The Fee Delusion

Fees are perhaps the most frequently discussed, and least well understood, factor in financial product marketing. Financial organizations that serve professional groups often focus on low fees to obscure the fact that their investment arm is understaffed, under qualified, and generally delivers poor service and performance. The simple reality is that in the field of investments, as in many complex fields, differentiated value isn't free, but mediocrity can come very cheap.


To illustrate, consider the following 3 proposed investments:


Advisor A proposes an investment in a fund with a history of performing in-line with stock markets. The manager performs slightly better during really poor periods in the market, slightly worse in really good markets, and averages returns of 1% better than stocks over the last 10 years, after accounting for fees and costs. Note that this performance would place the fund in the top 95% of all funds, as most funds don't come close to this track record. This fund has dropped by more than 35% from its peak twice in the past ten years. This fund charges a fee of 1%.


Advisor B proposes an investment in a systematic strategy, with a history of performing very differently than stock markets over time. The performance of this fund is largely independent of the direction of stock markets, and the fund has never been down more than 25% from its peak. It has performed about 10% better than stocks over the last 3 years, after fees and expenses. This manager charges a fee of 2%.


Advisor C proposes an investment in a fund with a history of exactly tracking the performance of stocks over the very long-term. This fund does well when markets to well, and poorly when markets do poorly. This fund has also been down more than 35% from its peak twice in the past 10 years. This fund charges 0.4% in fees.


All other things equal, which Advisor's proposal would you go with?

Mutual Funds: A Low Probability Bet


Before answering, I urge you to consider the following chart, which illustrates the probability that a fund which ranks in the top 25% of its category will even be ranked in the top half of its category four years later. Remember that funds selected at random would, on average, be in the top half of their category about 50% of the time. However, we see that top funds in one year have, on average, only about a 40% chance of being in the top half 4 years later. That is worse than random chance.

Source: Gene Hochachka, February 2008

http://ssrn.com/abstract=1094246

The Passive Option


Given the chart above, one could be forgiven for believing that it is not possible to deliver differentiated performance, and in fact there is a very large and credible contingent of the investment community that operates on that basis. This way of thinking is called 'passive investing', and I am willing to concede that for the majority of investors, this is probably the way to go. I concede this for most investors because it is actually very hard to find an Advisor or a fund manager who actually does add value over time, especially after fees and commission. Hard, but certainly not impossible, and potentially highly rewarding for those who do.


If you embrace a passive approach, the only logical strategy is indexing. This is a low-cost strategy which involves purchasing a diversified basket of broad-market Exchange-Traded Funds and holding them forever, with periodic rebalancing. A buy and hold strategy that emphasizes a diversified basket of global asset classes is almost certain to outperform cash in the bank over periods longer than 10 years. However, investors are vulnerable to behavioral biases that will make it hard for them to stick with this strategy when things inevitably turn ugly. Further, the unpredictable path of returns may have a substantial negative impact on your ability to achieve, or maintain, financial independence.


For investors that choose this route, we would be delighted to provide guidance on how to construct a well diversified portfolio of ETFs that will benefit from the ebb and flow of capital and opportunity in global stocks, commodities, real estate and bonds. Under IIROC guidelines, I am not allowed to provide specific investment advice here without first knowing your long-term objectives and risk tolerance. A fairly quick phone call can establish these basic parameters (believe it or not), and we will provide this quick advice at no cost, and with no further obligation.


One final thing on passive investing: there is no conceivable reason to use mutual funds for a passive approach. If you embrace this philosophy, you acknowledge, quite legitimately, the low probability that a manager will add value over time. So why are you investing in mutual funds which charge you 1% or more for the slim chance that the manager will do just that, when you can open an account at a discount broker and purchase Exchange Traded Funds or index mutual funds for as low as 0.25%? It's madness!


Where an Active Approach Can Add Value


I made the case in the previous section for most investors to apply a passive approach to their investments. This means taking your money out of mutual funds and putting them into a basket of very low cost Exchange Traded Funds. However, while a passive approach is likely the best option for most investors, who lack the time, motivation, or acumen to find quality active managers, smart, motivated and open-minded investors who take the time to learn the nuances of different active styles can realize tremendous value. This task is difficult, but certainly not impossible.


Managers that deliver consistent returns over time generally possess some combination of the following 4  qualities:

• Insider information - yes, this happens all the time, and is quite illegal. No, your mutual fund manager doesn't have any. If he did, he would be making 2% plus 20% of the fund's profit at a hedge fund.

