By Susanna Gibbons, CFA
Ah, Lake Wobegon. Where all the women are strong, all the men are good-looking, and all the children are above average. Sounds a lot like the pursuit of active management, doesn’t it? The belief that we can find investment managers that are top performers drives everything. In a 1991 article, The Arithmetic of Active Management, William Sharpe basically chides us for acting as though we can all be above average. He notes: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.” (Sharpe, 1991)
Most of the academic research on the performance of investment managers is completely consistent with this notion and demonstrates that there is very little persistence in performance over time. There is some variability in results when viewed over the short term (generally less than a year), but by and large, performance is strongly mean-reverting. (Luckoff, 2010) This should not come as a surprise to anyone in the active management world – it is extraordinarily difficult to consistently beat a benchmark, let alone remain in the top quartile or even the top half.
Using a broader range of quantitative measures for selecting asset managers does not really provide additional hope. The Sharpe ratio is among the most widely used measures, and it adjusts historical performance for the excess risk in the portfolio relative to a benchmark. Theoretically, the higher the Sharpe ratio, the more skill the manager has.
Except that the skill purportedly measured by using historical numbers does not translate into future performance. Just as prior period Alpha is not predictive, high Sharpe ratios are also not predictive of future performance. In fact, they aren’t even predictive of continued high Sharpe ratios.
Why, then, do we continue to use these frameworks as a way of identifying which managers to hire? Investment Consultants put enormous effort into managing their approved lists, conducting “searches” for new managers, and in general acting as gatekeepers for asset owners. Recommendations will not include managers without strong three-year track records at a minimum, in spite of the fact that we know these results have little bearing on expected performance going forward.
In fact, it’s even worse than that. There has been some research on the performance of emerging managers, and it consistently shows strong performance – primarily in the first two years. (Aggarwal & Jorion, 2008) (Preqin, 2013) (Liu, Ma, Shi, & Wang, 2017) According to Aggarwal, “each additional year of age decreases performance by 48 basis points, on average”. The best performance from these managers comes before consultants will recommend them. We are knowingly, willfully leaving performance on the table.
And all of this begs the question: where did the three-year track record come from in the first place? I stumbled across an article recently that suggests that, essentially, the investment business-backed into it because it needed enough data points to calculate Alpha and Sharpe Ratios. In “Are 3-Year Track Records meaningful?” Corey Hoffstein argues that in statistical analysis, 30 samples is the minimum needed to rely on a normal distribution – a requirement for meaningful Alpha and Sharpe calculations. A 3-year track record gives investors the bare minimum required for a (theoretically) meaningful calculation. (Newfound Research LLC, 2016)
The problem, though, is that monthly data should not really be annualized as most consultants do – to multiply by the square root of time. This method would be fine in the absence of serial correlation, but stock returns have a great deal of serial correlation (momentum), so the calculation actually overstates the Sharpe ratio by as much as 65%. (Lo, 2002)
Okay, so we have to have a three-year track record because that’s the minimum amount of data needed for a calculation we know will be wrong, using time series that we have determined have no ability to identify which managers are going to outperform in the future. We then take the three-year requirement and establish a barrier to keep out managers who actually do have a likelihood of outperforming. That’s our framework for identifying excellence. Yikes.
The tools that have evolved over the years to help asset owners make really complex decisions are actually working against their best interest. These tools have had a disproportionate impact on women and people of color. The barriers to starting a new investment fund are high, and the likelihood of being able to keep an emerging business going for three years if you do not already come from a position of privilege is discouragingly low. Those three years have nothing to do with manager performance; they serve only to keep “the unwanted” out of the business, and asset owners are paying the price. Dismantling any entrenched system is hard, particularly when it has been wrapped in complex formulas and years of accepted practice.
We are well past due to escape from this fanciful world, this Lake Wobegon of investing that never actually existed. However risky it feels to step into the real world, it is time.
References
Aggarwal, R., & Jorion, P. (2008). The Performance of Emerging Hedge Fund Managers (draft). Unpublished.
Hendicks, D., Patel, J., & Zeckhauser, R. (1993). Hot Hands in mutual funds: Short-run persistence of relative performance. Journal of Finance 48, 93-130.
Liu, S., Ma, J., Shi, H., & Wang, C. (2017). The Performance of Emerging Managers and Funds. Minneapolis: Carlson Finance & Consulting Lab.
Lo, A. W. (2002). The Statistics of Sharpe Ratios. Financial Analysts Journal Vol. 58, No. 4, 36-52.
Luckoff, P. (2010). Mutual Fund Performance and Performance Persistence: The Impact of Funds Flows and Manager Changes. Gabler Verlag.
Newfound Research LLC. (2016). Are 3-Year Track Records Meaningful? Boston, MA: Newfound Research LLC.
