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excess returns

The puzzle of selecting a financial advisor

(complete) Beating the market has become nearly impossible by Julie Segal Institutional Investor September 18, 2013

man digging in the desert 2013-09-Julie-Segal-Is-Alpha-Dead-article-page-1
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Charles Ellis is a master storyteller. When Ellis served on Yale University’s investment committee from 1992 to 2008, his colleagues, who included David Swensen, went so far as to call the advice and wisdom he imparted through his stories “Charlie’s parables.” So when I decided to research whether alpha – investment returns above what a plain old index fund would give you – was just a fairytale that the investment industry told itself bedtime, Ellis was my guy. I asked the author of “Winning the Losers Game” and the man who wrote the forward to Swensen’s landmark book on portfolio management to talk to me for a video series we were filming on the murky topic of why institutional investors rarely beat the market. It isn’t a new problem (Ellis first wrote about it in 1972), but it has been getting steadily worse, and I believed I might be writing alpha’s obituary – not good when your job is writing for a publication named “Institutional Investor.”

When indefatigable-Ellis called me back on a dreary day at the end of March, he graciously said no to the video, assuring me I would never want to interview him on film, as he doesn’t know how to speak concisely. We then spent an hour talking about what prompted him to write “Murder on the Orient Express: The Mystery of Underperformance,” a short, Agatha Christie – inspired peace in the Financial Analyst Journal last year in which he lays the blame for the inability of pension funds, endowments and others to invest well at the feet of the “usual suspects.” Everyone is guilty in Ellis’s estimation: money managers who overpromise, investment committee’s operating under bad governance structures, consultants who want to protect their franchises and poorly paid, thinly staffed institutional investors.

But the 75 – year – old Ellis is polite, perhaps to a fault. He assures me that all these people sincerely believe they are doing the right thing and that it’s hard to identify the “son of a bitch” (well, maybe not polite to a fault) who is truly responsible for the colossal failure to find alpha. To make his point, Ellis takes me on a long and often touching detour to explain how we can be part of the problem even as we are oblivious to the specifics of the role we are playing. He enlists the movie “The Help“, in which young, card playing white women are blind to the tragic effects of segregation all around them, to make his point that people in the investment industry are doing their best, even if in inexorable forces are preventing them from delivering their promised product.

Ellis, who founded consulting firm Greenwich Associates in 1972 to provide strategic advice to financial services firms, warned me he is going to stop talking, tells me how much fun he is having and asks how he can be of help. I tell him I want to know why the aggregate amount of alpha – a measure of risk – adjusted excess return – seems to be drying up. Why is it that investors can collectively discover and then quickly ringing out all the value from an investment idea? Ellis has pointed to a lot of mistakes that investors make, like dumping funds at the worst possible moment; I ask him why a small – cap stock manager might have a harder time today picking stocks that will beat the average then he or she did in the 1980’s.

I had evidence that it was happening. A few months earlier, before he landed at Credit Suisse in New York as head of global financial strategies, Michael Mauboussin had shown me statistics that he had prepared for a Columbia University class on security analysis that he was teaching, illustrating that the margin of out performance – that is, alpha – of US large-cap – mutual funds has been steadily shrinking for 40 years. “The difference between the best and the average manager is narrowing, so the results get narrower,” says Mauboussin. “We saw it at the Olympics: the gold medalist wasn’t that much faster than the athletes who won the silver and bronze. That’s also happening in investing.”

Trend of US Large-cap fund manager performance and distribution anotated

I became interested in how alpha had gotten harder to find during the 2007 quant crisis. Traditional asset managers, which I had been covering since 1998, always tell investors and reporters the same thing when markets fall: markets can be irrational at times, so keep your head down, keep dollar – cost averaging, and your portfolio of equities and bonds will work in the long term.

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Price discovery Vs. Values discovery: Should Advisors Search for Alpha or Gamma?Featured

 

head-hunters-hire-your-competitors-top-sales-people claw machinePrice discovery: the alpha-seekers dilemma

In his recent Financial Analysts Journal article ‘The Rise (and Fall) of Performance Investing[i]”, Charles Ellis among other things, frets that improving market efficiency increases the difficulty of locating managers who will produce consistent alpha. He reminds us “Price discovery is the skillful process of identifying pricing errors not yet recognized by other investors.” Ellis observes”… the skill and effectiveness of active managers as a group has risen for more than half a century, producing an increasingly expert and successful (or “efficient”) Price discovery mechanism.”