OR

• A systematic approach with very little qualitative interference based on manager ‘intuition’
• A focus on asset allocation, not stock-picking
• A rigorous strategy for risk management

There are some superb talents in the investment industry who have demonstrated incredible performance persistence through time: George Soros, Steve Cohen, John Paulson, and a few others. So far as I know, these managers do not use any specific system to manage money, but instead are able to see into the future via a black box in their heads. Notably, none of these managers is available for average investors, though they charge extremely high fees (5% plus a percent of total portfolio growth). Further, I could count the number of consistently successful investors of this type on two hands. I don't include Warren Buffet because he is not an investor in the contemporary sense. Rather, he is a business man who purchases companies and then adds value through extraordinary management. This is an important distinction!

Thankfully, there are far more examples of true systematic approaches with very long track records of adding extraordinary value to investors. Here is a list of some of these funds, along with their December 2010, and calendar year 2010 returns, and total assets under management, courtesy of Jez Liberty of Au.Tra.Sy blog:

Organisation / Fund	Return	YTD *	AUM **
Abraham Trading1	8.28%	8.30%	$456M
Altis Partners2	5.66%	11.52%	$1,609M
Aspect Capital3	6.16%	15.35%	N/A
BlueTrend4	6.71%	15.98%	$8,000M
Campbell & Company5	N/A	N/A	N/A
Chesapeake Capital6	13.90%	10.86%	$835M
Clarke Capital7	9.08%	42.62%	$38M
Drury Capital8	9.05%	0.63%	$305M
Dunn Capital9	10.95%	30.75%	$275M
Eckhardt Trading10	8.87%	21.08%	$418M
EMC Capital11	5.90%	6.72%	$180M
Hawksbill Capital12	11.79%	57.58%	$83M
Hyman Beck & Co.13	12.82%	8.49%	$512M
JWH & Co.14	-5.18%	5.20%	$25M
Man AHL Diversified15	4.80%	11.60%	$1,223M
Millburn Ridgefield16	5.58%	12.65%	$1,090M
Rabar Market Research17	10.51%	24.59%	$179M
Saxon Investment18	1.18%	6.10%	$89M
Superfund19	10.93%	12.93%	N/A
Tactical Investment Mgt20	10.60%	68.99%	$66M
Transtrend21	3.60%	14.88%	$5,826M
Winton Capital22	3.73%	14.43%	$17,010M

Many of these systematic managers charge hefty fees, but have delivered remarkable long-term performance. For example, Jim Simons’ Renaissance Medallion Fund (not shown) charges 5% management fees and a 44% (!!) performance fee. Despite these burdensome costs, Medallion has consistently returned 35% per year in performance after deducting all fees. Unfortunately, Medallion fund has been closed to new investors since 1993. MAN Group’s AHL Diversified Fund has been open to new investors since its inception in 1990. This fund has returned 15.4% per year for investors after charging a 3% management fee and a 20% performance fee. It has reported fund losses over a calendar year only once: in 2009.


There are several Canadian systematic funds, most notably Acorn Diversified in Oakville, and Auspice Capital out of Calgary. Of course, Butler|Philbrick & Associates applies a systematic approach for its clients as well.


Conclusions


Unfortunately, high fees do not necessarily guarantee superior service or investment performance. You are, however, unlikely to receive superior service or performance for low fees. Investment advisors and funds who rely on low fees to capture and keep clients generally fall into 3 categories:

1. They are in the early stages of building their businesses, and with few qualifications
2. They have a focus on client volume instead of performance and/or superb service
3. They do not offer differentiated value

Highly qualified professionals that deliver differentiated value to their clients are confident charging a reasonable fee for their services. For other professionals, this should not come as a surprise.


Perhaps the main point of this essay is to demonstrate that there is no logical basis for investing in traditional actively managed mutual funds, no matter how low their fees are. Given that your probability of choosing a strong traditional mutual fund which will remain in the top half of its category just 4 years from now is worse than random, an average investor should ALWAYS prefer a diversified basket of passive Exchange Traded Funds.


Investors with the acumen, motivation and perseverance to investigate active managers will discover that there are phenomenal managers and strategies out there that have the potential to fundamentally alter the trajectory of their investments, and the landscape of their retirements. These managers do not compete on price - but smart investors won't care.


