Valuable Insights from Nobel Prize Winners

Nobel prizeLast week the Nobel committee awarded Eugene Fama, Robert Shiller and Lars Peter Hansen the Nobel Memorial Prize in Economic Science. At first, it would seem that Drs. Fama and Shiller make for a very odd couple. Dr. Fama believes in efficient markets while Dr. Shiller argued that the stock market in the late 1990’s and U.S. house prices in the early 2000’s were the result of “irrational exuberance.” Yet, there are valuable insights to learn from both Drs. Fama and Shiller.

Dr. Fama’s was that, because relevant information is quickly incorporated into asset prices, professional fund managers are unlikely to beat the market. His research followed that of another Nobel laureate, Paul Samuelson, who in his 1974 essay demanded “brute evidence” that active money managers could beat the market index. Such evidence has not been found. Dr. Fama’s work led to the development of the index-tracking industry. This allows investors to diversify their portfolios at low cost. Dr. Fama inspired the founding of Dimensional Fund Advisors (DFA), which follows an indexing strategy and exploiting market anomalies. Some DFA funds are used by DWM for portions of our equity and fixed income holdings.

Research of vast statistical evidence has shown that returns earned by active managers seldom outpace the S&P 500 index. Further analysis showed that the failure of active managers was the result of the costs they incurred. As John Bogle, founder of Vanguard puts it: “The average manager is only average, but only before these fund operating expenses, advisory fees, turnover fees and sales loads. After those costs, active management becomes a loser’s game (for equities).”

Dr. Shiller has always been a skeptic. His basic theory has been that financial assets are unlike consumer goods- when their prices rise, that creates more demand, not less. He believes that it is no use hoping that “rational” investors will drive prices back to fair value. Dr. Shiller is a professor of economics and Yale and his wife is Dr. Virginia Shiller, a clinical psychologist in private practice in New Haven. Back in the 1980s, Dr. Robert Shiller became the founder of the field of behavior finance, incorporating psychology into economics, particularly looking at bubbles in stock and real estate markets.

Dr. Shiller was one of the founders of the Case-Shiller Index, which measures real estate prices. He also developed “the Shiller P/E” which uses price and earnings to measure whether the stock market is overvalued. He predicted the dotcom bust due to a “Shiller P/E” of 44 as compared to a long-term average of 16. He predicted the housing bubble in 2006 citing the fact that house prices rose by 7% in real terms from 1890 to 1997 and then by 85% between 1997 and 2006.

Dr. Shiller’s work was used by DWM in early 2008, when we issued our “Bubble Bust Report” for clients and helped them reduce their equity positions and start to use alternative investments to better protect their portfolios. Like Dr. Shiller, we are cautiously optimistic at DWM.

The NYT interviewed Dr. Shiller last Sunday and asked him about his relationship with Dr. Fama. I thought he had a great response. He said, “Well, Gene and I have a lot in common, more than you might think. I use many of his theories. Not all of them, of course. But he’s a very good guy. It’s like having a good friend who is a devout believer in another religion. You can learn a lot from a friend like that, even if you don’t pray in his church.”

The Debt Limit and Beyond

sterner queenMaybe we need a stern, bossy matron in D.C. to “kick some butt.” Barron’s pointed out Saturday that back in 1975, the Australian government shut down in 1975 over a budget impasse. Queen Elizabeth II (queen of Britain and Australia) came in and fixed the problem. She and the local governor-general fired the prime minister, passed a temporary funding bill, and held elections to replace the culpable Parliament. Australia hasn’t had another shutdown since.

Since that time, our American politicians have shut down our government 18 times. This time, the stock market seems to be treating the shutdown like the boy who cried wolf. Investors have seen this show before and the markets haven’t dropped. In fact, it appears that the current debacle in D.C. has some convinced that QE “tapering” is even further off, and therefore, it’s “a great time to buy.”

