the research puzzle

the research puzzle http://researchpuzzle.com a blog by tom brakke Sat, 28 Jan 2012 15:22:47 +0000 http://wordpress.org/?v=3.3.1 en http://wordpress.org/?v=3.3.1 an independent review http://researchpuzzle.com/blog/2012/01/24/an-independent-review/ http://researchpuzzle.com/blog/2012/01/24/an-independent-review/#comments Tue, 24 Jan 2012 13:27:17 +0000 tom brakke http://researchpuzzle.com/blog/?p=2077 research puzzle stressed the importance of hearing (and truly considering) alternative points of view before making an investment decision.[1] This one proceeds on to examine how investment organizations (and buyers of investment services) can benefit from having an independent review of their processes.

Reviews by outsiders come into play in a variety of ways. Sometimes their use is enforced, as when independent monitors or consultants are required as a part of a regulatory action,[2] but those are unusual cases. Certain kinds of external reviews (such as third-party valuations, assessments of trading costs, and specialized performance attribution services) are common in the business, but those of investment process are relatively rare.

Organizations that are subject to due diligence reviews as a part of selling their services tend to see that as the ultimate check of what they are doing. But while some of that due diligence is in-depth and insightful, much is merely check-the-box and perfunctory. Plus, the outcome of the review is not intended to improve the process, just to make a decision about it. Something more is needed.

Granted, the culture at some organizations leads to regular examinations of the "how" as well as the "what." But that's unusual. Too often a strategy session that's supposed to be about process ends up with a discussion about pressing investment decisions. It is very hard to step away from them long enough to take a thorough look at how decisions are made. It's not what investment professionals are good at or interested in, so it doesn't happen often.

And the same is true for those who are charged with making decisions about investment managers and other service providers. Sometimes it's because there is a choke point of information. The classic example involves the members of the boards of mutual funds. While they are supposed to be independent of the asset managers that they use (and, in fact, should be making judgments about them), the information that they are given comes from the asset managers themselves. Instead, their primary inputs ought to be analyses from independent sources with unfettered access.

A very destructive tendency is the inclination to make decisions based upon the actions of a peer group. I recently had an exchange with the officer of a foundation who is involved in a major review of its approach. As I told him, "the biggest problem is that they [such reviews] often become an exercise in benchmarking." While it's important to have some idea of what others are doing, the findings become behavioral anchors that impede real progress. (If you are interested in issues faced by those who buy investment services, check out The Prudent Fiduciary Digest.[3]) An independent review must take an expansive look forward, not a restrictive look backward.

For thoughts about how asset managers can also benefit from such a review, check out the latest piece by Mariko Gordon of Daruma Asset Management.[4] As she indicated, "when you're in the trenches, it can be hard to shift perspective and see the bigger picture." So Daruma had someone to do a review and found much of value. The money quote: "Disinterested parties bring a detached perspective that is impossible to come by in-house."

While I've never called myself an "investment process auditor" (the description used by Gordon) and often am involved in a more comprehensive look at an organization, this is the core of what I do for a living. So, let it be clear that I'm talking my own book when I say that research firms, asset managers, institutional investors, RIA firms, and other entities need to regularly examine how they do what they do. It helps to have someone there with fresh eyes to see things that you may not.

If you don't want to hire me, hire Dan (who helped Daruma) or someone else who can take an objective look at what you are doing. You'll find pieces that have drifted out of place. And you'll be become better prepared for the next due diligence review that you have, the next presentation of your ideas, the next market spasm that puts your process under stress, and the next twist of the investment world.

[1] the research puzzle : The title was "point counterpoint.": http://researchpuzzle.com/blog/2012/01/19/point-counterpoint/
[2] the research puzzle : The Global Research Analyst Settlement had both; here's a PDF of my series on it.: http://researchpuzzle.com/files/view/settlement-series.pdf
[3] tjb research : The first issue of the free newsletter will be published soon; you may sign up via this link.: http://tjbresearch.com/prudent-fiduciary-digest/sign-up-form.html
[4] On Daruma's Watch : Gordon's newsletters are always entertaining and informative.: http://www.darumanyc.com/newsletter/Daruma_2012_01.html]]> point counterpoint http://researchpuzzle.com/blog/2012/01/19/point-counterpoint/ http://researchpuzzle.com/blog/2012/01/19/point-counterpoint/#comments Thu, 19 Jan 2012 13:16:17 +0000 tom brakke http://researchpuzzle.com/blog/?p=2061
The implementation of that idea would involve significant financial sacrifice, as institutions and individuals would be required to make hard choices to meet the new, more conservative plans. It's the right thing to do, but it would be painful. Conversely, there are many improvements to investment decision making that don't involve that kind of trauma. All that's needed is the will to do things better.

That's the case with the need to hear both sides of a story before making an informed decision. "Well, well," you might say, "We always do that." I beg to differ.

I've seen many different parts of the investment business in my time and it's a business of advocacy, not of balance. From the street corner advisor to the master of the universe, the purveyor of investment ideas does not give the other side of the story unless pressed (sometimes hard). It's just not in their DNA.

Therefore, the buyers of investment products need to seek out those other opinions aggressively and to eliminate the structural impediments to good decision making. Largely it's a matter of design and leadership. You can tell right away the nature of the decision processes at an organization by simple observation of how information is arrayed for consideration and what is left out. Often there is no standard way of evaluating ideas in an evenhanded fashion and the whims of the person in charge dictate the flow of information.

A simple but very productive alternative can be summed up in two words: point counterpoint. What if the decisions you were involved in systematically included an advocate and that famous character, the devil's advocate, appointed to forcefully and effectively argue the other side of the question?

Implementing such interactions in the decision process is not hard, it just requires a bit of structure and management commitment. There are well-known hedge funds that have adopted similar approaches, inviting an analyst with a bullish scenario to debate one that is bearish.[2] Such approaches are much less common than you might think and the natural in-house contrarians at firms are often ostracized rather than effectively used to explore the range of possibilities.

In another realm, consider a member of an investment committee at a pension plan or foundation. When ideas are presented to that person -- new asset class exposures, new investment vehicles, new managers to hire -- they usually come with recommendations from the consultant and the staff members. What are the weaknesses and alternatives? Is the range of possibilities really explored? Is the idea presented fully and fairly in a way that will lead to a truly informed decision? Most often not. The committee ends up being a rubber stamp a very high percentage of the time because the decision process is structured in a way that ensures it.

There are simple ways to offset those tendencies, but everything starts with a willingness and an inclination to seek out differing points of view. I was struck by a tweet the other day from one voice in cyberspace to another, "You are a great counterpoint to my oft bearish instincts. What are your thoughts on China GDP numbers?"[3] There is a seeker, unafraid to admit that his own perspective is narrow and looking for other insight wherever it might be found.

That is the essence of good decision making.

[1] the research puzzle : For new readers, these arrows in postings are used to provide additional information about linked material.: http://researchpuzzle.com/blog/2012/01/03/the-haircut/
[2] Kynikos Associates : Jim Chanos, for example, arranges meetings with Street analysts that have buy recommendations on his short positions in order to see what his firm might have missed.: https://www.kynikos.com/KYNIKOS/WEB/me.get?web.home&SSLREDIRECT=a614bc088d2487855e05e0561cc9f43b3f9ef4d1deda4a56884f8b6f
[3] Twitter : The author, @hedgefundinvest, is an anonymous professional investor.: https://twitter.com/#!/hedgefundinvest/statuses/159317293497724929]]> the haircut http://researchpuzzle.com/blog/2012/01/03/the-haircut/ http://researchpuzzle.com/blog/2012/01/03/the-haircut/#comments Tue, 03 Jan 2012 15:09:35 +0000 tom brakke http://researchpuzzle.com/blog/?p=2039
They are all simple. Not simple to implement, but simple in concept. Yet they are practical, not theoretical.

The first I'll call "the haircut." I speak not of a haircut on the stated value of a security for margin purposes, capital requirements, or the like, but rather of a haircut of expectations that should be a part of investment planning (and almost never is).

While it's a bit of a fool's game to predict asset class returns, it is necessary to have some baseline values as a framework for planning -- and in some situations (as with pension plans) there is a requirement to put a stake in the ground with a specific expected return. It's most common to look to historical returns (like "the famous nine percent"[1]), when it makes more sense to take a probabilistic approach that incorporates the fundamental building blocks of future return, most importantly the current valuation of each asset class. With either approach, when you come up with a number, that's when the haircut needs to be applied, and it shouldn't be just a modest trim.

Planning should build in a margin of safety -- a big margin at that. Not a few tenths of a percent off of the estimate of future returns, but several percentage points. Yet as I look around, I don't see that being done.

Take pension plans. Corporate and government plans consistently have used expected return projections that are too high. In most cases, I'd argue that they have been too high even if the goal is to predict the most likely return profile, but that shouldn't be the goal. The goal should be to minimize the likelihood of substantial shortfalls, which arrive at just the moment when they are hardest to remedy. The same goes for foundations and endowments.

And individuals. A financial plan that is based upon return assumption that are too aggressive is inherently risky; the normal functioning of financial markets means that the assets in the plan could be under pressure just as the vagaries of life make themselves known. Without a sizable haircut, historical returns clearly qualify as "too aggressive" when making plans.

So, why do organizations and individuals keep adopting these ill-advised forecasts? Because it hurts to do the right thing. Lower projected pension plan returns mean benefit cuts for workers, more contributions from them, or higher taxes for government plans and lower earnings for the companies that have plans. Charitable organizations would have to scale back their operations to adopt a more conservative approach. Individuals would have to save more or spend less to meet their goals.

The other reason for the status quo is that there are enablers who bless the projections. Pension consultants and other experts christen some level of return as reasonable, based upon modern financial market history (which itself is too limited in time to provide an accurate framework for estimation), and don't adjust it to reflect the skewed risks from a poor forecast. Financial planners may do a Monte Carlo simulation when preparing their advice, but most plans still use return projections that are much too optimistic.

Conversely, what's the worst that can happen if modest assumptions are used? In situations where shortfalls develop, by definition they would always be less onerous than those under the standard way of operating. And greater-than-expected results would deliver a flexibility that would allow future goals to be met even more easily. (That is, if the decision makers resist the age-old temptation to increase return forecasts just because recent results have been good.)

It's important to note that this is not a prediction about anything. I have written about how the realities of "bond math"[2] in the current environment make many fixed income return projections wildly out of line, but it could very well be that other assets could pick up the slack. This is, instead, a finger pointed at a practice in the industry that has done great damage. It's time to call it a mess and take the scissors to it.

[1] the research puzzle : This piece is from that famous fall of 2008.: http://researchpuzzle.com/blog/2008/10/29/the-famous-nine-percent/
[2] the research puzzle : From a series I wrote on investment styles.: http://researchpuzzle.com/blog/2011/08/29/bond-math/]]> seeing the trades http://researchpuzzle.com/blog/2011/12/28/seeing-the-trades/ http://researchpuzzle.com/blog/2011/12/28/seeing-the-trades/#comments Wed, 28 Dec 2011 13:38:54 +0000 tom brakke http://researchpuzzle.com/blog/?p=1921
Those questions propel the great wheels of analytical machinery that spit out recommendations on what to buy and what to avoid in the world of investments. It can seem as if those who work on that machinery are like Charlie Chaplin in Modern Times, tightening the bolts on the gears one moment and being swallowed by the machine the next.[1] The answers get spit out until the world changes, the line is retooled, and things start all over again.

Some of us are ill-suited for an industrial approach to analytical work, which is why I've been writing pieces on "investment states and styles,"[2] looking for ways to add value by redefining the process and/or the categories. While I'll do similar postings going forward, this one marks the end of that particular series.

A few years ago, I helped an acquaintance who worked as an expert witness on a model of damages for a large pension fund. The analysis was done in response to the revelation of corporate malfeasance at one of the firms in which the fund had invested. Among the fund's outside managers were quite a number that had been active in the stock. To prepare the model, the expert witness had access to the transaction records from the fund's custodial bank, and I was hired to help him make sense of them.

