GMO Quarterly

Just a thought, but with a few exceptions, there are not that many who are seriously questioning valuations relative to future potential growth rates.  But think about it, why would you create a rod for your own back?  If your job is to invest, then you may not wish to be hamstrung by valuation dilemmas.  Claim markets are overvalued and you have to do something about it.   I tend to be in the rod for your own back side of the room, but I can see an argument for claiming valuations are good, albeit one that has nothing to do with value.

Excerpts from the GMO Quarterly Letter:

as value managers listening for any assets, anywhere, that are screaming to be bought, the world currently sounds a deathly quiet place.

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Russian Roulette– further information

Here are some other links (FAIR, SIPA, Ken Kivenko) and other miscellaneous leverage references.  Please note that not all links relate to views that I would support: many are intended to show some of the dubious aspects of the promotion of leverage, so be warned.

I have had a response from FAIR Canada to one of my posts on leverage and note an excerpt from that response and links to a number of their documents below:

FAIR Canada

“Leverage continues to be a growing problem in our view.  In our letter to the CSA, we thought it was important to point out the linkages between the financial institutions lending the money to pursue these strategies (B2B Trust  being a prime example, but not the only one by any means) and the advisors who seek to gain through increased assets under management and/or greater embedded commissions and how this interaction buts consumers at risk:”

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Russian Roulette– more data

Leverage strategies using high cost retail investment products expose investors to significant risks, especially at fair to high market valuations.   Even very low cost strategies are exposed to significant risk as the market and economic cycle matures strongly suggesting that leverage is more strategic than a long term asset allocation play.  

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Surfing on the edge of a razor blade….another post in the Russian Roulette series.

For the retail investor, leveraged investment with high cost investment products is a bit like surfing on the edge of a razor blade: you either have an exhilarating ride of a lifetime or you end up crashing with all the ugly consequences.

What we should be aware of are that costs and timing are important, and so is the sophistication of the strategy, though neither are really given due consideration at the retail level.  As it is, recommending high cost, long term, leveraged strategies is like placing those investors on fast sledges at the top of mountains with no ability to break or manoeuvre.  

Importantly the ups and downs of the leveraged strategy are not symmetrical with the returns of the market so you can effectively bin the vast majority of risk disclosure.

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Russian Roulette: why is borrowing to invest so ingrained in Canadian culture?

I am not talking about the obvious “commission incentive” here for advisors.  No, I am talking about the laissez fair attitude (almost a belief in a divine right) towards the risks of inappropriate leverage and the easy assumption, including the apparent complicity of regulators, that a mere insufficient disclosure of risks using unrealistic assumptions (if any) is enough to provide due warning to/inform a client when the accompanying sales practises are ignored by regulators. 

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Russian Roulette: leverage and seeing through the marketing message…

How on earth are investors meant to be able to assess the risks and returns on borrowing to invest strategies when they are not provided with the hard data on which to assess the risks of their decision and when everything they read suggests only the unsophisticated are unable to appreciate the incredible benefits of leverage?

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Brief comments on Mckinsey “QE and ultra-low interest rates: Distributional effects and risks”

QE and ultra-low interest rates: Distributional effects and risks (McKinsey)

McKinsey state that QE does not appear to have affected equity prices.  In a sense, you could say that because most of the cash used to buy the bonds has remained on the Fed’s balance sheet, and because the supply of money itself has little impact on future real returns, and if investors and agents assume that QE itself will not directly impact economic activity then in a rationale world it is unlikely that QE would impact equity prices – equity prices being determined by the future real supply of returns.

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Structured notes: designed to deceive; some research!

The focus of structured products on a small segment of the return distribution, while ignoring the impact of negative scenarios does likely play on investors mental framing issues.  Unfortunately, regulators (in Canada especially) have stood back from dealing with these specific issues, partly because they do not fully understand them.  It is much easier to ask that a suitability box be ticked and for the investor to take responsibility for the decision than for regulators to get involved.  Can you imagine the impasse on agreeing a point of sale of document for structured notes: how would they face up to questions such as “Just what is the risk?”, “just what is the historical return on these products?”, “what are their option and structure costs?” ?

And now for some academic support to the over pricing of structured notes:

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Designed to deceive: structured notes

Their high costs transfer return to the issuer and costs to the investor, skewing the risk/reward profile of investment outcomes; they also complicate the management of the portfolio by taking away liquidity and yield and ultimately return, forcing the portfolio itself to awkwardly adjust for their absence.  Most of those who recommend complex products on a regular basis have little respect for the portfolio and little fundamental construction knowledge.  The structure and the marketing of these products is designed to deceive.

I recently had a structured note placed under my nose for comment: a 3 year auto callable structure.  I really do not know how investors are meant to understand how these work and you really do need to understand how risk is priced to appreciate what it is you are buying and paying for.

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Why are benchmarks important in mutual fund point of sale documents?

In response to a recent blog on benchmarks and behavioural economics I have been asked to comment on the importance of benchmarks in point of sale documents.  The following is the detail supporting that response, and (at the end of the post) a set of answers to a number of questions:

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Benchmark indifference is demand flow critical…old hat not new!

