the research puzzle

the flaws of finance

tom brakke — Sat, 12 May 2012 18:51:36 +0000

James Montier delivered the keynote speech at this year's annual conference of the CFA Institute. It was titled simply, "The Flaws of Finance." Just as simply, Montier's job title was given as "investment professional." His informative and entertaining talk (which is available online[1]) was a perfect prelude to presentations about the topics of the day, many of which reflected three colliding elements -- the investment profession, the business, and theories of finance.

To summarize my impressions of the conference I will be doing a series of postings, on this site and on research puzzle pix, where the first dispatch appeared.[2]

Montier's talk was structured around four flaws: Bad models, bad policies, bad incentives, and bad behavior. Taken together, they have proven to be a toxic mix for the modern financial system, investment decision makers, and all who have had to pay to clean up the mess.

While models are alluring, "finance does not equal physics" and "market participants are not inert," but active. Finance is a social science and the simplifying assumptions of many models render them helpful in only a theoretical way, since they repeatedly fail the test of reality. The capital asset pricing model (CAPM) and value-at-risk (VaR), each widely used, might provide interesting food for thought, but their underlying assumptions render them not only fallible but dangerous in practice.

Unlike CAPM's definition, Montier says that "volatility isn't risk." Ultimately, he believes, risk is the permanent impairment of capital, but the analysis of risk is multifaceted and can't be summarized by a statistic. Plus, ignoring illiquidity and leverage, as CAPM does, "is just silly."

Similarly, it's hard to justify the tenets of VaR, which led to the errors of the financial crisis, since the model cuts off "the very part of the distribution that we need to worry about." Using trailing volatility and correlation results in a virtuous circle that works until it doesn't, when its evil cousin (the vicious circle) comes into play. And since everyone is using the same models, an institutional risk can become a systematic one.

That's especially true since policy makers were convinced of VaR's worth by the very banks that created it. Montier called that "the world's best example of regulatory capture."

To make matters worse, layered on top are the bad incentives that permeate our financial system (which I wrote about in an eight-part series in early 2009[3]) and the well-documented behavioral errors that distort investment decision making. It is those errors that Montier thinks prevent us from seeing so-called "black swans" as the "predictable surprises" that most of them are, built upon a foundation of popularity, expensive valuation, leverage, and illiquidity.

Montier had a long list of suggestions for theorists, practitioners, and policy makers. Many of them had to do with attitudes toward models, including a renewed sense of skepticism about what they actually can do. Importantly, we must abandon our unattainable "obsession with optimality" that blinds us to the failures of models and theories. But that is difficult for us, for just as we become impressed with the elegance of models, so too do our clients. As a result, "we have a habit of liking complexity, because complexity impresses. It allows people to charge high fees. It keeps outsiders out." We "rely on complexity to baffle and bamboozle" when what our clients really need is to understand the uncertainty and murkiness of the markets.

As to the belief "that markets would do the right thing [to correct excesses] -- we know that's not the case." We have witnessed a failure of theory and practice, as well as a blindness to financial history and the triumph of expediency over ethics.

In related news, four days after Montier's speech, J.P. Morgan announced its trading loss. Point by point, you can add the specifics as annotations to a story that is already writ large. If investment professionals won't work to correct the flaws of finance, who will?

[1] CFA Institute : Montier's remarks appear about eighteen minutes in.: http://cfapodcast.smartpros.com/web/live_events/Annual/Montier/index.html
[2] the research puzzle : This link will provide an updated list of the entire series as it proceeds.: http://researchpuzzle.com/files/view/cfa-annual-2012.pdf
[3] the research puzzle : Frankly, not much has changed since then.: http://researchpuzzle.com/files/view/incentives-series.pdf

to infinity and beyond

tom brakke — Thu, 26 Apr 2012 11:48:34 +0000

Last Saturday, there was an article in the Wall Street Journal entitled, "Time to Cut Back on Apple?"[1] Given the explosive rebound in Apple's share price in response to its earnings release, a commenter after the fact responded simply, "Answer: NO."

Apple has become the largest stock in the S&P 500 due to its sharp move higher (it's up more than 50% so far this year alone). The normal decision making process can become distorted when that occurs; I was quoted in the article to that effect.

Jeremy Grantham has written persuasively that institutional "investment behavior is driven by career risk."[2] Investments are made not just on their merits, but in comparison to the crowd of investors against which you compete and the benchmark against which you are measured.

Therefore, as an investment manager, what should you do with Apple? It has an outsized impact on your benchmark due to its size -- and it has been on a tear. Do you overweight it or underweight it or hug its index weight? That decision will likely be the biggest single driver of your relative performance. If you don't think that matters to the person making buy and sell decisions, you haven't sat in that chair.

But it's not just relative weighting. Imagine going to a road show where you sit with portfolio managers from other firms. "How much Apple do you own?" is likely to be a question from one of them before long. What do you say? What do you want to say?