We went through the managers one by one, looking at the trades -- when the stock was bought and when it was sold. It was an interesting exercise, in that the stock was owned by a variety of different kinds of managers. The nature and the timing of the decisions told a story of each manager, as did the execution of the trade orders, which ranged from from small lots being parceled out algorithmically to huge block trades being worked by Wall Street desks.

Think about that level of detail. Having it, you can get an incredible view of a manager's evolving exposures and can see exactly when adjustments are made. Lacking it, you are forced to try to fill in blank after blank. It might not be the key to the kingdom, but possessing transaction information fundamentally changes the nature of due diligence.

While there are products that provide that kind of transparency (old-fashioned wrap-fee accounts and their cousins the"clones" among them), it is certainly not the norm to have access to that information, unless you are an institutional investor using separate accounts. Even in that case, the trail of analytical bread crumbs that is available is often not inspected to any great degree.

That's a pity. The chicanery ("window dressing" and "painting the tape"[3]) common for some managers at the close of each year comes into plain view. More importantly, actions that illuminate (or belie) a stated investment policy are visible too, providing the raw material for the kind of due diligence questions that should make up the bulk of interactions with managers. There are no better "how" questions than ones that arise from observable actions (even minor ones) of a manager at a specific market moment. They can't be found in the performance numbers and statistics and exposures cited in investment manager review books, although they make those numbers come alive.

Look where others don't look. Examine every detail that you can. Follow the trades where they lead you.

[1] Doctor Macro : Here's a classic movie still of the scene.: http://www.doctormacro.com/Images/Chaplin,%20Charlie/Annex/Annex%20-%20Chaplin,%20Charlie%20(Modern%20Times)_01.jpg
[2] the research puzzle : Here's the whole series.: http://researchpuzzle.com/files/view/states-and-styles.pdf
[3] Wall Street Journal : See this recent Jason Zweig piece for a primer such "performance art.": http://online.wsj.com/article/SB10001424052970203686204577116352886527644.html]]> one tremendous tell http://researchpuzzle.com/blog/2011/12/05/one-tremendous-tell/ http://researchpuzzle.com/blog/2011/12/05/one-tremendous-tell/#comments Mon, 05 Dec 2011 22:45:42 +0000 tom brakke http://researchpuzzle.com/blog/?p=2000
Anyone can look at past performance. The more quantitative among us can also debate the evidence displayed by a variety of statistical measures, thinking that we'll find a key to unlock the code as to which managers are good and which are not. All of that has worth in the analytical process, but it's also all backward-looking, and is almost always given too much weight by decision makers. It is in the interplay between the quantitative measures (easy to get and generally cheap) and the qualitative aspects of due diligence (unfortunately, time-consuming and expensive) that the real insights are found.

As previous postings have indicated, often you are trying to look beyond entrenched categorization schemes[2] to see things that others don't, but that's not always the case. Take, for example, the financials. If you are evaluating equity managers right now, that sector is a tremendous "tell" as to how a manager operates.

You start with a treasure trove of historical information. Look at a manager's last seven years of investment in the sector. How did the overall exposure to the sector vary? What kinds of companies were in the portfolio? Which risks were taken and which risks were avoided? Is there evidence that the manager's style as executed matched the style as promoted? How did the approach to the financials change across that tumultuous period?

A simple overlay of the percentage of the S&P 500 represented by financials over time[3] versus that of the manager's portfolio should give some clues. Which one leads the other? How big is the divergence at any point in time? The sub-sector and security weights will also help you to see how active a manager really is and what circumstances trigger trades.

I could go on with the questions. The purpose of them is to gain an understanding of how a manager thinks and operates. That will tell you more about what will happen in a variety of environments going forward than any of the quantitative measures, although the migratory paths of the various statistics give lots of hints how manager behavior has evolved in the past and how it might in the future.

Obviously, a manager's answers to your questions must be judged in terms of his or her stated goals. Those whose processes chiefly rely on technical or quantitative analysis have different considerations than those with fundamental approaches, and every equity style category (growth, value, momentum, sector rotation, etc.) has its own traps. With that in mind, what happened and why?

But enough looking backward. The reason for focusing on the financials is not just because of their checkered past but because they present unique issues going forward, especially (but not exclusively) the banks. So, if you are looking at a quantitative manager, how have the algorithms been adjusted over time? What triggers exposures now?

For fundamental managers, you should look at how resources have been altered. Sectors that have done poorly often have had changes in personnel and staffing levels may have been cut (along with outside research services that specialize in the area). The performance patterns you could see might be different simply due to structural choices at the management firm.

One thing to watch out for is poorly-informed bravado, since sweeping generalizations about future prospects and intrinsic value are often made despite a distinct lack of critical information given the lack of transparency at many financial firms. The bottom line is that how an investment manager approaches what is known versus what is unknown regarding the financials is an incredible indicator right now. Putting them through the ringer by way of pointed questions about the sector will give you more of what you need to know about them than almost anything else you could do.

[1] the research puzzle : This PDF updates with links and descriptions as each posting is completed.: http://researchpuzzle.com/files/view/states-and-styles.pdf
[2] the research puzzle : I have written on this topic before, including one look at "where we draw the lines.": http://researchpuzzle.com/blog/2008/10/13/where-we-draw-the-lines/
[3] Bespoke Investment Group : Bespoke periodically publishes this look at sector weights -- check out the change in the financials.: http://www.bespokeinvest.com/thinkbig/2011/10/18/sp-500-sector-weightings-wither-financials.html]]> stardust http://researchpuzzle.com/blog/2011/11/09/stardust/ http://researchpuzzle.com/blog/2011/11/09/stardust/#comments Wed, 09 Nov 2011 14:54:28 +0000 tom brakke http://researchpuzzle.com/blog/?p=1951
stars

In fact, I have in front of me a single page (standard magazine size) that has no less than five hundred six of the things, arrayed for the purpose of dazzling the viewer into thinking that if there's that many stars in their firmament, one particular firm must surely approximate investment heaven.

The stars are, of course, awarded by Morningstar. Taking a break from an ongoing series on investment styles,[1] it's time to think about a classic case of ratings turning into something they are not meant to be.

The Morningstar system is one of the great marketing constructs of all time. But what do those five-pointed symbols mean?

They are, by definition, a look backward at the performance of a mutual fund.[2] The ad with all the stars -- like all such ads -- includes a statement that, "Past performance is no guarantee of future returns." The lawyers make them say that, but the firms that buy the ads intend for you to think the opposite.

The funds and their managers that reach the pinnacle are five-star generals, of a sort, having earned the awards from previous market campaigns that may or may not say anything about their ability to wage battle under the changing conditions of investment warfare. Whether you think the Morningstar ratings matter or not, matter they do. And those stars are but one aspect of this market truth: Because of the expense and difficulty of good due diligence, there is a chain of reliance that leads to smart, sophisticated people depending on the evaluations of others. Yet, I'm often surprised how little the users know about what the raters do and how they do it.

The proximate cause of these musings is the upcoming roll-out of the Morningstar Analyst Rating for funds.[3] The firm intends to provide ratings that look forward, with a new system that represents analyses based upon five Ps: people, process, parent, price, and performance. Whether it is successful in identifying the best funds prospectively, it is notable that it would even attempt to do so given the power of its star ratings in the marketplace.

I expected the new system to have spawned many more articles about what its introduction means. Millions of dollars are spent by mutual fund firms to deliver stars to your eyes -- what will be the effect of a bold initiative that reminds us of the fact that the existing system looks backward, reinforcing the tendency of investors to chase and thereby to lose? And what of investor allocations to funds that have followed the the addition and subtraction of stars?[4] Will they start to follow the analyst ratings instead? Or will it be business as usual?

The stars are most powerful retail investment ratings scheme extant, and Morningstar is in effect competing against its own dominance by introducing the analyst ratings. Perhaps it got tired of seeing firms use the stars in ways that end up harming the investors that are charmed by them.

Morningstar has its work cut out for it with this new endeavor, but the firm should be admired for trying to change a game that it controls. I'm sure that fund companies will still sprinkle stardust around indiscriminately, but maybe advisors and investors will see that it's more sawdust than anything else.

[1] the research puzzle : This PDF updates that series as it progresses.: http://researchpuzzle.com/files/view/states-and-styles.pdf
[2] Morningstar also uses stars for other vehicles, some of which do not involve past performance. Its ratings of individual stocks, for example, are based upon the relationship of market price to the firm's estimate of intrinsic value, as adjusted by other factors.
[3] Morningstar : Here is an explanation from the firm; take a look at the comments as well.: http://news.morningstar.com/articlenet/article.aspx?id=439233
[4] SSRN : Here's an example of the research that's been done on this topic.: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=286157]]> a very delicious direction http://researchpuzzle.com/blog/2011/10/31/a-very-delicious-direction/ http://researchpuzzle.com/blog/2011/10/31/a-very-delicious-direction/#comments Mon, 31 Oct 2011 14:10:52 +0000 tom brakke http://researchpuzzle.com/blog/?p=1940 Pensions & Investments focused on the changing strategies of institutional investors in response to the low-yield environment of today. That brutal reality was the subject of an earlier chapter ("bond math") of my ongoing series on investment styles,[1] which now proceeds with a look at one of the most important aspects of due diligence, style analysis, and manager selection.

And that is the extent to which the prevailing environment -- what has worked and what hasn't worked -- alters the actions of investment managers, those that choose them, and the process itself. The title for this posting comes from a quote in that P&I article; John T. O'Shea of J.P. Morgan remarked how the three-decade drop in yields drove returns in "a very delicious direction."

As investment trends go, that's an extremely long one. When it finally reverses, the ripple effects will last for years, because there is little appreciation for the extent to which investor behavior has been distorted by the length and magnitude of the move in interest rates.

But there are other "very delicious directions" of lesser renown and shorter duration that alter the actions of investment decision makers. They come and go, attracting attention and money until disappointment sets in. The well-documented phenomenon of chasing performance affects individual investors, professional investment managers, and those fiduciaries who are charged with selecting managers. By the time many jump on "the next bandwagon,"[2] it has become the last bandwagon.

It is easy to lose sight of the impermanence of the factors that generate the numbers that captivate us; our evaluations get sloppy in the face of attractive returns. How we describe and analyze an investment style can morph and be molded in ways we don't realize until there's a reversal of fortune.

When I was an independent consultant on the Global Research Analyst Settlement,[3] the first three years were a period of market quiescence. The last two were anything but. As a result, the patterns of research performance changed dramatically. Looking at a narrow measure of performance to determine who was "good" and who wasn't would have guided you in precisely the wrong way when it mattered most.

It seems to me that (in addition to the aforementioned fixed income elephant in the room) one area that needs a great deal of scrutiny right now is the effect of currency movements on results for U.S.-based investors. Many who buy individual stocks, for example, could not explain the economic or accounting impact of a sustained move higher for the dollar on the companies that they own. Investment managers who have generated good numbers relative to their benchmarks by using foreign securities talk about greater opportunities in those other lands, but are less forthcoming about the extent to which the performance comes from currency effects -- and downplay its importance when talking about their strategies. Likewise, returns attributable to holdings in gold and other commodities should be considered in light of the way in which they move relative to exchange rates.

I recently received a note from a hedge fund manager saying that if he were hiring now, he'd look for someone who managed to make a lot of money investing in no-growth Japan over the last two decades. Why? He said, "We don’t know how to trade/invest when there are not big winds at our back or in our face."

Of course, we expect investment managers to generate performance as they can. It's just that we need to remember that we aren't very good about figuring out whether it's "wind-aided" and never to be repeated again.

[1] the research puzzle : This PDF will update with a link and description for each posting through the end of the series.: http://researchpuzzle.com/files/view/states-and-styles.pdf
[2] the research puzzle : This piece, from that fateful fall of 2008, includes an image of the life cycle of an idea and the "stuff" on the line.: http://researchpuzzle.com/blog/2008/10/02/the-next-bandwagon/
[3] the research puzzle : Here's a series of nine postings I did about the settlement after its end.: http://researchpuzzle.com/files/view/settlement-series.pdf]]> degrees of difficulty http://researchpuzzle.com/blog/2011/10/10/degrees-of-difficulty/ http://researchpuzzle.com/blog/2011/10/10/degrees-of-difficulty/#comments Mon, 10 Oct 2011 12:22:55 +0000 tom brakke http://researchpuzzle.com/blog/?p=1919 the research puzzle is intended to give those who make investment decisions (fiduciaries, gatekeepers, advisors, individuals) some different ways of thinking about the choices that they make.

