently waits for opportunities to buy out competitors when they are distressed, uniquely illustrates proper wealth management and are but two forms of value investors.

Economic Worldview

Understanding these terms is important because it affects one’s economic worldview and the ability to make prudent investment decisions consistently. As Dylan Grice of Edelweiss Holdings describes it:

Language is the machinery with which we conceptualize the world around us. Devaluing language is tantamount to devaluing our ability to think and understand.” Grice continues, clarifying that point, “linguistic precision leads to cognitive precision.”

Value investors understand that compounding wealth depends on avoiding large losses. These terms and their proper definitions serve as a rock-solid foundation for sound reasoning and analytical rigor of market forces, central bank policies, and geopolitical dynamics that influence global liquidity, asset prices, and valuations. They enable critical foresight.

Proper definitional terms clarify the logical framework for an investor to benchmark their wealth, net of inflation, rather than obsessing with benchmarking returns to those of the S&P 500 or other passive indexes. Redefining one’s benchmark to inflation plus some excess return properly aligns target returns with life goals. Comparisons to the returns of the stock market are irrelevant to your goals and induce one to be dangerously urgent and speculative.

Value investing is having the courage to be opportunistic when others are pessimistic, to buy what others are selling, and to embrace volatility because it is in those times of upheaval that the greatest opportunities arise. That courage is derived from clarity of goals and a sturdy premise of assessing value. This is not an easy task in a world where the discounting mechanism itself has become so disfigured as to be rendered little more than a reckless guess.  

Properly executed, value investing seeks to find opportunities to deploy capital in such a way that reduces risk by acquiring assets at prices that are sufficiently below intrinsic value. This approach also extends to potential gains and creates a desirable performance asymmetry.

In the words of famed investor and former George Soros colleague, Jim Rogers, “If you buy value, you won’t lose much even if you’re wrong.” And let’s face it, everybody in this business is wrong far more than they’re right.

Summary

Analytically, safety, and profits are rooted in buying assets with abnormally large risk premiums and then having the patience to wait for mean reversion. It often requires the rather unconventional approach of identifying those areas where there is distress and misguided selling is occurring.

As briefly referenced above in the definition of wealth, a value investor manages money as a capitalist business owner would manage his company. A value investor is more interested in long-term survival. Their decisions are motivated by investing in companies that are doing those things that will add to the substance and durability of the enterprise. They are interested in companies that aim to enhance the cash flow of the operation and, ideally, do so with a very long time-preference and as a habitual pattern of behavior.

Unlike a business owner and an “investor,” most people who buy stocks think in terms of acquiring financial securities in hopes of selling them at a higher price. As a result, they make decisions primarily with a concern about what other investors’ expectations may be since that will determine tomorrow’s price. This is otherwise known as speculation, not investing, as properly defined by Graham and Dodd.

Although value investing strategies have underperformed relative to growth strategies for the past decade, the extent to which value has become cheap is reaching its limit.

We leave you with a question to ponder; why do you think Warren Buffet’s Berkshire Hathaway is sitting on $128 billion in cash?

Sailing Versus Rowing : Active Versus Passive

Investor preferences shift between active and passive investing in a cyclical manner. Periods where the market has a strong tailwind of momentum behind it tend to attract a greater demand for passive strategies especially when that momentum carries on for a prolonged period of time. Alternatively, periods of market turbulence tend to swing sentiment back to active investing as a means of avoiding the risk of large losses. In the most recent bullish cycle the combination of market direction and the availability of index-friendly instruments like exchange-traded funds (ETFs) have resulted in an unprecedented shift towards passive strategies and securities.

To clarify the difference between the two investment approaches, active investing seeks to outperform the market by beating a benchmark such as the Dow Jones Industrial Average or the Barclays Aggregate bond index. Passive investing on the other hand pursues a strategy that mimics a benchmark index and attempts to replicate its performance. It is a contrast that has been effectively described by Ed Easterling of Crestmont Research as rowing (active) versus sailing (passive). Active investors are engaged in constant evaluation of companies and their fundamentals as means of finding value investment opportunities while passive investors are at the grace (or mercy) of the winds of the market wherever they may blow.