Preqin. (2013). The Performance of Emerging Manager Funds. Company Website, Hedge Fund Spotlight.
Sharpe, W. F. (1991). The Arithmetic of Active Management.
Author Archives: Susanna Gibbons, CFA
The Madding Crowds
By Susanna Gibbons, CFA
Managing Director, David S. Kidwell Funds Enterprise
Carlson School of Management, University of Minnesota
One of the things we constantly remind students of as they evaluate different stocks is the need to understand what the market has priced in. It’s a ridiculous question, really. If a stock is trading at $20 a share, is it because everyone thinks it is worth $20? Or because half of the world thinks it is worth $15, and the other half $25? Or any of an infinite number of combinations? How would we even know? Equity markets in the United States are sufficiently large to balance a really wide range of views, and that is the whole point of market efficiency. This understanding has driven most investors into passive investing strategies, particularly where markets are deep and liquid. There is collective wisdom even in the madding crowds, and sophisticated investors choose not to defy it.
It is fascinating to see how quickly we abandon that discipline when it comes to thinking about the market for U.S. Treasury Bonds. Certainly, there is a great deal of market segmentation that might lead to inefficiencies, but no one really makes that argument. The discussions have, for decades, centered on “how low-interest rates are right now”. Why would anybody buy bonds when interest rates are so low?
In a recent piece published by Morgan Stanley, “A Borrower Not A Lender Be”, Andrew Sheets argues precisely that. Economists at Morgan Stanley believe that economic growth is accelerating, and this justifies borrowing at current levels, but certainly not lending. The growth opportunities cited all provide excellent support for the faster growth scenario – increased spending on combatting climate change, higher infrastructure spending, higher levels of capital investment across all sectors. But there is a flip side to each of these coins. These investments all entail significant economic transitions, and unless we consider the losses that might also result, we have no context for judging the growth.
If you believe that capital markets are efficient – and Treasury Markets in particular – then you have to consider the possibility that there are a range of negatives which the upside-only view is missing. What could detract from the economic growth driven by these opportunities?
A lot. Just a few examples:
- The climate transition involves lots of new spending on wind and solar power, utility scale battery, and new delivery mechanisms. The faster this transition occurs, the more quickly our existing infrastructure is displaced. Stranded assets in the coal sector have already become a problem, and this will ripple through to other fossil fuels based largely on the cost of extraction.
- Corporate Office Parks, an innovation of the Disco era, remain largely deserted. Executives are starting to crow about how excited people are to “return to work!” (as though employees have not been working all along…) but many remain reluctant for reasons both personal and pandemic. Hybrid work looks like the direction we are headed, rendering much of our existing infrastructure obsolete – but investment in the future appears premature. We don’t really know what the hybrid model looks like, so we don’t know what type of real estate we should be investing in. Increased spending on 5G and other forms of connectivity are paired with stranded real estate investments.
- Municipal infrastructure needs are changing. Given the increased number of drought-impacted areas, it seems likely that we will need to completely rethink our model for water and sewer management. There are a wide range of technological solutions more suited to drought prone areas, and existing systems may need to be substantially abandoned or re-tooled.
- It seems likely that in 5-10 years, automobiles will have shifted to an all-electric fleet nationally. Think about the impact on gas stations around the country. All of this existing infrastructure will be obsolete, even as new investments in charging stations ramp up.
- Demographics are shifting in complex ways. The baby boomers are retiring, and moving out of their income producing years into their savings-depleting years. They are dis-investing. At the same time, Millennials are delaying or rethinking child-bearing. Population growth is unlikely to support increased economic activity.
More than at any time in my career, growth opportunities are abundant but paired with equally abundant opportunities for losses. The range of potentially stranded assets is breathtaking, as we re-think fossil fuel dependence, work modality, and the very structure of our families and personal lives. Capex cycles are usually driven by replacement, expansion, and secular shift – and today, it looks like we are facing some massive secular shifts.
What are markets pricing in? To repeat, it is a ridiculous question, but it seems more ridiculous to assume markets are wrong, without considering all the possibilities being captured by current prices. I happen to think we will see extraordinary growth in some areas, balanced by stranded assets, outdated infrastructure, and climate-related property damage in others. On balance, the outlook for economic growth is both rosy and grim, and probably close to zero over the intermediate-term – which is precisely what markets are implying.
When thinking about whether or not to invest in bonds in the current market, the issue is not how low-interest rates are. The issue is entirely around what level of growth we can expect, in the aggregate, going forward. The decision to borrow or lend should be based on what level of growth we expect in the future. Unfortunately, our expectations are likely predicated on a world that no longer exists. Nominal GDP has trended lower since 1980. In the 1990s, we dreamt of the nominal growth world of 8% from the 1980s. As the new century dawned, we assumed that the 5.5% of the 1990s was the new normal. Then 4.3%. In the last decade, growth was 3.9%. We believe ourselves to be looking forward but have always assumed a return to a yesterday just out of reach. Why should we believe at this juncture that we will finally, finally, recapture the past?