How about visiting a pension plan for a quarterly review meeting, with numbers that lag the index because you don't have any Apple? Where do you think that conversation is going to go?

Or let's say that you are in a large investment firm and were the one person who took an early and outsized position in the stock. How has your success altered the way you interact with others, when your every move with the stock is scrutinized? If you have become known as "the Apple guy," how will your decision making about it change?

Recently, a sell-side analyst downgraded Apple to a "hold" (not exactly a bearish call). In his report he pledged allegiance to the company and its products -- and practically apologized for his action. He was still ripped by believers.

There are times when a money manager that trims a stock as a part of her risk management discipline might wish that it would go down for awhile to show her colleagues it was a good move, despite the fact that with a still-large position she should be hoping it goes to infinity. Every decision is magnified, every emotion is amplified. It can all become more behavioral than analytical.

These are the dynamics that build and compound and embed when you have such an unusual (but not unprecedented) situation. You also get managers straying from their stated mandates to try to capture some of the performance magic. The small cap and emerging markets specialists that own Apple are a long way from their stated expertise. Often the value versus growth dimension comes into play too, although Apple is a special case in that respect because it can be seen as both (which adds to its narrative power).

There are many other ways that decision processes are altered at the institutional level under these circumstances and it occurs with individuals too, even though they don't face the career risk component that money managers do. Collectively, the inflections in behavior can swamp the fundamental developments at the company, sometimes in unexpected ways.

In the Journal article, a money manager who has close to twenty percent of his fund in Apple was quoted as saying that it would be "more risky not to have a heavy position." Whether that's your view or the conceptual opposite, now may be a good time to deconstruct your expectations and to understand the unique challenges that you face.

[1] Wall Street Journal : This is the article, which as of the time of my writing was not behind the Journal's paywall.: http://online.wsj.com/article/SB10001424052702304331204577352223280900012.html?mod=wsj_share_tweet#
[2] GMO : That quote is from the first sentence of his April 2012 quarterly letter.: http://www.gmo.com/America/

discipline and creativity

tom brakke — Thu, 19 Apr 2012 11:40:08 +0000

It is not easy figuring out how much structure to put into an investment process and exactly how to make that happen. Every organization is different and the culture of one might tolerate quite a bit of process and even thrive as a result of it, while a kind of "process lite" might fit better at another.

As always, what you do and what you say you do ought to be in sync. While that sounds obvious, if you say, "We're top-down sector rotators," what does that really mean? How does it work? What structural elements have you put in place to deal with the most common errors that can occur?

Whatever your investment approach, there is a body of knowledge available to you about it. From the industry performance data on that strategy, to academic research on the market drivers of it, to the trail of decisions at your own organization, there is plenty of evidence available to you on the patterns of errors you are likely to make. What are you willing to do to avoid them?

A read of The Checklist Manifesto by Atul Gawande (this is the last in a series of postings about it[1]) piqued my interest in the use of checklists within investment organizations. But while I can see the power of them to significantly improve decision making, I know how unwise an overbearing implementation of them would be.

Discipline is a necessary component of an investment process. The right kind and the right amount, applied at the right time, doesn't impede the creativity of decision makers, but rather nourishes it. "The checklist gets the dumb stuff out of the way," wrote Gawande, so that our brains can deal with the hard and interesting and important matters at hand. But tell that to a portfolio manager and I can predict the response you'll get; most would see a checklist as anything but liberating.

A good first step is the documentation of decisions and the institution of feedback loops so that those decisions are evaluated in a systematic way as time goes by. To repeat what I wrote in the second-ever posting on this blog, "a regular look back at assumptions and decisions -- a series of feedback loops, if you will -- that is woven into the fabric of an organization increases its chances of success over time."[2]

That will yield an idea of the pressure points in your process where failure tends to occur. An in-depth look at those individual decisions may reveal that in the heat of the market battle the same mistakes are made over and over, just as a doctor can forget to do little things during a stressful operation unless there's someone else (perhaps using a checklist) there to remind him.

The chances are that the use of checklists in certain parts of your process would improve performance. If that's the case, how much disruption of your current culture are you willing to endure in order to get that better performance? Perhaps I should ask that of your clients.

Asset managers in particular need to be able to tell their story by talking about process to their clients and prospective clients, and to the gatekeepers that assist them in the allocation of their capital. And what do they want? "A systematic and repeatable investment process" is what they say -- and great performance, of course.

Checklists would seem to be made to order, since they lead to a process that is more systematic and repeatable. But an overlooked issue comes into play here: Making changes in your process can be viewed as a negative development by others, even if you are doing it to increase the probability of success in the future.

Just as the structure of a process must balance the need for discipline and that for creativity, the process of today must yield to that of tomorrow, thoughtfully improved for the challenges ahead. Too often "systematic and repeatable" turns out to mean "static." Instead, a process should be evolutionary.

It will come as no surprise after these five postings that I think that checklists, as boring and rudimentary as they can be, can result in better decisions by those that operate in the exciting and complex world of investments. That they aren't more prevalent says more about the culture of the business than about their efficacy.

