“One of these days in your travels, a guy is going to show you a brand-new deck of cards on which the seal is not yet broken. Then this guy is going to offer to bet you that he can make the jack of spades jump out of this brand-new deck of cards and squirt cider in your ear. But, son, do not accept this bet, because as sure as you stand there, you're going to wind up with an ear full of cider.”
-Guys and Dolls
The holy grail of investments: higher returns without additional risk
Investment managers have a difficult job. They invest in securities – stocks, bonds, and so on – to meet specific goals. By far, the most common goal for active investment managers is to outperform a corresponding benchmark, either in absolute performance or risk-adjusted performance terms. By that measure alone, most active managers don’t succeed. Furthermore, with literally thousands of investment options which retail and institutional investors can select, investment managers must compete hard to win the attention of investors and their agents, i.e. investment consultants.
As with any product or service, there are salesmen for investment managers: marketing staff, wholesalers, external client liaisons, and internal support teams. As agents, we are constantly bombarded with compelling sales pitches for various investment products. As fiduciaries, we spend a lot of time going through the fine print of those sales pitches, trying to set realistic expectations for these products and a comprehensive understanding of how they might (or might not) work within our clients’ portfolios. Wary of the competition, sales teams are under great pressure to accentuate the positive and sell their products.
At a basic level, investments encompass the trade-off between performance returns and risk. Generally, the investments or portfolios with the highest return potentials have the greatest risks. When investment products are promoted to us, we always try to remain cognizant of the potential benefits and risks. By coincidence, in the past couple of weeks, we had several sales teams come to our offices to advertise idiosyncratic products which, from a prima facie point of view, are being promoted as investments with greater relative return potential without additional risks.
From an investment standpoint, this looks like magic - getting something for nothing. Rather, this idyllic selling proposition should make investors particularly wary and even more dedicated to find flaws in the investment process for these products. This implicit promise should raise the hair on the back of your neck. There has to be a catch. Put another way: imagine you had an absolutely perfect, certain, money-making investment. Why would you need public investment?
Even fully fraudulent products like Bernie Madoff’s Ponzi scheme were not described as riskless since that assertion would draw even more attention. Nevertheless, we are often presented with investment products with attractive characteristics and slick marketing material which often minimize the additional risks. In this newsletter, we’d like to describe our analysis of an inflated investment and how to temper the aggressive salesmanship.
A fantastic investment opportunity: the SAP
Let’s dig deeper into one of these products. Investment manager ACME came into our office a few weeks ago to promote the ACME Structured Asset Portfolio (which we’ll call the SAP, going forward) which includes a diversified basket of US and international stocks and bonds as well as some exotic asset classes, like REITs and commodities. The ACME SAP performance looks spectacular at first glance, with only long-term upside performance relative to its benchmarks, in both absolute return and risk adjusted return metrics. Basically, it looks like it participates fully in upside market rallies and deftly avoided the deepest downside contractions over its ten year history. It’s a single diversified portfolio with superior returns relative to a customized benchmark.
Understanding the process
The first rule of investment performance, often applied front-and-center to disclosures and disclaimers is this: past performance is not a guarantee of future results. So you have to ask, what process did the portfolio managers use to earn outsized return? Once you understand the investment process, you then ask, is their process repeatable? After all, when you buy an investment product, you aren’t buying the product’s history. Instead, investors hope that the process used to generate the attractive return history continues to succeed the future.
So what process do the SAP portfolio managers use to get these outsized returns? It turns out they rely on differentiating long term price trends with short term excessive trading trends. In other words, pattern recognition. For instance, they might look at the traditional ebb and flow of the US large cap stock universe and see an up-and-down annual variance of 20% around an average target value, which trends up at 8% per year. At the moment, they’ve noticed the US large cap stock universe is trading 30% below its target price. Furthermore, they’ve noticed a lower volume of stocks leading the stock market downward, adding credence to the notion that the momentum of the stock market is primed to change directions. Adding up this information, they’ll decide now is a right time to overweight their allocation to the US large cap stock investment sleeve. They reason that the market is oversold and prone for an upward trend. In other words, this product won’t “fight the tape” and try buying into a steep selling trend; in investment parlance, this fund accepts the dominance of momentum trading and won’t act as a contrarian buyer on steep market drops.
This sort of technical based trading (i.e. focused on stock prices rather than intrinsic company data) investment management style moves in and out of favor. In the financial crisis of 2008-2009, several pattern recognition styled investments deeply underperformed because the patterns which had defined the relationships between various asset classes were challenged and reset after 2009.
Historical patterns are not guarantees; they can change, even on a large scale like the economy. As a large scale example, the past 30 years of fixed income yields and returns seem unlikely to repeat during the next generation, as interest rates change. As a smaller scale example on a sector scale, who could have guessed the weight which technology companies would have on the stock market? Five of the top ten largest companies in our stock market - Apple, Google, Microsoft, Facebook, and Amazon - are technology companies; some of these didn’t even exist fifteen years ago. So, going back to the ACME SAP, what happens to performance if the targeted trend of 8% annual returns drops for the next thirty years as productivity expansion reaches the point of diminishing returns? The SAP model would be overbuying and not fully participating in the global growth story, due to a flawed model.
Looking at annual performance of the ACME SAP also reveals that the product’s greatest relative advantage came as a one-time event. The majority of the portfolio’s excess returns come from avoiding the worst of the 2008 financial crisis. (In most other years, the SAP merely kept up with blended market returns and even underperformed once fees were applied.) Avoiding the 2008 financial crisis is not a small matter; most investors would be thrilled with dodging that bullet. However, institutional clients tend to prefer a consistent record of continuous outperformance as opposed to a single, albeit large, benefit. A single data point is a potential outlier, and insufficient to indicate the continued strength in an investment process.