Collectively, we continue to believe in the efficiency of markets. Individually, though, we each have the hubris to believe in our own non-consensus forecasts, even as we are proven wrong time and again. Things do change. Maybe this time will be different. Yes. Maybe this time.
And so once again, Charlie Brown lines up to kick the football…
About Susanna Gibbons, CFA
Susanna has over 30 years of industry experience across multiple asset classes – equities, alternatives, and fixed income; and multiple roles – analytical, portfolio management, asset allocation, and educational. She serves on the Investment Advisory Council for the Minnesota State Board of Investments, the Editorial Board for the CFA Society of Minnesota, and as chair of the Investment Committee for the Girl Scouts River Valleys. She is currently exploring the integration of Environmental, Social, and Governance (ESG) principles into decision making, is passionate about teaching sustainable investment practices, and is a fellow within the Institute on the Environment, University of Minnesota. She earned an MBA in Finance from the NYU Stern School of Business and is a Chartered Financial Analyst.
WIIF Women in Investment & Finance: a swing and a miss – a series exploring why companies aiming for diversity are striking out
Spring Training
Spring is nearly here. In spite of the seemingly never-ending snow and cold, the days are getting longer, and the sun just a bit brighter. With a new season just around the corner, optimism is in the air. There is always so much hope in the beginning – so many promises, so much potential, young rising stars, and real progress seems just around the corner. And then – WIIF! We are hit smack in the face with reality.
I am speaking, of course, about another International Women’s Day. Another year where we proclaim the importance of expanding diversity in the investment business, diversity in executive ranks. We women all march off to our conferences where we learn about the many ways in which we are inhibiting our own careers. We listen to inspirational stories from incredible women who have succeeded against the odds. We learn yet again how important diversity is to organizations, as they affirm their commitment to our careers.
And yet the numbers are not budging. According to research by the New York Times women represent just 10% of portfolio managers. CFA Society Minnesota’s own numbers show the number of women who hold a CFA remains stuck in the teens. We have adopted this notion that we just need to introduce women to the business sooner, we need to make them aware earlier. If we could just let them know when they are Sophomores in college, First years, high school students, toddlers. None of that explains, though, why boys somehow figure out there are good career options, and girls don’t.
Maybe girls are not stupid. They are, perhaps, responding appropriately to the very limited set of career options they see as available to them. The are rejecting a culture that appears to them to herald The Wolf of Wall Street, a frat-ish atmosphere that seems anything but welcome. They are reminded of the sense of powerlessness that haunts so many of them in so many ways as they realize what the world has in store for them.
If we expect girls to embrace opportunities in the investment business, they need to see that there is a future for them. They need to see powerful, smart intelligent women succeed in the business – not because they need role models, but because they need to believe that success is possible. It’s hard to see that success is possible when for women, it has been so rare.
Here’s my suggestion for demonstrating that success is possible: Hire and promote talented senior women. We are all weary of hearing that “the women just aren’t there.” Go out and find them. The last time your organization had a senior opening, what did you do to identify a diverse candidate? Was any compensation or bonus tied to success in finding diversity? Did anyone work on a strategy for identifying diverse talent? Did you do anything different from your normal process? If nothing different is attempted, it’s hard to imagine different results.
This is a country that has put a man on the moon. We carry computer/television/phone/gps tracking devices in our pockets. We have developed a pillcam to take pictures of the small intestine, antibacterial nanoparticles, autonomous vehicles. But somehow, we are unable to figure out how to hire diverse candidates to manage our portfolios? This is not even plausible, and lays bare the insincerity of the effort.
It’s time to stop pretending that you want diversity, while doing nothing about it. If you say you want to succeed in this game, then take a swing. Every strike will bring you closer to the next home run.
#changingperceptions
Are you interested in contributing a blog to this important series? E-mail Diane at support@cfamn.org to volunteer.
Spatchcocked
Always on the lookout for a better way to prepare a Thanksgiving dinner, I recently came across what I believe to be the latest and greatest method: Spatchcocking. By removing the backbone of the Turkey, you are able to lay the Turkey flat on a cookie sheet, and roast it in a little over an hour. According to my research, the bird will cook thoroughly & evenly, and the shortened roasting time (not to mention height in the oven) makes preparation incredibly efficient.
Interestingly, it appears that spatchcocking is also the rage on Capitol Hill. After a year with few achievements to show for it, there are many members of Congress who appear to have very little left in the way of a backbone. As a result, the current tax plan is being rushed through the legislative process at an incredible pace. Whether this level of efficiency is as desirable in re-writing the tax code as in cooking turkeys seems highly questionable.