[1] the research puzzle : This PDF has links to all of the postings.: http://researchpuzzle.com/files/view/checklist-manifesto-series.pdf
[2] the research puzzle : It was about "the wayback machine.": http://researchpuzzle.com/blog/2008/05/28/the-wayback-machine/

a cognitive net

tom brakke — Wed, 18 Apr 2012 11:37:52 +0000

In The Checklist Manifesto, Atul Gawande extols the virtues of checklists and says, "They provide a kind of cognitive net."

As I examined in the previous posting in this series,[1] that net can catch errors in simple processes and it can prevent failure in more complex ones. How might checklists be applied in the investment world?

Gawande has a section in the book about investors, including Guy Spier, Mohnish Pabrai, and a third that wished to remain anonymous. (The author dubbed him "Cook.") Pabrai described a process in which he searches widely for ideas to consider, a mode from which he shifts when he finds one that seems worthy of consideration. Then he starts to dig very deeply and if it seems promising, his excitement builds and he goes into "greed mode." Spier calls it "cocaine brain." The behavioral instincts kick in and start working against you. That's when they have found checklists to be of great value: They keep you grounded and focused and attentive to the possibilities, good and bad.

These are not checklists that get run through in minutes, but ones that are meant to ensure that the investigative process is thorough and that the critical errors that tend to be made are mitigated to the extent possible. Unlike flying an airplane or building a building, these checklists are designed to increase your chances of success, not avoid failure altogether. The markets don't allow you the opportunity to approach perfection, but you can get better.

Each of the investment managers included in the book is a value investor. Can those that approach the challenge of investing from different angles also benefit from the use of checklists? Well, strange bedfellows that they may be, traders that look at the technical patterns of an investment rather than its fundamental worth have also been known to use checklists. And at its core, quantitative investment -- be it via the old fashioned monthly rebalancing variety or today's algorithms that operate in nanoseconds -- is an automation of checklists. But such systematic approaches are relatively rare elsewhere; investment decision makers like it up on the high wire of decision making, with no cognitive net.

The experience of the three value investors have made them checklist evangelists, but "they have found takers slow to come." Even at Cook's firm, if he's not involved in a decision, checklists don't get used. In a business where investors follow each other into positions, they tend not to copy successful methods. Gawande saw the same thing in his own field of medicine, where a safe surgery checklist demonstrated remarkable results, but was slow to be adopted. Had a drug or medical device shown the same efficacy, he noted, doctors would be all over it.

Gawande hits the nail on the head: "It somehow feels beneath us to use a checklist, an embarrassment. It runs counter to deeply held beliefs about how the truly great among us -- those we aspire to be -- handle situations of high stakes and complexity. The truly great are daring. They improvise. They do not have protocols and checklists."

And when we put a group of them together in an investment organization, what kind of process do we get? For starters, probably one that upon close inspection doesn't resemble the pictures of process[2] in the marketing pitch book. There's not as much structure there as you would expect. Could there be a better way?

Tommorrow: This five-part series ends with thoughts about discipline and creativity in investment process.

[1] the research puzzle : This PDF is an index of the postings.: http://researchpuzzle.com/files/view/checklist-manifesto-series.pdf
[2] the research puzzle : This posting, about "picturing process," struck a chord with a number of firms that have wrestled with this problem.: http://researchpuzzle.com/blog/2011/06/02/picturing-process/

freedom and expectation

tom brakke — Tue, 17 Apr 2012 11:45:03 +0000

In The Checklist Manifesto, Atul Gawande wrote, "We are besieged by simple problems." And "simple" does not mean unimportant, just relatively easy to deal with when a little rigor is applied. Checklists fit the bill and can be remarkably effective at minimizing those problems.[1]

But what about complex problems "where outcomes remain highly uncertain"? After all, that's what characterizes much of the business of investment organizations.

Gawande offers some examples of complexity for consideration. The first is the construction of a skyscraper. It's not like the old days, when a "Master Builder" supervised everything from start to finish. Now projects can involve sixteen different trades that have to be coordinated, and elaborate interconnecting checklists guide each set of experts along a carefully planned path. If you've been in a construction trailer, you've seen the sheets hanging on the walls that show the progression.

According to Gawande, the major advance in the science of construction has been "the perfection of tracking and communication." That's because there's another dimension to the checklist structure that isn't at first noticeable: At certain points and under certain conditions, the parties need to get together to "talk things over as a team." That's because the biggest failures in construction result from a lack of communication.

The two types of checklists -- one precise, picky, and step-by-step; the other one structured to ensure that everyone sees the big picture and works together to solve problems -- reveal a surprising philosophy "about power and what should happen to it when you're confronted with complex, nonroutine problems." Rather than a traditional command-and-control approach to deal with those situations, power needs "to be pushed out of the center as far as possible."