The graph below highlights the underperformance of active strategies versus the S&P 500 index in past years which further explains the growing popularity of passive investing.

This article is primarily focused on fixed-income passive investing, however, many of the issues brought up in this article can be applied to most asset class ETFs and securities that allow ease of passive investing.

How Passive Investing Works

The mechanics of passive investing in the stock market are straight-forward. Select an equity index to which you would like to gain exposure, for example the S&P 500 or the MSCI China Index, and then buy the stocks in the proper amounts that are tracked in that index to replicate the performance. Done manually this can be a complex and cumbersome exercise especially when trying to replicate the index of a less-liquid market. As the market moves and the value of the securities underlying the index change, one must rebalance their holdings to remain aligned with the index. For a deeper understanding of the many factors that make replicating an index diffiuclut please read our article The Myths of Stocks for the Long Run Part V.

The advent of index mutual funds and more recently exchange-traded funds handle the complexities of multiple holdings, weightings, and rebalancing allowing an investor to simply pay a small fee, buy a ticker and essentially own an index. An investor’s ability to obtain general equity exposure or to build a portfolio with customized exposures has never been easier with the  proliferation of ETFs.

To offer some perspective about just how many ETFs are available, consider there are 38 ETFs available that are focused on U.S. energy stocks and over 132 ETF’s hold Exxon Mobil (XOM) shares. Looking abroad to less liquid markets, one would find ten U.S. incorporated funds holding Indian stocks. The simplicity and customizability currently offered in the market is quite powerful.

Bond Exposure

Traditionally, investors gained exposure to bonds through individual debt securities offered by brokers. Unlike stocks, the availability of most bonds, not including U.S. Treasuries, is dependent upon the inventory held by one’s broker or their ability to source a bond from another broker. As such, finding a specific bond is more challenging and comes at a higher cost for an individual investor than buying an individual stock. A similar problem can emerge in the event an investor wants to sell a specific bond. This problem results in an indirect fee called the bid/offer spread and on occasion can cost the investor multiple percentage points.

There are other considerations related to the dynamics of buying individual bonds versus acquiring bond exposure through a fund. These issue are well-articulated by Lance Roberts.

The advent of index mutual funds and ETFs relieves much of the frustration and high costs of buying and selling specific bonds.

The protocol described in selecting equity funds above is similar for bonds in that one can identify investment preferences in various major bond categories quite easily. The primary categories include:

  • Treasuries securities
  • Mortgage-backed securities, asset-backed securities and collateralized debt obligations
  • Agency bonds
  • Municipal bonds
  • Investment Grade corporate bonds
  • High yield corporate bonds
  • Emerging market bonds
  • Developed nations sovereign bonds

It is relatively easy, through these funds, to quickly gain exposure that tracks an index covering any variety of these options and specific sub-catagories of these options.

Not As Advertised

The flexibility and customizability offered through the world of index mutual funds and ETFs is remarkable. As such, there is a natural inclination by investors to assume that one will get precisely what has been advertised by these funds. However, confidence in that idea is easily challenged. Much of what has been developed over the past several years, especially with many ETFs, remains untested. The following are concerns investors should be aware of:

  • Tracking Error: ETF exposures to certain markets might not be precisely what the investor receives. For example, it has been documented that an investor who wishes to invest in an ETF for the equity market in Spain actually gets exposure to a variety of companies that although domiciled in Spain, produce most of their revenue outside that country. In that instance, and many others like it, an investor would not get the exposure to Spain he or she expects and may indeed be very disappointed in the ETFs tracking of the index for Spain.
  • Optimization: The structure of index funds and ETFs are such that in many cases the fund managers are only able to establish positions in the underlying stocks or bonds of the indexes they track with some imprecision. This means they will use creative means of gaining desirable exposures and then gradually, if possible, reposition over time in order to more closely track the index. This tends to be a much bigger problem for bond funds. Since full replication of a bond index is generally not possible, bond funds rely on “optimizing” the portfolio in order to most effectively replicate the index.