Notes

<sup>* YTD: Year-To-Date performance.
** AUM: Assets Under Management.
1. Abraham Trading was founded by Salem Abraham, after he was introduced to Managed Futures and Trend Following by Jerry Parker. He is considered as a “second-generation” Turtle.
2. Altis Partners started trading in 2001 and now manage over a $1B with their Altis Global Futures Portfolio. The figures referenced in the performance table are not provided by Altis Partners and no reliance should be taken as to their accuracy, and as a consequence the figures may not be in accordance with any CFTC / NFA performance reporting requirements.
3. The four founders of Aspect (Eugene Lambert, Anthony Todd, Michael Adam and Martin Lueck) were significant members of one of the most succesful funds in managed futures – AHL (Adam, Harding and Lueck).
4. BlueTrend, from BlueCrest Capital, is one of the largest Trend Following funds – headed by Ms. Leda Braga
5. Campbell & Company is one of the oldest Trend Following firms, operating for around 4 decades.
6. Chesapeake Capital was founded by Jerry Parker, a former Turtle.
7. Clarke Capital was founded by Michael Clarke in 1993. The programme tracked here is Millenium.
8. Drury Capital, Inc., was founded in Illinois in 1992 by Mr. Bernard Drury.
9. Dunn Capital was founded by Bill Dunn.
10. Eckhardt Trading is the firm managed by William Eckhardt, who co-led the Turtle experiment with Richard Dennis
11. EMC Capital was founded by Liz Cheval, a former Turtle.
12. Hawksbill Capital was founded by Tom Shanks, a former Turtle.
13. Hyman Beck & Co. main principals are Alexander Hyman and Carl Beck.
14. JWH & Co. was founded by John W. Henry, Owner of the Boston Red Sox.
15. Originally ED & F Man. Became a succesful CTA under Larry Hite and went on to form part of The Man Group plc, which subsequently bought AHL to form the Man AHL: the systematic trading division of the Man group.
16. Millburn Ridgefield have been trading Trend Following models since the early 1970’s.
17. Rabar Market Research is the company of Paul Rabar, a former Turtle.
18. Saxon Investment was founded by Howard Seidler, a former Turtle.
19. Superfund founder and CEO: Christian Baha.
20. Tactical Investment Management was founded by David Druz, a student of Ed Seykota.
21. Transtrend is a Trend follower CTA based in Netherlands
22. Winton Capital is a London-based CTA founded by Dave Harding (also co-founder of AHL).</sup>

Newton's First Law of Market Mechanics

"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” - Sir Maynard Keynes

Magical Momentum

The venerable Jeremy Grantham, one of the world's greatest and most experienced value investors, devoted considerable space in his most recent quarterly missive to the perennial thorn in the side of traditional value investors: price momentum.

A market or stock exhibits price momentum if, over a period of 6 to 12 months, it demonstrates strong price performance relative to its peers. More importantly, it has been clearly proven across all time periods, markets, and geographies, that strong historical price momentum is a superb predictor of future price momentum, at least over a 3 to 6 month horizon. That is, markets and stocks that have performed most strongly over the prior 6 to 12 month period are more likely, on average, to also perform most strongly over the next 3 to six months.

The chart below, from Charles Kirkpatrick's stock market bible, Beat the Market demonstrates the degree to which the prior 12 month returns to stocks are able to explain the following 3 month performance. In fact, the relationship is nearly perfect, with the prior 12 month returns explaining almost 90% of the 3 month future returns (note R2 of 0.893 in the chart below). Further, the prior 12 months performance explains almost 73% of future performance over the successive 6 month period as well, though the relationship breaks down by 12 months out.

Source: Charles Kirkpatrick, "Beat the Market" (2008)

This flies in the face of both intuition and the dominant theory about how markets work. Intuition and common sense support the ubiquitous mantra of, 'Buy low, sell high'. Modern Portfolio Theory asserts that markets are efficient, and trends can not persist. Why would a rational investor chase an expensive market?

It turns out that, as happens so often in investing, the common sense approach is dead wrong. In fact, stocks, sectors and markets that have dropped the most over the prior 6 to 12 months will perform poorly on average, despite potentially being 'cheap' by traditional measures. Cheap stocks tend to get cheaper. On the other hand, buying stocks near current highs, and which have gone up the most over the prior 6 to 12 months, has been an extraordinarily successful strategy over time.