As investment professionals, how can we make sense of this process, and incorporate the proposed changes into our analysis? I don’t think we can. There seems to be overwhelming agreement that the tax code is too complex, and needs to be simplified, and that taxes (especially corporate taxes) are too high, and need to come down. The headline grabbing number of reducing the statutory tax rate from 35% to 20% suggests that a lot more money will be dropping down to the bottom line, and this belief has fueled the continued rally in equities.
However, if you look at what corporations actually pay in cash taxes, the Companies in the S&P 500 are, in the aggregate, paying an effective tax rate of – you guessed it, 20%. If the deductions and tax breaks that currently riddle our system are eliminated at the same time, there shouldn’t be any drop in taxes paid. Instead, you will see a shift in the winners and losers. Some companies that currently pay next-to-nothing will have to start writing checks, and others will likely get some relief.
It is virtually impossible to anticipate all of the implications of such a significant structural shift in the tax system. The Commonwealth of Puerto Rico provides a cautionary tale as to the dangers of such dramatic shifts. In the 1970s, Congress passed Section 936 of the tax code to encourage manufacturing companies to locate on the island, which spurred growth. When the tax break was eliminated in the 1990s, it kicked of a long cycle of deterioration from which Puerto Rico has yet to extricate itself.
Now, I am not arguing that we ought to use the tax code to achieve such narrow policy objectives. In fact, I think it is a terrible idea. I mean – Section 936? That’s a lot of sections of code. I do think that simplification is good idea. But unwinding this mess will be hard. Our entire economy has evolved alongside this current tax system over years, and companies have structured themselves, made investment decisions, and planned for a future based on that system. A complete and sudden shift will be economically jarring. There is enormous complexity to simplification, and the risk of unintended consequences will be high. Before running off spatchcocked to push through this turkey of a bill, I really hope Congress slows down a little. Instead of ending up with a tasty roast, the long-term impact of hasty tax reform could be pretty foul.
Second Hand Shoes
I love second hand clothing stores. In large part, that is how you can spot a bond person: from their love of identifying marginal relative value in obscure, non-scalable ways. The corporate bond market itself is nothing but a big swap shop (see my post “Thrift Shop” from November 15, 2013). Even so, I have a few rules that I try to live by with respect to used goods, and the main one is this: Don’t buy second hand shoes.
I bought a pair of second hand shoes once. They were Stuart Weitzman, black, with a funky composite heel. They looked amazing, they fit perfectly. They were a bargain. I wore them to work the very next day, feeling pretty proud of myself for having scored such a find. As the day wore on, I started to notice small black chunks of what I thought was dirt start to accumulate under my desk. I ignored it. I went out for lunch, and those small black chunks became large black chunks, and I realized that the funky composite heels of these shoes were flying apart at an alarming rate. I arrived at Marshall’s, two blocks away, essentially barefoot as the shoes collapsed beneath me, and was forced to purchase a cheap replacement. I now understand that there is a complexity to footwear that makes second hand shoes especially risky. That risk is un-analyzable, so second hand shoes should not be included in one’s portfolio.
I try to apply that same rule to the corporate bond market. If you keep it simple, and focus on risks you can understand and analyze, I think you can do pretty well in either the primary or the secondary market. But the market also offers plenty of opportunity to purchase what I think falls into the category of second hand shoes. My favorite current example is bank capital securities.
The market has been through several iterations of bank capital securities. As the regulatory landscape and public opinion continues to evolve, so do capital securities. Some of these securities have done extremely well – they have relatively high coupons, and generate a fairly reliable stream of income. But the devil is in understanding the details. Reading through a typical prospectus on these instruments, one finds gems such as “Interest Payments Discretionary ….the Company shall have sole and absolute discretion at all times and for any reason to cancel an interest payment ….” Or another favorite – the company can redeem the notes at par if there is any regulatory change. Also, if capital falls below a certain level – let’s say 7% — the security disappears entirely or becomes a different security, the terms of which might not even be known. What kind of bond doesn’t have to pay interest, and might or might not pay principal?
As an investor, I have owned these in the past, and I guess there are times when they make sense. But these securities are not exactly the classic pair of black pumps or mahogany penny loafers, and I don’t think they age especially well. Newly issued, there’s probably a nice window of regulatory clarity and attractive pricing that justifies their peculiarities. Right now, though, investors seem downright complacent about the risks involved in owning these securities, layering them into portfolios in an effort to boost yield.
I made the mistake last week of buying another pair of second hand shoes. They didn’t fall apart entirely, but once again chunks of material started peeling off them, and I was reminded how important it is to heed life’s hard-earned lessons. If I get tempted to dip my toe into some bank capital securities, someone please remind me of how quickly the bottom can fall out of these things, leaving you barefoot on the street at the worst possible time.
Don’t buy second-hand shoes.