Monthly Archives: February 2011

Indexing Schmindexing

One of my general “life rules” is that anything, whether inherently good, bad or indifferent, usually becomes bad if taken to the extreme.  For example, if a glass of wine at dinner can aid digestion (something some experts will attest to), then a bottle (or two) at dinner should really help out, right?  If exercising three times a week for 30 minutes each is good for one’s health, then working out 7 times a week for 3 hours each day is even better, right?  You get the picture.

This concept also raises its ugly head in the investment field from time to time.  Take diversification, for example.  If owning 30 stocks is a good way to reduce non-systematic risk (that is, the risk associated with one stock), then owning 50, 100 or even 300 would be better, right?  Well, the studies I’ve seen suggest the opposite.  A portfolio of 30 stocks (assuming the holdings are intelligently spread out across different sectors) can be optimally diversified.  Adding even one more stock, according to the smart guys who measure this stuff, does very little to aid diversification.

Indexing may be another example of this.  Indexing is simply the idea of “buying the market” via funds which by design are supposed to mimic some underlying index such as the S&P 500 or the Dow Jones Industrial Average.  Indexing, at its genesis, was a simple concept, allowing investors who were happy with just market returns to achieve them.  The conceit here was that “beating the market” was something better left to the professional investors.  Indexing made sense for the average person who lacks the time, resources, training, discipline and perhaps inclination to work hard enough to beat the market.  Easy stuff.  So far so good.

At some point, the people who were in charge of marketing index funds (after all, most financial products are sold, not bought…) began using some very impressive research reports produced by professors of finance at impressive universities which showed that index investing could produce returns better than some portion (half or more) of professional managers.  To the mathematically inclined, this should be no surprise if the distribution of returns of mutual funds is a normal distribution, which it is.  Additional research piled on suggesting that if one were adjust for taxes and fees, indexing looked even better.

This is about the point where something good (indexing) gets taken to the extreme and becomes bad.  I will let Don Philips, President of Morningstar’s fund research, fill in the details.

He said, “At some point… index fans went from making the honest and helpful argument that indexing is good to making the hyperbolic and divisive case that anything other than indexing was not only bad, but also morally suspect.  Extreme index supporters went from asserting that indexing beats the average fund to implying that it beats all funds…. Their words have grown more extreme, as seen in a recent statement from an ETF provider that likened active fund managers to big tobacco companies, claiming that active management was as dangerous to investor wealth as tobacco is to our health.”

My sense is that the index marketing guys have been very successful in convincing the public of this idea.  Many people I speak with feel that “beating the market” is impossible and that indexing is the only way to invest.  To me this idea is ridiculous.  There are very many professional managers who have beaten the market for many, many years.  I’m not going to name names, but I could.  Many of these fund managers are my heroes, my role models.  I am trying to employ many of the same investment tactics, strategies and philosophies which they use.  Can I beat the market?  For many reasons (including some compliance ones), I must demur on this question.  But I can say without equivocation that I am trying to beat the market every year.  I believe it can be done.

Let me offer one final point which supports my belief.  In one of the egghead journals (those that use formulas!) which I read regularly, a study looked at aggregate returns produced by the hedge fund industry over a 14 year period.  This study showed that the hedge fund industry, in total, produced excess returns (alpha) in every single year from 1994 to 2008.  Said another way, the hedge industry as a whole, beat the market every year, regardless of the direction of the market.  The market can be beaten by a lot of people, a lot of the time.

So far, I have not seen an adequate response to this revelation from the index people.

Enjoying the Hamster Wheel

As the latest earnings season comes to a close, I did a quick tally and realized that the fourth quarter of 2010 represents my 112th earnings season.  My first response to that was “Wow, that’s a lot of quarters!”  My second thought was “Why would anyone care that much about quarterly earnings?”  My third thought is the topic of today’s essay.

Unlike some (maybe even most) professions, the professional investor rarely has the feeling of completing something.  We don’t build bridges, deliver closing arguments in a court case or enjoy the season’s last game.  Our work is ever on-going.  The closest we get to this feeling of completion is when the quarter ends and we can measure our performance for the last three or even 12 months.  Then, the very next day, the new performance measuring period begins.  Whatever success we might have enjoyed last quarter immediately fades away as the new quarter starts.

Every day the market is open, I am working.  Even on “vacation” I feel the need to keep in touch with the market’s action.  Each morning I scour the news overnight from Asia and Europe to assess the tone and try to image the potential impact on the U.S. markets.  During the earnings season I am busy listening to conference calls and reading analyst reports about the quarter releases.  Sometimes there is no new news.  Sometimes companies provide major surprises, not always good surprises.