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The article postulates;”As the skill of competitors converges, luck becomes increasingly important in determining the increasingly meaningless performance rankings of investment managers.” It warns “Investment professionals know that any long term performance record must be interpreted with great care.” As evidence, Ellis offers a study of investment performance produced using manager selection consultants. “Despite considerable time and effort and access to managers’ data, the self-chosen task of investment consultant firms has proved far more difficult than expected. As a group, selection consultants have caused their clients to underperform by 1.1% of assets.”[ii]

keep-calm-and-set-meaningful-goals dnldValues discovery: bold proposition or capitulation?

Given the uncertainty of finding managers who will consistently add alpha, Ellis suggests we re-emphasize “Values discovery” in our client relationships; which he defines as “…the determination of each client’s realistic objectives with respect to various factors, including wealth, income, time horizon, age, obligations and responsibilities, investment knowledge and personal financial history, and designing the appropriate strategy.”

 

 

Does Values discovery produce measurable results?

Happily, according to recent Morningstar research, Ellis’ “Values discovery” earns our clients, large, tangible returns. In their Morningstar paper “Alpha, Beta, and Now … Gamma”, authors David Blanchett and Paul D. Kaplan[iii] “… introduce a concept called “Gamma,” which is designed to measure the additional expected retirement income achieved by an individual investor making intelligent financial-planning decisions.

“Measuring Gamma: Although financial planning spans a tremendously broad range of potential decisions, in this paper, Blanchett and Kaplan start out by measuring Gamma for five specific retirement-based planning issues: determining asset allocation based on total wealth; applying a dynamic safe withdrawal rate strategy; incorporating guaranteed retirement income products (e.g., annuities); making tax-efficient allocation (i.e., asset location) decisions; and optimizing the portfolio by treating client cash flow needs as liabilities and matching investments and their risks appropriate to manage (and hedge) those liability needs”[iv].

Values Discovery is more powerful than price discovery

Surprise: Values discovery is more accessible and powerful than Price discovery

To gauge planning’s contribution; the research compares a base case – what investors do on their own, against against a set of retirement planning strategies. While the improvement varies with client circumstances, the authors found the planning strategies make a significant difference;”… a Gamma of 28.8%, meaning $1.29 for every $1 generated by the base set of assumptions.[v]” So taking a smarter approach to generating retirement income (by working with a planner) earns investors substantial tangible rewards. Unlike Alpha, everyone can earn Gamma because better planning is not a zero-sum game.

Values plus Price discovery create a viable client planHolistic approach: blend Values and Price discovery

Based on evidence that used alone, each yields much less benefit than the combination, orthopedists prescribe a combination of surgery and exercises to treat an injured limb. Similarly, Ellis describes the practice of investment management as “two hands clapping”; “…one hand based on the skills of Price discovery and the other based on Values discovery.” Advisors employing the two-handed approach blend Alpha and Gamma consistent with their firm philosophy and appropriate to each client.

Ellis concludes “[Values discovery] is an admirable way forward that would inspire client loyalty—with all the attendant long-term economic benefits—and would provide practitioners with deep professional satisfaction. Although not as exciting as competing on Price discovery, investment counseling based on Values discovery is greatly needed by most investors—institutional investment committees as well as individual investors—and surely offers more opportunities for real long-term success to both our profession and our clients.”

 

[i] Charles D. Ellis, CFA; “The Rise and Fall of Performance Investing”, Financial Analysts Journal, July/August 2014 pages 14-23 Article Link see also Article Link

[ii] According to Tim Jenkinson, Howard Jones, and Jose Martinez, “Picking Winners? Investment Consultants’ Recommendations of Fund Managers,” Article Link

[iii] David Blanchett and Paul D. Kaplan; “Alpha, Beta, and Now … Gamma Measuring the importance of intelligent financial planning decisions.”, Morningstar Advisor December/January 2013 pages 60 -63 Article Link

[iv] Morningstar Tries To Quantify The Value Of Financial Planning – 1.8% Gamma For Retirees?, Posted by Michael Kitces on Monday, November 12th, 12:01 pm, 2012 in Planning Profession. Article Link

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Excerpts from “Beating the market has become nearly impossible”

By Julie Segal  Institutional investor Sept 18,2013

Intense competition, technological advances and regulatory changes have left [institutional] investors struggling; raising the question “is alpha dead?”