This edition involves complexity and how it is assessed. If sports like gymnastics and diving are judged on the basis of the difficulty of the maneuver that is being attempted, should we be doing the same with investing? How would we do that?

Or let's take climbing. While the cliff line at Blue Mounds State Park[2] is only a hundred feet or so high, I can get to the top of it the easy way or the hard way. How should you judge my performance? How about if I climbed El Capitan with no ropes or crampons?

These thoughts come to mind in response to a piece in the Wall Street Journal by Ben Levisohn about Jeffrey Gundlach and DoubleLine.[3] (Today's research puzzle pix also concerns Gundlach and his fund operation, so check that out for a chart and additional commentary.[4]) Levisohn's article says that Gundlach "has built an intermediate-bond fund that is far from typical."

That he has and, as someone who applauds managers who take active risks rather than hugging benchmarks, I have no problem with that. But the complexity of the DoubleLine funds is beyond the ken of most investors. As the article says, Gundlach's strategies make it "difficult for run-of-the-mill financial professionals, let alone retail investors, to understand what he is doing and how the portfolio will react under different scenarios." I'd take it even farther: There's a large swath of very sophisticated investors who don't understand much of it either.

So, what is an investor to do? Of course, not to take performance at face value and extrapolate it forward. I was quoted in Levisohn's story on a couple of relevant points. First, Gundlach has had the luxury of picking and choosing tranches of mortgage securities that may not be available as DoubleLine's assets under management grow. By chance, I had quoted Gundlach himself last year about how "size matters."[5] The topic was also referenced on his August conference call, when he talked about the counterparty risk taken on by large bond funds that do swaps because they can't find cash bonds in the size they need.

Second, the practice of buying on the basis of stated yields, so prevalent in the industry, is particularly questionable when a fund is growing rapidly or when it is using intricate mortgage strategies, both of which apply to DoubleLine.

This is a particularly interesting case study in so many ways. There is a huge amount of key-person risk at DoubleLine. Gundlach has proven to be a brilliant investor, but the proverbial bus doesn't make exceptions on that basis. Plus, if you've followed his career you might assert that there are risks that accrue by virtue of his personality.

Unfortunately, fund filings are infrequent or you could dig into the holdings to see how the exposures are changing. So the best way to invest with DoubleLine would be via a separate account where you could see what was happening in something close to real time. Even then, though, it's a situation where very few would be trained to do the proper due diligence and it would take an incredible amount of effort.

Maybe, given all of that, DoubleLine should just go into the "too hard" pile. Not necessarily, but its products should definitely be sized carefully in an allocation scheme. You don't want to put too many of your eggs in one basket if you can't really understand what's going on, even if you admire the manager.

Investing is not a sport where the degree of difficulty is factored into the scoring system. Therefore, you need to take it into account yourself as best you can when making choices, even ones that seem attractive on the surface.

[1] the research puzzle : This PDF link will show the series as it evolves.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/states-and-styles.pdf
[2] Minnesota DNR : The park is in extreme southwestern Minnesota.: http://www.dnr.state.mn.us/state_parks/blue_mounds/index.html
[3] Wall Street Journal : The article appeared on October 5.: http://online.wsj.com/article/SB10001424052970204422404576596733531835492.html?mod=ITP_thejournalreport_1#articleTabs%3Darticle
[4] research puzzle pix : The topics covered in pix go from individual securities to asset classes and economics, and include looks at funds of all types (mutual, exchange-traded, closed-end, and hedge).: http://rp-pix.com/hd
[5] the research puzzle : For asset managers, size can make things easier or harder, as the posting's simple graphic illustrates.: http://researchpuzzle.com/blog/2010/11/03/size-matters/]]> broken charts http://researchpuzzle.com/blog/2011/09/27/broken-charts/ http://researchpuzzle.com/blog/2011/09/27/broken-charts/#comments Tue, 27 Sep 2011 10:03:56 +0000 tom brakke http://researchpuzzle.com/blog/?p=1905
What to do in response to that broken chart in front of you? Well, there are sites galore that will give you advice on that. If you've read the research puzzle before, you know you won't get it here. Instead, we'll turn the tables and say that what you do with that broken chart will speak volumes as to what your real investment style is.

Thus, the timing of the recent brokenness is propitious, in that there's a series in progress on this blog regarding indicators of investment style that are outside of the normal ones that you read about.[1] This posting can be boiled down to a question to ask of investment managers (regarding a current holding), "What do you do when faced with a broken chart?"

Those with strict price momentum disciplines should say that they get out. More importantly, if you track their trades, they should demonstrate that they do just that. The same goes for most technical traders, even if they don't apply the momentum moniker to what they do. If that's not the case, then you have the workings of an important due diligence angle.

It is, however, the actions of fundamental investors in response to price breaks that are the most interesting.

There are some who profess a sales discipline that amounts to selling when a chart breaks. I recall one former investment manager who came to a finance class I was teaching with a list of rules that his firm always followed in managing stock portfolios. One of them was that if something went down 15% after purchase, it was sold. Period. (I often have wondered how that actually worked out in practice.)

Usually, fundamentalists resist that approach -- and buy aggressively if they think that the thesis is still intact and they have cash on hand. That results in famous stories like those about managers who stepped up during the crash of 1987 to buy good companies at very cheap prices.

Unfortunately, there are lots of examples on the other side of the ledger. The dot-com crash provided a host of them, as some managers kept buying the stocks as they went lower and lower. It happened during the same time frame with lots of big cap names, many of which subsequently fit the description of "yes, the thesis was still intact but we didn't realize that the ridiculously high valuations could revert to more normal levels."

And then there were a few calamitous examples of big-name asset management firms who didn't see Enron for what it was and bought it all the way down. Their reputations -- and those of analysts who liked the company -- were damaged greatly as a result. Conversely, those who avoided the mess thrived, including fundamental analysts who figured out the ruse, momentum traders who sold the broken chart, and quantitative research firms and portfolio shops whose factor models essentially said, "price declines + cash flow issues = trouble." (For some of those quant research outfits, that one action provided years of marketing advantage versus their fundamental brethren.)

What is surprising to some is how important the technical picture is to many investment managers that are thought of as fundamental players. I listened to a conference call the other day where the fact that "the chart looked like death," to use the manager's description, clearly affected his unwillingness to even look at the investment in question.

Broken charts are fodder for some very fruitful due diligence investigations. What do managers say they'll do in response to one? Will there be an automatic action? Will there be a more intense look at the investment, with new sources of information and an examination of theses contrary to theirs? Or will there be reflexive buying?

Then, what do they actually do in comparison to what they said they'd do?

If you want a way to classify managers that gets at what differentiates one from another, you could do worse than starting with those questions and the subsequent evidence found on a trail of broken charts.

[1] the research puzzle : This PDF will be updated through the end of the series as each new posting is written.: http://researchpuzzle.com/files/view/states-and-styles.pdf]]> algo city http://researchpuzzle.com/blog/2011/09/20/algo-city/ http://researchpuzzle.com/blog/2011/09/20/algo-city/#comments Tue, 20 Sep 2011 11:05:52 +0000 tom brakke http://researchpuzzle.com/blog/?p=1880
So, as part of a sideways look at investment styles,[1] it makes sense to think a bit about the spread of the algorithmic culture.

If a simple definition of an algorithm is "a set of rules for solving a problem," then we can see that they are at the very heart of investment process, whether it's found in computer code or the brain of a sixty-year-old investor that's been building that set of rules his whole career. But increasingly it's the former, taking a bigger and bigger share of the duties from the latter. And all the major firms are happy to help you make the transition (witness, "Where to go when you need an algo"[2]).

There has been a lot of attention paid to high-frequency trading (HFT), its effects on markets, and whether the game has gotten out of hand. We'll leave that for another day and focus on algo penetration into more traditional parts of the business.

The first stop is in the trading realm, where a very high percentage of trades occur via some type of algorithm. HFT accounts for much of that activity, but also included are orders for asset management firms, for example. Instead of blocks worked by traders with their Wall Street counterparts, many orders are now parceled out by machine according to prescribed rules.

In portfolio management, there are purely quantitative approaches and purely qualitative approaches and everything in between. Ascertaining where a manager is on that continuum is very important. The patterns of returns and patterns of errors differ based upon the mix between qualitative and quantitative (and the processes that govern the integration of them).

Research can be automated as well, so knowing whether a firm is strictly quantitative or not can help you figure out how to use the research well -- on its own or in concert with other research. (A tip-off to quantitative research in the written form is the stilted wording; it's difficult to get the verbiage to sound natural, although you've probably read some research that was composed by a computer and not realized it.)

All of this brings up critical questions for due diligence (assuming you don't take the view that the proof is in the performance). How do you figure out where the human issues are and the algorithmic issues are (which, of course, are human issues too, committed to code)? It is harder to audit a machine, but as with auditing a qualitative investment process, it's all about picking up the pieces of the mosaic and figuring out where they go.

There will always be unknowns, but by understanding as best you can the overall decision structure, you can get an idea of how a firm is different from others -- and whether it has made the proper adjustments in light of changing market dynamics.

Among the outlier events to be worried about are so-called "runaway algos," although other problems can unfurl slowly over a long period of time, as happened with AXA Rosenberg.[3] And, you have to remember that the computers run in packs too. So "live by the algo, die by the algo" might be an appropriate motto. Whether through direct programming or via some artificial intelligence, the computers do what has worked, just like humans. Therefore, a previously-winning strategy can come unwound quickly. The quant fund bath of August 2007 is a good example of that.

We are all skipping our way to Algo City it seems. When we get there, we need to get a good look at the wizard behind the curtain, with his levers and his dials, and determine whether he knows what he's doing -- and whether the machine is doing what he wants it to do. That all requires taking a fresh look at the due diligence process, to make sure the the yellow brick road is all that it is promised to be.

[1] the research puzzle : This PDF will update with information about the series of postings on the topic.: http://researchpuzzle.com/files/view/states-and-styles.pdf
[2] Securities Technology Monitor : Interesting review; too bad it is in an annoying, unnecessary, click-seeking slideshow format.: http://www.securitiestechnologymonitor.com/photo_gallery/1_78/28931-1.html
[3] SEC : This is a summary of the charges and settlement related to the firm's computer error.: http://www.sec.gov/news/press/2011/2011-37.htm]]> a reasonable price http://researchpuzzle.com/blog/2011/09/07/a-reasonable-price/ http://researchpuzzle.com/blog/2011/09/07/a-reasonable-price/#comments Wed, 07 Sep 2011 12:12:44 +0000 tom brakke http://researchpuzzle.com/blog/?p=1806
But first, a question: Does one go looking for a GARP manager? When you read about searches for managers by institutional investors, you don't see ones for "a GARP manager," but rather for attributes related to market capitalization and definitions of growth/core/value. If GARP is an overarching philosophy that works, shouldn't we be seeking out those that can do it well? (That's a question that can apply to other strategies that don't fit the standard manager grid. Are they incorporated as we stumble upon them or is there a better way to build around them?)

GARP is one of those styles that spills across boundaries. It's billed as a way to combine the strengths of growth investing with those of value investing, with that phrase "a reasonable price" providing the hope that the manager won't fall in love with growth because she's watching out how much she pays for it. I've also seen the phrase applied in other ways, such as in "momentum at a reasonable price," which is an interesting concept to consider, although MARP sounds funny to me.

There are a couple of ways to differentiate GARP managers in addition to the capitalization bands in which they play. First is that notion of "reasonable price." What does it really mean in practice? Specifically, how does Manager A define it versus Managers B and C? And how do those definitions shape the security selection process and the sell discipline? What are the bounds of reasonableness? How do they adjust in different market valuation regimes? A careful examination of buys and sells and portfolio attribution should reveal critical differences among managers.