As we have pointed out in previous blogs, one of the greatest assets, if not the greatest, we have in America is the fact that Treasury debt is the only risk-free asset in the world. It’s the backbone of the world’s financial system. China and others invest their money in Treasury bills. Today, the U.S. dollar is not even close to being unseated as the world’s primary reserve and trading currency. Can you imagine how the world would be viewing our mess in Washington if the worldwide currency was not U.S. dollars? We certainly wouldn’t be borrowing 10 year money to finance our deficits at 2.70%. We might be paying twice that rate and increasing our annual deficits commensurately.

We’re all hoping that an agreement is put in place by October 17th. If not, the government loses its borrowing authority and it can only pay out the cash it has on hand. By the end of the month, that would mean the U.S. could miss a bond payment, which would create a huge mess. The banks rely on treasuries to trade with each other overnight. If you take away trust in the financial system or U.S. debt, it would be, as Joe Nocera on NPR Saturday expressed, “cataclysmic”. In Mr. Nocera’s worst-case scenario: “The banks would freeze up. There will be no borrowing. It’ll be like Lehman. The stock market will go down. It has the potential to be a real disaster.”

Certainly, we all hope and expect that our government will pull us through this short-term mess once again in the next couple of weeks. However, at some point in time, people worldwide may stop trusting the dollar. At that point, it will lose its advantage as the world’s only risk-free currency. Then, America will be on the same slippery slope as many countries around the world are today.

Yes, wouldn’t it be nice to have a stern, bossy matron to “kick some butt” in D.C.? If she isn’t coming soon, perhaps, as NYT writer Thomas Friedman and the Rootstrikers group have suggested, we should push for a third major political party. Two days ago, a Gallup poll showed 60% of Americans, disgusted with Washington, would support this option. Let’s hope it happens, sooner rather than later.

DWM 3Q13 Market Commentary

Detterbeck_sample_for_title_page_(just_mountains)[1]It is hard to get excited about the near term outlook for financial markets given the negative news we constantly deal with. For example, the government is currently in shut down mode, we face another debt ceiling impasse in a few weeks, and the Fed has decided that the US economy isn’t strong enough for the Fed to taper bond buying yet. In the bizarro world of investing, traders actually like to hear “bad news” like that the economy isn’t that strong. Why? Because then the accommodative Fed policy can continue. And that is reason #1 behind the stock market rally since 2009 and why markets continued to be strong in 3Q13. Times will be a’changing when this artificial foot on the gas takes a break.

Almost all asset classes jumped in 3Q13. Equity markets, and not just the domestic ones, had big returns. The S&P500 was up 5.2% and diversified international stock funds were up 10.2%. Fixed income markets, after a disastrous 2Q13, bounced back nicely with the average taxable bond fund up 0.8% for the quarter. And the liquid alternative funds that we followed generally posted modest, yet solid returns.

To reiterate our view on investment management philosophy, we would like to point out a few things. First things first: it is not about which individual stock one holds. That is, its not whether you own Coke or Pepsi in your portfolio. If you want to play individual names, you certainly can, but we wouldn’t advise a big allocation to that. Why? Because it’s kind of like going to Vegas. Vegas is fun, but that’s gambling, not investing. DWM is about controlled investing. We don’t look to hit home runs. We look to preserve capital by protecting the downside and growing the portfolio in a controlled manner.

Empirical studies show that what it is all about is how much you have allocated to the different asset classes. That is, how much you have in stocks, bonds, and alternatives. Keep in mind that these asset classes all behave very differently.

  • Stocks historically offer the greatest rate of returns, but come with the most volatility. Furthermore, some market timers would tell you that stocks are “long in the tooth” right now given the amazing run they’ve been on since bottoming out in early 2009.
  • Fixed Income has historically been viewed as a “safe haven” and has provided 7-9% returns over the last 30 years. Yet that coincided with a steady declining interest rate environment that is most likely now over. Fixed income still provides a significant role in everyone’s portfolio as a diversifier and capital preservationalist, but expected returns going forward should be significantly lower than the high single-digit percentage rate that investors have become accustomed to.
  • Lastly, alternatives provide an additional asset class that can produce new sources of returns with lower correlation and reduced volatility. We expect volatility and returns to be somewhere between what you would expect of stocks and bonds, with an extra bonus emphasis on downside protection.