As an illustration of this effect, please examine Chart 2, which shows the relative performance of U.S. stocks from 1927 through 2008 ranked according to their prior 12-month price momentum. For example, the red line shows the performance of the top 10% of stocks, as ranked by their 12-month prior price performance, and re-selected quarterly, while the dark blue line at the bottom shows the performance of the bottom 10% of stocks. The red line shows how you would have done if you had stuffed your portfolio at the end of every quarter with the stocks that were up the most over the prior 12 months. Vice versa with the blue line. You can see that strong stocks outperformed weak stocks by 10,000 times over this time period.

Source:  Ken French Data Library

Chart 3 below demonstrates how constructing a portfolio by holding the top performing stock market sector (i.e. energy, technology, financial services, etc.) over the prior 12 months would have been a very effective strategy over the long term. In this case the green line tracks the performance of a portfolio which buys the top performing stock market sector over the prior year. The blue line holds the top two best performing sectors, while the red line reflects a basket of the top 3. The blue line at the bottom shows the performance of a simple "Buy and Hold" strategy. Note that holding the top single sector provided performance 6 percentage points per year higher than "Buy and Hold" over this very long period.

Source: Mebane Faber (2010)

Professional Lemmings

Jeremy Grantham offers us a typically shrewd theory for why momentum effects are so prevalent in markets. His theory rests on the sound premise that career risk drives the vast majority of investment decisions. In his words, everyone who works in the markets, "behaves as if his job description is 'keep it'." Referring to Sir Maynard Keynes' economic texts, Grantham adds,  "Keynes explains perfectly how to keep your job: never, ever be wrong on your own." [emphasis mine]

In other words, Advisors and managers know that, even if they lose substantial capital for clients, they are unlikely to lose clients, or be fired from their jobs, so long as everyone else is losing big money too. The rational approach for Advisors and managers from this perspective is to look around and see what the other guy is doing, and beat him to the draw.

Grantham again: "And if everyone is looking at everybody else to see what’s going on to minimize their career risk, then we are going to have herding. We are all going to surge in one direction, and then we are all going to surge in the other direction. We are going to generate substantial momentum, which is measurable in every financial asset class, and has been so forever. It’s the single largest inefficiency in the market. There are plenty of inefficiencies, probably hundreds. But the overwhelmingly biggest one is momentum". [emphasis mine]

Mutual fund managers are a great case in point. Would you be surprised to learn that, if a mutual fund manager is charged with a Canadian equity mandate, and Canadian stocks drop by 50% in a year while the manager's fund drops by 45%, the manager receives her full bonus? She earns her full compensation despite the fact that she lost 45% of her clients' capital in that year. This is because she has very narrowly and explicitly been charged with keeping up with the performance of the Canadian stock market. The manager's greatest risk is in deviating from the performance of Canadian stocks; she is much less concerned with losing money.

Given the risks she faces, would you expect this manager to be more concerned with maximizing her funds' risk-adjusted performance, or will she be more concerned with what her peers are doing so she isn't left behind?

Keynes also discussed in great detail the convention of 'extrapolation', which is the tendency for people to base predictions on what has happened in the past. All of us embrace extrapolation in order to make sense of a very uncertain world, even though we know from experience that predictions of any kind are unstable, especially out further than a few months. Analysts are famous for extrapolating because, by definition, if you make a prediction of any kind, you are susceptible to career risk. This can be observed in how economists and analysts provide estimates that cluster together, like a school of fish trying to confuse a shark. Even when very substantial fundamental changes are afoot, analysts will only change their estimates of the future in small increments over time, as they wait for confirmation from their peers. For this reason, the investment community is very slow to adapt to change, which allows for trends to form and amplify over time.

Let He Who Is Without Sin Cast the First Stone

As you can imagine, all investors, not just professionals, help to create momentum. Individual investors are also extremely sensitive to another important emotional factor: envy thy neighbor. Don't feel bad, though; even some of the greatest minds of the last millennium were equally susceptible. Take Sir Isaac Newton, for example, who invested quite early in the 'South Sea Bubble' in Britain in the early 1700s. The following chart shows the trajectory of the bubble, and Newton's decisions along the way.

Source: Marc Faber

Note that Newton did quite well in recognizing the opportunity early on, and exited quite happily less than 6 months later with a tidy profit. One might surmise that he felt prices of ships were fairly valued at that point, and having substantially improved his economic lot, felt satisfied - at least for a while. For as prices continued to rise, past $300 where Newton sold, past $500 where all of his friends were becoming rich beyond their wildest dreams, he eventually couldn't take the social pressure of watching his friends get rich while he stood on the sidelines. So he did what many investors do: he entered the market with his total personal fortune (how else to catch up to his friends?), and was eventually wiped out as the bubble collapsed. 