Most people equate GARP with the PEG ratio, so it's at this point that I direct you to one of my most popular postings of the past, which talked about how "unpegged" the slavish use of that valuation measure has become.[2]

That posting highlighted the sloppy growth rates used throughout the business that make PEG ratios and other growth-based metrics suspect. So, the critical skill for GARP managers is not really the "reasonable price" that found its way into today's title, but the ability to assess growth. Without that, you have "extrapolation at a reasonable price." (Yes, EARP.)

Therefore, due diligence on GARP managers can focus mostly on their processes for analyzing and predicting growth, and it takes relatively few questions to determine whether a manager is doing anything remotely interesting or unique in the estimation of growth rates. As with many other factors in investing, it's not so much the precise level of anticipated growth that matters, but the rate of change and, especially, signs of reversal of past trends in growth rates. Working off of consensus forecasts of growth is unlikely to lead to much if any analytical advantage.

Whether you are looking for a GARP manager or applying the principles of that approach yourself, the search for reasonableness should begin with growth, not price. While careful valuation is important, if you get the growth wrong with regularity, nothing else will matter.

[1] the research puzzle : This index will be updated as further postings are completed.: http://researchpuzzle.com/files/view/states-and-styles.pdf
[2] the research puzzle : This piece looks at the history of the PEG ratio and issues with how it's applied.: http://researchpuzzle.com/blog/2010/02/10/unpegged/]]> bond math http://researchpuzzle.com/blog/2011/08/29/bond-math/ http://researchpuzzle.com/blog/2011/08/29/bond-math/#comments Mon, 29 Aug 2011 12:14:23 +0000 tom brakke http://researchpuzzle.com/blog/?p=1858
At its most basic level, bond math is straightforward, showing what return will come your way under a set of assumptions. Take the current U.S. Treasury ten-year note and look at the total return that it can produce over the next three years, based upon the ending yield:

$bond-math$

Let's say you'd like to get returns like those of the last twenty-five years on similar bonds, namely in the neighborhood of 7.5% per year. Good luck. Even if yields fall to 0.1%, you'll get an annual return of less than 6.5% for those three years. By the way, do you think they'll fall to 0.1%?

This, of course, is an uncomfortable fact for corporate, union, and public pension plans, not to mention individuals looking at projections from their investment advisors and financial planners. Many have not lowered their expectations to reasonable levels given their default asset allocations and the relentless reality of bond math when market rates are low.

So, a key consideration when evaluating investment managers or their strategies is the likelihood of success in a given market environment. Sure, ten-year rates can go to 0.1%, but I dare say it's not a good bet. Similarly, when equities as a class are trading at valuations significantly higher than normal, they can go higher still, but based upon historical precedent and economic forces over any reasonable time horizon they tend to deliver returns below historical averages.

Given the market structure in place, does the strategy under review make sense and is it being implemented by the investment manager in a way that doesn't expose you to a set of risks that is different than you might expect?

In a time of low rates, is a manager venturing further out the yield curve or down in quality or into unfamiliar vehicles to try to deliver returns? At what point do you question the strategy and adjust your expectations, or do you just hope for the best?

Looking at it a different way, no matter the asset class, if the prospect of producing attractive returns is getting more unlikely, do you really expect the manager to call you up and say that you should consider withdrawing money? That would mean no management fee for the manager, so it rarely happens. Instead, there is a drifting along with the market waves, even when an abrupt change of course would be better.

Of course, benchmarks drift as well. All else being equal, the duration of a bond index goes up as rates drop and the valuation of a stock index goes up as prices climb. If you are using a benchmark as your guide, you are playing a relative game (and may lose situational awareness[2]).

While the title of this piece is "bond math," I use the phrase to represent a concept that applies more broadly: The natural constraints of an investment style or strategy can be too easily ignored. Your due diligence processes should involve looking for and thinking about those constraints at every turn and your selection of managers should be limited to those that admit that they exist.

Almost by definition, that excludes many who have had eye-popping performance for a time and have attracted attention and assets as a result. Seeing constraints didn't get them to the top of the charts and they aren't likely to change their ways. Avoiding such managers is a key to investment success.

[1] the research puzzle : Here's the previous posting, which opened the series.: http://researchpuzzle.com/blog/2011/08/04/of-states-and-styles/
[2] the research puzzle : That was the title of a previous posting on issues related to such relativity.: http://researchpuzzle.com/blog/2009/10/26/situational-awareness/]]> of states and styles http://researchpuzzle.com/blog/2011/08/04/of-states-and-styles/ http://researchpuzzle.com/blog/2011/08/04/of-states-and-styles/#comments Thu, 04 Aug 2011 12:09:58 +0000 tom brakke http://researchpuzzle.com/blog/?p=1831
But while our state of residence matters greatly -- especially regarding the taxes we pay versus others -- we often think of who we are and where we live in other ways. Enter the CommonCensus Map Project,[1] a crowd-sourced site that shows how people actually characterize the region or town or neighborhood where they reside. Here's a portion of one that shows how cities dominate areas without regard to state lines:

regional_map_adj

You can see how this concept could be extended into "states" of a different kind -- how cultural beliefs and shared traditions tend to cluster, even in our mobile society.[2] While aggregating information on the Internet wasn't possible back then, the seminal effort in this realm came thirty years ago, with the publication by Joel Garreau of The Nine Nations of North America.[3] Think, for example, about how he anticipated the emergence of Ecotopia (in a narrow slice of the Pacific Northwest) and MexAmerica (in the Southwest).

OK, so what does all of this have to do with investments? I have written before about "where we draw the lines"[4] and how drawing those lines can restrict flexibility in a way that hurts the decision making process (and results). Yet large swaths of the business operate as if the lines came from some investment god and were immutable, as if those state lines, to borrow the analogy, were the be all and end all.

But they aren't. So, how do we look at the "real" maps of investment style and process? How do we go beyond the simple descriptions to get a more nuanced view of how asset managers differ from one another? And, while we're at it, wouldn't it be nice if we could put those maps in motion, to observe the ebb and flow that occurs in response to market events and competitive pressures?

Unfortunately, crowd sourcing won't work in this case (although some hints can be gathered from surveys of one kind or another), so observation and inference will have to do. In future postings, I'll examine some of those territories. As my ideas unfold going forth, I will convey them in words -- don't expect me to get out the electronic colored pencils and draw a map of the investment world showing the conventional boundaries and the unconventional regions that cross them.

Those who choose investment managers need to understand where those managers "live" -- and not by using the equivalent of a 1960s-era globe in a classroom. Managers themselves, especially those who don't fit easily within the boundaries, must figure out how to communicate their location on the map (and how they move about it) while being aware of the geographical orthodoxy of the day.

Not quite a magical mystery tour, but we'll have some fun along the way.

[1] CommonCensus Map Project : It was created by Michael Baldwin.: http://www.commoncensus.org/index.php
[2] Check out the sports maps on the site, for example. (Although I know that there's one incredible concentration of Yankees fans in North Dakota that hasn't been captured on the MLB map.)
[3] The Garreau Group : Under "new stuff" you can see that Garreau is still applying the concepts.: http://www.garreau.com/main.cfm?action=book&id=3
[4] the research puzzle : One aspect to consider is how those lines are perpetuated in our analytical processes.: http://researchpuzzle.com/blog/2008/10/13/where-we-draw-the-lines/]]> fixing a hole http://researchpuzzle.com/blog/2011/07/25/fixing-a-hole/ http://researchpuzzle.com/blog/2011/07/25/fixing-a-hole/#comments Mon, 25 Jul 2011 20:14:28 +0000 tom brakke http://researchpuzzle.com/blog/?p=1820
I have a relative whose house was swallowed by a river and others who have battled to get their crops in the ground, so the little story I am about to tell is nothing in comparison to what they've been through. But a few days ago I got a call that some of that water was getting into our house during a nasty rainstorm.

The facts of it all are unimportant, but as I went from the site of the problem to the work bench to the garage, looking for tools and trying to craft a homemade remedy for the problem (while getting completely soaked), I had a couple of things running continually through my head: The Beatles' tune "Fixing a Hole" and the realization that I should have been better prepared for the situation. The tools I needed weren't as organized as they should have been and some of the makeshift fixes that I could have created required me getting at materials that were difficult to access when time was of the essence. Furthermore, I realized that had I ignored some clues that would have tipped me off that trouble was ahead.

It got me thinking, too, that as investors we sometimes act in a similar fashion. When the weather is fine, we enjoy it, and when it gets ugly, we get frantic. When it comes to investment process, the best time to fix the hole is before the rain gets in, to be constantly on the lookout for things that can go wrong, repairing those that can be mended in advance and preparing for a wide range of possibilities going forward, by being trained and ready (and having the tools where you can find them).

Those at investment firms face a variety of challenges in addition to those of decision making process itself. The "back office" and "middle office" of an organization have gotten increasingly complex and a failure in an important function can be devastating. Plus, the marketing of a firm's products may rely on a theme that is destined to fizzle out, yet the extent of the strategy in place is to ride it while it's hot.

The underpinnings of a firm's philosophy may appear rock solid, but be anything but. An excerpt in the Wilson Quarterly by Tony Rothman, a lecturer in physics at Princeton, provides an apt analogy. He said that the conceptual beauty and explanatory power of physics are compelling, but that over time "the hairline cracks in the edifice become more apparent, as do the dirt swept under the rug, the fudges, and the wholesale swindles . . .." For the most part, "the subject is presented as one of completeness, while the holes -- let us say abysses -- are planked over in order to camouflage the danger." So too the tenets of an investment strategy, especially when a big ticket is on the line.

Sometimes the weak spots that need to be fixed at a firm involve replacing key employees. Too often concerns about the poisonous effects of a person's behavior are papered over because of his or her investment acumen or marketing power -- until it's too late. Typically, when everything finally comes to a head, the hole that needs to be fixed is a sizable one indeed.

During the financial crisis, investors small and large -- and the leaders of investment firms -- felt like I did during that downpour, scrambling for solutions and regretting the lack of preparation. Hopefully we won't have a test like that again soon, but now's the time to take a fresh look at where the holes are likely to appear.]]> decades of work http://researchpuzzle.com/blog/2011/07/20/decades-of-work/ http://researchpuzzle.com/blog/2011/07/20/decades-of-work/#comments Wed, 20 Jul 2011 11:46:34 +0000 tom brakke http://researchpuzzle.com/blog/?p=1807
Should you want to get a crash course on the findings of those studies, a new working paper provides a wonderful survey. It was authored by Mark Bradshaw of Boston College and it's titled, "Analysts' Forecasts: What Do We Know After Decades of Work?"[1]

As Bradshaw notes, "a seemingly disproportionate amount of research has focused on sell-side analysts" versus other investment decision makers, as of five years ago already amounting to over five hundred papers. His own paper summarizes the main findings of that body of work and its evolution over time, including "what we know (or think we know)" about analyst behavior, via short summaries of key studies, grouped thematically.

Analysts were "elevated to the status of an economic agent in the capital markets" at least in part because information was readily available (about their earnings estimates and recommendations) and "academics very much enjoy analyzing distributions (i.e., means, medians, standard deviations, etc.) and correlations." However, Bradshaw sees other reasons for the attention: Analysts are key intermediaries in the dissemination of market information and they can serve as proxies for other players in the investment ecosystem to study beliefs and actions.

Unfortunately, the research methods used in the academic studies "do not really measure the most interesting part," the "analysts' analysis." Which is not to say that the studies are unimportant or without merit, just that the "how" of it all ends up being inferred rather than examined. Bradshaw touches on some promising forays into new avenues of research, but the bulk of the scholarship to date focuses entirely upon a couple of aspects of the job, those estimates and recommendations.

There are too many items of interest in the paper to do justice to them here, many of which I have dealt with previously in one way or another:

Are analysts too optimistic? The body of work says, "Yes," but Bradshaw considers that a "sweeping generalization" that doesn't account for the "meet or beat" phenomenon,[2] the selection biases that come into play in choosing stocks to cover, or the issues related to the use of non-GAAP earnings by data services, which are subsequently used in the academic research.

Are analysts inefficient? Studies of one sort or another have shown analysts to generally overreact or underreact to certain kinds of information, but isn't that the nature of decision making in general? And, as Bradshaw says, "the tyranny of measurement error contaminates our ability to draw strong conclusions."