Reading the fine print
We’ve said this before, but it bears repeating: you always have to read the fine print on a contract. The additional disclaimers will often reveal details necessary for full comprehension. As the product is presented in the first 80% of the presentation, you might be forgiven for thinking that the product’s historical record applied equally to you – as a retail or institutional investor in the United States looking for a global balanced investment solution. In terms of actual allocations, the weights of the ACME SAP are determined by global market capitalization, with a significant weight into international countries. That’s not a red-flag per se, but it does mean investors should be cognizant of what they bought. First, the investment process has been tested primarily on international markets. Second, most US investors, right or wrong, still have a home country bias wherein they expect a core of US security exposure with international securities balancing this weight. Home country bias is potentially too strong in the United States, but the high allocation to global securities certainly could be made clearer in the presentation materials.
It might also dispirit you to notice that the performance data in the presentation is all hypothetical. The performance numbers doesn’t reflect the real experience of any actual investor. Rather, it reflects gross returns (without fees) in overseas currency which has been hypothetically converted to US dollars. The performance we see is hedged the US dollar for the presentation, but it hasn’t happened for real clients, who are mostly European. More specifically, the hypothetical dollar hedging occurred without any costs applied, neither investment management fees nor transaction costs. In the real world, hedging incurs some modest transaction costs. Further, hedging out currency risk is imperfect, as the standard currency swap and futures lots won’t perfectly coincide with the daily allocations of the fund along the way, so hypothetical performance is not a substitute for real world historical results.
The primary way to demonstrate fiduciary prudence is to compare the product to the results of peers or a corresponding benchmark. This is why benchmarks are important to include. The ACME SAP uses a customized benchmark, but there are a number of inherent decisions which go into making a customized benchmark, and they can be easily manipulated to suggest value.
Let’s start with the fact that we are evaluating a multi-asset product. Broadly allocated and complicated strategies have more amorphous benchmarks than simple mandates. Consider, a simple US large cap core benchmark is generally benchmarked against the S&P 500 or Russell 1000. There isn’t too much room for picking a favorable index. By comparison, a single benchmark for a diversified portfolio has a variety of potential index and peer group categories benchmarks including the separate risk series family benchmarks (e.g. Dow Jones, Morningstar, S&P) along a full spectrum of conservative, moderate, or aggressive models. The customized benchmark can be static and unchanging or dynamically reweighted to reflect the changes underlying asset allocations.
When investors are comparing performance to a customized benchmark, the underlying sleeves of that benchmark never get the scrutiny from inexperienced investors they deserve, and revisions to the benchmark are never questioned. The individual benchmark sleeves in customized benchmarks can be altered. For instance, if the international investments in a multi-asset portfolio are starting to lag, the underlying index of the customized benchmark could be alternated between the MSCI EAFE or MSCI ACWI ex USA index at will, depending on which looks better. There is a difference between these indices (primarily the proportion of emerging market securities) but both indices are commonly used, and opportunistically interchanged, by active investment managers.
Moreover, multi-asset portfolios which include alternative investment sleeves have a plethora of options for this frequently misrepresented space. For instance, will the commodities sleeve in the customized benchmark be based upon relatively stable treasury based instruments, like TIPs or a volatile market weighted commodity index like the Goldman Sachs Commodity Index? Will the long/short and global macro hedge fund management sleeves be compared to an aggressive equity based index, like the MSCI World, or an arbitrary return bogey like the Treasury Bills +5.0%?
Beyond index benchmarks, peer group category benchmarks, if they’re even included, can change based on small variations. For individual sum-of-parts customized benchmarks, there are many peer group category options. For example, there are more than a dozen categories where alternative investments are allocated, each with their own current index, and several of which have changed over time, adding to the complexity and potential for manipulation. For all-in-one category benchmarks, a multi-asset fund might still find itself in a stable risk series category (i.e. Moderate Allocation), a global mandate (i.e. World Allocation), or a flexible category (i.e. Tactical Allocation).
None of this is to say that ACME SAP is a bad product. It might be fantastic, but the marketing materials are (naturally) designed to overlook any potential flaws and an inexperienced investor could easily think they are buying a “sure thing”. Our fundamental point is this: there is no such thing as a sure thing in investing.
Only the most rare and unscrupulous minority of salespeople will indulge in full-blown falsehoods, pyramid schemes, or Bernie Madoff level frauds. Most salesmen aren’t liars and they usually personally believe what they’re telling you. However, their financial incentive for believing their own spin creates a clear predisposition to advance their product. If money is changing hands, there is an incentive in the mind of the seller. The incentive may cloud their ability to be completely forthright. The seller might provide some manipulated numbers – not out of dishonesty but out of salesmanship. They will have an incentive to ignore some of the less-than-flattering elements of the product. They can swap benchmarks to whatever is most favorable at the time, perhaps genuinely feeling that the appropriate benchmark has changed. They can include historical performance of similarly run products from the same manager if they can argue that the fund is a continuation of the same product, just in a different vehicle. They can change the time horizon to include or omit different portfolio manager performance records, depending on which compares more favorably.
Here’s the takeaway lesson: if money is changing hands, exercise healthy skepticism. Moreover, if you’re handling someone else’s money – which defines any fiduciary relationship – it is your duty to exercise some critical thinking. It may be in your best interest to get an unconflicted expert to evaluate your investment options impartially.