We all should be glad that these asset classes operate very differently as it provides the “smoothing effect” on the overall portfolio. Because of this, overall portfolio returns may lag what equity markets do in bullish times, but more importantly, they shouldn’t experience huge downside losses when times get rough. And without those big holes – like the 35-50% holes all-out equity investors found themselves in 2008 – it takes a much smaller time to dig out and hence geometric compounding can do its thing, leading to ultimately better long term results.

That said, we have enhanced our quarterly reports by breaking out asset class performance. Clients will see this near the end of their reports. We also are providing an Asset Allocation “soil chart” which shows the client’s asset allocation over time. We think this helps explains exactly how and why the overall “household” portfolio is performing the way it is.

Drop us a line if you have any questions on asset allocation or investment philosophy. Or even better; come to one of our upcoming seminars this month focusing on how to invest in a rising interest rate environment, followed by an hour of fun. In Charleston October 23rd, and Palatine October 30th. We hope to see you soon!

Brett M. Detterbeck, CFA, CFP®


What exactly is an Alt? Plus: Monthly Investment Spotlight: MFLDX

The case for alts
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I attended an Alternatives Investment Symposium last week in downtown Chicago where some great information was shared. The topic “what exactly is an alternative” was discussed as the question comes up quite a bit from clients and prospects of advisors.

There really is no one true definition, but most experts agree on four key elements:

  • An alternative can mean an alternative asset class – Alternatives can simply be anything that is not considered a traditional asset class like stocks, bonds, or cash. Interestingly, an alternative today may not be an alternative 10 years from now, the same way emerging markets used to be considered an alternative but are a mainstream traditional today.
  • An alternative can mean an alternative investment strategy – Alternatives can be something where you are using a traditional asset class but in an alternative investment strategy. For example, a long/short equity fund utilizes stocks but it is alternative in its investment strategy approach, i.e. it can go short.
  • An alternative is alternative because it is generally non-correlated to the traditional markets – In other words, alts zig when the rest of your portfolio zags. Why is this such a good thing? Because by complementing your traditional asset classes with alternatives, your portfolio will have a tighter range of return outcomes (aka “ a smoothing effect”) which translates into smaller downsides. Smaller downsides mean better geometric compounding, and hence better long-term returns. Investor psychology studies and personal experience remind us that not everyone is a fan of non-correlation when stocks are roaring, but the fact is one cannot count on 20%+ stock returns year in and year out. Not to mention that the 30yr+ bond bull market is over. One must look elsewhere for proper diversification, real positive returns, and protection of the portfolio.
  • One needs at least 15% in alternatives to really make a difference – For those that understand the Efficient Frontier, this is what you need to move your portfolio up and to the left! To enhance the risk-adjusted profile of your portfolio, you want at least 15% in alternatives to complement the traditional part of your portfolio.
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Now on to this month’s focus: Mainstay Marketfield Long/Short Fund (symbol: MFLDX). A long/short equity investing strategy takes long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short strategy seeks to minimize market exposure – we finance industry folk like to say reduce beta – while profiting from the stock gains in long positions and the price declines in the short positions. A similar strategy is a market-neutral strategy where the dollar amounts of the long and short positions are equal. In this case, market beta would be zero. One doesn’t care which direction the market is headed as long as the stock picking / manager ability is going the right direction. And for MFLDX, it sure has. It’s been in the top 3% of all long/short equity funds for the last five years. The fund is up over 11% per annum vs the S&P500’s 10% per annum total return in the last 5 years while taking on about ½ the risk (0.57 beta).

Like most long/short managers, the beta moves from 0.3 to 0.8 depending upon their outlook, so there almost always is a net long bias. That said, it can offer equity market participation with some downside protection. MFLDX is a great example of an alternative investment strategy that utilizes traditional investment vehicles. 

In the past two years, more than 150 alternative mutual funds have been launched, up from a little more than 100 between 2008 and 2010. $25 billion has flowed into these funds in 2013 alone. You’ll be hearing more and more about these as this area just gets more popular. It’s our job to help filter through the noise and find the good ones. We will continue to keep you informed through communications such as these.