Nortel anyone?

Conclusion

I couldn't possibly wrap up this essay more eloquently, or with more credibility, than did Mr. Grantham himself.

"Let me end by emphasizing that responding to the ebbs and flows of major cycles and saving your big bets for the outlying extremes is, in my opinion, easily the best way for a large pool of money to add value and reduce risk. In comparison, waiting on the railroad tracks as the “Bubble Express” comes barreling toward you is a very painful way to show your disdain for macro concepts and a blind devotion to your central skill of stock picking. The really major bubbles will wash away big slices of even the best [value] portfolios. Ignoring them is not a good idea."

A strategy of following the market's strongest trends - that is acknowledging the tendency for investors and managers to herd, extrapolate and focus on career risks - has demonstrated consistently strong risk-adjusted performance over time. Mr Grantham's explanation of this phenomenon helps to cement our long-term focus on these factors to deliver superior risk-adjusted investment performance.

Retirement at the Casino

Clients and others who have seen us speak, read our material, or know us at all, understand that we at Butler|Philbrick & Associates don't make any investment decisions without a proper understanding of the odds, and the range of possible outcomes. We are optimists, but err on the side of caution.

The Quantitative Wealth Management Analytics Group, or QWeMA Group, based out of the Fields Institute near the University of Toronto, also embraces this focus on probability, and has applied it to the field of retirement planning in a novel way.

Traditional retirement plans have no way of accounting for the range of possible future outcomes, in the markets, with inflation, or in your own lifespan. The QWeMA Group's solution, on the other hand, accounts mathematically for the full range of possible outcomes, and assigns a probability to retirement success. As you will see in some of the videos produced by QWeMA's founder, Dr. Moshe Milevsky, a closer inspection of traditional plans shows that they will fail up to 50% of the time. For an in-depth case study about the vulnerabilities in traditional retirement plans, please see our article in Dental Practice Management's December issue, starting on page 36.

The following video by Dr. Milevsky explains the tradeoffs facing retirees, and how they can effectively plan for their future by finding an optimal mix of retirement income, product mix, and investment strategy. The video is over 17 minutes long, but grab your spouse, a glass of wine, and invest in your future. Be sure to return to this article after watching by hitting your browser's 'Back' button.

Welcome back!

Dr. Milevsky demonstrated how you can alter the sustainability of your retirement by reducing your income and altering your product mix. He also illustrated how different income levels and product mixes affect retirement sustainability and the legacy you leave behind.

There are other ways to improve your retirement options that Dr. Milevsky did not discuss in the video. One of the ways is to broaden your investment opportunity set to include international stocks, commodities, REITs and alternative strategies, in addition to domestic stocks and bonds. If you are like most Canadian investors, your portfolio is focused almost exclusively on Canadian stocks. While this has worked out well over the past ten years, investors may be missing important future opportunities by sticking so close to home. Further, adding even a very simple risk management system, such as the timing system we described in our Ontario Dentist article, can improve your sustainable retirement income by over 50%.

As an example, for a couple with a $1,000,000 retirement portfolio, following this simple system would have increased sustainable income from less than $50,000 per year for a traditional balanced portfolio, to over $90,000 per year. The same applies to expected legacy, where this simple investment approach would have more than doubled the amount left behind at the end.

Chart source: Ontario Dentist (2010)

The Value Bias

I am perpetually mystified by the pervasive insistence by investment professionals that 'value' dominates 'momentum'. This debate really comes down to the age-old question of whether any one person (or team of analysts) can consistently identify 'cheap' companies which the market, in its collective wisdom, has neglected. More broadly, this debate is about whether any one expert, or team of experts, can consistently forecast the future better than 'the crowd' can through its collective actions. This is a key plank of adherents to Behavioural Economcs; lots more on this subject here, here and here.

Value investors rely on [their own perceived] keen powers of observation and analysis, or a unique understanding of the industry or company of interest, to identify inexpensive companies which the market will eventually reward by raising their prices to some perceived 'fair value'. These investors would then [in theory] sell the company at their calculated 'fair value' and move on to invest in other [theoretically] 'cheap' companies.