A stunning example of that is the amazing response to Hurricane Katrina by Wal-Mart. While government entities were floundering and other private businesses were paralyzed, Wal-Mart accomplished feats that were unimaginable under the circumstances. How? "Conditions were too unpredictable and constantly changing. They worked on making sure people talked."

That's probably a little easier in a firm where people were trained to do cheers together, rather than in the investment world where many think of themselves as independent actors first and foremost. But while Wal-Mart had always tried to foster teamwork, there was no question that it had a heavy hand of control in its operations historically, which wouldn't have worked in response to Katrina.

Gawande:

"No, the real lesson is that under conditions of true complexity -- where the knowledge required exceeds that of any individual and unpredictability reigns -- efforts to dictate every step from the center will fail. People need room to act and adapt. Yet they cannot succeed as isolated individuals either -- that is anarchy. Instead, they require a seemingly contradictory mix of freedom and expectation -- expectation to coordinate, for example, and also to measure progress toward common goals."

Freedom and expectation.

The words jumped out at me when I read the book. Freedom is highly prized in the investment world, yet organizations can smother it with structure or let it run virtually uninhibited; there are mistakes on either end of the spectrum. So, what is the key to "just right"? Perhaps it is found in that other word: Expectation.

The expectation for investment professionals? That they "add value" by means of their technical proficiency. Communication with others? Helping the organization succeed? No, everything is secondary to producing the numbers now, and while the incentive structure may include a nod to teamwork, it is an afterthought in the scheme of things.

As a result, a culture thought to be optimized to deliver performance produces weaker organizations rather than stronger ones.

The next posting offers more on the "cognitive net" of checklists and the making of investment decisions.

[1] the research puzzle : This is the third posting in a series on checklists, which are indexed in this PDF.: http://researchpuzzle.com/files/view/checklist-manifesto-series.pdf

expert audacity

tom brakke — Wed, 11 Apr 2012 10:31:35 +0000

When Chesley Sullenberger landed Flight 1549 in the Hudson, he was hailed as a hero, but bringing the plane down and getting the passengers off safely was a team effort. Co-pilot Jeffery Skiles somehow had completed restart attempts on both engines and was also able to run through most of the procedures to ditch the airplane -- "something [the crash investigators] found difficult to replicate in simulation." And the flight attendants (Shelia Dail, Donna Dent, and Doreen Welsh) ensured that 150 people were able to get out of the two of four exits that were viable, within three minutes.

But Sully got the press, by and large, and America was happy to embrace another man with "the right stuff," especially since the financial crisis was raging and American exceptionalism seemed to be a thing of the past.

If you read the first part of this series on The Checklist Manifesto,[1] you can guess that its author, Atul Gawande, saw something else at play: Teamwork and, yes, checklists, which have been drilled into airline personnel for decades now.

Both of those have been lacking in Gawande's field of medicine, with "its central belief that in situations of high risk and complexity what you want is a kind of expert audacity.” And that's true in the world of investments too, where lip service is given to the benefits of teamwork and process, but expert audacity is expected to win the performance derby every time.

As anyone who has spent time around investment stars knows, the kind of culture that is created to support them usually doesn't lend itself very well to the investment equivalent of landing in the Hudson. Instead, the environment can be much like that which Gawande has seen in operating rooms, where a head surgeon rules the day and is rarely challenged. Few are willing to speak up, leading to "a kind of a silent disengagement, the consequence of specialized technicians sticking narrowly to their domains. 'That's not my problem' is possibly the worst thing people can think," but it happens all the time (even in the investment world where people tend to be smart and opinionated).

Just imagine those tendencies compounded by an incentive structure that is built upon individual performance and where bonuses can be doled out or heavily influenced by the rock stars with the right stuff. Well, you don't have to imagine. The kind of culture where rewards are chased and concerns aren't discussed is exactly that which -- on the sell-side and the buy-side[2] -- led to the aforementioned financial crisis.

The star system isn't universal in the business, but it is dominant. And often one of the stars is also given the title of chief investment officer at some point along the way, a further acknowledgment of their track record -- and a position for which most are wholly unprepared. Oh, the part of it where they are supposed to opine about the market? That they can do and do well. But the real work, of creating an organization that builds on an array of talent and a confluence of ideas to meet the needs of clients? Not so much.

Expert audacity can be found in many professions. Take architecture, for example, and Frank Lloyd Wright. His genius gave us the prairie style, which I love. But along with it came imperiousness, acolytes, and more than a few leaky buildings that were hard to live in.

Contrast that with the process for erecting a skyscraper that Gawande details in the book. Of course, there are still visionary and imperious architects around (just as there will always be visionary and imperious investment professionals), but their ideas take physical form in a far different way than they did before.

Next up: What investment organizations can learn from those who build buildings.