Do analysts face potential conflicts of interest? Yes, indeed -- six different kinds of conflicts are reviewed. As in other areas, though, it's crucial to look at the economic significance of the apparent conflict making broad statements about the implications of the findings. (This area of study fits naturally with an examination of incentives, a subject that the author feels has been shortchanged in academic research.)

By virtue of the sheer amount of research that has been written, there is a sense that we understand analysts and how they behave. But because of the design of that research, Bradshaw says that what we have are studies "of associations, not behavior." We end up knowing hardly anything at all about that critical "how."

Furthermore, what results is "a gross mischaracterization of the analyst's job function," with it being thought of as creating earnings estimates and issuing recommendations.[3] Those two tasks now rank at the bottom of the heap in terms of the things clients want from the Street, yet they still get virtually all of the attention from academics -- and from bloggers and tweeters and the mainstream media. Rarely has a high-profile job been so misunderstood by so many (partially because the firms themselves perpetuate that focus).

So decades of work by analysts and decades of work by the academics who have studied them, yet there is so much that hasn't been revealed.[4] But if you want to see where we've been and get some ideas about where we should go, Mark Bradshaw's paper is the place to start.

[1] SSRN : The version of the paper I reviewed was dated June 2011.: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1880339
[2] the research puzzle : See "taking another look," which includes a link to Jeff Miller's review of that issue on A Dash of Insight.: http://researchpuzzle.com/blog/2010/10/18/taking-another-look/
[3] the research puzzle : I have written extensively about rethinking the components of an analyst's job. See, for example, "those darn analysts.": http://researchpuzzle.com/blog/2010/06/24/those-darn-analysts/
[4] tjb research : Although, the "how" which is missing from these analyses is the bread and butter of my consulting business.: http://tjbresearch.com/]]> banging the drum http://researchpuzzle.com/blog/2011/07/13/banging-the-drum/ http://researchpuzzle.com/blog/2011/07/13/banging-the-drum/#comments Wed, 13 Jul 2011 11:36:08 +0000 tom brakke http://researchpuzzle.com/blog/?p=1789
Exhibit A: This firm is a strong advocate for a particular investment strategy. Three months ago, it was trumpeting the quick start out of the gate this year by one of its products and citing its leading performance position versus competitors, neglecting in the process to say that the product has ranked near the bottom of its category since it was introduced a few years ago. Subsequently it stumbled and did poorly during the second quarter.

No matter. That makes this a perfect time to buy, according to the firm, since the strategy has been temporarily out of favor. So, buy it when it's the best for a quarter, buy it when it's the worst for a quarter -- just buy it.

The firm advocates tirelessly for its strategy (which, by the way, is worthy of consideration). But if you look to it to provide information on how that strategy could best be used and when it's unlikely to do well, you're out of luck. It's in the business of marketing, not education.

Exhibit B: A different organization has come to be closely associated with a particular investment theory (one to which I'm partial). Its products have led the way in the adoption of the theory and its materials are informative and persuasive. Except that they always come to the same conclusion. No matter the investment problem under review, you know that by the end of whatever you are reading, the investment theory will have been touted as holding the key. Here, too, the organization hasn't sketched out the weaknesses of that theory to any degree (although I can figure some of them out on my own).

Exhibit C: This is really a list -- a very long list -- of those who blog and tweet about their successes but not their failures. They go silent if things don't work out their way, but claim victory whenever they can. (I pay reluctant attention to some for the occasional insight that they provide, while others are avoided entirely.)

Exhibit D: Also a list, this one is made up of those who see the solution to every problem in the tenets of their economic and political beliefs, no matter the pretzel logic it takes to fit the facts to the theories. I like learning from those with views that differ from my own, but if everything is passed through a filter of entrenched beliefs without regard to the evidence, I eventually quit listening.

Everyone talks their book -- me too.[1] But if I am curious about what you do or the ideas that you promote, I want to hear about everything, warts and all. I want to know what the shortcomings are and why they don't dissuade you from your advocacy. If you have an investment idea, give me the other side of the story. If you want me to give you my money or someone else's, tell me what's likely to go wrong. If it does go wrong, tell me why and what was learned.

Back in the day, I was a percussionist -- I can appreciate banging the drum. But it really gets old after a while.

[1] the research puzzle : My "book," if you will, can be found in this PDF guide to the research puzzle.: http://researchpuzzle.com/files/rp-guide.pdf]]> double counting http://researchpuzzle.com/blog/2011/06/28/double-counting/ http://researchpuzzle.com/blog/2011/06/28/double-counting/#comments Tue, 28 Jun 2011 11:45:55 +0000 tom brakke http://researchpuzzle.com/blog/?p=1779
Under the microscope today is detailed fundamental analysis. You don't have to go far to find those who scoff at this decidedly old-school way to assess value in the market. I saw a comment the other day that professional analysts don't know anything more than the typical day trader, which is laughable, but the real question is whether that knowledge is being effectively applied to make money.

It's not hard to cite examples of successful investors who are experts at poring over the numbers and seeing the picture differently than others, and we could talk about many aspects of their process, including risk control, time horizon, and the like. I've written before about the use and misuse of complex models like those featuring the discounted cash flow (DCF) approach;[1] the key for using DCF or other detailed evaluations is to take advantage of their complexity without falling victim to their pitfalls.

One way that the reliance on such models can go awry is by "double counting" without realizing it. Let's say, for example, you are doing a homemade model with a value twist. You might start with the notion of competitive advantage, now typically envisioned via the image of a Medieval "moat," which protects a business castle from attacks by competitive hoards. An assessment of the moat might work its way into a model in a mechanistic way, but it can also act more subtly on other model-building decisions by the analyst.

For example, a certain category of moat might lead to a specific discount rate being applied to cash flows, or to adjusting in some way the rate that would otherwise have been used. That's a reasonable approach, but what if (after the messy business of modeling the financial statements of the firm) you apply some kind of margin of safety to the intrinsic value you derive, and the amount of that margin is based essentially upon the same factors as your discounting exercise. Isn't that double counting?

Harder to ferret out are the ways in which that "messy business" in the middle is distorted by your overall impressions of the quality of a firm. Start out with the mindset that you're evaluating one with higher risks and the revenue line items you use might be less aggressive as a precaution and expenses a bit higher. So, the concern that you try to value in one place could show up again and again, leading it to be discounted over and over. (Of course, this could occur with a positive impression of a company as well as a negative one.)

You'd be surprised how often traps like these present themselves. I once stumbled into a situation like this when doing due diligence on a well-known research firm. The layering of expectations is usually hidden unless you have the opportunity to interview an analyst and dig into the model.

Similar phenomena can occur with other strategies. Do multiple chart views add value for the technical analyst or are they an exercise in confirmation bias? Do trading algorithms conflate inputs to amplify factor exposures in unexpected ways? Do "weight of the evidence" market exposure indicators end up with a thumb on the scale by virtue of how they are constructed?

The goal in every case is to have an objective application of the philosophy, without distortions or double counting. In practice, it's one of the most difficult things to do.

[1] the research puzzle : This posting, "of theory and practice," was part of the "letters to a young analyst" series.: http://researchpuzzle.com/blog/2010/12/08/of-theory-and-practice/]]> telling stories http://researchpuzzle.com/blog/2011/06/23/telling-stories/ http://researchpuzzle.com/blog/2011/06/23/telling-stories/#comments Thu, 23 Jun 2011 12:57:30 +0000 tom brakke http://researchpuzzle.com/blog/?p=1761
In the last posting, I wrote about the difficulties in trying to convey an investment process in graphical form.[1] There are a number of other challenges that you face in putting together the materials to use during a presentation. What should be included and what should be excluded? How should the presentation be pieced together? Is it robust enough and flexible enough that you'll be able to adapt to whatever situation you encounter and still get your message across?

There will be many factors involved in the manager selection process, but winning the business will depend on your ability to convey your ideas in an interesting way. We are all influenced by the power of persuasion and a well-told tale. That's true in human endeavors generally, in business for sure, and throughout the investment industry.[2]

So, the brief time that you have with a prospective client is critical. Obviously, you want to win the business and you want to avoid saying anything that will cost you dearly when the final decision is made. (Anyone who has been in these situations can provide examples of a tossed-off phrase that doomed an otherwise good pitch.) Yet, a stilted and dry presentation is an uninteresting one. You need to tell the stories that convey who you are and what you do.

Importantly, you need to avoid the inevitable temptation to stretch the truth. You should help prospective clients understand what they are in for -- what might happen under your watch, good and bad, given the range of possible market environments. The stories you tell should reveal and not obscure.

While we all like to talk about our success stories, the failures we have had can often be more enlightening. Yet I sometimes see pitch books from investment managers that detail a number of past situations, all of which ended in success. Everyone knows that the market isn't that accommodating -- you shouldn't be afraid to talk about the things that went wrong.

Some of your stories should be "in your pocket," ready to go in case you are asked certain inevitable questions. Trying to cram too much into a presentation is usually counterproductive, yet the tendency is to tell everything you know. Consequently, you get rushed for time and fail to communicate effectively.

The "stories," I should say, aren't just the anecdotes and incidents of your career or bits of market lore -- they include the facts about you and your firm. You see, when I say, "tell stories," most investment professionals reflexively go into war-story mode. But I mean something completely different: Presenting the information in a relaxed (but professional) style and connecting with the decision makers who will decide your fate. If you win the business, you'll be presenting to them at review meetings in the future. Don't leave them dreading the possibility.

They have only one chance to hear from you. Make it count.

[1] the research puzzle : "Those who have tried to picture investment process know how difficult it can be to take a complex set of analyses and interactions — that often don’t proceed in an orderly fashion — and present them in a way that’s simple and compelling, yet faithful to what you really do.": http://researchpuzzle.com/blog/2011/06/02/picturing-process/
[2] the research puzzle : I visited this theme earlier in a piece on "narrative power.": http://researchpuzzle.com/blog/2010/03/25/narrative-power/]]> picturing process http://researchpuzzle.com/blog/2011/06/02/picturing-process/ http://researchpuzzle.com/blog/2011/06/02/picturing-process/#comments Thu, 02 Jun 2011 11:56:29 +0000 tom brakke http://researchpuzzle.com/blog/?p=1718
Often what you see fits this format:

It may be presented in a linear fashion rather than circular one, but simple, step-by-step graphics like this are typical, often featuring arrows to indicate movement between the steps. For evidence, do a search of "investment process" on Google Images.[1] Pyramids are popular too -- and you'll see some flow diagrams that are like the ones you may have learned in a computer programming class way back when. (For even more fun, you can sort the Google results by color to see which images are visually attractive and which are, well, garish and off-putting.)

Those who have tried to picture investment process know how difficult it can be to take a complex set of analyses and interactions -- that often don't proceed in an orderly fashion -- and present them in a way that's simple and compelling, yet faithful to what you really do. Those who have sat on the other side of the table (the buyers of investment services) can attest to the fact that after awhile most of them look pretty similar and that rarely do any give a clear indication of what differentiates a particular firm from all of the others.

One of the challenges results from trying to create an interesting story while giving the person listening to the pitch something to take away from the meeting. It's easier to do a presentation like those often given at TED,[2] where the visuals are used to intrigue and to augment the story being told rather than to document it. For instance, if I was doing a talk on investment process, I could see using the "birds on wires" photo that showed up in those Google search results,[3] but it would be hard to use it in a standard pitch book and expect it to stand on its own very well. For better or worse, some words need to be on the page (the "worse" part of it all, of course, is that a high percentage of presenters end up reading them by rote and missing the opportunity to really communicate with the audience).

A consistent and effective design template is important when crafting a pitch book, but even when that's in place, it can be wasted by bad choices as to content. For instance, it's common to see poorly conceived or executed charts in investment presentations, but there are usually better alternatives readily available. The pages about process and other amorphous concepts are more problematic. Everyone wants a compelling graphic to illustrate process, but if it really illustrates nothing, why use it? What percentage of those Google search results would you describe as attractive and informative?