Momentum investors, on the other hand, implicitly believe that markets are smarter than they are. They are on the lookout for companies in which the market has already demonstrated an interest by raising the price of their stocks. They reason that, if the 'market' likes the stock, then so should they. Who are they to argue with the collective wisdom of thousands of investors who are actively committing their hard-earned capital to these very stocks?

This article aims to make three important points:

1. Active investing works: I present 2 different screens which add significant value over time relative to buy and hold.
2. Investors are biased to systematically overemphasize the importance of a 'value' approach while under-emphasizing the power price momentum.
3. Outstanding investment results have been achieved by combining two very different, but independently effective approaches.

Value investors apply the traditional stock market wisdom of 'Buy low, sell high'. Or at least that is their ambition. Far more often, their experience is 'Buy low, and then wait a very, very long time for the company to prove its merit.' The very best value investors, like Warren Buffet or Peter Lynch, have the patience to wait for companies to become very cheap before purchasing them, and then they have the patience to wait many years for the market to recognize the value of the companies they purchased. Warren Buffet, for example, held treasury bonds in his personal account from the early 1990s through to later 2008 while markets were in a euphoric state of overvaluation. How else would he have personal funds available to purchase large quantities of stocks in late 2008 during the market meltdown? Of course Berkshire Hathaway, his corporate investment vehicle, is first-and-foremost an insurance company, and therefore must be invested at all times, but also has a very long investment horizon given the duration of its liabilities.

The vast majority of investors (you and I included), are not able to wait for markets to become cheap before investing. Most people have a limited investment horizon, bounded by spending or retirement objectives, and can't sit in cash for 15 years waiting for markets to become cheap enough to purchase. Further, most people do not have enough patience to wait the many years it often takes to realize the 'value' in their 'value stocks'.

Momentum investors embrace the wisdom of 'Buy high, sell higher'. They buy stocks which are already in a positive trend, and expect the trend to continue. There is very strong evidence suggesting that this approach is highly effective, even using very simple measures of momentum, such as performance over the prior 12-month period, or the number of new 52-week highs experienced over the past 52 weeks. Further, this approach works for every asset class, including commodities which are impossible to value according to traditional 'value' measures.

I was reminded of this value bias when I read a recent article by the Applied Finance Group. Let me stipulate that I am a big fan of this group, which applies a unique quantitative strategy for finding attractive stocks. We are beginning to include their stock screens in our weekly scans, in which we identify stocks that appear in lists by many of the world's greatest screens, such as IBD, HighGrowthStockInvestor, FusionIQRank, CPMS, and others.

The article was primarily concerned with how momentum factors can add to the performance of a traditional value screen. We enthusiastically concur with this assertion, and apply it in our own portfolios. However, the first paragraph of the article states, 'Typically, long-term valuation is the main driver of stock performance, as shares of companies that are trading at a discount to their intrinsic values tend to go up over time [sic.]. If we were to attempt to quantify this, it appears that aggregate stock movement can be explained by long-term valuation adjustements roughly 75% of the time. The remaining 25% are best identified as momentum markets, which simply implies that a short-term event has created an environment that makes investors less concerned with long-term value and more focused on short-term issues [sic.]."

Then in the second paragraph the article makes an outrageous claim: 

"Due to its significant overall outperformance, we believe utilizing a trust-worthy valuation metric is of utmost importance in stock screening."

 What makes this claim outrageous is that the article then goes on to present two tables, which I have attached below for discussion:

Source: The Applied Finance Group

Source: The Applied Finance Group


Please attend to the numbers in the top red boxes in both tables. Table 1. shows the relative performance of stocks which screen in the top half (TH) of AFG's valuation metrics (i.e. cheap stocks) versus stocks which screen in the bottom half (BH). Note that high ranking value stocks (TH) outperform low ranking stocks (BH) by 7.9% per year from 2001 through 2009, using AFG's proprietary ranking methodology. Note also that this screen did a pretty good job on a 'per trade' basis: in terms of 'Batting Average", 67% of TH stocks outperformed, and 68% of their BH stocks underperformed in each selection period. This is pretty good stuff!


Now look at the top red box in Table 2., which shows the relative performance of stocks which screen in the top half (TH) of all stocks according to a simple momentum screen versus stocks that screen in the bottom half. You can see that high ranking momentum stocks (TH) outperformed low ranking stocks by 11.1% per year from 2001 through 2009.  The batting average is also fantastic, with 80% of top ranked stocks outperforming and 79% of low ranked stocks underperforming in each selection period.