[1] the research puzzle : Links to the postings in this series appear in this PDF.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/checklist-manifesto-series.pdf
[2] the research puzzle : This posting, about the failure of the buy-side, was part of a series in early 2009 on misaligned incentives in the investment business.: http://researchpuzzle.com/blog/2009/03/05/one-hand-clapping/

the checklist manifesto

tom brakke — Tue, 10 Apr 2012 11:43:39 +0000

In 2009, Atul Gawande published The Checklist Manifesto: How to Get Things Right.[1] Sometime later, a copy arrived at my office courtesy of a money manager, but it sat unread for many months.

I shouldn't have waited and, if you haven't read it, neither should you. I knew of Gawande from his articles in The New Yorker, but despite the favorable notices I read when the book was published, I really didn't expect much. Checklists? OK, right.

When reading it I was reminded how you can get ideas out of a good book that are found somewhere between its content and your experience. As it turned out, the process of making investment decisions was a topic toward the end of the book, but by then I had lots of notes about how the use of checklists might be applied to good effect in the organizations that I study and advise.

As a result, my take is a bit different from the reviews that I've seen from other investors. They have focused on the use of checklists for security selection, as if an individual is making the decision and ticking off the items to review and consider. And with good reason, since doing so is likely to add value by making the process more disciplined. My perspective is somewhat different, in that I see the promise in the much more difficult task of trying to improve organizational behavior and decision making.

Not surprisingly since Gawande is a practicing surgeon, his book features a number of medical examples. A notable one involved the insertion of central lines in the veins of patients. It is a common procedure with a few simple instructions for those conducting it. Yet, for one reason or another, steps were routinely missed when done from memory rather than a checklist. The use of one led to amazing reductions in the rate of infections, the number of deaths, and the total cost of care, "all because of a stupid little checklist."

The biggest impediment to such dramatic improvements? How we think about who does what. "Charts and checklists, that's nursing stuff -- boring stuff. They are nothing that we doctors, with our extra years of training and specialization, would ever need or use."

But it takes a team to do an operation, to build a building, and to make investment decisions in an organization. Who should do what? Is there "nursing stuff" and "doctor stuff" -- and specialists that can't communicate with each other -- or is there a cohesive, well-constructed team that is motivated to solve problems?

Gawande uses several examples from the history of flight throughout the book. Early in the development of commercial aviation, accidents caused by human error were common, even among experienced pilots. But over the decades, the culture of aviation has changed from one of swashbuckling to one of the checklist.

When a US Airways flight taking off from La Guardia hit a flock of geese, crippling the engines, the pilot (who had not been flying the plane) said simply, "My aircraft." The co-pilot responded, "Your aircraft." They had never flown together before, but thus commenced a methodical, by the book (or should I say checklist?) process in the cockpit, which was matched by the flight attendants in the passenger cabin. You know the rest of the story -- the most famous landing in history took place in the Hudson River.

Tomorrow: On "expert audacity" and the culture of investment firms.[2]

[1] Gawande.com : His website includes reviews, interviews, and even copies of some checklists.: http://gawande.com/the-checklist-manifesto
[2] the research puzzle : This PDF has the list of the postings in the series.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/checklist-manifesto-series.pdf

pathways

tom brakke — Thu, 22 Mar 2012 12:08:08 +0000

Images are effective idea triggers. For instance:

This is one of a number of graphs put together by Jay Jacobs, which he generated "as a way to understand the probabilities of the different betting options in roulette."[1] He told me that the analysis that he did was "a whim done over a weekend."

The instant I saw the first of these images, I thought of a posting I had written called "the error price,"[2] which was really about target prices in equity analysis -- and the idiotic industry practices that surround them. To quote: "A single-point error price would have many of the same problems as the single-point target price does, but including it in an analysis is the first step toward a much better framework for decision making, by simply acknowledging the existence of the other side of the distribution of outcomes."

Here and there you see a few firms that provide a simple look at their concept of that entire distribution, including Morgan Stanley, whose "risk-reward snapshot" for Apple provides a sizable range of potential prices across time (with the target price being within the band rather than at the upper edge of it).[3] A simple approach, but a helpful one, as long as you know the methodology for creating the range.

What is not provided by Morgan is some notion of the probability distribution, which is so easy to see on Jacobs' chart. What you'd like, of course, is an image that's driven by a model that has probabilities for the main drivers of the company and for low-probability, high-impact, non-normal events as well. Something like that sounds needlessly complex, but if a model is supposed to represent reality, shouldn't it be able to do some fancy what-ifs? Certainly the computing power exists today to transform that complexity into simple images that help investment professionals contemplate what might occur.

Of the image above, Edward Tufte would undoubtedly say that there was "too much ink" used, so if you'd want to take it from a weekend project to a TED presentation, you'd have some choices to make about how to show the information differently. And a day-to-day user would want tools that enabled her to drill down to the complex underlying assumptions and to manipulate the inputs in an interactive fashion. Roulette rules are pretty straightforward; market realities are not.

The visual gets one thinking about all the different ways that these analyses could be used. How would a fundamental analyst's distribution of outcomes differ from that of a quantitative analyst's for a particular company? Track that for awhile and you'll get a sense of whether and how the fundamental analyst adds value. How does the matrix change as valuation changes?