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man digging in the desert 2013-09-Julie-Segal-Is-Alpha-Dead-article-page-1

 

 

 

 

 

 

 

 

 

Alpha continues to shrink and become more rare

 

The margin between the best and the average manager is narrowing, so the results get narrower

…Michael Mauboussin, head of global financial strategies at Credit Suisse in New York, had shown me statistics that he had prepared for a Columbia University class on security analysis that he was teaching, illustrating that the margin of out performance – that is, alpha – of US large-cap mutual funds has been steadily shrinking for 40 years. “The difference between the best and the average manager is narrowing, so the results get narrower,” says Mauboussin.

Trend of US Large-cap fund manager performance and distribution anotated

 

 

 

 

 

 

 

 

 

There’s been a big decline in the % of managers beating their benchmarks

[Suzanne Duncan, the 40-year-old global head of research for State Street Corp’s.Boston – based Center for Applied Research]…cites a joint paper from the Center for Applied Research and the Fletcher school of Law and Diplomacy at Tufts University that found less than 1% of 2,076 US mutual funds tracked between 1976 and 2006 achieved superior returns after costs. She also refers to a working paper from the University of Maryland that reports that before 1990, 14.4% of equity mutual funds delivered alpha, whereas in 2006 only .6% of the managers could say the same thing. The authors define funds that produce alpha as those having stock – picking skills sufficient to provide a surplus beyond recovering trading costs and expenses.

Increasingly, luck may be the factor separating today’s top-performing manager from their equally skilled peers

… [The Paradox of Skill], a concept developed by the late biologist Stephen Jay Gould to explain that in many fields, as people become more skilled, luck ironically becomes more important in determining outcomes. “Absolute skill rises, but relative skill declines, leaving more to luck,” Mauboussin explains.

… In investing the paradox of skill means that many managers are producing similar results. In other words, alpha is going down.

Was alpha more plentiful in the ‘good old days’?

…For [Peter] Lynch [manager of Fidelity Magellan fund] alpha was easier to get in the beginning than at the end. Mauboussin points me to the work of finance professors Jonathan Burke and Richard Green, which shows that between 1977 and 1982, when the market was still below its 1966 high, Lynch produced a mind – boggling two percentage points of gross alpha per month. During his last five years managing Magellan, Lynch delivered 0.2% monthly in gross alpha, as the fund had grown from about $40 million when he started to $10 billion in assets.

Some of the low-hanging fruit has been plucked

…Investors benefited from the profits to be had in whole new categories of investments, such as high – yield bonds and the ability to tap international markets. “Some of the low – hanging fruit has been plucked,” says Robert Hunkeler, who has overseen International Paper Company’s pension fund for more than 16 years. “When I think back to the 80’s and early 90’s, it wasn’t uncommon that a large allocation to international equities would have given you a big leg up over your competition. High – yield bonds were still called junk bonds, and many people didn’t invest in them because of that. Those were what I call cakewalks.”

Fiercer completion makes it harder to produce extraordinary returns

[Mark Lasry , co-founder of New York – based Avenue Capital Group, a $12.3 billion alternative – investment firm that specializes in distressed investing] …makes the point that fiercer competition has made it harder to deliver returns. He says that debt that he buys at 65 or $.70 on the dollar today might have been purchased for 60 or even 50 cents years earlier. “As people understand what we do, sellers hold out for higher prices,” he says…

Harder to detect alpha when market returns are subdued?

…Investing in a low – return environment is extremely difficult. Returns for both stocks and bonds are expected to be in the single digits, at best, for the next several years, if not for the rest of the decade. Even a great alpha generator will deliver less if the pie is smaller.

Is alpha buried under near-zero risk-free rates?

… With the risk – free rate at a record low, it’s more difficult than ever to produce alpha. But it’s a great time to be writing about how difficult it is to find alpha, because investors rarely think about the increased risk that low interest rate’s present, Mark Lasry insists. “It’s just mathematically harder to find alpha because the risk-free rate is now essentially zero,”… Asset managers… measure potential investments against what they could earned by taking no risk, such as sitting on cash. At the start of 2008, the three – month LIBOR rate was 5%. Investors were paid 5% to sit on cash, or Lasry could take two times the risk-free rate to make a 10% return. Now, with three month LIBOR at 25 basis points, he has to take 40 times that risk to earn the same 10% return, which is what investors are demanding today.

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