This is a problem that is vexing even for large organizations with expansive marketing departments, so there aren't any easy answers and certainly no magic formula that I can give to you -- the approach that should be taken needs to fit the unique nature of a firm. But the sad truth is that forcing a picture of process often distorts it rather than communicating it clearly, and rarely makes it memorable for those you are trying to impress. If you can't do it well, don't do it at all.

[1] Google Images : Here are the results.: http://www.google.com/search?tbm=isch&hl=en&source=hp&biw=1275&bih=792&q=%22investment+process%22&gbv=2&aq=f&aqi=g1&aql=&oq=
[2] TED : "Ideas worth spreading," indeed.: http://www.ted.com/
[3] Texas Presbyterian Foundation : In this case, it comes not from the site of a money manager but that of a foundation.: http://www.tpf.org/institutions/investment-process/]]> three years on http://researchpuzzle.com/blog/2011/05/26/three-years-on/ http://researchpuzzle.com/blog/2011/05/26/three-years-on/#comments Thu, 26 May 2011 12:09:50 +0000 tom brakke http://researchpuzzle.com/blog/?p=1736
May of 2008 was not the best time to start writing about investment process. The next many months were all about survival and "sharpening the saw" of methodology seemed like a luxury in times of economic chaos and crisis.

Yet, the events of that period provided ample evidence that delving into the "how" of investment decision making is not just an intellectual exercise. "How could this have happened?" was a common question. The answer? "One decision at a time."

And so the postings went on and on, about one a week. I am reminded of the novelist Frederick Manfred, who tried to write one or two pages a day and ended up with more than thirty books to his credit.[1] Even coming a few at a time, the words do add up; you can take a measure of mine by consulting a PDF guide to the research puzzle that I recently created.[2]

The subject matter has been wide-ranging and multi-disciplinary, and iconoclastic, or so I'm told. All of that is a reflection of who I am and how I approach the investment world on behalf of clients for whom I provide consulting service and/or investment advice. Of course, there's no automatic benefit from recasting a problem in a different mold than others use, but if you don't at least make the attempt, you'll never know what other possibilities existed.

A look back would not be complete without a thank you to those who have helped me with ideas, those who have promoted my work, and especially those who have been faithful readers of this blog and its sister publication, research puzzle pix.[3] The online discourse has enriched my work, by exposing me to new ideas, resources, and people -- many of whom I have befriended without ever actually talking to them, even on the phone.

Unfortunately, it's easy to get swept up in the virtual activity. Last year, I wrote a bit about the challenge of balancing creative activities with information gathering in a posting about "the cave and the flow."[4] A second dimension is the division between work done for pay and work done for free, and it's important to find the right mix in that realm as well. I expect to write a bit less on the websites going forward and to concentrate on providing longer, more detailed bespoke research related to my consulting and advisory work.

But as I look at my notes for upcoming postings, I won't be vacating this space anytime soon (God willing). Three years on, I'm still excited by the challenge of putting words to ideas, and grateful that you have given up your time to consider them.

[1] Center for Great Plains Studies : Manfred wrote primarily about "Siouxland." I was lucky enough to know him.: http://www.unl.edu/plains/publications/resource/manfred.shtml
[2] the research puzzle : The guide will be updated once a quarter at the same web address going forward.: http://researchpuzzle.com/files/rp-guide.pdf
[3] research puzzle pix : Each edition of pix features a chart of interest and some commentary. The most recent chart is always found in the sidebar of this site.: http://rp-pix.com/
[4] the research puzzle : In today's world, "navigating the information flow in a productive manner is a never-ending challenge.": http://researchpuzzle.com/blog/2010/05/14/the-cave-and-the-flow/]]> up on the farm http://researchpuzzle.com/blog/2011/05/23/up-on-the-farm/ http://researchpuzzle.com/blog/2011/05/23/up-on-the-farm/#comments Mon, 23 May 2011 11:44:55 +0000 tom brakke http://researchpuzzle.com/blog/?p=1722
LinkedIn dominated the market chatter last week, so if someone was to do a piece on valuation, expectations, and the proclamations of bubbles, that would be the hot topic to address. Alas, things move pretty slowly in the puzzle cave and there already has been much written about that social networking site and its IPO. So, I'll instead return to the land -- farmland -- that has in many ways become the "it" asset class of the day.

In March, Robert Shiller was widely quoted as saying that farmland was his "favorite dark-horse bubble candidate for the next decade or so," that it seemed to him to have "the most contagious ‘new era’ story right now."[1] More recently, he has apparently become a believer himself: "My only bullish call is farmland." According to a published report, Shiller cited its "limited supply" as the foundation of his call.[2]

The current fundamentals seem supportive of such an argument, so there's no need to dispute that here. However, they seemed equally supportive in the late 1970s before a nasty drop in land prices that wiped out a lot of farmers (and the businesses that sold to them).

To put the question in further perspective, let's go back to LinkedIn and a posting about it by Todd Sullivan.[3] In response to those who claim that valuation doesn't matter for a hot stock like LinkedIn, Sullivan simply says, "That's a crock." I agree, as indicated in a recent pix, when I wrote that changing price levels alter "the matrix of probabilities" regarding future returns.[4]

But you only get an idea of that matrix if you actually use numbers to try to quantify the possibilities, to attempt to understand whether you are far out on a limb of low-probability hopes or on the thick part of that limb, up against a massive trunk of true economic value. Either way, a storm could come along and knock you to the ground. However, on one end of the limb, little more than a prairie gust could do it. On the other, it would take an economic tornado.

So, what are the numbers that Shiller uses? How does he think farmland is valued right now? Furthermore, how many in the army of ag acolytes have actually looked at farm-level economics to think through the problem?

Saturday's New York Times included an article on the risks and rewards of private placements, which mentioned the rationale for an upcoming one that will hold farmland for its investors: "The attraction is the promise of steady returns in an asset class that has historically done well in both uncertain and inflationary times."[5] Really? If that's the pitch, I'd like to see the numbers used in the offering document.

And I'd like to see some decent work on what might happen if you buy farmland at the prices being paid in the Upper Midwest today. What are the likely long-run returns given a range of crop prices, of yields, of costs, of interest rates? I'd be glad to use such analyses to make a judgment about the wisdom of locking up capital for years -- if only I could find them.

In my mind's eye, I see a fellow in dirty bib overalls and a decade-old seed cap, pulling a pencil from behind his ear and using the back of a piece of paper to do some simple math. I don't know what numbers he'll come up with, but if he can't make them work, no one can. All the pretty charts and global context and extrapolated trends won't matter if the figures once learned in the one-room schoolhouse down the road don't add up.

[1] Bloomberg : Shiller's comments accompanied the "chart of the day," which showed the performance of farmland over time.: http://www.bloomberg.com/news/2011-03-23/shiller-singles-out-farmland-as-bubble-candidate-chart-of-the-day.html
[2] InvestmentNews : He was speaking at the annual conference of the Investment Management Consultants Association.: http://www.investmentnews.com/article/20110516/FREE/110519945
[3] ValuePlays : Sullivan "seeks to buy undervalued issues with an upcoming catalyst.": http://www.valueplays.net/2011/05/20/yup-pe-does-matter/
[4] research puzzle pix : Check Point (CHKP), the topic of the posting, is another of those easy examples of why that is the case.: http://rp-pix.com/ed
[5] New York Times : The title of the article is, "An Investment Asks, How Much Can You Afford to Lose?": http://www.nytimes.com/2011/05/21/your-money/21wealth.html]]> the china syndrome http://researchpuzzle.com/blog/2011/05/11/the-china-syndrome/ http://researchpuzzle.com/blog/2011/05/11/the-china-syndrome/#comments Wed, 11 May 2011 11:44:03 +0000 tom brakke http://researchpuzzle.com/blog/?p=1699
A few weeks ago, I had done a "pix" showing the charts of four Chinese blow-ups,[2] each of which remains halted, trapping the owners that had an interest in participating in the exciting stories the companies told. (The prior edition of pix[3] also dealt with perceptions and reality in China, in that case related to copper inventories being used as collateral.)

Just as a fraudulent stock can cause grievous harm to a portfolio, a widely-held investment thesis gone wrong can disrupt the very nature of the investment ecosystem. I will state right up front that I'm not a China expert, know almost nothing about its economy, have not done due diligence on its companies, and have never been there. I don't know whether the gap between assumptions and truth is narrow or wide, or whether information that we receive is as accurate as is found elsewhere in the world. In other words, I'm just like most people, whether they've invested in China or not.

As we do with other countries, we rely on Chinese government statistics to inform our decision making. How much do we know about them? How good are they? While there are qualms expressed in some quarters, lacking other sources, most investors accept them as is. Does that make sense?[4]

It is important to ask the questions, since the assumption of a "Chinese bid" underlies much of the investment material that you read. The nation's demand for commodities takes center stage -- as in Jeremy Grantham's latest piece, which details the enormous percentage of global demand accounted for by China.[5] But the Chinese appetite for other things -- industrial equipment, consumer goods, services of all types, and (hopefully) Treasury bonds among them -- is critical to macro and micro forecasts alike. And, on the supply side, the slightest of indications regarding its policies on rare earth minerals can send the prices of stocks in that business soaring or plummeting.

In terms of investment process, it's important to decide how to approach this situation. Conventional wisdom about the Chinese phenomenon is deeply entrenched and information about the nation's economy and companies is generally being taken at face value. Investors must consciously decide whether that is an acceptable strategy or whether a margin of care needs to be applied.

In The China Syndrome, the movie propitiously released just before the crisis at Three Mile Island, the public wasn't being told the truth by the management of the nuclear plant. I have no idea whether the analogy applies to China's information strategy and am not predicting an economic meltdown for it. But to leave the issues unexplored or not factored into the structure of risk management would be to place faith where it might not deserve to be.

[1] Jody Eisenman on Finance : This was my first exposure to Eisenman's website.: http://www.jodyeisenman.com/2011/04/the-china-syndrome/
[2] research puzzle pix : This site features a wide variety of charts about different investment ideas, vehicles, and asset classes.: http://rp-pix.com/dx
[3] research puzzle pix : It was based on a great article from FT Alphaville.: http://rp-pix.com/dw
[4] Bloomberg Businessweek : These questions go beyond China, of course. This link connects to an important article about how the "public memory systems" in the developed world aren't what they used to be.: http://www.businessweek.com/magazine/content/11_19/b4227060634112.htm
[5] GMO : The list is on the sixth page of this PDF.: http://www.gmo.com/websitecontent/JGLetterALL_1Q11.pdf]]> i don’t know http://researchpuzzle.com/blog/2011/05/05/i-dont-know/ http://researchpuzzle.com/blog/2011/05/05/i-dont-know/#comments Thu, 05 May 2011 14:05:31 +0000 tom brakke http://researchpuzzle.com/blog/?p=1681 Wall Street Journal, was one of the panelists on a recent webinar for financial advisors. He said that when giving presentations to advisors in the past, he had been booed when he told them that at times they should just say to their clients, "I don't know."

When to say those three little words is actually an important consideration for investment professionals of all kinds. Consider a recent posting by Jan Schultink: "When pitching VCs it is better to say 'I don't know' if you do not know the answer to a question than making something up that turns out to be wrong later. Management integrity is a more important investment criterion than having all facts readily accessible in your head."[1]

The gap between that recommendation and the standard approach used by many investment experts is wide indeed. Pundits are expected to command all those facts, to project confidence, and to be precise in their predictions -- on television, in print, and in their meetings with clients. An acquaintance who had the chance to hear a portfolio manager in front of an audience related to me how every question was answered with authority (even the one he had expected would be a stumper), with specific forecasts rather than indications of the range of outcomes that were possible. He admitted to being impressed by the portfolio manager but not knowing how sensible the predictions were.

That air of authority sells from the rooms where investment committees dole out billions to the offices where advisors work with individual investors. In a phone conversation, Zweig told me that an advisor approached him after a speech one time and said, "My clients hire me to tell them what they should think, not to tell them, 'I don't know.'" He recalled that the advisor then said something like, "The only way I can do that is by knowing the answer or pretending to."