Or think of mapping a portfolio's possible returns if it has a lot of embedded optionality. A pre-2007 image of structured finance exposures would have shown some alarming scenarios if illustrated like this -- that is, if the underlying assumptions were sound.

Which reminds me of Monte Carlo simulations for financial planning. If the baseline assumptions are flawed or skewed, the answers you get could be destructive, a point that I made in a comment on a recent Michael Kitces posting about longevity risk:[4] Most Monte Carlo simulations are run with expected return forecasts that aren't conservative enough, so all that computational horsepower can feel like it's getting you somewhere that it's not.

In investment analysis, we seek ways to think robustly about the pathways of the future for a security, a portfolio, or an asset/liability problem like retirement. Images can be remarkably effective at helping us do so, which makes the relative lack of effective ones in most investment materials disheartening, but pretty pictures aren't enough if they don't represent the possibilities in a reasonable way.

[1] Behavioral Security : Here's the original posting. This image is that for "betting on three numbers.": http://beechplane.wordpress.com/2012/03/06/visualizing-probability-roulette/
[2] the research puzzle : This essay is from early 2010.: http://researchpuzzle.com/blog/2010/01/06/the-error-price/
[3] Business Insider : In typical BI fashion, this links to a slideshow with additional information from Morgan Stanley.: http://www.businessinsider.com/chart-of-the-day-how-apples-shares-blast-to-1000-2012-3
[4] Nerd's Eye View : Kitces writes, "My passion is to help advance the financial planning body of knowledge and distill complexity into practical applications . . ..: http://www.kitces.com/blog/archives/285-Whats-Your-Longevity-Assumption-Are-Planners-Being-Too-Conservative.html

analogies and anomalies

tom brakke — Wed, 14 Mar 2012 11:53:04 +0000

I seem to be in the throes of alliteration and firmly stuck on the first letter of the alphabet -- the last essay concerned assumptions[1] and now the topics are analogies and anomalies. Come to think of it, those three words make a nice triangle of analysis (another "a"!).

Recognizing patterns comes with the territory for an investment person, whether the nature of your analysis can be described as fundamental, quantitative, technical, or some combination thereof. Each of those approaches is driven by historical information and events, with the patterns of the past leading to decision rules of various kinds, whether that happens consciously or subconsciously.

There's no doubt that the stories of the markets flow largely based on comparisons that are readily at hand. The key questions are whether we are any good at recognizing patterns and whether our analogies help us or hinder us.

Many years ago, a leading light in the investment business wrote that one of the best predictors of investment success was how someone scored on the Miller Analogies Test.[2] I have never taken the test or read research about it, but from my experience I agree with the provider's assertion that the ability to understand analogies is "one of the best measures of verbal comprehension and analytical thinking."

As does the reader of a novel, an investor seeks an apt and insightful analogy, not a worn or misplaced or stretched one. Of course, that's true in most every human endeavor and economic decision making activity. In 2005, Harvard Business Review published an article about how great business strategists "know both the power and peril of such comparisons."[3] Unfortunately, everyone is so busy making analogies that they often fail to recognize the peril part of the equation.

Which brings us to anomalies. Unearthing them is not only part of vetting analogies, but it's a necessary step of "best practice" in investment endeavors of all types.

However, if you do a web search on "investment anomalies," you'll get pages of links about supposedly persistent anomalies (such as those related to value, momentum, and size in equity investment) and how you can exploit them. Those incongruities have provided years of academic debate and research (and have been the foundation of countless investment strategies), but they are anomalies relative to a set of theories about how markets work, so the debate is likely to go on ad infinitum, and that's not what this posting is about.

That said, it is the "story" of those theories that provides the backdrop against which the things that don't fit can be seen. In that sense, they are similar to the stories against which any investment sleuth works, seeking anomalies to be explained. The examples are endless, such as an analyst catching a footnote that puts the apparent reality of a company in question; a corporate bond portfolio manager seeing a bond that isn't priced to fit the matrix of characteristics that define it; or someone doing due diligence who is faced with a small clue that an asset manager's process doesn't seem to fit with what it says it does.

Differential information is critical and early warnings are highly prized, yet as an industry we waste a lot of time borrowing and reinforcing conceptual structures that are already formed rather than trying to shoot holes in them. And most strive too hard to find analogies when anomalies are staring them in the face and going unrecognized or unexamined. Often they seem minor and are therefore easy to brush off as unimportant.

As I've tried to say in various ways since I started this blog,[4] in order to solve a particular research puzzle you need to approach it from all angles. No one loves creating an analogy more than me, but finding anomalies adds the most value.