What gives? The authors assert that, "...long-term valuation is the main driver of stock performance". However we can plainly see that, with 18 years of data on almost 7000 global stocks, momentum substantially dominates value as a selection criteria, with 11% returns versus 8% respectively.


This is not uncommon. The dominant investment theories of our time are Modern Portfolio Theory and the Capital Asset Pricing Model. These models rely on a value-based framework to identify securities for investment, and to allocate efficiently among those securities. Substantially all of the capital that is invested by major institutions worldwide is allocated by according to these theories. Unfortunately, these theories assume that momentum effects can not exist, despite hundreds of years of evidence to the contrary. Fortunately, this leaves those of us who follow momentum-based strategies with a dramatic advantage. We largely ignore the basic tenets of CAPM, while we use MPT for efficient capital allocation, but with greatly modified parameters.


I promised to show you how two independently effective, but very different, approaches to investing can combine to deliver outstanding investment results. Courtesy of The Applied Finance Group, Table 3 shows the performance of stocks that have met both criteria: TH of value screen AND TH of momentum screen. By buying the TH of this combination screen and selling short the BH, and investor would have realized 20% returns from 1991 through 2009.


Now that is really powerful stuff.


Source: The Applied Finance Group

Volatility Gremlins

The term 'Volatility Gremlins' was coined by Ed Easterling of Crestmont Research to describe how volatility impacts the growth of investment portfolios. The term is perfect. Gremlins are annoying, but not particularly dangerous - unless there are a great many of them. They might take food while you aren't looking, or throw your laundry on the floor. Maybe they'll play little jokes on you, like hiding your keys, or your wallet. You wouldn't want one as a pet, but neither would you be frightened if you encountered one on a hike.

Volatility Gremlins play similar tricks with your portfolio. You may hear that markets have gone up by 8 percent per year, but you've only seen 5%. Your financial plan might say you can safely take $70,000 per year in retirement income, but your nest egg is shrinking more quickly than expected. What's going on?

Volatility Gremlins work by tricking you into thinking average returns are the same as compound returns. Let's work through an example.

If you experience returns of 5%, -15%, and 25% over three years, your average return over the 3 years is 5% per year. However, your compound return is just 3.7%. Those sneaky Volatility Gremlins snatch away 1.3% per year, or over 25% of your returns! Not so harmless now, eh? Table 1. and Chart 1. show more examples of how a wider disparity (or volatility) in returns results in lower compound returns, even while average returns are constant at 5%. The example above is 'Case E' below.

Table 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Chart 1. Volatility Effect on Average and Compound Returns

Source: Crestmont Research, Butler|Philbrick & Associates

Volatility Gremlins really hit above their weight class when you are taking money from your retirement portfolio to meet living expenses. In this case, the nasty critters can make off with a very substantial portion of your annual income, if you aren't careful. This is because of the impact of taking money from your portfolio during periods when it has declined in value. Money that is withdrawn when markets are down can not be used to help the portfolio recover.

So how much of your annual retirement income might Volatility Gremlins be snatching from your wallet when you aren't looking? The amount could be quite substantial. Chart 2. illustrates the impact of increasing levels of volatility on the retirement income of an average retiree.

Chart 2. Higher Volatility in Retirement Portfolio Results in Lower Safe Portfolio Income

Source: Milevsky (2005), Faber (2010), Shiller (2010), Butler|Philbrick & Associates. For Illustrative Purposes Only

Astute readers will notice that Volatility Gremlins get very excited at the idea of pilfering income from retirement portfolios. In Chart 2. we can see the effect of increasing volatility on a $1 million retirement portfolio which:

1. delivers 7% per year growth after inflation;
2. for a retiree who expects to live another 25 years, and;
3. who wants to be 85% confident that he won't run out of money.

Observe that a retiree with a low volatility portfolio, at say 7% annualized volatility (green bar), can safely withdraw over $71,000 per year. In contrast, a retiree with a volatile portfolio, at say 17% annualized volatility (red bar), can safely withdraw less than $52,000 per year. The Volatility Gremlins make off with 36% of the latter retiree's income!

I have spilled much ink describing ways for investors to lower risk in portfolios, so I won't go into the details here. You will note in Chart 2. that I make reference to Faber's Tactical Asset Allocation portfolio as a lower risk alternative. Readers who are interested in methods to capture robust returns while dramatically lowering portfolio volatility are invited to visit our web site (http://www.macquarieprivatewealth.ca/specialist/butlerphilbrick/case-studies) for more articles and studies.