In fact, last week a couple of these negative surprises from companies led my portfolio to experience something close a miracle.  Each day the Wall Street Journal publishes in its “Markets” section the four best and worst stocks of the previous day.  Well, one day last week, two of the worst performing stocks were in my portfolio.  According to David Miller, my stats professor from Columbia, a miracle is simply something that has a very low probability of happening that actually happens.  Given the thousands of stocks out there that could be the four worst performers and given that I only own 30 names in my own portfolio, to have two of them be among the worst performers can only be seen as a miracle.  Random luck cannot explain it!

I continue to think that both of these stocks are cheap and should be owned, but ouch, right?

For me, the challenge and fun of the investment business is successfully navigating the unknown.  No matter how much you study and analyze, sometimes you just have to deal with surprises.  This is a good thing.  And I am not complaining one iota about the sometimes repetitive nature of my vocation.  There is nothing wrong with repetition.  Consider the beauty and dexterity displayed as a Macy’s worker gift wraps a present for a loved one.  Or the marvelous agility of the surgeon who ties off another perfect one-handed suture.  Do you think Paul McCartney gets bored singing “Get Back” in concert?  Sure can’t tell by the way he performs it.

No, I don’t mind being on this hamster wheel in the least.  There is tremendous variety in what I do as a capital market generalist.  I have to be conversant in the language of many industries – from semiconductor production equipment to baby clothes; from oil shale drilling to nuclear energy; from Panamanian airlines to the cobalt spot market; and so forth.  Monitoring and measuring the value in all the companies I follow is wonderfully fun, and when done properly, highly rewarding for me and my clients.

Oops, another company just reported, talk to you later…

Egypt, Jobs and Why Mr. Market Doesn’t Care

On Friday, January 28th, the market (as measured by the S&P 500) fell 1.8% in the wake of news out of Egypt.  On that day, the news was unsettling, and most of the analysis in the media was inconclusive.  The biggest pessimists were suggesting that Egypt’s problems could lead to massive instability in the Middle East, an important source of oil for the entire world.  Oil prices spiked on this news as well.

Last Friday, the employment numbers for January were released.  The number of jobs created in January was far below expectations, with weakness shown in both the private and government sectors.  Granted, this same report indicated that the unemployment rate fell to 9.0%, but this seemingly “good news” could be spun negatively as one considers a person who stops looking for work actually has the same impact as a person who finds a new job.

The casual observer would no doubt conclude that both of these developments should be big negatives for the stock market, and yet the S&P 500 rose nearly 2% last week.  What gives?

First of all, the market does not like uncertainty.  The reaction to the situation in Egypt was simply the market responding to this.  As more information and analysis became available, investors have concluded that whatever the outcome in Egypt, it is not likely to develop into any of the worst case scenarios imagined early on.  Second, the market really seemed to like the stream of earnings reports it saw last week.  Good news regarding earnings appears to have trumped all other matters last week.

Most of the time the market only really cares about a handful of things:  1) earnings, 2) interest rates, 3) sentiment and 4) the direction and changes in the other three things.  Earnings in aggregate are continuing to surprise on the upside.  The fact that a couple of the stocks I closely follow rose over 10% last week suggests that the expectations may still be too low for some companies out there.  Interest rates have nudged up a bit recently, but the Federal Reserve has all but guaranteed an easy money policy at least through the middle of the year and maybe to the end.  Sentiment is a bit of a mixed picture, but I still think that it is net-net positive for the market.  Professional investors and strategists appear to be universally optimistic about the market’s prospects for 2011.  Usually this would be a yellow flag.  However, retail investors remain highly skeptical of the market as measured by the funds flow data.  This is a huge positive for the market.  Only when EVERYONE loves the market and “KNOWS” it’s going higher, do I begin to worry about sentiment being a negative factor for the market.

The stock market has had an unusually strong run since last August.  Most professional investors I speak to would be happy to see the market consolidate a bit here, and maybe flatten out for a while.  It’s also important to note that bull market corrections of up to 10% are not uncommon.  But I don’t think developments like Egypt or the jobs numbers (which tend to be a lagging indicator anyway) would be the reason for a correction.  No, a more likely candidate for the market to retrace a bit would be some new concern about either earnings or inflation/interest rates.  Absent something big like that, the market seems poised to move higher (not a prediction!).