[1] the research puzzle : It was on the need for "assumption hunters.": http://researchpuzzle.com/blog/2012/02/23/assumption-hunters/
[2] Pearson : This is the home page for the test. If you take it, let me know what you think.: http://psychcorp.pearsonassessments.com/haiweb/Cultures/en-US/site/Community/PostSecondary/Products/MAT/mathome.htm
[3] Harvard Business Review : Here is the article preview.: http://hbr.org/2005/04/how-strategists-really-think-tapping-the-power-of-analogy/ar/1
[4] the research puzzle : The very first posting was "look at the little things.": http://researchpuzzle.com/blog/2008/05/27/look-at-the-little-things/

assumption hunters

tom brakke — Thu, 23 Feb 2012 14:34:13 +0000

Are you an assumption hunter?

The title comes from a piece by Grant McCracken, who (among other things) writes a website with the very descriptive title of This Blog Sits at the Intersection of Anthropology and Economics. I camp out on that corner quite a bit too, so I'll admit to a fondness for McCracken's work.

The text of the PDF[1] is brief, to the point, and very unlike standard-issue academic research. The focus is on businesses and the assumptions that drive them -- where those assumptions come from, how they fail, and how hard they are to kill. They get so ingrained that they are invisible for all practical purposes, but they are powerful beyond imagination.

And those assumptions will eventually collide with an evolving world. Therefore, they can't be viewed in isolation, but in light of what's on the horizon. That's tough (and creative) work -- anticipating change is easier said than done.

In order to understand what is being presupposed, McCracken outlines a series of "excavations" that identify lingering management models (of whatever vintage); beliefs held dear by the firm (such as the founder's vision); the clashing ideals of the polyglot of different professions at a company (think of engineers and marketers in a room); and the culture of the industry in which a company operates.

You need assumption hunters to ferret them out, to identify the decaying and destructive ones for what they are and to recognize when a firm is ill-suited for the environment on the horizon. Who should do it? McCracken says such a role is naturally the province of those trained in the liberal arts. (That sound you just heard was a bunch of clicks from investment types, leaving this posting just as I was about to speak to them.)

But when you think about it, what more could I want in an analyst than to be an assumption hunter? One that has deep understanding of the operating model, the financial model, and the tenets of the culture that others don't see but that will determine whether a firm being covered is a "fit" for the future or not?

And wouldn't you like to have a portfolio manager that has those abilities? A great one usually understands how different kinds of investors interact and how prices move as assumptions flow from one group to another. Falling in love with a company or stock or an asset class is not what an assumption hunter does.

For someone like me who studies investment decision makers, real assumption hunters are hard to find. It's so easy to go along with how the investment business operates, with how vehicles are being valued, with whatever is producing returns at a given moment, and whatever the powers that be at your organization happen to favor. Assumption hunters are by their very nature disruptive, pointing to beliefs that are shared without question (and starting up with the questioning soon thereafter).

As a result, they are very valuable. If you work in an investment organization (or for an institutional investor that allocates money) and you have an open slot, I'd counsel you to hire an assumption hunter instead of adding just one more of what you already have. I think you'd get better returns.

Perhaps one day someone will put "assumption hunter" on their business card. It will probably happen more quickly in the world of corporate culture that McCracken wrote about than in the investment ecosystem that I write about. In either case, such a person will make people uncomfortable. That's the whole point.

[1] Convergence Culture Consortium : This is one in a series of papers by C3.: http://www.convergenceculture.org/research/c3-assumptionhunters-full-public.pdf

everything is connected

tom brakke — Thu, 09 Feb 2012 15:11:18 +0000

There are times on a consulting assignment when new problems to solve seem to pop up every minute. Similarly, when performing due diligence on an investment firm, the questions often pile up faster than the answers.

They can come from almost anywhere -- and aren't limited to the functional area that is the main focus of the review. My motto is: "Everything is connected."

That might seem obvious, but it is a fundamental principle that is all too easy to forget. In large firms, the core functions of operations, investments, and marketing/client service are isolated from each other, with limited interactions. In a recent white paper, Jim Ware and Keith Robinson of Focus Consulting Group talked about those different subcultures, which they called "investment tribes."[1] Each has its own cultural attributes, aspirations, and values. And given the standard approach to managing investment decision makers (that is, not managing them much at all), even within the "investment" category it is difficult to have a commonality of purpose.

That is also true at smaller organizations. Even when key people wear multiple hats and have a better understanding of the issues across the business, the functions tend to be viewed discretely.

That's one of the biggest mistakes a firm can make. There ought to be an unbroken conceptual thread that connects the elements of the firm. If you're doing due diligence, some of the easiest clues that you can find are those that linger at the intersections of the three main functional areas. The actions and statements of the people involved -- and the audit trails of activity in each area -- provide fertile ground for understanding the reality of the professed philosophy and the sustainability of the performance.

As a generalist, it is natural for me to think that way, and I'm not surprised when an assignment leads me in unanticipated directions. A project to evaluate a firm's investment process (or to translate it into an effective marketing message that clearly and faithfully represents a firm's capabilities) can turn quickly into a focus on operations if important questions linger there. An independent review[2] of a firm -- whether instigated by its own desire for improvement or performed by someone on a due diligence mission -- should not be limited by preconceived notions of what matters and what doesn't.