I was just reading an article in the Canadian Investment Review, “Time to toss your benchmark to the curb”, which discussed the performance of benchmark indifferent managers and the out performance of fundamental indexing versus traditional market cap indexing.  Now if you have been stuck in some efficient market nirvana for the better part of your working life you might find this all a bit of a shock.  But this is old hat , not new!

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The lost world of asset allocation Part 3: Risk Premium Differentials and Liability Frames.

One of the most important determinants of asset allocation is the risk premium on risky investments. 

The lower the risk premium on risky assets the less rationale there is for their inclusion and the longer the time frame of “risky asset risk” that a portfolio will need to manage.  Asset allocation decisions that involve allocating to longer term higher risk growth assets to provide the differential expenditure (income and capital liabilities less portfolio dividend, interest and other income) are about capturing differences in risk premiums.

But this also requires that asset allocation is also framed in terms of units of liabilities as opposed to just units of assets, such that risk management uses size and timing of liabilities as the primary determinant of rebalancing transactions and asset allocation decisions.   The time frame of risk for risky assets is framed likewise in liabilities.

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What is investment risk?

“What is investment risk” is both simple and complex and in order to assess the information needed to assess risk we first of all need to qualify the world view of risk and return and then the model we are using to manage the risks and their impact. All this is beyond the subject matter expertise of the individual investor and why point of sale documentation can only ever inform about the broad nature of risk and return but never be sufficient to allow the investor to fully own the decision. Ownership of the transaction decision resides with ownership of the process and the significance of risk assumed with respect to risk via structure, assumptions and costs.

At a very basic level, risk is what happens to a price between two points in time and the impact of that movement in price – it can be both positive and negative.  But what gives rise to risk is more important than a mere list of risk factors, or indeed a narrow quantitative measure of risk.

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Standard deviation may not tell the whole story but it does tell a story

In terms of risk, a prior positive demand flow (+ve standard deviation) has more impact on liability risk in an out of equilibrium world, so that arguments that suggest that a statistic that fails to focus only on the downside is meaningless are incorrect.

Way back when the world was more enamoured than today about standard deviation I openly discussed its weakness in terms of managing liability risks.  This was primarily to do with the fact that mean variance optimisers did not incorporate liabilities into the portfolio construction (optimisation process) and ignored relative and absolute valuation issues. 

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Active management outperforms–fact or fiction…

The mutual funds industry has recently latched onto some recent research that has stated that active funds out perform and is using these arguments to sell its active funds while ignoring the fact that not all active funds are the same and that most of its advisors, who operate under loose professional and ethical standards, lack the expertise, ability and accountability to deliver.

There is a rationale that states that deeply active managers are more likely to outperform and the more active they are the greater the probability of out performance.  At a physical level this is likely true if we equate deep active with contrary and assume that deep active is a small minority and is playing off the index-like active/inactive majority. 

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Long run predictability of asset prices..

Robert Shiller and Eugene Fama were two of three academics who won the Nobel Prize for economics for different accounts of asset price predictability: the former regarding its bounded long term predictability and the latter regarding its short term unpredictability.

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The lost world of asset allocation–part 2, the liability profile

This post is in response to a recent article by Rob Carrick on “conventional” asset allocation approaches, titled Longer lives, new investing approaches. It commented on asset allocation rules of thumb to give you your equity allocation and bond allocations.

The trouble is these rules of thumb are meaningless in terms of deriving optimal asset allocations.  How you construct a portfolio should depend on a number of things.  One of the most important determinants of of asset allocation is the liability profile, which in layman’s terms is income and capital needs as a % of the portfolio value.

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The lost world of asset allocation: part 1

How you construct a portfolio should depend on your world view of risk and return, your investment discipline, your resources, systems and expertise, how liabilities are met from assets and the way in which withdrawal risks (of which longevity risk is one of many risks) are managed, the risk and return assumptions you use to assess what liabilities a portfolio can meet (in the face of risk) and how an optimal allocation is adjusted for risk aversion and performance preferences.   

But in reality it can be whatever way the wind is blowing and this just does my head in.  At times, you really have to believe that the only thing keeping us humans where we are, are the shoulders of giants, because without these giants the extraneous weight of our ignorance would surely crush us.  

And to the point…….I have been meaning to comment on some of the many articles I have seen recently on “conventional” asset allocation approaches.   A recent article by Rob Carrick, Longer lives, new investing approaches was a mark I could not ignore:

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Is it really all about transparency?

The following is a quote taken from a recent Preet Banerjee article from the online Money website.

“But it should be noted that advisers can achieve transparency in a commission model simply by being transparent. If they take the time to break down the costs and embedded compensation that commissioned products carry, they fulfill the ultimate expectation of consumer advocates: providing investors with informed choice.”

Unfortunately this is about as far from the ultimate expectation of consumer advocates as the earth is from the centre of the Milky Way, and Preet’s logic is as about as mind boggling as the inestimable distance between the two.

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