Zweig has counseled advisors to have a client fill out a forecast of key market indicators for the year ahead, at the same time the advisor does too -- then to have each look at the other's predictions, whereupon the client sees that the advisor has filled in each blank with a question mark. If the client is one that's looking for predictions, it's a risky marketing strategy, although the clients that stay are likely to be better grounded in the realities of the investment challenge.[2]

So the investment professional is caught between two realities: Clients want answers and markets are unpredictable. No matter whether you are a sell-side analyst pitching a stock, a portfolio manager hoping to manage a large portion of a pension plan, a strategist responding to a reporter's questions, or a financial advisor working with a bricklayer, how you deal with that dissonance will set the stage for the nature of the relationship going forward. Greater understanding of the task at hand and increased long-term trust result from honestly conveying the uncertainty, but there is a short-term cost, and if the business is lost because of that openness, it's a high cost to pay.

Zweig reminded me what Peter Bernstein said was the major lesson that he had learned during his long career. Simply, it was that "we don't know what the future holds."[3] We forget that first principle all too frequently on our own, and by its nature the investment business encourages that amnesia.

Say it after me, "I don't know."

[1] Idea Transplant : Schultink writes a great blog about "slides that stick" and other considerations for those giving presentations.: http://blog.ideatransplant.com/2011/04/i-dont-know.html
[2] Zweig's other suggestion, to save the client's predictions (and to bring them out in response to second-guessing after the fact), sounds even more explosive, although the ensuing imbroglio would probably serve to "deselect" a client that has unrealistic expectations.
[3] NABE : This PDF by Bernstein elaborates upon that phrase, which appears in various ways throughout his works.: http://www.nabe.com/am99/bernsteinsp.pdf]]> wagging the dog http://researchpuzzle.com/blog/2011/04/28/wagging-the-dog/ http://researchpuzzle.com/blog/2011/04/28/wagging-the-dog/#comments Thu, 28 Apr 2011 16:25:21 +0000 tom brakke http://researchpuzzle.com/blog/?p=1643
One is that an analyst-run fund can cause friction between the research staff and portfolio managers. Those managers may feel like the analysts are concentrating too much on the research fund and not enough on them. To assess the likelihood of that occurring, it's important to understand the structure of the fund and the culture of the firm. The article on the Morningstar website that rekindled my interest in analyst-run funds[2] provided information on five such funds from well-known asset managers. (I also looked at Morningstar's reviews and analyses on its Direct platform and reviewed fund documents.)

The funds generally maintain sector neutrality versus an index, in principle isolating the stockpicking expertise of the analysts by eliminating the sector weightings of a portfolio manager. Even within a sector, though, the methodology for selecting and weighting stocks is critical. What is it? Is there enough stock-specific alpha to be found? Is it not captured by the portfolio managers of other funds?

This gets to the heart of the issue: the roles and responsibilities of the parties and who is good at what and why. Answering the question about whether it makes sense for a firm to have a research fund requires analyzing the patterns of behavior of analysts and portfolio managers. If a research staff's recommendations can be described as value-added, but the firm has struggled to outperform its rivals or to beat the indexes it says it can, the research alpha is being swamped by the weighting errors of the portfolio managers.[3] Such a situation obviously presents an issue for a firm, in that an analyst fund identifies the research department's expertise, but also highlights the fact that its traditional funds are not delivering as promised.

Conversely, if the portfolio managers of the other funds not only use research well but excel at the other parts of their jobs, what good is the research fund for the client? It gets positioned as an "index-plus" fund, which may fit the needs of those looking to minimize tracking error, but it's rarely more than a niche product.

Other considerations:

How good is the raw material (the research recommendations)? This is a maddeningly difficult question to answer, as my previous writings on the topic have indicated.[4]

How do analysts add value within the organization?[5] What do you do with the recommendations of analysts that aren't very good at picking stocks but that are essential to the organization in other ways?

How do the stocks within a sector get selected and weighted? The funds in question all appear to have portfolio managers of a sort that are key actors in that regard. (The term "high conviction" comes up a lot in coverage of these types of funds. For behavioralists, that raises the specter of the well-documented issue of overconfidence in decision making and questions about how the intra-sector weightings come to be.) I prefer a quantitative overlay that works directly off of the research output.[6]

Reviewing the filings illustrates how little some firms say about their investment processes. Analyst reports from Morningstar add some helpful information, but in each of these cases I'm left with a series of questions about how they do what they do. I would want answers to the general questions above, plus the firm-specific ones, before deeming a fund worthwhile.

Ultimately, the questions narrow down to whether the fund as executed is good for the firm and good for the investor. For each, I think that the structure that is least disruptive to the core research process is preferable. In addition, it is absolutely essential that the incentives for analysts that are put in place don't lead to the research-fund tail wagging the research-function dog, or the organization and its clients are better off without it.

[1] the research puzzle : It was called, "the analysts get their turn.": http://researchpuzzle.com/blog/2011/04/27/the-analysts-get-their-turn/
[2] Morningstar : It was authored by Karen Dolan.: http://news.morningstar.com/articlenet/article.aspx?id=377734
[3] While I have written extensively about the dangers of the relative performance derby, it is a fact of life and the issues related to analyst funds are best looked at in that light.
[4] the research puzzle : Check out the "research performance" postings in this new PDF guide. : http://researchpuzzle.com/blog http://researchpuzzle.com/files/rp-guide.pdf
[5] the research puzzle : See "those darn analysts" for an exposition of the functions of the typical analyst.: http://researchpuzzle.com/blog/2010/06/24/those-darn-analysts/
[6] This is, in fact, the way that the analyst fund that I was involved with was structured. A variety of different kinds of overlays are possible.]]> the analysts get their turn http://researchpuzzle.com/blog/2011/04/27/the-analysts-get-their-turn/ http://researchpuzzle.com/blog/2011/04/27/the-analysts-get-their-turn/#comments Wed, 27 Apr 2011 12:45:51 +0000 tom brakke http://researchpuzzle.com/blog/?p=1640
There are all sorts of permutations and combinations, with some investment professionals with other labels thrown into the mix, but that is the basic structure. Those marketing asset management services are largely in the business of selling experience, expertise, performance, and whatever unique spin on investment philosophy and process that a firm might have. But there often doesn't appear to be much difference among the contenders, which is why the selection process frequently hinges on performance and personality.

So, firms that have large and experienced research departments try to differentiate their firm on that basis. If research is foundational to the process, then their clients are buying an organization, not a star manager. (Those looking for a star might go through the motions, but they'll select the star's firm almost no matter what else might be off kilter.) Therefore, the research department can be a marketing asset as well as an investment one.

Creating a stable and capable research department is no easy task. Most analysts want to be portfolio managers, not career analysts. They either move on to portfolio management or on to another firm, creating a built-in turnover issue, especially for smaller firms. Life as an analyst at a buy-side shop can be tough: You have a lot of bosses (the different portfolio managers), you get second-guessed quite a bit, others get the glory for your good ideas, and you get the blame for the stinkers. The status is less than that of a portfolio manager and so is the pay.

Firms sometimes offer loftier titles and better compensation, especially to key analysts that can make a difference. In addition, though, analysts like to see that their ideas are recognized and used. Whether that happens depends largely on the culture of the organization (and whether the commitment to research is lip service or fact).

One vehicle that has the potential to address many of these issues is an analyst-run fund, where analyst ideas are on display more directly. Conceptually, they provide analysts with a direct outlet for their ideas, without the filter of a portfolio manager (although there are usually constraints of one kind or another). They can also serve as advertisements for the organization, showcasing the power of the research department and the extent to which the firm has created a framework for highlighting the work of analysts and giving them an outlet for their ideas that doesn't rely on the results of their salesmanship to others.

A recent article in Morningstar took a look at the analyst-run funds of five major investment organizations, and yesterday's edition of research puzzle pix[1] featured the performance of them since the beginning of 1996. However, because of changes in all of the funds over time, it's hard to draw conclusions about what approaches have worked and what firms have had success in this niche (if any have).

No matter. We'll press on, and in the next posting we'll look at some of the issues involved in taking investment ideas directly from analysts and making a portfolio of them.[2]

[1] research puzzle pix : The current pix always appears at the bottom of the sidebar to your right (unless you're reading this via RSS). This is the permalink to the posting referenced.: http://rp-pix.com/el
[2] the research puzzle : That posting, "wagging the dog," is now available.: http://researchpuzzle.com/blog/2011/04/28/wagging-the-dog/]]> for the prudent fiduciary http://researchpuzzle.com/blog/2011/04/13/for-the-prudent-fiduciary/ http://researchpuzzle.com/blog/2011/04/13/for-the-prudent-fiduciary/#comments Wed, 13 Apr 2011 11:43:58 +0000 tom brakke http://researchpuzzle.com/blog/?p=1457
It is tempting to say that things are back to normal. The markets have recovered (albeit with the heavy lifting having come from the extraordinary fiscal and monetary stimulus that remains in force) and investment firms have returned to business as usual. However, many individual investors remain skittish, and those who serve as fiduciaries are faced with a particular challenge.

They make investment policy decisions for pension plans, foundations, and the like -- and assume a fiduciary duty as a result. That is quite a burden to bear, especially now, when many of those fiduciaries don't know what to believe or in whom to trust. On any given committee or board, there are individuals with a fair amount of investment training and others for whom many of the principles are fuzzy and the details unfamiliar, yet they all carry the responsibility for the decisions that are made.

Thankfully, a new monograph from the Research Foundation of CFA Institute provides a great platform from which to address many of the issues. Authored by Jeffery Bailey, Jesse Phillips, and Thomas Richards, it is entitled, A Primer for Investment Trustees.[1] And it is a primer, written for Molly, a new member of the investment committee at Freedonia University,[2] which oversees "a defined-benefit (DB) plan, a defined-contribution (DC) plan, an endowment fund, a foundation, and a self-insurance trust."

The monograph walks Molly through governance structure, investment policy, investment objectives, risk tolerance, asset classes, performance evaluation, and ethics. Each section ends with a nice list of "takeaways" and "questions Molly should ask." It provides a terrific summary of the basics for any trustee (the book's use of that word is synonymous with my use of "fiduciary"), although even its relative simplicity hints at the amazing range of knowledge that a prudent fiduciary should have.[3]

The authors hew a bit more to the status-quo line than I would have had I been given the assignment to instruct Molly, but you have to start somewhere. An intermediate-level companion piece should question more forcefully some of the underpinnings of current methods that deserve further scrutiny -- "best practice" is not static and fiduciaries should be constantly questioning the norms of the day rather than playing along with the crowd.

There are inherent tensions that face Molly: She must learn from the past but not let it blind her to other possibilities; recognize her own risk tolerance versus that of others on the committee and the overall mandate; think about whether she is being too quantitative or not quantitative enough in evaluating investment performance and managers; wrestle with the hard issues of relative performance versus absolute; evaluate the positives and negatives of "somewhat arbitrary" asset class distinctions and benchmarks; allow the various actors (staff, consultants, investment managers, etc.) to fulfill their roles while knowing when to address shortcomings; and be aware of the social dynamics that can destroy the ability to come to agreement and just as readily lead to the dangerous territory of groupthink. And that's just for starters.

It is true that "favorable investment markets have a way of masking uninformed and poor trustee oversight, and weak investment markets often expose weaknesses and magnify a trustee's fiduciary risk." The members of an investment committee -- be they new to it like Molly or as confident as the person who has been there for years and thinks he's seen it all -- would benefit from reading this book and using it as the foundation for a discussion about the opportunities and perils they face together.

Believe me, it's a much better use of their time than listening to an investment manager drone on about the state of the economy or the stocks that are sure to do well.

[1] CFA Institute : This page includes a link to the PDF.: http://www.cfapubs.org/toc/rf/2011/2011/1
[2] A nice tip of the hat to the Marx Brothers and Duck Soup.
[3] research puzzle pix : The title of this posting comes from a subhead that I use when doing items in pix that are of special interest to fiduciaries. This link takes you to editions that include them.: http://rp-pix.com/?s=prudent+fiduciary]]> an important notice http://researchpuzzle.com/blog/2011/04/06/an-important-notice/ http://researchpuzzle.com/blog/2011/04/06/an-important-notice/#comments Wed, 06 Apr 2011 11:06:59 +0000 tom brakke http://researchpuzzle.com/blog/?p=1442
We won't get into the privacy issues here (for example, perhaps we should also be concerned about "authorized" third parties). Nor will we explore the investment implications for firms, positive or negative.[1]

Instead, let us dream about other bad things happening. (I guess those are properly called nightmares.) Such dreaming is a key part of risk management, but it's the hardest part of it. It's easy to look back on what has occurred before and to consider what would happen to the markets, our assets, and our plans if history were to repeat itself. It's especially easy to "fight the last war."