Everything is connected. Whether you are evaluating an investment manager or trying to improve your own approach, you need to explore it all to see the whole picture in high definition.

[1] Focus Consulting Group : This is the PDF. If you're interested in the culture of investment organizations, you should be on the email distribution list at Focus.: http://www.focuscgroup.com/index.php/download_file/view/51/
[2] the research puzzle : The last posting featured an explanation of why an independent review can add value for any investment decision process.: http://researchpuzzle.com/blog/2012/01/24/an-independent-review/

an independent review

tom brakke — Tue, 24 Jan 2012 13:27:17 +0000

The previous 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

tom brakke — Thu, 19 Jan 2012 13:16:17 +0000

In celebration of the new year, I'm looking at some big ideas. The first was "the haircut,"[1] which focused on the damaging but standard practice of using expected returns as the foundation for much investment planning.

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

tom brakke — Tue, 03 Jan 2012 15:09:35 +0000

At the start of a new year, there is a tendency to think grand thoughts. So, the first few postings of 2012 will focus on some big ideas about investment decision making.

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

tom brakke — Wed, 28 Dec 2011 13:38:54 +0000

Does a strategy "work"? Is a manager "good"?

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

tom brakke — Mon, 05 Dec 2011 22:45:42 +0000

The general theme of this slowly-evolving series of postings on investment styles[1] is that an important part of the process of due diligence is finding different angles from which to view a strategy or an asset manager.

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

tom brakke — Wed, 09 Nov 2011 14:54:28 +0000

Should you find yourself reading the sort of publication that is tailored to investment advisors or do-it-yourselfers, you'll see lots of these:

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

tom brakke — Mon, 31 Oct 2011 14:10:52 +0000

The lead article in the October 3 edition of 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

tom brakke — Mon, 10 Oct 2011 12:22:55 +0000

The current series[1] here on 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

tom brakke — Tue, 27 Sep 2011 10:03:56 +0000

They are everywhere. The charts of broken dreams. OK, not everywhere, since "there's always a bull market somewhere." Those that only own long bonds haven't had the recent experience that others have had, although their time in the barrel will come one day.

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

tom brakke — Tue, 20 Sep 2011 11:05:52 +0000

Algorithms are everywhere these days. They control what we see online, even when we don't want them to. They are behind all sorts of marketing, even when we don't understand that to be the case. And they play a significant role in the investment world.

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

tom brakke — Wed, 07 Sep 2011 12:12:44 +0000

One investing approach is summed up in four letters: GARP (growth at a reasonable price). That description is widely used -- and when used it's assumed that we're all talking about the same thing. For this next chapter of a series on investment styles,[1] we'll examine some ways in which that might not be the case.

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

tom brakke — Mon, 29 Aug 2011 12:14:23 +0000

In our look at the geography of investment style,[1] there are elements to consider that fit into those classifications that are commonly used within the business and then there are factors that are pervasive in nature. This posting concerns an example of the latter.

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:

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

tom brakke — Thu, 04 Aug 2011 12:09:58 +0000

For those of us living in the United States, the boundaries drawn so many years ago between this state and that define the political scrum. We live in red states or blue states or perhaps one that's thought to be in play (which reliably means more political advertisements per capita than elsewhere).

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:

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

tom brakke — Mon, 25 Jul 2011 20:14:28 +0000

During this year of odd weather patterns, the Upper Midwest has gone from cooler than normal to extremely hot and muggy. The one constant has been water. It's everywhere.

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

tom brakke — Wed, 20 Jul 2011 11:46:34 +0000

When you think about it, the profession of securities analysis is not that old (although people have been making judgments about the value of investments since time immemorial). Similarly, analysis of the work of the analysts themselves only really got going about forty years ago, when academic researchers started studying those who make forecasts about and recommendations on common stocks.

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

tom brakke — Wed, 13 Jul 2011 11:36:08 +0000

The names have been changed to protect the guilty.

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

tom brakke — Tue, 28 Jun 2011 11:45:55 +0000

Each investment strategy must be judged on its own merits. What is the investor trying to do? Does it make sense given what we know about how markets work? What are the strong points and weak points of the approach -- in concept and in application? In what environments will it likely "work" and when will it falter?

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

tom brakke — Thu, 23 Jun 2011 12:57:30 +0000

Imagine that you are walking into a room to try to win a competition against other investment managers, with a hundred million dollars going to the one that is deemed to be the best fit. Those on the other side of the table have looked at the performance numbers and seen written reviews on those that made the final cut. After meeting with each one, they'll make a selection.

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

tom brakke — Thu, 02 Jun 2011 11:56:29 +0000

Much of my work takes place at the intersection of investment process and communications, so I have seen a fair number of pitch books and client review books in my time. Trying to represent an investment process visually is rather difficult; it's tough to capture the process and still have a page/slide work effectively within a presentation (and be in concert with the overall design and brand).

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/