Bond offerings, like stocks, are finite so if the size of a fund grows as a percentage of the underlying index constituents, it will increasingly face the constraint of replicating the index and effectively mimicking index performance.  Optimization is imperfect so the ETF will suffer performance drift from the target index. Unfortanately, the flaws of replicating are often exagerated during periods of market stress when investors expectations are the highest.

  • Underlying Liquidity: Another related issue that arises with bond funds is that of establishing daily market value. The market price of some bonds held in a fund, especially those that are investing in less liquid markets, may not be readily available. If a bond fund holds securities that are illiquid, meaning they do not trade very often, then a realistic current price may be difficult to obtain. Many fixed income ETFs hold thousands of securities some of which do not trade daily or even weekly. This means that pricing is dependent upon estimates of the value on those bonds. These estimates of value may be derived from a third-party pricing service, surveys of bond market trading desks and internally generated models. Mis-pricing of securities is a known problem and one not typically considered until the fund is forced to sell. If the fund receives an inordinate number of redemption requests, what happens if they have bonds that do not trade very often but are nevertheless required to liquidate based upon investor requests? It is likely the sale price could vary, and sometimes significantly, from the last assumed price. Again this is most likely to occur at the wrong time for investors.

These concerns have not yet emerged as a deterent in the new age of passive investing popularity. We have only seen slight glimpses of what may be ahead in terms of challenges for the passive investor but it is fair to say this could be a major problem.

Investors naturally assume they will be able to exit as easily as they entered these funds and at the stated value seen on their statements or trading screens. In a calm market the concerns are minor but there are serious questions about that reality should a wave of selling hit bond ETFs all at once.

Although somewhat unique in its characteristics and certainly not a bond ETF, the recent debacle related to the inverse VIX ETF, XIV, seems to foreshadow some of the issues highlighted here. The graph below shows the price of XIV over the last two years. Investors unaware of how the NAV for XIV was calculated were certainly in for quite the shock.

Data Courtesy Bloomberg

Risk Analysis – The Benefit of Stress Testing

Given the importance of the issue of liquidity and what may transpire in an adverse scenario, we decided to look at the performance of a few ETFs and their related indices through the financial crisis as an indication of what a possible “worst-case” scenario might hold. In doing so, we acknowledge no two historical events are the same but the analysis seems important to consider.

From peak to trough, between April and November 2008, the Barclays Corporate Investment Grade index fell -10.8%. At the same time the LQD ETF which tracks that index fell -12.2%. The Barclays High Yield index fell -32.3%. In the same time frame the two high yield ETF alternatives, HYG and JNK, fell -29.8% and -34.5% respectively.

Today, these funds and others like them are much larger than they were in 2008. Furthermore, Bloomberg recently reported that many corporate debt funds are reaching further down the credit and liquidity spectrum in efforts to boost returns and some are even replacing high yield bond exposure with equities. As Lisa Abramowicz put it, “While this is somewhat concerning, it’s also logical. Fund managers don’t see any imminent risks on the horizon that could shake markets, and clients will penalize lower returns.

The remarkable thing about this observation is that paying too high a price for an asset is in itself an imminent risk.  One could convincingly argue that point as the most basic definition of risk. Nonetheless, it does indeed offer an accurate profile of the current character of the market. Unlike actively managed funds where the manager evaluates individual securities, there is no price discovery mechanism for index funds and ETF’s as their only consideration is whether or not they received a dollar to invest.

Summary

According to Benjamin Graham, this approach to putting money to work in the market defines the term speculation as it does not apply “thorough analysis” nor does it “promise safety of principal and an adequate return.” Although sympathetic to the idea that it is different this time as profit margins do indeed remain unusually high, the more defining characteristic is the means companies are using to sustain those profits. It is what has been referred to as corporate self-cannibalism as debt is ever accumulated as a means of buying back shares or paying dividends. The eventuality is credit downgrades and self-destruction.

Data Courtesy St Louis Federal Reserve

The cyclical nature of passive and active investing will continue to play out and that which is wildly popular today will eventually turn unpopular. The hidden risks embedded in passive vehicles will emerge and those who so enjoyed the cheap grace of effortless and exceptional market gains will end up begging yet again for mercy amid the markets’ unforgiving justice.