It's much more difficult to look forward and speculate about what might go wrong the next time something really does goes wrong. But you can guess that one category to be concerned about is the reliability of networks and their security systems. In that realm, we could imagine doomsday scenarios of the electrical grid going down or the proverbial "being bombed back to the stone age."

For those of us that labor in the investment markets, the "stone age" was when there were pieces of paper that changed hands as economic interests did. That's long gone and hopefully never coming back; that era has been supplanted by a wired one with different kinds of risks, many of which we haven't yet encountered.

And so we must ask ourselves, even though we don't want to, what would happen if . . .?

If there was a disruption in the payments system, in the functioning of the exchanges, in -- let's get down to brass tacks -- the informational structure at your own broker?

There are safeguards and contingency plans, but what is a realistic assessment of the probabilities of failure for the systems great and small that form the foundation of investment commerce? How much due diligence has been done by regulators and institutional players (the same groups we always rely on to do our dirty work) on the systems themselves? How much planning for outlier events?

Many of the potential problems in this realm fall into the category of cyber crime. We know one of NASDAQ's businesses was hacked, and there may have been other incursions that we aren't aware of. Such activities may be state-sponsored, designed to make money, or just the result of hackers on a joyride of sorts, seeking to exploit the holes in the system that has evolved. (There are always holes.) Other disruptions may be the result of unintended consequences, as the structure of the business gets more complex and the moving of electrons becomes a game in itself. The list could go on to include natural disasters, attacks, and other events we'd prefer not to consider.

The reality is that just as we don’t think of the physics of everyday life, we don’t contemplate the “normal workings” of investment market structure. They are assumed. Should they ever be disrupted, what are the ramifications? How would you react? What, if anything, can you do to prepare?

The next time an email arrives that is entitled, "An Important Notice," what surprise might it reveal? We don't get any clarity by not asking the hard questions.

[1] Of potential direct impact: Epsilon contributes more than twenty percent of Alliance Data System's revenue, but the stock has not fallen much as of this writing, a few days after the breach.]]> muni blues http://researchpuzzle.com/blog/2011/03/31/muni-blues/ http://researchpuzzle.com/blog/2011/03/31/muni-blues/#comments Thu, 31 Mar 2011 12:08:30 +0000 tom brakke http://researchpuzzle.com/blog/?p=1429 Governmental Accounting, Auditing, and Financial Reporting, but everyone called it by its nickname.

Upon examination, it was clear to me that the small town for which I worked needed to tidy up the books a bit, although it wasn't an easy sell, since I was self-taught and the auditor and city administrator had degrees and experience. Small town, piece of cake, right? Well, no.

Structurally what was needed was the implementation of a complete fund accounting system. There might have been only five thousand people in town, but that little burgh had more than twenty different kinds of operations, among them an electric utility, a water and sewer operation, street assessment projects, tax increment financing districts, debt service funds, and a liquor store (I had worked there too). Each required segregation for financial reporting and the accounting treatments needed to be different from one to another.

I thought of all of that when I recently passed through a town in Illinois on a road trip to Florida. I happened to pick up the local paper and read a story about the school district's finances. The superintendent was quoted: "One of our board goals is to look at our finances and determine if we have cash we can invest and earn interest on." It seems that a previous state-sanctioned program had shown that there were "no funds suitable for immediate investment," but that "the district should check again in a few years." So, the plan was to participate in another review.

The story then had some items noting the "other business" dealt with by the board at the meeting. The first bullet: "Recognized the district’s financial profile designation, which at 3.8 on the 4-point scale earned the district a mark of Financial Recognition from the state."

I would have thought that a 3.8 would include effective cash reporting and management thereof.

Amid a heated debate about municipal finances -- and bold predictions by big names of how many bonds will or won't go into default -- it seems that the general issue of accounting and reporting hasn't been examined very closely. It undoubtedly has improved in general since I labored over the Blue Book, but what's the current state of the art?

The website of the Government Finance Officers Association has a simple statement of "best practice."[1] I asked the organization about the extent to which its recommendations had been adopted and how many states require GAAP and the timely submission of financial reports. It did not have specific answers.

There are a lot of broad assumptions being thrown around about the nature of the muni market, but the revealing secrets are to be found in the careful analysis of the financial details, issuer by issuer -- work not unlike that performed by those few that looked at mortgage securities tranche by tranche when the first signs of strain became evident there. Or by those that bucked orthodoxy and called out bank risk for what it was.

Some politicians have been playing "kick the can" to placate stakeholders (and feather their political nests), just as many corporate managers play games of their own to placate shareholders (and feather their financial nests). Throwing light on the shortsightedness of each is one of the good things that can come from difficult times.

Unlike the esoteric mortgage securities mentioned above, which were the province of supposedly sophisticated institutional investors, individual investors are key players in the world of municipals. How they react to any further declines in prices will be a key determinant of whether this becomes a big deal or not. Do you think that they know whether rigorous standards of accounting and financial reporting are being applied?

Instead of singing the muni blues, it's time to hit the books and see what we find.

[1] GFOA of the US & Canada : In addition, you can visit the "about us" link on the home page to see a detailed list of the organization's objectives.: http://www.gfoa.org/index.php?option=com_content&task=view&id=1461]]> anne berkshire hathaway http://researchpuzzle.com/blog/2011/03/21/anne-berkshire-hathaway/ http://researchpuzzle.com/blog/2011/03/21/anne-berkshire-hathaway/#comments Mon, 21 Mar 2011 20:53:50 +0000 tom brakke http://researchpuzzle.com/blog/?p=1411 Huffington Post.[1] Supposedly when the actress Anne Hathaway graces the news, the stock of Berkshire Hathaway goes up.

At a minimum it's a clever story, connecting our love of celebrity (in Hollywood and on Wall Street) with the algorithmic culture that drives trendy websites (like Huffington) and news trading strategies alike. Throw in an electronic movie poster of the Oracle and Miss Hathaway in the altogether and it was bound to gain attention. The Atlantic picked up the story a few days ago,[2] and it's been on the twitter and blog circuit ever since, helped out by some quotes from John Bates, a computer scientist who helps hedge funds with their algorithmic strategies.

"We come across all sorts of strange things in our line of business, strange correlations," Bates is quoted as saying. "And I've had a lot of interest in this for a long time because it's really often the secret source for certain hedge funds."

The comments on the two stories point out the silliness of picking out a few dates that appear to make the case (although there were actually eight instances cited -- way more than the six observations that some of the commenters were scoffing at). Since the writers of the articles didn't bother to look at how Berkshire did relative to the market on those days, I labored over that project and discovered that it was real alpha -- the stock only underperformed on one of those days. (I'm sure we will soon be treated to a treatise that explores the hypothesis in even greater depth. It will probably note that the highest price paid for Berkshire in the last two and a half years was on the day after the Oscars. Hmmm.)

There are some correlations that are easy to spot. Both Buffett and Hathaway have that intangible known as pluck, and they play to the camera better than their counterparts, although that's a lot harder in her business than in his.

Underneath the veneer are some interesting questions for investors, one of which is not, "Should I buy Berkshire in advance of her next movie?" The rise of algorithmic trading is, by design, going to lead to some notable errors. Is this one of them? Who knows.

The longstanding ritual of trying to "correlate everything against everything," as Bates indicates trading firms do, is the nature of investing. Most of us just do it in slow motion, trying to piece together connections in information -- whether qualitative or quantitative or visual -- that we think can give us an edge. But when a computer is stripping bits and pieces on the fly to send trades automatically, there are bound to be some unusual effects.

Until the misses are very large or disruptive for a firm, we won't hear of them.[3] But the increase in algorithmic trading and related strategies has changed the way that securities trade. While we joke about this story, it's part of a new market structure that has altered the playing field for investors, and those changes appear to be intensifying.

At a minimum, tactics need to be adjusted. Taking that message to heart, I wanted to do a paired trade with the long I established in Anne Berkshire Hathaway. I figured that a short sale of James Franco-American Spaghetti would make sense, but it's a part of Campbell Soup, so it wasn't quite right. I'll keep looking.

[1] Huffington Post : It was published on March 2.: http://www.huffingtonpost.com/dan-mirvish/the-hathaway-effect-how-a_b_830041.html
[2] The Atlantic : This one was written by Alexis Madrigal.: http://www.theatlantic.com/technology/archive/2011/03/does-anne-hathaway-news-drive-berkshire-hathaways-stock/72661/
[3] New York Times : The AXA Rosenberg one was brutal for that firm, but it was not a news-related strategy.: http://www.nytimes.com/2010/06/20/business/20stra.html]]> investment brackets http://researchpuzzle.com/blog/2011/03/17/investment-brackets/ http://researchpuzzle.com/blog/2011/03/17/investment-brackets/#comments Thu, 17 Mar 2011 16:52:36 +0000 tom brakke http://researchpuzzle.com/blog/?p=1399
I think bracketology reached its high point in 2007 with the publication of The Enlightened Bracketologist: The Final Four of Everything.[1] The book features a wide array of contests, with the winners picked by experts in each area. From conspiracy theories to pickup lines to sidekicks to guitar solos, plus golf swing thoughts, plastic surgery disasters, male vices, and many more. A hundred and one brackets in all.

Some even veer into the investment realm. Buffett wiped out all of his competitors for best CEO, of course, even though he's anything but a typical CEO. The winner in the economic indicators tournament? "Whatever last year's forecast was," which came out of the Incestuous Regional and was crowned with this conclusion: "Elegant, minimalist, and beats other forecasts with surprising frequency."

As for investment strategies, Clark Winter[2] did the picking. Ironically given current events, his winner was "Japanese equities." Prefacing his comments by indicating that no investment is always best and that he was talking about 2007, he went on to say that the things that perform best over time "are those that provide the most leverage." Well, it was the dance of the times.

One of the things that I like about the book is that there are descriptions of why the winner of some key "games" came out ahead. That's a good lesson for us as we consider our own brackets of investment possibilities at any point in time. Writing down your expectations helps to synthesize your thoughts and provides documentation to look back at as part of the necessary evaluation process.

Given the number of different investment vehicles and strategies, we all would fill out our brackets differently. We have our favorites -- and those we would never pick because they burned us years ago.

Some of us love to play the long shots and others select the number-one seeds. We choose from the perennial contenders that are always in the mix and the Cinderella stories of late. Chinese retail REITs scored a hundred points a game last year? They'll be picked to go deep by many, even if they lack a defensive strategy.

There are those who focus on the teams with momentum and those who look for the ones with sound fundamentals. (You have to be careful; uranium looked to have both not that long ago.) The arbitrageurs seek an edge in the mispricings of the crowd's picks, hoping to lock in the odds just before the window closes. And the hedge funds consult orthopedic surgeons to estimate the pace of a star's recovery.

For those keeping score in an attempt to find out who is best, selecting an appropriate time frame is critical. While we know when the NCAAs will be over for the year -- even if we don't know who will be cutting the nets -- the market tournament goes on and on. As a result, investments and investment managers are commonly judged according to the calendar, with new winners holding trophies each month, quarter, and year for competitions that may or may not have demonstrated their skill.

The investment arena of today allows for all sorts of game plans -- and a little guy in his basement might even pull off the upset of the year against an industry behemoth. You may be a prop trader, in effect filling out a new bracket sheet every day. Or you might be a value investor that shrugs his shoulders and says, "Go ahead, play your little games that don't matter. Let's take a look in five years to see who won."

What a business. Let the games continue, without end.

[1] Bloomsbury USA : The book was edited by Mark Reiter and Richard Sandomir.: http://www.bloomsburyusa.com/books/catalog/enlightened_bracketologist_hc_103
[2] Clark Winter : Then at Citigroup Global Wealth Management; now he's on his own.: http://clarkwinter.com/]]>