Paul Volcker Invalidates Modern Portfolio Theory

US Federal Reserve ex-Chairman Paul Volcker, whose policies under President Carter in the later 1970s and early 1980s single-handedly stuffed the inflation genie back into its bottle, and laid the foundation for the world's longest period of uninterrupted growth, set aside his prepared remarks at a Federal Reserve of Chicago event yesterday and instead delivered a "blistering, off-the-cuff critique leveled at nearly every corner of the the US financial system", according to the Wall Street Journal. In addition to rants about "relentless corporate lobbying by banks and politicians to soften the rules" and candid remarks about how the "financial system is ... absolutely broken", Volcker had this to say about financial markets:

"Normal distribution curves - if I would submit to you - do not exist in financial markets. It's not that they are fat tails - they do not exist. I keep hearing about fat tails, and Jesus, it's only supposed to occur every 100 years, and it appears every 10 years!"

This statement is a startlingly frank denouncement of the very foundation of contemporary investment theory. The primary assumption of Modern Portfolio Theory, and its corollaries, the Efficient Markets Hypothesis, and the Black-Scholes Merton model, is that financial market returns conform to a normal distribution. If we acknowledge the possibility that financial market returns do not conform to a normal distribution, we must by extension reject the validity of MPT.

Readers might be familiar with this chart, which plots the distribution of actual monthly stock market returns from 1870 through 2009. Note the spikes on the curve far out to the left and right. If you look closely (or click to bring up a larger version of the chart), you can see the statistical likelihood of these monthly returns occurring if we assume returns ARE normally distributed. Note the month at the far left which, under MPT assumptions, would be expected to occur just once since the big bang - how unlucky for us that it happened to occur in our lifetime.

Source: Shiller (2009), Butler|Philbrick & Associates

Of course, this is not news to clients of Butler|Philbrick & Associates and readers of this blog. We have posted often about the fallacy of MPT and the normal distribution, and how this fallacy affects investors (see here, here, here, here, here...). However, Mr. Volcker's statement should inspire substantial anxiety among the 'Thundering Herd' of Advisors and Consultants to the world's wealthy, who allocate billions of dollars of pension and wealthy investor capital to funds, managers and strategies which depend entirely on the veracity of MPT.

If you have observed a gap between the actual growth experienced by your portfolio, and the growth you expected to see in your portfolio, we may have discovered the culprit. Here's a 'back-of-the-napkin' theory:

Source: Butler|Philbrick & Associates

Do Past Returns Predict Future Returns? Not Very Well - In the Short Term.

An article in this week's Barron's (subscription required) cites a study by Eaton Vance where they analyzed 10-year rolling returns on the S&P 500 back to 1926. The study found that just 4% of 12-month periods experienced negative returns. They also discovered that average annual returns to stocks in the 10 years that followed periods with negative 10-year returns were 9.8%, with a range of 7.2% to 15%.

Unfortunately, the Eaton Vance study fails the sniff test in a number of important ways. First, while 10-year returns have been very poor, the current 10-year period began with market valuations over 4 standard deviations from long-term averages (See chart 1.) Current valuations, with a Shiller PE of 20.6, place stocks within the top quartile of valuations going back to 1870, despite stocks' poor performance over the past decade.

Source: Shiller (2010), Butler|Philbrick & Associates (2010)

In fact, an optimized regression of forward 10-year returns against prevailing Shiller PE provides for a mean expected real return to stocks over the following 10 years of 4.6%, versus a long-term average real-total return of 6.6% (see chart 2.)

Source: Butler|Philbrick & Associates

Further, a simple regression of 10-year returns to 10-year forward returns demonstrates conclusively that the relationship is statistically weak. In fact, the R-square of the regression yields an explanatory factor of just 10%. In other words, prior 10-year returns explain just 10% of future 10-year returns (See chart 3.).

Source: Shiller (2010), Butler|Philbrick & Associates


What we do know is that long-term returns can be quite volatile indeed. The following charts show rolling 10, 20 and 30 year real returns to the S&P since 1870. 



Source: Shiller (2010), Butler|Philbrick & Associates (2010)

Source: Shiller (2010), Butler|Philbrick & Associates (2010)

Source: Shiller (2010), Butler|Philbrick & Associates (2010)